An Italian Success Story and Beyond…

Italy’s current account is finally adjusting. No longer is it simply stuck in the ‘red zone.’ Since December 2004 Italy has had only four months in which its current account has not been in deficit. In June Italy’s account was at zero and it has posted its third non-negative balance on current account in the past seven months.

The chart shows the progress as the trade balance has turned sharply higher.

Italy is still getting some life out of exports on its year/year result. But exports are slowing and over shorter horizons export growth is sequentially getting weaker. But imports have declined by more as domestic demand in Italy has collapsed.

This description reveals how hard it is to call an adjustment program ‘a success’. Italy’s current account adjustment is a success. But having imports sequentially imploding at annualized growth rates of -4% year/year and -15% over three and six months is no one’s idea of success. It is a financial success that Italy is reaping in its external accounts as it swallows the harsh medicine of austerity and suffers declines in GDP.

Italy still has competitiveness problems as it has seen it domestic price level rise much faster than Germany’s while it has been locked in the same currency Zone with it. But Italy’s situation is hard to decompose since it really has a much more competitive North where most of the (recorded) GDP comes from. It is hard to judge how really competitive Italy is. But since end 2004 Italian exports have grown only about 38% as fast as German exports. German exports ran faster than German imports while Italian exports ran slower than Italian imports over that period. The German trade position strengthened and Italy’s weakened. But now Italy is making trade account progress but most of that is being done on the import side spurred by weak growth and declining imports.

Austerity is a crude tool to restore price competitiveness and Italy has not accomplished that yet with its austerity. So when Italy springs back into recovery its imports will recover and exports will not be able to keep up unless Italy also finds some industrial policy to improve competitiveness. Trade adjustments gained through the growth-reducing aspect of austerity are not permanent; they provide relief but not a fix. Austerity is not a fix unless it is adopted as new permanent life style.

Italy’s national data seem to paint a grim picture. I reality Italy is rather rich country but one with a history of tax avoidance. Like many European countries most revenues come from a relatively high VAT instead of an income tax. Most Italians are able to evade the income tax but when it comes time to buying stuff, they can’t evade the VAT at the point of sale. But now, there have been some programs implemented in Italy to try and fetter out tax cheaters by forcing people to show that they have earned income (declared earned income!) to support their purchases of big ticket items. This program could wind up simply weakening further Italian spending. Also, new rules have made it harder for Italians to withdraw cash.

Italy is in a lock down mode. Its policymakers are struggling to make progress in raising tax revenues. Still, its economy is far more successful than other troubled EMU borrowers. But Italy’s approach to its crisis has led to a severe hit to GDP. GDP is falling at a 2.9% annual rate in Q2 and by 2.5% Yr/Yr. In such an environment fiscal targets get hard to hit as Spain, Portugal and Greece well know. But progress on current account deficit reduction is still likely as we in the case of Italy. Italy has patched though some of these administrative programs to try and re-start the flow of tax revenues cut short by recession. Over the long haul either the government sector will have to be shrunk or new tax compliance procedures will have to become more effective.

All of Europe meanwhile has its eye on Greece. The newest story is that there is a German plan supported by a number of Northern European nations to get Greece to ask for a temporary leave of absence from the euro Zone. But this is a fool’s errand. We all know that Greece would not make such a choice. Greece would not decide such a thing. It would make such a choice only by being pressured by offering it such a poor alternative. Who would believe that Greece would exit and that all the Zone’s problems would go away? And, if Greece were to be given more money to go away would there be proportional payments made to it by Germany and Italy and Spain and Portugal etc? Does anyone think that if Greece’s drachma could be revived that the escudo and peseta were not right around the corner?

In some game theory applications it has been suggested that Italy might have the most to win from leaving the Zone. The reason is that Italy is a marginal case to stay and solve its problems. Italy can stand on its own two feet. If it leaves the Zone early it could get out while the getting is good and be outside looking in when the really troubled nations suffer and hit up the Zone for more shared loans to keep them afloat.

The European political season is closing in and it is not clear what that means. It may mean that politicians will not want a euro disaster to spill out ahead of their own election cycle. This might suggest a policy of appeasement. But it may also mean that they do not want to approve any more monies diverted to Greece or for other bailout reasons. And those two objectives work against one another. The idea of getting Greece to agree to go is as brilliant as it is stupid. It would be a solution if you could get people to believe it. But who would? And who would think the buck (or euro…actually euro exit) would stop there?