As one of the so-called PIIGS nations, Italy seems to have flown under the mainstream media's radar screens for the most part, until recently. That is, other than Prime Minister Berlusconi's predilection for slightly younger girls and bunga bunga parties, there has been very little coverage of the issues facing the world's third most indebted nation. I thought that a brief look at the fiscal situation facing Italy would be in order especially in light of Moody's threat to downgrade Italy's debt within the next 90 days. Moody's rattled its sabre over Italy's debt for three reasons:
1.) Challenges to Italy’s economic growth due to macroeconomic structural weaknesses that will prevent meaningful economic growth and a likely increase in interest rates over time.
2.) Risks surrounding implementation of plans that will reduce Italy's more than ample stock of sovereign debt.
3.) Risks posed by changing funding conditions for Eurozone nations with high levels of debt (i.e. the Greece, Ireland and Portugal factors).
As source material for this posting, I am referring to the OECD's Economic Survey for Italy for 2011 found on the website for Italy's Department of Treasury among other sources with additional links highlighted in the text of this blog entry.
As a statistical introduction to the country, Italy had 60,626,442 residents on December 31, 2010. Italy's population grew by 286,000 on a year-over-year basis solely through immigration. In the first quarter of 2011, there were 22.9 million persons employed in Italy with 2.2 million people unemployed for an employment rate of 56.8 percent and an unemployment rate of 8.6 percent, down 0.5 percentage points on a year-over-year basis. Italy's GDP in the first quarter of 2011 rose by a minuscule 0.1 percent compared to the previous quarter and a rather tepid 1.0 percent when compared to the first quarter of 2010. Italy's consumer prices rose by 0.1 percent on a month-over-month basis in June of 2011 and by 2.7 percent in comparison to the same month one year earlier. That should be enough basic statistics to whet your appetite.
The Great Recession was particularly difficult for Italy's economy. Economic growth dropped by 7 percentage points during the period following the global crisis and, since growth in domestic Italian productivity is very weak despite low interest rates, GDP is not expected to return to its pre-crisis level before 2013 - 2014. To combat the economic debacle of 2008, Italy's government shifted its expenditure profile toward budget-neutral social and industrial support rather than deficit increasing fiscal stimulus programs. This approach was taken because of Italy's past transgressions with high debt and deficits particularly since 1980. According to the Centre for Economic Policy Research, Italy's public debt is now roughly equal to the country's national income and interest payments on the debt are approximately 10 percent of government revenue.
Italy's nominal public debt is the third largest in the world after the United States and Japan and its public debt-to-GDP ratio is the eleventh highest with both debt and deficits increasing sharply since 2007. Italy's mountain of debt, which is expected to reach 119 percent of GDP in 2011 (second only to Greece (with a debt-to-GDP of 150 percent) in the Eurozone) will require careful management. Here is a graph showing the changes in Italy's debt-to-GDP ratio from 1861 to 2009:
Note that the value of 1.0 is where debt equals GDP (or where the debt-to-GDP ratio is 100 percent). Note the rapid climb during the period from 1970 to the early 1990s where the debt-to-GDP ratio rose from a very manageable 25 percent to just over 120 percent.
In raw numbers, the Bank of Italy's External Debt Statement released on June 30th, 2011 stated that Italy's external debt reached €1.831 trillion ($2.618 trillion), up from €1.817 trillion ($2.598 trillion) on December 31, 2010. Here is a screen capture of the statement:
If we take a look at my favorite metric, per capita debt, Italy’s sovereign debt stands at $43,183 per person. In comparison, United States debt stands at $46,268 per person and Japan’s stands at $69,715 per person. Yes, I realize that this is not a commonly used metric but personally, I find it easier to relate to than the somewhat abstract debt-to-GDP calculation.
Italy's budget deficit as a percentage of GDP reached 5.4 percent in 2009 and dropped to 4.6 percent of GDP in 2010. Further tightening over the period between 2011 and 2013 is expected to reduce the deficit further to 2.2 percent of GDP by 2013. As a side note, we must remember that, according to the Stability and Growth Pact signed by all Eurozone Member States, the deficit-to-GDP ratio must not exceed 3 percent and the debt-to-GDP ratio must not exceed 60 percent. In the case where Member States exceed the deficit ceiling, the following will take place:
“Identifying an excessive deficit…
The EDP (Excessive Deficit Procedure) sets out criteria, schedules and deadlines for the Council to reach a decision on the existence of an excessive deficit. This decision is taken within a fixed time period after the deadlines - of 1 April and 1 October - for EU Member States to report their government finances to the Commission. No EDP procedure will be launched if the excess of the government deficit over the 3% of GDP threshold is considered temporary and exceptional and the deficit remains close to the threshold.
…and requesting the Member State to correct it
When the Council decides that a deficit is excessive, it makes recommendations to the Member State concerned and establishes deadlines for effective corrective action to be taken. The Council monitors implementation of its recommendations and abrogates the EDP decision when the excessive deficit is corrected. If the Member State fails to comply, the Council can decide to move to the next step of the EDP, the ultimate possibility being to impose financial sanctions.” (my bold)
Don’t you find it interesting that a Member State that is already obviously suffering fiscal pain would be subjected to additional financial sanctions? I wonder how well that slap on the wrist will work when the cupboard is obviously empty? At the very least, Italy is very guilty of exceeding the debt-to-GDP guideline.
Back to the situation in Italy. By cutting their deficit-to-GDP ratio to 2.2 percent by 2013, the result would be a very modest drop in the debt-to-GDP ratio to 115 percent by 2013. The government expects to close the gap between spending and revenue by cutting expenditures through public sector pay freezes and reductions in tax evasion. Here is what the OECD recommends:
"If there is some slippage in these measures, further spending cuts will be needed, if necessary supplemented by revenue-raising measures such as broadening tax bases by eliminating many tax breaks and reduced rates. Taxes on a number of environmentally-related externalities could also be introduced or raised. Increasing real-estate taxation can raise revenue because it is difficult to avoid and the short-term distortions are small; there are limits, however, because high property taxation may reduce incentives to save and invest. Plans to reduce tax evasion should be carried through. To maintain the credibility of these plans, tax amnesties, such as that in 2009-10 on undeclared funds held overseas, should be avoided."
Italy has already enacted measures that will deal with future pension liabilities with some reforms dating back to the 1990s. Early implementation of pension reforms have stabilized pension expenditures relative to GDP however, average pensions relative to wages are higher than in most countries. By means of comparison, Italy's Gross Replacement Pension Rate for average earners is 68 percent and the rate for the United States is a rather paltry 39 percent. Among OECD nations, the weighted average rate is 59 percent with the Netherlands in first place at 88 percent and the United Kingdom in last place at 31 percent. In 2010, Italy introduced legislation that increased the retirement age for women in the public sector from 61 to 65 years of age starting in 2012. This is expected to save only $1.76 billion by 2019 but will still reduce the ratio of pension expenditure to GDP over the next 35 years. By 2060, the Gross Replacement Pension Rate is expected to fall by 25 percent from its current level. This will result in higher employment needs among older workers in an economy that already suffers from youth unemployment rates in excess of 25 percent.
I think that's enough of an introduction to the fiscal issues facing Italy and its citizens. In conclusion, I find the situation currently facing Italy most interesting, especially in light of the current highest level debt and deficit discussions taking place in the United States. The fact that Italy is at least confronting the looming demographic issue facing their future pension liabilities is fascinating, especially in light of the $100 plus trillion funding shortfall facing America’s Social Security entitlement program over the coming decades. At the very least, in Italy there has been an acknowledgement that there is a looming pension problem unlike in America where politicians seem to completely ignore the obvious signs that all is not well with the government-funded social safety net. In addition, while there is no doubt that a sovereign debt default by Italy would wreak at least temporary havoc on the world’s bond markets, once again, it would be a rather small event compared to the devastation created should the United States be faced with either a significant downgrade to their debt portfolio or an outright default.