Italy: Devaluation or Deflation

Italy is in recession. There is nothing extraordinary about this, as Donald Rumsfeld notoriously said ‘stuff happens’, and economies do have their ups and downs. But this recession is a little different, since it is structural and not cyclical. For the Italian economy to return to a better trajectory something has to be done, but what? Morgan Stanley’s Vicenzo Guzzo offers two alternatives: devaluation, or deflation (actually the way he puts the alternatives it sounds to me more like a case of: “with which instrument would you prefer I cut your throat sir, the stanley knife or the chain saw”?).

If Italy intended to restore the pre-1999 competitiveness level, it would have to experience a 25% currency depreciation. While the euro is now down over 5% from the start of the year, such a large correction appears unlikely at this stage. In addition, the economy has steadily lost ground also vis-?-vis its euro area trading partners, as the breakdown of the trade data suggests. Euro depreciation would provide no oxygen on that front. In order to return to pre-1999 competitiveness levels, Italy would have to abandon the current exchange arrangements. To put it bluntly, it would have to drop out of EMU. A 25% devaluation is equivalent to what the economy experienced between 1991 and 1995. Exports scored double-digit gains in the aftermath of the realignment, but domestic demand fell heavily and debt services costs hit 12.5% of GDP. In a replay of those years, Italy would either default on its debt or run toxically tight fiscal policy. This is simply not an option, in my view.”

So Italy is caught. To devalue it would have to leave EMU. But then even if it could and did, it would go bust. So, on Guzzo’s reading, the only remedy left is substantial deflation, that is an ongoing reduction of wages and prices which would enable competitiveness to be restored. This sounds very much like the 1930’s and an Italy stuck with a modern version of the gold standard. It also sounds like going through a recession which could turning out lasting for a number of years, even if this was politically feasible it would be extraordinarily painful for many of those most immediately affected.

This, of course, is a question which is widely treated in the textbooks. So would anyone like to suggest a rival ‘escape strategy’?

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About Edward Hugh

Edward 'the bonobo is a Catalan economist of British extraction. After being born, brought-up and educated in the United Kingdom, Edward subsequently settled in Barcelona where he has now lived for over 15 years. As a consequence Edward considers himself to be "Catalan by adoption". He has also to some extent been "adopted by Catalonia", since throughout the current economic crisis he has been a constant voice on TV, radio and in the press arguing in favor of the need for some kind of internal devaluation if Spain wants to stay inside the Euro. By inclination he is a macro economist, but his obsession with trying to understand the economic impact of demographic changes has often taken him far from home, off and away from the more tranquil and placid pastures of the dismal science, into the bracken and thicket of demography, anthropology, biology, sociology and systems theory. All of which has lead him to ask himself whether Thomas Wolfe was not in fact right when he asserted that the fact of the matter is "you can never go home again".

18 thoughts on “Italy: Devaluation or Deflation

  1. Everyone under the age of thirty gets a job serving tables in London and sends remittance payments to their folks back in Italy.

  2. “Everyone under the age of thirty gets a job serving tables in London and sends remittance payments to their folks back in Italy.”

    They’ve already done that, they need something additional.

  3. “This sounds very much like the 1930?s and an Italy stuck with a modern version of the gold standard.”

    On the nail. And Italy’s enthusiasm for Europe, perhaps the only country where there is popular-on-the-streets Euro-enthusiasm, will be dead as a dodo by the end of it.

  4. The Italian tax system is a mess and tax evasion is rampant, which leads to general tax pardons again and again.

    Simpliying the Italian tax system might be a good start. It might even increase state revenues!

  5. Proper analysis, Edward. The wish would be to treat Italy as Ireland years ago and allow for substantial incentives for industry location in Italy. Italy needs a prounced service industry base strengthening.

  6. “tax evasion is rampant …”

    This is the case in all ‘latin’ countries. Part of the culture. I think the issue is a bit of a red herring here, becuse this tax evasion is also associated with having a ‘dual economy’ where the submerged economy is an important supplier of national wealth. You take the tax and you close the business, since the activity is no longer profitable.

    I’ll give you an example. Near to Barcelona one part of the textile industry has survived the influx of Chinese products by importing Chinese undocumented workers (15,000 is an estimate) to work on ‘just in time’ products here.

    The economist has a piece on Inditex which lives on this type of activity

    http://www.economist.com/business/displayStory.cfm?story_id=4086117

    So my guess is that there is a kind of ‘social compact’ not to collect on such sectors. John may remember that Ms Thatcher was even envious of this system in Italy at one stage – principally because it enables small businesses to start up and operate on very low wages and general overheads.

    Another major economy where this is an element not ‘officially’ acccounted for in GDP has to be the US. All the material on illegal immigration in the 90’s that I have read refers to the fact that the immigration rules were not enforced, due to pressure from employers. Now if people don’t exist for tax and social security purposes, this means that on paper the activities they do, and the wealth they create, don’t either. This has been enormous in the US going by what you can see from the migration numbers.

    Anyway, as I say, addressing this won’t solve their problems since real economic activity would probably reduce by more than the extra income the state gained.

  7. Now if people don’t exist for tax and social security purposes, this means that on paper the activities they do, and the wealth they create, don’t either.

    Or -inasmuch as this wealth makes it into the regular, reported economy- the productivity of legal workers is artificially enhanced.

  8. So Italy is caught. To devalue it would have to leave EMU. But then even if it could and did, it would go bust. So, on Guzzo?s reading, the only remedy left is substantial deflation, that is an ongoing reduction of wages and prices which would enable competitiveness to be restored. This sounds very much like the 1930?s and an Italy stuck with a modern version of the gold standard.

    It also sounds like the Netherlands in the early 80s. From the Economist:In 1982 representatives of business and trade unions (the unions’ leader at the time being the durable Mr Kok) signed an accord in a suburb of The Hague called Wassenaar. Under this accord, later endorsed by the government, the unions promised to deliver pay restraint, including more decentralised wage bargaining, in exchange for a new emphasis on jobs. For its part, the government undertook to sort out its fiscal mess and to lower taxes. The Wassenaar accord laid the foundations for the economic renaissance of the late 1980s and 1990s, when the talk turned from Dutch disease to Dutch miracle.Pay restraint (and belt-tightning in general) can work. I have no idea under what circumstances it’s a good idea, and when it’s an horrendous idea.

  9. Jasper:
    The fragmented Italian unions can’t deliver pay restrain in the way that the Dutch unions could. And even in Holland the imposition of permanent wage constraint caused large problems for both trade unions and political parties.

  10. “Pay restraint (and belt-tightning in general) can work”

    Of course, I entirely agree, pay restraint can work, and I’m not so skeptical as Otto that the Italian unions couldn’t deliver something, but it’s the order of magnitude that is striking: Guzzo talks about 25%. This is big as a wage cut. And the problem is only partly the value of the euro, on the other side is the kind of manufacturing activity Italy engages in, it has a profile which is very at risk from the arrival of the ‘new global competitors’. It would need to adapt downwards wherever the euro was.

  11. Jasper, yep, a socialist leader and finance minister developed policies that were painful for his supporters but ultimately beneficial. But Kok feels he has ?dirty hands? http://www.casi.org.nz/articles/Dutch%20model.htm

    In France the early eighties, Delors initiated, measures are still called les r?formes honteuses. I just don?t see where the political will to embark on such a programme and pay the heavy political cost is going to come from in Italy ? but I don?t see an alternative either. Do people here believe Prodi has the ? vision? And as Otto says, can the Italian unions be persuaded?

    Europe is quite a useful excuse in such circumstances, as a leader of the Patronat and Sarkozy ally explains here; http://www.lexpansion.com/art/6.0.59165.0.html

    Edward, I get the impression that in Greece, it?s not just little start-ups that don?t issue receipts. The Government is targeting ?merchants, manufacturers, doctors and industrialists?. The idea that the proposed scheme – getting ordinary taxpayers to come up with receipts totalling ?4000 in order to qualify for tax entitlements – will actually make a difference indicates the scale of the problem. Are we getting an equally distorted picture of economic activity in Italy?

  12. And the problem is only partly the value of the euro, on the other side is the kind of manufacturing activity Italy engages in, it has a profile which is very at risk from the arrival of the ‘new global competitors’. It would need to adapt downwards wherever the euro was.

    This factor makes me think there might be some policy behind the Northern League’s referendum to go to a dual-currency system, beyond blind populism.

    Let’s imagine an Italy where Italians are paid wages in lira, and use lira for most of their consumption, while the state continues to use euros as the official currency and for its internal finances, and firms carry on foreign trade in euros.

    Let’s also posit that the lira is softer than the euro.

    This setup lets Italy devalue without officially leaving the EMU. Which in turn acts as an effective across-the-board protective tariff, protecting internal demand for its traditional low-value manufacturing industries.

    Given that Italy imports 80% of its energy, devaluation by any means would be painful, and propping up what are becoming commodity industries seems like a short-sighted development policy, but maybe there is a method to what otherwise seems like madness.

  13. “This setup lets Italy devalue without officially leaving the EMU. Which in turn acts as an effective across-the-board protective tariff, protecting internal demand for its traditional low-value manufacturing industries.”

    Two legal currencies side by side? Sounds rather “gresham-like” to me…bad money drives out good.

  14. Isn’t this what Germany has been doing in the past 5 years, having joined the euro with a visibly overvalued DM? Zero wage growth and the like. It’s taken a while, but it’s paying off, in terms of competitiveness.

    If they don’t do it on their own, it will be forced upon them (the Italians) brutally by a new interest rate differential for their debt.

  15. “This setup lets Italy devalue without officially leaving the EMU. Which in turn acts as an effective across-the-board protective tariff, protecting internal demand for its traditional low-value manufacturing industries.”

    This would be the the Stamp Scrip idea once favouyred by Irving Fisher.

    http://userpage.fu-berlin.de/~roehrigw/fisher/

    Funnily enough it was invented by a German living in Argentina, and the idea was widely used during the Argentine financial crisis.

    “Silvio Gesell, who died recently, was a German business man and quasi-economist. He lived in Argentina and wrote some of his many papers in the Spanish language. In 1890 while in Argentina, he proposed essentially that particular substitute for money which now bids fair to sweep this country, under the name of “Stamp Scrip.””
    Irving Fisher

    I agree Robert that what the ‘liga’ is up to is far from clear. Berlusconi finally surfaced yesterday to say that Italy couldn’t leave EMU (what is this, three weeks later). Not everything in Italy is transparent, and my feeling is that Berlusconi uses the Liga and uses Fini when he needs someone to do or say something he can’t publicly do himself. So who knows what lies behind all this. Some attempt at a hybrid system may be introduced at some stage though.

    “Zero wage growth and the like. It’s taken a while, but it’s paying off, in terms of competitiveness.”

    Zero wage growth can only work if you have inflation, if you are in a deflation recession you need cuts, and meaty ones. That would be the first point.

    Then there is the question of whether this has worked in Germany or not. On the supply side it certainly has. The German company is now highly efficient, and can seemingly beat the pants off eg its US rivals in the highly competitive export markets. But again we are seeing the weakness of excessive ‘suppply side’ obsessions, since Germany is not pulling out of the dolldrums, there is no life in internal consumption. This is a side effect of the deflation that has been applied to wages. Remember that stomach medicine you took that gave you back ache? Well in economics, sometimes things are like that too, and sometimes the side effects are worse than the original problem.

    “it will be forced upon them (the Italians) brutally by a new interest rate differential for their debt.”

    This is what we are expecting, I guess a lot depends here on how the SPG is applied. If it isn’t, then this means that the rest of thge member states effectively guarantee Italy’s debts, and there is no reason to expect the yield band to widen greatly. Of course this won’t get Italy out of recession, or stop the importas coming in.

  16. “Two legal currencies side by side? Sounds rather “gresham-like” to me…bad money drives out good.”

    You’re obviously right here. Everyone heads to the bank to trade their scrip for real euro notes, and then proceeds to stuff them into their mattresses.

    Of course Robert could be right, the fact that it won’t work doesn’t necessarily stop people trying.

    (Funny thing, among yuppies here in Spain having cash is definitely out, so how ‘un-you’ for them to have to go the local bank branch with a wheelbarrow to get hold of the notes.)

  17. Isn’t this what Germany has been doing in the past 5 years, having joined the euro with a visibly overvalued DM? Zero wage growth and the like. It’s taken a while, but it’s paying off, in terms of competitiveness.

    The East-German mark was wildly overvalued (at 1:1 compared to the West-German mark) after unification. I think (as in: don’t really know for sure at all) this was probably more damaging than the claimed overvaluation of the DM in the EMU. East-Germans would have been better of if their wages were competitive compared to the rest of Eastern Europe.

    And it’s more comparable to the subject at hand: Italy also has two economies that really ought to have two sets of wages and benefits, one for the North and one for the South. This means that (uncompetitively) high paid jobs from the North can move South as well as abroad.

    It will, however, mean one more possibility for Italians to cheat on benefits.

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