I. Introduction

1. The 2003 Article IV discussions with Italy focused on policies to secure strong growth and to safeguard fiscal sustainability, and the following three chapters provide background analysis on these issues. The discussions took place against the background of lackluster growth in Italy over the past decade and stagnation during the first half of 2003, accompanied by sizable losses in export market shares. The latter may to some extent be linked to losses in price competitiveness, with inflation consistently exceeding the euro-area average since the beginning of monetary union in 1999. Accordingly, Chapter II takes a closer look at the reasons behind Italy’s persistent inflation differential vis-à-vis the euro area. Strong, durable growth will also require a narrowing of Italy’s large regional imbalances through a catch-up in income levels of the South—and the historical experience in this regard and recent policy initiatives are reviewed in Chapter III. Finally, Chapter IV focuses on a key issue for securing fiscal sustainability—that is, the outlook, and possible reform steps, for pension expenditure.

2. The determinants of Italy’s inflation differential vis-à-vis the euro area, and possible implications for competitiveness, are reviewed in Chapter II. Italy’s consumer price inflation differential vis-à-vis the euro area has averaged about ½ percentage point since the beginning of monetary union, and reached 1 percentage point in mid-2003. This is to some extent surprising, given Italy’s relatively weak growth performance. The empirical results presented in Chapter II suggest that price level convergence was an important determinant of the inflation differential, with Italy’s price level estimated to be considerably below the euro-area average. In addition, estimates that account for the tight employment conditions in the North also provide some explanatory power for Italy’s inflation differential. As suggested by other studies, this is likely to reflect the particular wage setting behavior in Italy, with wages determined primarily by labor market conditions in the North. The empirical results do not indicate a role of Balassa-Samuelson-type productivity catch-up and inflation differentials. In any case, these effects are unlikely to have played a large role in the Italian case, where productivity growth has been low in recent years. Looking ahead, the chapter’s results suggest that further price level convergence could lead to additional real exchange rate appreciation in coming years. This adds urgency to adopting policies that will avoid potentially adverse repercussions for exports and growth.

3. Regional convergence over the past four decades is reviewed in Chapter III, with a particular focus on recent policy initiatives. In terms of regional disparities, Italy stands out relative to most euro-area countries, for example, in terms of per capita output as well as labor market performance. In broad terms, the disparities are concentrated between the relatively developed Center-North and the lagging South. An array of policy initiatives during past decades has failed to deliver sustained regional convergence, particularly during the quarter century form 1970 to 1995. However, more hopeful signs have become visible since the mid-1990s, indicating a resumption of a gradual convergence process. Moreover, the results reported in Chapter III suggest that this process has been driven by faster growth in total factor productivity. The results also indicate that growth benefits from public investment in infrastructure increased considerably in the South since the mid-1990s, although the level of this investment declined during this period. Also striking are regional differences in the growth benefits of public infrastructure investment in earlier years, with the benefits considerably lower in the South than in the Center-North up until the 1990s. This points to large inefficiencies in the South and provided one of the reasons for the more recent policy shift toward greater transparency and accountability. While the apparent improvement in investment efficiency in the South suggests that the recent policy shifts are beginning to bear fruit, it is still too early for firmly establishing this link. Furthermore, the improved relative economic performance of the South came partly about by relatively low output growth in the North in recent years (rather than very strong growth in the South).

4. The possible case for additional pension reform is reviewed in Chapter IV, focusing on three key concerns. First, fiscal sustainability: notwithstanding far-reaching reforms during the 1990s, aging-related spending is likely to rise (in relation to GDP) until about 2030. This threatens fiscal sustainability, particularly in view of Italy’s high public debt-to-GDP ratio. Second, creating room for other reform priorities: recent (and ongoing) labor market reforms have strengthened the argument for a broader reform of the social protection system, as the current system is heavily tilted toward pension spending, which is among the highest (in relation to GDP) for industrial countries. Third, intergenerational equity: the long transition period to the defined contribution system, introduced with the 1990s reforms, generates significant pension benefit gaps between workers with very similar contribution periods. With these three concerns in mind, the chapter provides simulations for future spending trends under alternative macroeconomic assumptions, and illustrates the quantitative implications of several pension reform scenarios. The results suggest significant savings from increases in the effective retirement age, and the government’s current reform proposals—which still remain to be finalized—could present an important step in this direction.