Bogdan Lissovolik

Italy’s economic performance over the past few years has been disappointing. Despite the benefits accruing from its participation in the European Economic and Monetary Union (EMU), growth has lagged, competitiveness has fallen, and government accounts have progressively weakened. The sources of this poor growth performance have been major focuses of recent IMF staff research, as have the structural, fiscal, and financial policy challenges arising therefrom. Staff papers have also investigated aspects of Italy’s financial and regional development, and longer-term issues related to debt sustainability and pension reform in the context of impending aging-related pressures.

The current output slowdown has generated substantial academic and policy debate in Italy. One particularly puzzling aspect of economic performance since the late 1990s is that the significant increase in employment that Italy has experienced has not been matched by broadly commensurate increase in output. Put another way, the growth impact of rising employment has been almost fully offset by worsening productivity. Sgherri (2005) examines the nature of Italy’s exceptionally low productivity performance using information drawn from the comovement of output, employment, and inflation to distinguish trends from cycles. The results point to a sizable deterioration in trend productivity growth since the mid-1990s, yielding estimates of potential annual output growth as low as 1¼ percent in 2004.

The apparently large structural component to the growth slowdown has raised questions on the extent to which it is related to a loss of competitiveness since the advent of monetary union. Kent (2003) investigates the sources of Italy’s small, but persistent inflation differential vis-à-vis the euro area, concluding that it is partly related to convergence in price levels and tight employment conditions in the north. Looking ahead, the paper suggests that pressures for real appreciation are likely to persist, which will require adopting policies to safeguard price competitiveness. Sgherri (2006a) instead emphasizes the productivity element of the competitiveness problem. Her analysis of cross-country data and estimates of trade equations specific to Italy for 1980–2004 point to an across-the-board deterioration of Italian competitiveness in recent years, with poor productivity growth, rather than euro appreciation, the main culprit. The results suggest that Italy’s competitiveness problems are largely homegrown and are likely rooted in its inefficient model of dynamic specialization and its economic and policy rigidities.

Some of the particular institutional and policy causes behind the weak growth are examined in two papers by Lissovolik (2005, 2006). The first focuses on the business environment and the legal system, two areas where Italy fares relatively poorly in standardized international quality measures (especially with regard to the length of its legal processes). Cross-country correlations based on objective measures of institutional quality show a close association with long-term growth. The results suggest the link likely goes from the quality of the business environment to growth, though data problems impede a thorough investigation of the direction of causality. The second paper looks at how policy choices might have influenced Italy’s recent medium-term performance, using subnational European Union (EU)-wide and Italy-specific data in cross-section and panel regressions for 1995–2004. It concludes that national product market rigidities and high labor tax rates have depressed growth within the EU. In addition, the paper finds that within-Italy regressions, which also extend the work of Vamvakidis (2003) on growth and regional disparities, offer comparatively weak evidence of adverse effects of export specialization on regional growth, against the background of substantial regional convergence in Italy since the mid-1990s.

Despite considerable employment gains as a result of ongoing labor market reforms, Italy’s employment ratio is still among the lowest in the euro area. Vamvakidis (2002) shows that there could be substantial scope for employment gains if Italy’s rigid system of regional centralized wage bargaining permitted greater wage differentiation in line with productivity differences and local labor market conditions. The empirical evidence suggests that a more decentralized wage bargaining system would increase Italy’s regional wage dispersion by 5 percent, bringing it close to the euro-area average and substantially reducing unemployment in regions with low productivity.

Competitive and efficient financial and corporate sectors are also essential to promoting growth. Drummond, Maechler, and Marcelino (2006) investigate competition in the Italian banking system in detail. They find that although competition has increased in recent years, banks still operate in a high-cost and high-income environment, suggesting scope for further efficiency gains. In particular, greater market contestability would serve as a powerful incentive in this regard. Focusing on the impact of the financial system in general, Muñoz (2006a and b) examines macroeconomic transmission mechanisms and household behavior with respect to risky assets. She finds substantial structural differences between Italy and the United Kingdom, including evidence of household liquidity constraints in the former. Drummond and Friedman (2005) evaluate Italy’s corporate governance in light of recent high-profile bankruptcies. The overall assessment is favorable, especially since some weaknesses in investor protection had already been rectified by the so-called post-Parmalat legislation.

Italy’s fiscal accounts remain a focal point of academic interest, given the high public debt and the complex trade-offs involved in adjustment and reform. A number of studies have advocated the adoption of a transparent, rules-based framework that would ensure an effective fiscal policy. Daban Sánchez and others (2003) argue for the adoption of binding expenditure-constraining fiscal rules in the four largest euro-area countries, with the case of Italy being particularly compelling, given its very high public debt. A complicating factor in the implementation of such a rules-based framework is the fiscal devolution under way in Italy. Fedelino (2005) reviews developments in fiscal federalism in Italy and draws on the experience of other countries to distill lessons about how to design the framework to implement such a decentralization. With the obvious caveats concerning the primacy of the domestic political process and the need to account for country specificity, this review highlights the importance of transparent and stable rules, effective monitoring, and enforcement mechanisms.

In the context of short- and medium-term forecasting and policies, a key issue is the effect of impending fiscal consolidation on economic growth and investment. Sgherri (2006b) provides estimates of the associated fiscal multipliers, based on an intertemporal model of durables consumption. The results suggest that Italian households are relatively farsighted, which implies small multipliers and, hence, a relatively minor adverse effect on growth of an eventual expenditure-based adjustment. Fedelino (2006) examines options to reduce the impact on public investment of tight budget constraints through the creation of public-private partnerships (PPPs), which are relatively little used in Italy but are expected to become more common. Although the experience in a number of countries suggests that PPPs can play an important role in fostering public investment, they should not be a vehicle for evading budget restrictions, and experience demonstrates that careful project implementation is essential. Greater project prioritization, enhanced transparency in recording these operations, and the transfer of an adequate degree of risk to private partners would be instrumental to the efficiency of these operations.

Over the long term, Italy’s fiscal outlook is dominated by concerns about debt sustainability. In this regard, a relatively bright spot over the past decade has been the improvement in the outlook for the public pension system. Zanforlin (2003) documents the success of various pension-related reforms from the early 1990s in reducing future liabilities. Still, simulations suggest that aging-related spending is likely to rise considerably in Italy over the next two decades, partly as a result of continuous increases in health care spending. The paper highlights the need to jump-start economic growth, ensure substantial medium-term fiscal adjustment as a complement to pension reforms, and create room for a broader overhaul of the social protection system, which is so far heavily tilted toward pension spending.