Department of "Urrk!"

Ed Hugh catches some very alarming advice from Vicenzo Guzzo: large-scale deflation is never a good idea. Looser monetary policy at the ECB level is a good idea:

A Fistful of Euros: 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-à-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’?

Comments

[shah8]

Heh, and what about a bigger issue, for me?

Italy is massively corrupt and cronyist. Deflationary procedures are mainly needed to mitigate some against leeches. Vast swaths of the country has been allowed to run down in certain respects. I just don't see how dropping out of the euro helps at all. The instant that happens and italy attempts to increase spending and lower the currency, the largest impact would be certain export orientated businessmen getting wealthier, and probably a chain reaction of either other countries dropping out or of increased internal protectionism on the continent. The structural adjustments that are needed have not happened because of cronyist government. It is doubtful anything would change unless that does. In the end, I strongly doubt that Italy would be *permitted* to leave the EU unless there was a general dissolution.

[Jussi]

Can we pleeease blame it all on Berlusconi?

[otto]

How is looser ECB policy going to improve Italy's position vis-a-vis its Euro partners?

It isn't.

[Tom Cecere]

Isn't demographics a part of this issue? I thought even when I went to school (dark ages, 1970's) it was pretty clear that growing populations of working people would lead to growing economies, given a minimum level of economic infrastructure. Italy (and Spain) are on the downside of that curve, no? Is their GDP per capita in recession? Is this question really stupid?

[Buce]

To call Italy "corrupt and cronyist" is not to blame it all on Berlusconi. He looks unusually bad because (a) he's there now; (b) he is more open about it than some of his predecessors; and (c) for a few brief shining moments in the early 90s, it looked like Italy might change its historic ways. Berlusconi came to power full of grand promises to (loosely translated) "clean up the mess in Rome." It's interesting to speculate on whether (a) he thought it would be far easier than in fact it would be; or (b) he simply never had any intention to do it. Conventional wisdom of course leans to (b), but I suspect that there may be a bit of (a) as well. Comparisons to Arnold in Calif (though Arnold is not nearly the thug that Berlusconi is) are tantalizing.

[Jake]

Any one read Bob Altman's commentary in the WSJ today? Any thoughts? (I realize it is a not too well correlated w/ this thread, sorry!)

[brad Setser]

Altman offers a soft version of Bernanke, with an emphasis on "it won't last" but with a tinge of "expect low interest rates for some time." Read the Gross article that Brad Delong links too, then read Altman -- they are all part of the same debate.

re: Italy. I agree that deflation is never a good idea -- particularly if you have as much debt as Italy. Real interest rates can be quite large with signficant deflation even if nominal rates are around 3%. Among other things, the debt dynamics get ugly. But for Italy to regain competitiveness without outright deflation, but rather lower inflation rates than the rest of the eurozone, the overall eurozone inflation rate probably needs to be a bit higher. 2% overall may be too low -- far too low -- in an environment where some economies need to adjust by having lower inflation rates than their partners.

I also worry that if China holds religiously to its peg, and continues to suppress domestic inflation through steps that I don't fully understand, the US/ RMB real rate may adjust in part through deflation in the US. I don't think the US cannot outsource all manufacturing -- there are limits to how much debt the US can trade for goods, and right now, i don't see evidence that the US will earn enough selling services like "design and engineering" to pay for all its imported goods.

[edward]

"the US/ RMB real rate may adjust in part through deflation in the US."

That is if deflation in China isn't even stronger :).

I think "push to shove" time isn't too far away on all this. Maybe John Snow's advice to the next G7 meet-up will run something like this: "follow my lead, and every man for himself".

[edward]

BTW Brad (Delong): looser monetary policy won't work, we're way beyond this now.

The problem is structural, Italy (and Portugal, Greece and Spain) have specialised in supplying certain kinds of manufactured products (and tourism) to the rest of the EU. Now the new eastern europe members and China are assuming this role, and they can't convert to higher value activities quickly enough. Look at the average education levels. I don't remember Italy off hand, but Spain, Portugal and Greece have something in the 8 to 9 years per head. Germany and France have 12 to 13 years. Think Mincer equations as a rough and ready rule of thumb. And demography is important in many ways, but here in the difficulties of improving general educational level with a top heavy population in terms of age.

This is why I was so opposed to all that nonsense they used to spout about Harrod-Samuelson-Balassa: it just wasn't relevant to the case in hand. But it did seem like a convenient 'excuse'.

Economics matters.

[rvman]

Further deregulating the firm creation process and labor markets seems a good first step to a stronger Italy. Loose unilateral (ie, out of Euro)monetary policy is just a short-term band-aid, at best, and economic suicide, at worst. Or does no one remember the inflation 'loose' monetary policy has traditionally created for the Lira? We are not talking a country with a history of prudent currency management here.

[otto]

"We are not talking a country with a history of prudent currency management here."
Quite a lot of inflation is entirely compatible with economic growth. cf Italy's growth 1950-1980.

"Further deregulating the firm creation process and labor markets seems a good first step to a stronger Italy."
Dream on. It was the impossibility of doing this which was part of the cause of Italian inflation in first place.

[STS]

Does the ECB have any room to catch up with the US example in manic money supply creation? Not that this would be particularly sound advice, but ever since GHWBush managed the deflation of the S&L credit balloon the US has ratched up its anti-deflationary cushion while I have the impression the Europeans have been more traditionalist.

Maybe this is what the parody Snow "quote" earlier is directed at? "Everybody pump up the money supply and see whose balloon pops last?"

[CapTVK]

STS,

Could you define "manic" money supply creation for me? According to the ECB the M1 money supply has had annual 10%+ growth rates for the last 2-3 years.

[P O'Neill]

A question: if Italy is so messed up, why is there a property boom? In the table from the most recent Economist story on the global housing boom, the Italian market doesn't look much less overheated (at least in growth rates) than some of the Anglo markets where the boom is a bit more understandable. Now of course the low ECB rates drive some of it. But shouldn't we be wondering about the rush of investable cash into non-producible assets in an economy whose real side is in the tank?

There's been a Deaton-Laroque paper floating around for years with a model suggesting that an efficient land market would be one where the government owns it all and rents it out. Gets rid of speculative distortions. Looking at the global property mania amidst relatively low real investment, I think they are right.

Links:
Economist
http://www.economist.com/opinion/displayStory.cfm?Story_id=4079027

Deaton-Laroque
http://www.wws.princeton.edu/~rpds/downloads/deaton_laroque_housing_land.pdf

[Ed]

The obvious third alternative is devaluation of the euro.If the ECB were so presurized, how long before it follows the policies of China and starts accumulating dollars?

[STS]

CapTVK:

"Manic" isn't meant to be any more precise than "lots". I read your post as a reply in the form: "no the EU isn't much behind the US, so no real relief there", which I thought was the drift of Edward's posts as well.

I was really hoping to elicit a more quantitative comparison from those who are better informed about the relevant numbers.

[Matt]

The statement Morgan Stanley's Guzzo makes is just wrong: Italy's real effective exchange rate has appreciated by about 5 percent, not 25 percent, since the launch of the euro. That's about the same as the real effective appreciation for the euro zone as a whole. Perhaps Guzzo has some other measure of "competitiveness" in mind, but the REER is the standard measure.

[Robert Waldmann]

I have to comment on this post. Sad to say, I spend my life in academia and cyberspace and don't bother with the economic news of my country of residence (I live in Rome).

So what is they way out otehr than inflation in the rest of the Euro block (won't happen) devaluation or deflation ? Well as the Economist entitled a survey on Italy "epure si muove." By rights Italy should long ago have joined Argentina in the ash heap of the global economy, but it has done OK so far. Personally I am not panicking.

My solution would be to introduce price indexed bonds (real interest bearing bonds as in the US and UK) then after a few years go back to the lira and devalue. The idea is with real bonds, the total disreputability of the lira would not add inflation/exchange rate risk to real long term interest rates for the real economy. The problem with my solution is that it should always work and should work fine for private firms wether or not the public sector takes the lead. I mean why should mhign nominal interest rates based on expected inflation or depreciation affect firm's borrowing costs if they use the optimal debt instrument ? Damned if I know, but it does seem to be a rather important issue out there in the real world (sorry I should say the nominal world or the reality based world).

Notice my plan is to hammer holders of Italian debt by inflating it away. I am a holder of Italian debt.

I suppose default would work fine too. I've never seen what's supposed to be so terrible about that.

Anyway my proposals won't be implemented and I'm still not so worried (if there were any chance they would be implemented I would be panicking).

So why am I so unworried ? well stuff happens. Also, some things are more predictable than others and one of the most predictable things is that Italians say "it is not cyclical it is structural" regularly every recession. Also I care a lot about employment. Here the big event is around 1996 (when Berlusconi was first voted out of office). Since about then, employment in Italy has been growing. Note I didn't say rapidly, before that, it was stagnating. I think the reason was major labor market liberalization (also reform to licencing may have helped). I don't like to say that about the labor market, because I like job security, but the results of the Spanish and Italian experiments are dramatic.

Italy now has a moderate (by appalling continental standards) unemployment rate. Now way it is going to deflate any time soon (not saying it won't happen but will take more absurd changes in competitativeness).

Of course, to get a capatilist type labor system, Italy had to wait for a prime minister raised in the Italian Communist party. It all makes perfect sense once you've been here a while. Someone up thread said such reform is impossible in Italy. It is possible, it happened, and it made a huge difference.

below comments on comments upthread

On loose money, Italy does not have it's own currency or money supply. Italy would have to go back to the lira. Of course Italy can, the rest of Europe is not going to invade or anything. besides most of them didn't want to use the same money as Italians anyway. It would mean a huge spike in interest rates. I don't see why this would imply either default or draconian fiscal policy though. Italy might have to re-introduce capital controls (eliminated in Dec 1992). Italians save a lot,so if capital controls can be re-introduced, the state can run huge deficits.

I should point out that my sense of the devaluation is that it was, by far, the best thing I have seen happen to the Italian economy (I've been here since 89). Since then Italian performance has been good compared to the rest of Europe (I am thinking mostly of employment).

Now on the housing boom, I think the answer is already in the thread. A reputable economist mentioned default on the national debt. Italians invest in houses, because they consider them safely real and personal, unlike Bot's (Italian T-bills). I don't actually personally know an Italian who has complete faith in the full faith and credit of the Italian Republic.

On Berlusconi a or b (meant to clean up the cronyism mess in Rome or never had any intention) there is good reason for all thinking people say b (no problem for Silvio, he had a majority). Before the mani puliti scandals Berlusconi was the most extreme and blatant crony in Italy. His media empire is based on unlimited finance from publicly owned banks (banco nazionale di lavoro which has also given me money) and ignoring the law (from my house I can see the TV antennas he built without permission. The law was regularly changed to legalize his actions. It still is , of course, but this was before he was prime minister. No one thought he would clean up the mess in Rome in the sense of fighting cronyism and corruption. The closest people came is "he's rich already so he won't have to steal".

I mean it would be like electing Jack Abramoff on a clean up Washington ticket. Berlusconi's election in 94 was proof of ethics fatigue -- people were sick of the disruption caused by investigations and afraid that they might be forced to pay their taxes.

I am serious about the last point. Every time Berlusconi was accused of tax evasion (always with massive proof) his poll numbers jumped up.

[anne]

Excellent, Robert. Would Italy really give over the Euro however?

[Hamilton Lovecraft]

Borrow trillions, cut taxes, and grow the economy out of the problem.

If it's good enough for Bush...

[Elaine Supkis]

I saw the Italian fashion shows this year.

Yech.

Based on this, I knew that Italy was going to do poorly. Gack. Really bad shows this year. What happened? Did all the good designers decide to go blind or what? I thought they loved us women.

[Egocrata]

For some reason, Spain has been doing exceedingly well in the last 10 years; by far the fastest growing big economy; ahead of Britain (and the US). Why? reform, reform, reform, fiscal discipline, and doing the homework.

Things are cheaper when done in time.

[dsquared]

Italy has an even better option than "default"; threaten to default and demand big budget transfers with menaces from France and Germany, who would cough up to avoid the consequences for the euro.

[Robert Waldmann]

Thanks Anne

I would say that Italy would have to suffer a lot and I mean a lot to seriously consider giving up the Euro. However, it has arrived as fringe politics and might become mainstream if there is a deflation.

My guess is no way Italy can extort anything much from France or Germany. It's like expecting Blair to get something serious out of Bush. Some countries do what they will and others suffer what they must. I have moved from the number one willer to a high ranking sufferer.

Spain had two huge reforms only one of which followed in Italy. Both allowed firms to hire people without lifetime tenure (no fire without cause). As I hate to say this had huge effects on employment in both countries. It is interesting that it was done by prime ministers who were socialist and recently ex communist respectively. More labor market reform will probably be possible in Italy if the center left wins the next election as ... non vorrei portare scalogna. I almost made a prediction about an election which is one thing I am trying hard not to do.

Spain also allowed foreign banks to compete. People in the USA probably can not grasp how aweful Italian banks are and how aweful Spanish banks were. There are now UK banks based in Spain. Loans based on normal banking practice and not which boss of which hopeless firm is freinds with the boss of the bank (or worse is the boss of the bank) make a huge difference. The banca d'Italia with no monetary policy to run is focusing on consolodation Italian banking and keeping foreigners out. Sad to say, bankers have a lot more pull than young workers, so I don't have high hopes for banking reform, which means taking it out of the control of Italians.

[Antoni Jaume]

Robert, I don't have much knowledge on this but my impression is that foreign banks in Spain had at most a lukewarm success. In 25 years I remember about Natwest, BNP, Crédit Lyonnais, but I'm not aware that any of them has more taht a testimonial presence now. Still Edward Hugh may know better.

DSW