The roots of the italian stagnation

Competitiveness measures the cost of foreign goods in accordance with that of domestic goods. Different measures of competitiveness (or its reciprocal, the true effective exchange rates, see Chinn 2006 for more) depend on consumer prices or on unit labour costs, and use weights produced from trade shares to compute a ‘foreign goods’ basket. The machine labour costs measure is specially interesting because it isn’t suffering from firms’ pricing policies which might vary as time passes and markets.

The machine labour costs-based indexes for Italy (green line) and Germany (blue) are shown in Figure 1. Between your first quarter of 2001 and the last of 2011, unit labour cost in Italy rose by 23 percentage points a lot more than in its trading partners (a genuine appreciation), while unit labour costs in Germany declined by 9.7 percentage points (a genuine depreciation). What explains the huge rise in the Italian relative unit labour costs?

Figure 1 . Unit labour cost-based real effective exchange rates

Source : Darvas (2012).

I decompose ‘competitiveness’, into its main determinants (see Appendix 1 of Manasse 2013 for a formal definition). A country becomes more competitive if the domestic relative (to foreign) average wage each hour falls, if the domestic relative average labour productivity rises, if the relative social security tax rate paid by domestic employers falls, if the domestic relative sales tax rate rises, and if the (trade weighted) nominal exchange rate depreciates. In this context, a country can improve its competitiveness by a ‘fiscal devaluation’, that’s, by raising the VAT tax rate, which exempts domestic exports but hits imported goods, and by cutting social security contributions (which benefits domestic however, not foreign producers). Given the concentrate on Europe, I really do not discuss the problems associated with changes in the nominal exchange rates with trading partners, nor the composition of trade and value added, that affect this is of real effective exchange rates predicated on unit labour costs.

Figure 2 shows the evolution of the common cost of 1 hour of work in Italy and Germany within the last decade. In 2000, the cost of 1 hour of work in Germany was almost double that in Italy (about 19 euro in comparison to 10.9). In following decade nominal wages each hour converged, although not completely: they rose by 39.5% in Italy against 21.1% in Germany.

Figure 2 . Hourly labour compensation

Source : Darvas (2012).

Labour productivity, however, didn’t follow wages. Figure 3 implies that labor productivity completely stagnated in Italy (+2.7% in the complete period) although it rose considerably Germany (+16.7%). Due to this fact, net of taxes, unit labour costs in Italy rose about 32.5% quicker than in Germany.

Figure 3 . Hourly labour productivity

Source : Darvas (2012).

Figure 4 plots the common tax rate on social-security contributions paid by employers. The difference between your levels Germany and Italy contribution rates is striking, though it is fairly stable (the Italian rate fell by two points and the German by one point between 20).

Figure 4 . Average rate of employer’s social-security contributions (%)

Consumption taxes show a different dynamics. Figure 5 plots the ratio of VAT revenue to GDP in Italy and Germany. Provided the ratio of consumption expenditures (the tax base) to GDP will not change across countries in different ways, we are able to infer the relative change in tax rates from the differences in the ratio of tax revenue to GDP (simply because the common tax rate is add up to the VAT revenue over GDP times by GDP over consumption). Starting in 2006, Germany raised its reliance on VAT considerably, thus engineering a ‘fiscal devaluation’ of around one percentage point, while from 2006 to 2009, Italy did the contrary. Over the complete period, however, the changes in tax rates were rather small.

Figure 5 . VAT revenue over GDP

Table 1 summarises the contribution of the different facets to Italy’s lack of competitiveness. Unit labour costs in 2000-12 rose in Italy by 35.3 percentage points and only by 3.17 points in Germany, producing a competitive loss of a lot more than 32%. The biggest share of the competitiveness loss is accounted for by the difference in the dynamics of the hourly wage rate, which rose in Italy by 18.4 percentage points quicker than in Germany. Since labour was much cheaper in Italy at the start of the period, we’d partial wage convergence. The problem was that labour productivity didn’t follow: to the contrary, it grew much slower (by 14 points) in Italy than in Germany. Overall, changes in the structure of taxation had a negligible effect on competitiveness. Finally, if we compare the developments in relative unit labour costs in Italy and Germany, with the dynamics of the true effective exchange rates described in Section 1, we are able to see that that other factors that affect competitiveness, such as for example changes of the composition of trade and of the nominal exchange rates (regarding non-EU trade) didn’t play a substantial role in explaining the Italian competitive gap.

Table 1 . A Decomposition of unit labour costs

What ‘should have happened’ in Italy because of productivity-enhancing reforms by its trading partners (largely Germany)? Predicated on the Dornbusch, Fisher, Samuelson ‘Ricardian’ model (1977), as some industries migrate abroad, the surplus labour supply must have reduced the domestic wage rate in accordance with the foreign wage rate. The actual fact that the contrary actually occurred exacerbated the consequences of the competitiveness gap.

It’s currently very trendy in Italy at fault Angela Merkel, Mario Monti, the euro and austerity measures for the existing recession, the worst & most prolonged of the post-War period. As the severity of the downturn is actually a cyclical phenomenon owing much to the fiscal contraction, its persistence, that’s, the inability of the united states to grow from it, is the legacy greater than a decade of too little reforms in credit, product and labour markets, which suffocated innovation and productivity growth, and led to wage dynamics which were completely decoupled from labour productivity and demand conditions. In a ‘rapidly changing world’, where trade and non-trade barriers were falling and commercial partners were rapidly innovating, the Italian reform inertia has generated up a competitive gap that the crisis has taken to the fore with dramatic and, in all probability, long-lasting consequences.

Editor’s note: This article is dependant on the author’s presentation at a conference on "Italy’s challenges amid the euro-crisis", a joint workshop of Bruegel and Dipartimento del Tesoro – Ministero dell’Economia e delle Finanze, Rome, .

Chinn, Menzie D (2006), “A Primer on Real Effective Exchange Rates: Determinants, Overvaluation, Trade Flows and Competitive Devaluation”, Open Economies Review 17, 115-143, http://www.springerlink.com/content/n4745m7668314m72/.

Darvas, Zsolt (2012), “Real effective exchange rates for 178 countries: A fresh database”, Working Paper 2012/06, Bruegel, 15 March.

IMF (2011), “Fiscal Devaluation: The facts and does it work?”, Appendix 1, Fiscal Devaluation Monitor, September.

Dornbusch, R, S Fischer, PA Samuelson (1977), “Comparative advantage, trade, and payments in a Ricardian model with a continuum of goods”, The American Economic Review 67(5), December, 823-839.

Phillips, A W (1958), “The Relation Between Unemployment and the Rate of Change of Money Wage Rates in britain, 1861-1957” Economica, 25, 283-299.

Manasse, Paolo (2013), working paper, predicated on presentation at a conference on "Italy’s challenges amid the euro-crisis", a joint workshop of Bruegel and Dipartimento del Tesoro – Ministero dell’Economia e delle Finanze, Rome, 8 May.