x Abu Dhabi, UAEWednesday 17 January 2018

Italy shelters from the crisis and so prolongs the storm

Italy does not seem like a country in crisis. That's because the measures necessary to improve the economy still have not been taken.

Because the Italian government believes it can't afford for the country to fail, it is doing everything it thinks possible to prevent this. Yet, precisely because of this premise, a return to health for the economy will take longer than might be imagined. The problem is, the crisis isn't as bad as it should be.

Visit Italy today and you might ask: "What crisis?" Shop fronts look normal; there's no visible desperation to move stock. And near Milan's central train station, in a workmen's cafe festooned with dusty football club jerseys and framed pictures of local teams, the tables are occupied with a healthy number of shift workers. The menu is dog-eared perhaps, but otherwise intact - the owner hasn't reduced prices recently.

A decade ago, it felt a lot different in East Asia, then undergoing the worst economic turmoil since the Great Depression. This, too, started with debt and the judgement of the market that default was imminent.

In mid-1997, speculators began an assault on the Thai baht, betting against the currency's peg to the dollar. Contagion soon spread. Stock markets went into free-fall, and factories shed workers or closed down. In Seoul, hand-painted signs appeared outside restaurants advertising "IMF lunch" - recession prices reflecting the humiliation of a bailout from the International Monetary Fund. But as wrenching and punishing as the crisis was, East Asia managed to recover in earnest a couple of years later.

Italy should be so lucky. And by extension, so should its neighbours in the euro zone. The difference lies in the nature of the two crises, the role of currencies and the prescriptions governments take.

East Asia's crisis was one of over-leveraging by the private sector. Companies determined that so long as currencies remained stable and undervalued, they could export their way into profit while paying off ever larger amounts of borrowing for new capacity. But when the market determined the debt to be larger than prudent, its first reaction was to take it out on the most liquid asset class, currencies. This eventually broke pegs and, as currencies fell further, economies swooned.

Two things then happened. Falling currency rates raised the prices that manufacturers had to pay for imported raw materials and parts. For exports to remain competitive, economies had to undergo a "domestic devaluation" to match the external devaluation of their currencies.

This meant cutting the value of another input that goes into goods - in practical terms, labour. By doing so, the price of goods was brought under control despite higher import bills for material and parts. Indeed, manufacturers went further than needed to zero out the effects of imported inflation. The result was increased competitiveness and very low prices that gave a big boost to exports. People were hit very hard, but the economy recovered.

By comparison, the crisis in Italy is a more relaxed affair. Sure, local papers ran headlines like "Ultimo chance per l'euro" as the EU met earlier this month for another summit. But you don't feel the same desperation in the streets or on the buses. And that's because for all the Pandoran undertones, it isn't as much of a crisis for ordinary folks.

It's taken a year for the crisis to meander across the Ionian Sea from Greece to Italy, the two countries whose troubles are most proximate. Hardly contagion-like. And the reason is that both countries' problems - no question, big ones - are not yet full-blown economic crises.

This is about government accounts. In the spotlight is state, not private, debt. Thus, the reflex has been to test fiscal reforms. Prime Minister Mario Monti's government hopes to balance the budget by 2013. To do this it wants, among other things, to cut pension bills and extend pay-in periods for some retirement plans, increase value-added tax and property tax collection, and inflict new levies on bank accounts, stocks and financial instruments. And it promises some barely defined sops towards growth. However, what is missing is an appreciation that at the root of the fiscal crisis are structural problems in the economy.

Unemployment in October was 8.5 per cent, the highest in over a year. But for a period of nearly three decades it has averaged nearly 10 per cent. Per capita wealth has plateaued in the past 10 years. Against this, it's hard to see how much worse Italy is right now.

One reason the depth of this crisis is not yet seen - which would concentrate minds on meaningful change - has been the way the market has expressed its verdict on Italy and Europe's other crisis states. Unlike in East Asia a decade ago, the currency has been relatively unscathed. Since early summer it has fallen 10 per cent; the Indonesian rupiah lost 80 per cent of its value by the worst point of the Asian turmoil. We all know that one reason the euro hangs on is that it is anchored by heavyweight Germany. But in addition, there is not a little hesitation among speculators about selling the euro for dollars, given hints the US has given that it does not want its currency to rise too far. No one wants to be burnt by the US Treasury. (This also explains the continuing interest in gold.)

Instead, credit agencies and their sovereign ratings have taken the place of market judgement. And because of this, the principal parties, governments, believe their first line of defence must be fiscal rectitude. However, the measures have done little to help business. In contrast, a currency crisis, as opposed to a ratings distress, would hit quickly and hard across the board and change the policy focus.

Sure, Italy should pare its fiscal outlay. But it has a larger problem, and that is the state of its private sector. If it had enough growth, tax collection should be sufficient to fund prudent levels of state liabilities. But the economy has been wobbly for years, and what it needs are more labour reforms than the country has mustered in the past two decades. But it has been difficult for the market to clearly transmit the policy prescriptions needed because of the euro's ties to non-crisis Europe. Fiscal consolidation may satisfy ratings agency, but a fixation on this delays the time when even harder decisions must be made.

Lunch, anyone?