Low interest rates, continuing injections of liquidity by the European Central Bank (“ECB”), fiscal stimulus to varying degrees assisted by low government borrowing costs, a fall in the Euro and sharply lower energy prices are hiding deep-seated and unresolved problems in Europe. Despite the ongoing Greek drama which is incapable of resolution, the European crisis is moving closer to the core. Italy and France may be the next dominoes to topple.
While the near term focus is political, the French and Italian election, any new government will face a series of problems that cannot be easily resolved, even if there is the will to tackle the political and economically difficult issues.
Defenders argue that Italy and France are large modern nations, with enviable economic pedigree. Italy and France are amongst the largest economies in the world.
Gross domestic product (“GDP”) per capita in 2015 is estimated at around US$35,000 and US$43,000. They have large populations, well-educated and productive workforce, well developed infrastructure as well as considerable economic and social capital. Both countries are major agricultural and industrial powers, strong in advanced technical products, luxury goods, food processing, pharmaceuticals and fashion. Both are major exporters and significant tourist destinations. France even has a favourable demographic outlook, with a birth rate just above replacement level mainly among its immigrant population. They are simply too large to fail.
But Italy and France share problems of slow growth, unemployment, poor public finances and structural problems. They have found it difficult to reform and face an increasingly difficult political environment.
Italy’s economy has shrunk by around 10 percent since 2007, as the country endured a triple-dip recession. Output has regressed to levels of over a decade ago. Overall unemployment is around 12 percent, with youth unemployment around 40 percent. Consumption and investment are flaccid.
The damage is long term, with as much as 15 percent of Italian industrial capacity destroyed, reducing employment and growth potential. Once its strength, Italy’s smaller enterprises have contracted as a result of low sales, declining profitability and lack of financing.
Italy has a current account surplus of 2.2 percent, reversing a number of years of deficits. The change reflects the deterioration of the Italian economy rather than a change in its trading position.
Banking system problems have exacerbated the contraction. Italian banks are hamstrung by around €360 billion of bad or doubtful loans, which has exposed inadequate capital and reserves. The most recent exercise to support banks (with a glorious title based on the Atlas) was underfunded and ill-conceived and did little more than support a few weaker banks at the expense of more solid enterprises. MPS has been effectively nationalised and no end is in sight to the problems.
This has constrained the supply of credit to the economy. Larger companies can use capital markets for finance but this option is less available to small and medium sized enterprises that are crucial to employment and activity. The lack of credit availability combined with the deformation of Italy’s industrial structure will constrain any recovery.
Total real economy (government, household and business) debt is over 250 percent of GDP, up 55 percent since 2007. This understates real liabilities as it ignores unfunded pension and healthcare obligations. While some recent pension reforms have been made, it will take some time for these to have any material effect on obligations. Household debt is low, relative to peers.Italy’s net international investment is -32 percent of GDP, superior to Spain (-92 percent) and Portugal (-100 percent).
Despite its commitment to fiscal reform, Italy is running a budget deficit of 3 per cent in 2014 and 2.6 per cent in 2015.. Government debt is US$2.4 trillion or around 132 per cent of GDP. Some analyst have it rising further towards 140 percent of GDP.
While the Eurozone debt crisis has been a factor, Italy’s problems are more fundamental with the economy having grown little since the introduction of the Euro in 1999.
Labour markets remain rigid, with high labour costs and multiple barriers to hiring and firing workers. Productivity improvements are also slow.
Italy’s economy is increasingly unbalanced with high end producers, such as those in luxury products and also advanced manufacturing, benefitting from demand from emerging markets. Other sectors, such as standard automobiles, domestic appliances and low-priced fabrics and clothes have found it difficult to compete with manufacturers based in emerging markets.
There are other structural problems. In World Bank studies, Italy ranks 45th out of 189 countries for ease of doing business. Infrastructure, dating back to the immediate post World War 2 era, is in need of renewal and lags leading economies. Italy’s large public sector and bureaucracy is legendary. Transparency International ranks Italy 61 out of 175 countries in perceived levels of public corruption, comparable to Romania, Greece and Bulgaria.
France shares Italy’s problems of low growth, high debt, fiscal and external imbalances and a lack of competitiveness.
French GDP growth is anaemic, being mainly under 3.0 percent per annum since 1999. France’s GDP per capita has lost ground to many developed nations, such as the US and UK, over the last 20 years. Unemployment is around 10 percent, having remained above 7 percent for much of the last two decades. Youth unemployment is over 20 percent.
France’s current account moved into balance in 2015. But it has averaged deficits of around 1 percent of GDP in recent years, a reversal of small surpluses a decade ago.
Total real economy (government, household and business) debt is around 280 percent of GDP, up 66 percent since 2007. This understates real liabilities as it also ignores unfunded pension and healthcare obligations.
France’s budget has not been balanced in any single year since 1974. French public debt is above US$2.5 trillion, or 96 percent of GDP. The current budget deficit is around 3.5 percent of GDP and has been between 4 and 7 percent since 2009. France has repeatedly sought more time to meet the mandated EU target of 3 percent. With characteristic Gallic insouciance, Prime Minister Manuel Valls told legislators that: “We are not asking. France makes its own decisions.”
In the World Economic Forum’s competitiveness rankings, it ranks 22nd, behind Germany (4th) place, and Britain (10th). In World Bank studies, France ranks 27th in terms of ease of doing business.
Labour costs are high and the market is inflexible. Welfare benefits are generous and zealously guarded. The agricultural sector and national champions in automobiles, heavy engineering and aerospace are protected and enjoy explicit or implicit subsidies.
Overseeing this system is a large and multi-layered government sector, nickname mille-feuille, for its resemblance to the sweet cream slice made of layer upon layer of paper-thin puff pastry. A 2010 book Absolument Debordee (Totally Snowed Under), penned by an anonymous local council official, described an inefficient and wasteful system. France has 90 civil servants per every 1,000 inhabitants against 50 in Germany. The government employs 22 percent of the workforce, well above the European average. Perhaps, this merely reflects General Charles de Gaulle’s difficult in ruling “a country with 265 different cheeses”.
Public spending is around 56 percent of GDP, the highest in the Eurozone, some 5 percent above Sweden and around 10 percent above Germany. The welfare system consumes 40 percent of public spending, while the remainder goes towards central and local government costs.
A 2005 report on French public finances concluded that “each time a new problem has arisen in the past 25 years, our country has responded with more spending.” This accounts for the fact that irrespective of the economic environment or the government of the day, it has been difficult to control public spending.
France and Italy cannot avoid a financial crisis in an environment of low growth and low inflation. Real GDP growth need would need to be around twice the current projected rates to stabilise and then reduce government debt-to-GDP ratios.
The required fiscal adjustment to start reducing government debt is around 2 percent of GDP, which would reduce growth needed to reduce leverage. A combination of weak economic activity and low inflation is causing Italy’s debt trajectory to spiral upwards, despite austerity and a primary surplus of 2 percent of GDP. In France, there is no sign that the budget is likely to be in surplus in the near future.
The real problem is the lack of competitiveness. Underlying many of these problems is the single currency. Before the 2015 fall in the Euro after the European Central Bank introduced negative interest rates and quantitative easing, Italy and France were faced with a 15-25 percent overvalued currency. This was compounded by the high leverage to the exchange rate for export competitiveness. Italy has a gearing of over 60 percent to the exchange rate due to the nature of its exports, compared to around 40 percent for Germany. Denied the option of devaluation to maintain international competitiveness, both countries have relied increasingly on debt funded public spending to maintain economic activity and living standards.
In the absence of a favourable exchange rate, Italy and France face the difficult task of large internal cost reductions to regain competitiveness. As the experience of Greece, Spain, Portugal and Ireland illustrates, this is a brutal and not always successful process. The adjustment would be assisted by strong export markets. But low growth in developed and emerging markets as both private and public sectors try to deleverage means that global demand is likely to remain muted.
Plus ça change, plus c’est la même chose…
Italy and France have promoted structural reforms, to increase growth and competitiveness.
Former Italian Prime Minister Mateo Renzi belatedly introduced labour market reforms. But generous benefits have not been eliminated, with entitlements and job protections increasing gradually with seniority. In France, the Hollande government introduced cuts in employers’ payroll charges on the low paid workers. It has made modest reforms to pensions, increasing the period of service needed to qualify for a full pension.
The reforms, whilst welcome, create a two tier labour market. Established workers enjoy traditional employment benefits. New contract workers received lower wages and have minimal job security, decreasing the effect on economic activity. It also creates an industrial sub-class of a new working poor with attendant social problems.
In both Italy and France, minimum wage levels, working hours, major entitlement programs and reform of the public sector remains largely taboo. French liberalisation measures have been minor, focused on extended retail trading hours, deregulation of intercity coach travel, procedural changes to labour tribunals to speed up proceedings and reduced protection for some professions.
Change is also slow. There is little appetite for confrontation on the scale of the UK miner’s strike. If the economy improves or deteriorates, reforms are frequently shelved as the time is not propitious.
A deep antipathy of capitalism and business impedes change. Ordinary Italians are understandably suspicious of deeply entrenched business oligarchies. Only around 30 percent of the French population believe in the superiority of the free market system.
Mistrust of market solutions is shared by both major French parties. Gaullist Prime Minister Edouard Balladur once defined civilisation as the struggle against the market. In his 2012 election campaign, French President Francois Hollande declared his “main opponent is the world of finance”. He was recycling both President de Gaulle who stated that “my only enemy, and that of France, has never ceased to be money” and Socialist President Francois Mitterrand who denounced “the power of money”.
A lack of appetite for political risk also impedes change. Italy’s legendary political dysfunction led Dictator Benito Mussolini to state that: “governing the Italians is not impossible, it is merely useless“.
None of the last four Italian Prime Ministers attained power by an election victory, ascending to their position by internal party manoeuvring. A fragmented parliament means that coalition governments are the norm, making decision making difficult.
In both Italy and France, the priority is to defend the already protected at the expense of the rising number of excluded. In Italy, 15 million people out of a population of 60 million now live in some form of deprivation, including over 8 million in a condition of serious economic hardship. In France, millions of long-term unemployed and young people especially those without qualifications face little prospect of employment.
These pressures manifest themselves in different ways. Politically, smaller parties like Italy’s Five Star Party and France’s Front National have gained at the expense of traditional holders of power. Even if they do not win government in their own right, parts of their agenda –anti-Euro, anti-immigration- are now firmly on the political agenda. Social conflict is also evident. In Italy, anti-immigrant sentiments are rife. In France, discontent at discrimination and lack of prospects is radicalising the sizeable Muslim minority.
In early 2015, in an interview with RAI, the Italian state TV network, Greek Finance Minister Yanis Varoufakis, argued that the Euro was fragile like a house of cards. It would collapse if Greece withdrew or was forced out on the single currency. He pointedly told his hosts that “Italian officials, I can’t tell you from which big institution, approached me to tell me they backed us but they can’t tell the truth because Italy also risks bankruptcy and they are afraid of the reaction from Germany“. His observation that Italy’s debt levels were unsustainable drew an immediate response from Italian Economy Minister Pier Carlo Padoan, who tweeted that Varoufakis’s remarks were “out of place“. Italy’s debt was “solid and sustainable“.
The response was characteristic of Italian and French denial of the precariousness of their position. There is no acknowledgement of poor economic performance, high and rising debt levels, unacceptable fiscal outlook, and the need for far-reaching structural reforms. There is no willingness to address the problems of the Euro and the incompatibility of monetary union and a single currency with national fiscal management and sovereign independence amongst Eurozone members. Both the population and their representatives refuse to face reality.
President Mitterrand was fond of saying that “il faut donner du temps au temps” (time must be given time to do its work). But for the last 15-20 years, Italy and France have been promising reform and improvement. Unfortunately, time is now running out, with potentially disastrous consequences for the nations themselves as well as Europe and the world.
© 2017 Satyajit Das
Satyajit Das is a former banker. His latest book is A Banquet of Consequences (published in North America as The Age of Stagnation to avoid confusion as a cook book). He is also author of Extreme Money and Traders Guns & Money