What's Wrong With Italy? A review of the country's economic and demographic challenges.

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The Euro, Demography and Italy's Long Term Growth Challenge Edward Hugh - Cortona, September 2011 (Revised and Upda

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A review of Italy's economic and demographic challenges, and the relation between them.

Transcript of What's Wrong With Italy? A review of the country's economic and demographic challenges.

Page 1: What's Wrong With Italy? A review of the country's economic and demographic challenges.

The Euro, Demography and Italy's Long Term Growth Challenge

Edward Hugh - Cortona, September 2011 (Revised and Updated)

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Summary Points• The most recent crisis was not an arbitrary phenomenon

• It was not simply a question of stupid and irresponsible financial products

• There are underlying macroeconomic and social process we need to understand

• The worst of the first stage of the crisis may be over, but we could now be entering a new and more dangerous phase

• The Euro itself forms part of the backdrop to the crisis

• As do long term changes in Europe’s demographic profile

• The greatest challenge facing any future Italian government is how to maintain welfare commitments in the face of population ageing given the level of accumulated debt.

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Italy

• Italy’s principal problem is long term low growth, not excessive interest costs• High accumulated government debt is a symptom of the problem not the cause• Italy’s problems are partly institutional and partly demographic, both problems need addressing• Median population age is an important economic indicator• Populations with high median ages tend to be export dependent• Export dependency gives a better, more precise measure of international competitiveness. • An export dependent country is internationally competitive when it has a large enough export sector to drive economic growth.• Italy will soon need to accept the proposed EU bond purchasing programme• If Italy’s growth problem is not adequately addressed there is a high risk that the country’s gross government debt level can spiral upwards out of control• Italy is also a high political risk country. It is the only country on Europe’s periphery where there are politicians who talk openly about Euro exit as an option.

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Italy Suffers From Low Growth ………… And An Ongoing Current Account Deficit

Italy’s average annual growth rate has fallen steadily in recent decades. The rate for 2001 – 2010 was about 0.6% and it is not excluded that during 2011 – 2020 it will be negative.

And the growth rate has dropped as the current account deficit has widened. There is an obvious connection – international competitiveness.

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Italy first fell into recession at the end of 2007 – some months before the other Euro Area countries - and didn’t come out of it again till the start of 2010 , so the economy contracted for two full years. GDP fell by 1.2% in 2008, and by 5.5% in 2009.

After an 18 month recovery, the economy again fell into a second “double dip” recession in September 2011, after a surge in borrowing costs forced the government to apply stringent austerity cuts in an attempt to recover investor confidence.

Double Dip Recession

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Sharp Economic Contraction

Thus the Italian economy continues to demonstrate its long term underlying weakness characterised by short recoveries followed by longer than average recessions. It is now widely expected to contract by around 2% in 2012, and then by another 1% in 2013. It could then grow moderately in 2014 – perhaps by 0.5% - but why should we expect the country not to fall back into recession again in 2016?

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Living Standards In Long Term Decline

After years of being stationary Italy’s population has risen sharply over the last decade – from around 57 to just over 61 million - but GDP hasn’t changed. The result has been a large fall in GDP per capita.

This fall has been in absolute terms, but in relative terms the change is also clear. Germany’s relative position fell steadily in the 1990s, then stabilised, and has even improved since the crisis. Italy’s fell slowly in the 1990s, then, since the turn of the century, the rate of decline has accelerated.

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The outlook is not appetising

As the population ages domestic demand moves into long term secular decline. Retail sales, for example, are now around 94% of the 2005 level.

And as public debt is paid down, government consumption will simply get less and less.

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Italy Didn’t Have A Housing Boom Pre 2008......... Yet Construction Continues To Decline

This trend is not likely to change. The winter 2011 Monti measures involved a substantial rise in property related taxes, implying lower property values in the future. In addition Italy’s demographics are not favourable to housing booms.

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So Now It Is All About ExportsGDP = Household Consumption + Investment + Government Consumption + Net Trade (Exports – Imports)

Now if household and government consumption are falling systematically, the only factor which can give a direct boost to GDP is the relative movement in exports and imports. Positive movement here can stimulate investment in the export (or tradeable) sector as expectations build for increased demand.

Total Investment = Investment for Exports + Investment For Domestic Demand.

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While Italian exports surged back after the financial crisis recession they never in fact attained their pre-crisis level, and now they are once more declining again. In addition, even though Italy’s goods trade deficit has reduced substantially over the last 12 months, it is still a DEFICIT.

Just Not Sufficiently Competitive?

As we can see in the chart on the right, the Italian economy was on an unsustainable path from the end of 2009 to mid 2011, as excessive government spending fed an import surge. As government spending was cut this import boom burst, and domestic demand collapsed, taking the country deep into recession.

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How To Define Competitiveness?

The REER (or Relative price and cost indicators) aim to assess a country's (or currency area's) price or cost competitiveness relative to its principal competitors in international markets. Changes in cost and price competitiveness depend not only on exchange rate movements but also on cost and price trends. The specific REER for the Sustainable Development Indicators is deflated by nominal unit labour costs (total economy) against a panel of 36 countries (= EU27 + 9 other industrial countries: Australia, Canada, United States, Japan, Norway, New Zealand, Mexico, Switzerland, and Turkey). Double export weights are used to calculate REERs, reflecting not only competition in the home markets of the various competitors, but also competition in export markets elsewhere. A rise in the index means a loss of competitiveness. (Eurostat Definition)

The issue of competitiveness has become one generating more heat than light in debate during the current crisis. The validity of one commonplace measure (REERs) widely used historically has been repeatedly questioned. In my opinion such questioning has been largely motivated by ideological and political motives in contrast to scientific ones. In fact the evidence is clear enough.

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Output & ProductivityHigh output per worker and high wages are perfectly compatible. The road to achieve this win-win combination is through raising productivity, thus maintaining unit labour costs constant, or even reducing them.

As can be seen from the accompanying charts, Germany achieved this combination between 2000 and 2008, while Italy didn’t. In Italy productivity stayed pretty much constant while unit labour costs rose, meaning salaries rose without the accompanying productivity, while in Germany unit labour costs stayed constant while productivity rose. This also gived the lie to the “cheap German wages” argument, since if wages hadn’t risen then ULCs would have fallen, which they only did briefly between 2006 and 2008.

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The problem in part is that value added is often a sectorial issue. For example agriculture and construction have historically been low value added and often high unit labour cost sectors, whereas petrochemicals or biotechnology are high value added but also often low ULC sectors, despite the fact that wages are higher.

Naturally most societies would like to have a large proportion of high value added activities, and a comparatively small proportion of low value added ones. But this isn’t as straightforward as it seems, since the transition from agriculture to biotechnology doesn’t move along what we could call a smooth production function. Namely you can’t simply transfer workers from one section to the other. It ain’t that easy. The large number of construction workers recently displaced in Spain can’t simply move into machine tool manufacturing, for example.

A countries ability to engage in what are high value activities at any moment in time depends on key factors like the skill, education and experience levels of the workforce, and these change only slowly. Critically the distribution of these factors depends to some extent on the age structure of the population.

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But in part the level of unit labour costs depends on the level of international competitiveness, which in part depends how much of the economy is in the tradeable sector and how much in the non-tradeable part of the economy. By tradeable we mean in competition with other producers or service providers beyond the national frontier.

The key mechanism assumed here is that the tradeable sector, being exposed to external competition, by definition needs to be more competitive to survive.

So a measure of a country’s lack of international competitiveness isn’t only that exports are too small, it is also that imports are too big, which is another way of saying that the domestic tradeable sector isn’t big enough. Normally this loss of competitiveness is associated with a growing trade and current account deficit, which means the process of non productivity supported rising living standards can only continue as long as some external agent is willing to finance it. When confidence that the process is sustainable subsides, people cease financing, and a crisis occurs. This is what happened to Italy in the summer of 2011.

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Export Dependency and International Competitiveness

But now I would like to introduce an additional concept which is generally not accepted in mainstream economic theory, the idea of export dependent economies. Basically the idea is that as populations age, demand for credit and with it the rate of increase in domestic demand wanes. As can be seen in the chart on the right below, household consumption in Italy surged in the 1990s, and the rate of growth in consumer demand was quite rapid. The consumer boom was also linked to Italy’s last housing boom. Then between 2000 and 2007 something changed, and the growth rate slowed. Any internally coherent macro economic theory needs to be able to explain this change. Then following the global crisis household consumption slumped, recovered slightly and then slumped again.

So if we go back briefly to the earlier chart on the composition of GDP, we can perhaps formulate a new and better definition of international competitiveness, which would be having an export sector which is large enough and growing dynamically enough to produce GDP growth in an environment where consumer demand weakens as populations age.

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The Demographics Of Export Dependency

As populations age beyond a certain point economies transit from being consumption driven to being export driven. Thus the process is not random or arbitrary, but follows a path which is, in principle, identifiable.

This is not a question of choosing between options or “growth models”. There is not a choice here, since there are deep underlying structural dynamics at work, and these dynamics seem to be intimately associated with the dynamics of the demographic transition.

The process is observable most clearly in those countries with the highest median ages attained by human populations to date – Japan, Germany and Italy. All three have median population ages of around 45. Hence one explanation for Italy’s low growth rate and high government debt is based on the fact that Italy still runs a trade deficit. .

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Population Ageing – A Unique Historical Challenge

We live in a world of rapidly ageing populations, not just in the economically developed societies, but in many emerging nations too. Due to the one child per family policy China will be one of the fastest ageing societies on the planet in the 2020s. The economic and social implications of such a global ageing process are bound to be profound. Two points stand out:

• the process is seemingly irreversible. • No other single force is likely to shape the future of national economic health, public finances, and policymaking over the coming decades.

Strangely, this issue receives only a fraction of the attention that has been devoted to global climate change, even though, arguably, ageing is a problem our social and political systems are, in principle, much better equipped to deal with.

In particular it would be interesting to discover why so many mainstream economists seem oblivious to the problem despite the fact that the developed world sovereign debt crisis seems so self evidently associated with the phenomenon.

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Life Cycle Effects – Franco Modigliani

Children are dependents, and hence net dis-savers for their families, which is why so many high fertility societies have such low savings rates. The secret to raising the aggregate saving rate is having less children.

In terms of a person’s adult life, those in their twenties and early thirties tend to be net borrowers as they are relatively low earners at the same time as they look to establish a family, buy housing, educate children etc. Societies with many people in this age group tend to see rapid credit growth.

At some point around middle-age the person then tends to move from being a net borrowers to becoming a net investor at just the time they enter their economic prime and accumulate financial assets to fund their retirement.

After retirement people tend to maintain their living standard by gradually shedding the financial assets they’ve been accumulating to fund their nonworking days. This process is not uniform, and older people generally tend to consume less and conserve their savings.

Modigliani’s life cycle hypothesis suggests that a population’s aggregate financial behaviour - just like that of an individual - changes depending on age.

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So Could Something As Simple As Movements in Median Population Age Help Us Understand How Economies Evolve?

Ours is an age of rapidly ageing societies, but not all societies are ageing at the same rate. The United States for example is still a comparatively young society. Indeed even in 2020 will still be younger than Japan was in 2000. Near replacement fertility and constant immigration have been the main factors behind the relative youth of US society.Societies are in some kind of homeostatic “bad

equilibrium” when they have fertility levels of five children plus per female. As fertility falls societies develop economically, and start to age through population structure impacts. What is so modern about our current situation is not the ageing itself, which started in Europe with the industrial revolution, but its velocity, its global extension, and the high median ages now being attained in some developed countries.

Japan’s economy is completely export dependent. In the US consumer demand is still an important component in economic growth.

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As far as we are able to understand the issue at this point, population ageing will have major economic impacts and these can be categorised under four main headings: i) ageing will affect the size of the working age population, and with this the level of trend economic growth in one country after another

ii) ageing will affect patterns of national saving and borrowing, and with these the directions and magnitudes of global capital flows

iii) through the saving and borrowing path the process can influence values of key assets like housing and equities

iv) through changes in the dependency ratio, ageing will influence pressure on global sovereign debt, producing significant changes in ranking as between developed and emerging economies.

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While population ageing is universal the short term impact will be much more localised. The pace of aging varies greatly across countries and regions.

The effects of the process are expected to be most pronounced in those countries that remained complacent in the face of several decades of ultra-low fertility rates (total fertility rates of 1.5 and under), which in effect means Japan, China, South Korea, the German speaking countries and much of Southern and Eastern Europe.

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Another way of looking at these demographic changes is in terms of the dependency ratio, which can be defined in a number of different ways depending on the problem being addressed. For present purposes what matters is the old age dependency ratio.

Less developed economies tend to have high youth dependency ratios, and as a result low savings rates. In mature economies the situation inverts – there is a high and growing elderly dependency ratio, and demand for private credit is weaker.

Those societies that are ageing more rapidly have higher elderly dependency ratios, and the proportion of over 65s is growing rapidly. The demand for pensions and health care puts increasing pressure on state finances, so the demand for public sector credit rises. Public debt is high – in Japan gross debt is now around 225% of GDP, in Italy it is 120% and in Germany 85%.

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In some cases not only will population age, it will also fall. In Germany total population is expected to fall from its current level of 82 million reaching anything between 69 and 74 million by 2050, depending on the future course of life expectancy, immigration and fertility. And the proportion of people aged 65 and older is projected to rise from just under 20% today to just over 33% by 2050. At the same time, the number of very elderly (those aged 80 and over) will nearly triple to as much as 15% of the total population.

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In Italy population is projected to remain more or less stationary, at around 60 million, at least until the 2030s, but the age structure of the population will be constantly shifting.

(Data: UN 2008 forecasts, median estimate)

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One Key Shift Occured In The 1970s.This Was The Point Where Each Generation Started To Get Smaller Than Previous One

Another Key Decade Comes In The 2020s. As the largest Population Cohorts Reach Retirement AgeThe Elderly Dependency Ratio Rises Substantially

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Demographic

Transition

From Very Young Societies

ToVery Old Ones

Societies with large numbers of people between 35 and 50 are highly productive

Societies with very high median ages are likely to have problems with innovation and creativity, and this issue is made worse if low growth leads highly educated young people to leave.

As the number of children per family drops health improves and young people are better educated

As a result societies get richer much more quickly

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All of which has to be reasonably obvious once you have gotten the basic idea.

The curious issue is why so few mainsteam economists and policy makers have “gotten it”.

Few seem to have noticed that the world has somehow changed since 2007. Most are simply waiting for things to magically “get back to normal”.

Even the IMF seems to have failed to notice that something “fishy” is going on.

Could it be that academic economists are simply blinded by the mathematical sophistication of those very models they thought would convert their discipline into a science?

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Is Italy Like Venice Sinking Steadily Into the Sea?

Ageing is irreversible. But it is possible to age more slowly. It is also possible, as a society, to age less painfully by stabilising the population pyramid and by rising the economic growth rate to fund welfare costs. Italy needs economic and demographic stability and sustainability.

Italy’s famous “leaning tower” has held upright for nearly a thousand years. It is unlikely we will be able to say the same about the country’s unstable population pyramid.

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Italian Fertility Has Fallen To and Remained Around 2/3 Replacement Level

Population Has Recently Grown Rapidly, But Only As A Result Of Immigration

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There Was A Significant Increase In The Italian Workforce And – Before The Crisis – In Employment

But Due To The Poor Productivity Performance And The Strength Of The Informal Economy This Did Not Translate Into Increased Economic Growth

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Italy’s problem obviously isn’t only demographic. If anything Italy’s demography has improved slightly over the last decade even while the economic situation has deteriorated. In part this is the result of a changed external environment. But there is obviously lots Italy could do to improve the situation. Especially as regards the quality of its institutions.

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Italy and The Eurozone Debt Crisis

Total Italian Debt Is Not Excessive In Comparison With Some Other Countries in The Eurozone, But Public Debt Is The Second Highest.

Despite Normally Having Had Primary Balances Italy Has Run General Budget Deficits since The 1980s

In Part The Problem Is The Weight of the Debt, The Burden of Interest Payments

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Italy Is Now Poised On A Knife Edge

Key Factors:

• Growth• Inflation • Interest Charges

Hence The Problem Of Market Pressure, And Interest Rates.

The IMF currently predicts that Gross Government Debt To GDP will peak at 124% in 2013. Any slippage on this and debt restructuring becomes inevitable.

Investors Are Worried. Market Responses are not just simple speculation. ECB support is critical, but so are radical measures to increase the growth rate.

As of June, Italian banks had borrowed more than 283 billion euros from the ECBand part of which was invested in high yield government bonds. Banks increased their holdings of Italian bonds by about 78 billion euros in the first half of 2012.

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Too Big To Rescue?

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Italy shrank further into recession in the second quarter with a 2.5 per cent annual decline. The 0.7 per cent quarterly fall in gross domestic product, only slightly better than the first quarter’s 0.8 per cent decline, means the economy has now been contracting for over a year

Italy’s Recession Deepens

And there is at least another year of the same or worse to come as spending cuts steadily bite and the Euro debt crisis rocks its way forward. The recession will weaken tax revenues and hit jobs and consumer spending, a vicious circle which makes it harder for Mario Monti, who is aiming to cut the budget deficit to 0.1 per cent of GDP in 2014, to meet his public finance goals.

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Consumer Confidence and PMI indicators suggest that the Italian government’s GDP growth estimates (of a contraction of 1.2% for 2012 and an expansion of 0.5% for 2013) are way too optimistic . The employers group Confindustria now forecast a contraction in GDP of 2.5% in 2012. A further fall of 2.0% is not unlikely as the European debt crisis worsens. Compared to the other forecasters I would be more negative on the outlook for both private consumption and investment activity. With a more negative outlook for the euro area economy – destination for 43% of Italian exports — these are unlikely to put in an unexpected stellar performance.

Hard Times Ahead

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Unemployment Rising SharplyItaly's unemployment rate hit a record 10.8 percent in June, up from 10.6 percent in May. There were 2.79 million people looking for work in June, according to seasonally adjusted figures -- a rise of 37.5 percent compared to a year earlier. Youth unemployment dropped from 35.3 percent in May to 34.3 percent. These are not yet Spanish numbers, but they are not to be sneezed at either

The number of people living in absolute poverty in Italy rose to 3.4 million in 2011, or 5.7 percent of the population, up from 5.2 percent in 2010.Those living in relative poverty for Italian standards were roughly stable at 8.2 million, or 13.6 percent. But among families with no workers and no pensioners, the relative poverty rate rose to 51 percent from 40 percent.

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The implementation of austerity measures in Italy is likely to have a substantial negative impact on the economy in the coming years. Given its lack of competitiveness, the economy lived off constant demand stimulus from the government. Without this the growth problem is likely to become worse.

There have now been five fiscal packages since July 2011, aimed at a cumulative fiscal consolidation of 5.2% of annual GDP (€85.8bn) between 2011 and 2014. With the majority of the measures concentrated in 2012, there will inevitably be a large negative impact on the economy throughout this year. Given the deep recession the country will be in over the next couple of years and poor potential growth prospects over the medium- and longer-term, Italy’s public sector balance sheet problems are likely to mount.

Although the 2011 fiscal deficit of 3.9% was not particularly high in comparison with many Euro Area countries the governments projection of a close-to-balanced budget in 2014 looks hugely optimistic. A more realistic expectation would be for the deficit to be under the EU 3% level at that stage, but the danger is this could well mean gross debt to GDP will be over 130%. Above the danger mark.

Fiscal Targets Look Increasingly Out Of Reach

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The ECB report produced criticism from the Italian consumers’ association Codacons, who complained that the ECB itself had not found a solution to this situation. “If companies are insolvent it’s because banks are strangling them, denying them credit,” Codacons said. Coldiretti, the Italian agricultural association, estimates that 60 per cent of companies in the sector risk being starved of credit as they face interest rates that are 30 per cent higher than the average of other sectors.

This problem is more complex than it seems. It is not so much a question of credit being strangled, but of demand being strangled as austerity bites. Companies who cannot sell profitably are a high credit risk. There is demand globally, but as I am saying Italy is insufficiently competitive to take advantage of it. The high cost of financing Italian government bonds is pushing up longer term interest rates, and discouraging investment, and this is an issue the ECB could address.

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The Euro Area’s Single Financial Market Unwinding

Italian banks have borrowed more than 283 billion euros from the ECB via the 3 year LTROs and use the liquidity obtained to buy government bonds which pay much higher yields. This helps bank profitability and enables them to recapitalise, but at the cost of reducing private sector credit. This is where the real “crowding out” comes.

Banks increased their holdings of the country’s bonds by about 78 billion euros in the first six months of 2011. This forms part of the “nationalisation” of Europe’s sovereign debt markets. Foreign investors cut their holdings of Italian government securities by 18 percent in March from a year earlier, according to the Bank of Italy. In the same month Italian banks boosted them by 39 percent.

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The possible Italian bailout is becoming a tricky political issue. The technocratic government of Mario Monti would like to get an MoU agreed before handing the country back to the politicians. The request for bond buying would involve ECB secondary market purchases.

But the ECB has made clear what it thinks is required. Countries with high unemployment need to “abolish wage indexation, relax job protection and cut minimum wages”, the bank said in its August monthly bulletin. The bank is not impressed with the Italian labour reform, which is too little too late, and thinks direct wage cuts are now the only remedy.

Unsurprisingly, many in Italy are becoming reticent about handing over their country’s future to an institution with such views, and pressure is mounting for Monti not to ask for help. That having been said, the country really has no alternative if it wants to stay in the Euro.

Easing In The Bailout

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Is Italy Facing A period of Growing Political Instability?

The “if Italy wants to say in the Euro” bit should not be taken lightly. Mario Monti warned recently that excessive pressures on the struggling countries was threatening the future of the Euro.

"I can assure you that if the (bond yield) spread in Italy remains at these levels for some time then you are going to see a non euro-oriented, non fiscal-discipline-orientated government taking power in Italy," he said on a recent visit to Helsinki.

He was, of course, referring to the ambivalence of Silvio Berlusconi on the Euro issue, and the outright hostility to the common currency displayed by the rising (5) star of Italian politics, Beppe Grillio. “After me the populists”, as Monti once said.

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Structural Reforms

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Dangers of Sovereign Debt Default?

According to a recent Standard & Poor's report, the timing of the current debt crisis is not a coincidence since cost of caring for the growing numbers of dependent elderly will both affect growth prospects and dominate public finance policy debates across the globe, and for many years to come.

Even if most governments have long been aware of the need to prepare for the looming problem, the rapid build-up of government debt over the past three years has effectively heightened the need to do more to advance reforms aimed at containing the risks to sovereign budgets, especially in countries with high expected future increases in age-related spending.

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A Delicate Balancing ActReasonable empirical confirmation exists that the recent surge in global imbalances was, in part, an offshoot of slow-moving underlying demographic determinants of global capital flows.

The near-term adjustments will mean more emerging market current account deficits and less developed market ones.

At a global level, demographic pressures will continue to imply that the increase in desired saving will exceed the increase in desired investment. This has one clear implication: globally interest rates can be expected to remain low.

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Longer, Healthier Working Lives

In terms of policies to address the pressures of ‘ageing’, the debate in terms of social security and healthcare often focuses on raising retirement ages to reduce dependency rates and alleviate fiscal pressures.

Extending working lives relative to the time spent in retirement will not only help address the pension issue, it should also serve to accelerate the tendency towards larger current account surpluses across most developed economies, in particular in those parts of Europe which are in the process of private sector deleveraging as part of their fiscal sustainability programme.

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Time To Act – What Can Be Done?

Short Term:

- Continuing and Continuous Structural Reform • Labour Market Reform• Pension Reform• Heath System Reform• Immigration• Formalise the Informal Economy

Longer Term:

• Raise Fertility Rates• Global Rebalancing Initiatives• Acceptance that the Modern Growth Era – like modernity itself – doesn’t last forever.

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Thank You For Your Attention