The Italian Predicament and European Deflation

Since the sequence of crises began in 2008 when the US "sub-prime" crisis exploded in the US, growth projections in virtually every part of the world have been too high and have been revised downward numerous times. It seems clear in retrospect that the models that underpinned the forecasts were incomplete in important respects.

In Europe, the sovereign debt markets destabilized after a two-year lag. That was certainly a dangerous multiple equilibrium situation in which deterioration in confidence led to higher yields which in turn threatened the public finances of overly indebted countries and increased the likelihood of some form of default. The Eurozone itself was in danger as a result.
ECB intervention in the form of a strong conditional commitment to control yields (the OMT just over two years ago) was the required circuit breaker. European sovereign debt yields and spreads reversed course and settled into more normal patterns.
Some analysts and policy makers apparently believed that the growth challenges of Europe were mainly the result of the sovereign debt instability. That is clearly not the case as European growth has slowed to near zero.

At present Europe has a dangerously low level of inflation, which creates the risk of a deflationary spiral. Roughly that involves inflation becoming negative, causing real interest rates to rise even if nominal interest rates are zero. Sovereign debt burdens become larger; growth and employment drop increasing downward pressure on wages and prices.
A second issue is structural flexibility. Setting aside imbalances and crises for the moment, there are powerful technological and global market forces that are requiring advanced countries to adjust in terms of employment and structure. In the past thirty years, roughly 1.5 billion workers in developing countries have been added to the global work force. Many are employed in the tradable sectors of their economies. Manufacturing supply chains and an expanding set of services have shifted to emerging economies.
In parallel, especially in the past 20 years, digital technologies have enabled to efficient construction of complex dispersed global supply networks. The same technologies have displaced or disintermediated labor in all economies, with the higher income countries facing the most strenuous challenges.
Adjusting to these powerful forces has not been easy – it never is. However structural rigidities in economies make the challenge worse by impeding the adjustments that are required to restore and sustain growth. The US economy is underperforming relative to potential for a number of reasons, principally underinvestment on the public sector side, but at 2% real growth, it is doing better than most of Europe. This can be attributed to a weakening dollar, the shale gas revolution, and the structural flexibility of the economy, which has allowed it to rebalance toward the tradable sector relatively quickly.
In a number of European economies, constraints imposed by policy in labor and services markets make the process of structural adaptation slower. Removing these impediments is and should be a high priority. It is also very difficult. Structural rigidities create value for those who benefit from them and they strongly resist the removal of these protections. The resistance is even greater in a low, zero or even negative growth environment.
The third and perhaps most important issue is related to debt levels and balance sheets. Certainly for the Italian economy, the combination of formal public debt at roughly 130% of GDP and high non-debt liabilities in the public pension system are a major challenge. In all countries in one way or another demographics and rising longevity have made these imbalances much worse.

To understand the issue, it is useful to step back in time. In the early postwar period, most advanced economies had higher levels of inflation than we currently have. High levels of inflation came to be viewed as the enemy of growth and equity. For growth, high and somewhat unpredictable levels of inflation acted as a deterrent to investment. And for equity, it imposed unfair burdens on retirees and those living on fixed incomes.
Central banks with government support (more or less) set out to lower inflation rates and expectations. With a somewhat painful transition, they succeeded, and by the mid-1980s, and slightly later in Europe as the introduction of the Euro approached, inflation targets settled in at about 2%. Generally good economic performance and financial market performance seemed to confirm the theory that low and steady inflation is unambiguously good.
On the whole this was a positive development, but something important got lost along the way. In fact inflation has benefits and costs and their relative magnitude depends on other factors and conditions.
Suppose, hypothetically for the moment, that a government has accumulated (for whatever reason) large debt and non-debt liabilities. Obviously it is necessary to change parameters of policies to reduce or even reverse the rate of accumulation. But that is not enough. The current debt and other liabilities exist and they impose a heavy burden on the fiscal deficit. If they are funded from current revenues, they crowd out growth oriented investment and key public services. And they impose a large and growing burden directly via taxation and indirectly via reduced growth on employment on the employed population and the young new entrants.
Recovery and restoration of growth, and a reasonable balance between the working population and the retired, requires reducing these liabilities. There are three ways to do this. One is growth, which in combination with fiscal discipline may solve the problem over time. The second is simply resetting the liabilities downward. The third is inflation. It is known that an upward shift in inflation lowers the real value of debt liabilities. It also lowers the real value of non-debt liabilities provided they are not indexed to inflation. It favors the young and the working population at the expense of those who are retired and living on savings, assets, pensions and fixed incomes. This is what we need but will not have.

If the system is way out of balance in terms of the burdens and benefits going to these two groups, then inflation may help in the rebalancing. Our aversion to inflation comes more from an era in which the imbalance was in the opposite direction.
Rent seeking, gaining privilege access to markets via influencing government is also a serious problem. When it gets out of hand, capturing value versus creating value via innovation or smart competition comes to dominate the landscape. Growth suffers.
Let me turn specifically to the Italian economy where pretty much all of the above analysis applies. While there are many dynamic elements in the economy, they are held back by structural rigidities. Desperately needed inflation to rebalance burdens and liabilities is nowhere in sight. The ECB may take measures to counter deflation, but there is little prospect of inflation at levels that would materially reduce public sector liabilities in real terms on any reasonably time horizon. At the moment, European inflation is close to zero and Italian inflation is negative. This means that the real value of the liabilities is constant or rising, not falling.
Competitiveness is also an issue. Eurostat data indicate that in the period after the Euro introduction, nominal unit labor costs rose rapidly in the southern European countries, while they did not in Germany. Hence the differential widened by as much as 25%.
Nominal unit labor costs from employers' point of view can rise either with wage increases, or because mandated taxes and related public services become more expensive.
A balanced growth pattern requires restoring the growth potential of the tradable sector. That means reversing these trends. Higher inflation in Germany and northern Europe would help accelerate re-convergence but that won't happen.
Relaxing fiscal austerity in the present circumstances is not a solution, because all it does is create more debt to fund the excessive and growing pension and other liabilities. Right now it may be fair to say there has been too much fiscal austerity, but there has also been too little fiscal and structural reform.
This leaves us in a very difficult situation. Probably the best one can hope for would be something like the following.

A weakening Euro would help, and that is consistent with steps that are needed to step away from the present deflationary risks. Serious reforms focused on reducing fiscal liabilities and increasing structural flexibility are essential. If undertaken, it might create conditions in which Germany and the EU would be more willing to relax the short-run fiscal constraints, especially if the additional flexibility were used to fund growth-oriented investments in education, skills, technology and infrastructure, as opposed to funding unchanged and growing public liabilities. This seems to me to be the core of the conditionality impasse in the EU now. With vigorous reform and short-run fiscal stimulus target at investment, it is an impasse that might be broken.