• Dip. The weakness of private consumption in Germany at the beginning of the year was nothing more than a technical correction following the advance effects triggered by the VAT hike. Private consumption will support growth in the second half of the year. Next year, it could even become the growth driver.
  • Support. Consumption is receiving impulses from real wages, which for the first time in eight years are again rising appreciably in 2007. There is also scope from falling energy spending. The lower heating bill is more than offsetting the additional strain from record-high gasoline prices.
  • Employment. The most conspicuous support is, however, coming from the labor market. Another 300k new jobs will be created by year's end. Companies in key industries are already complaining about a labor shortage. Over the medium term, there is the threat of capacity bottlenecks and mounting wage pressure.
  • Interest rates. It is therefore no wonder that the ECB has indicated further hikes after this week's move to 4%. The slightly less aggressive rhetoric does, however, confirm our expectation that 4.50% will mark the end of the road. Consequently, the Bund yield (10Y) will also peak at the turn of this year at a now slightly upward revised forecast of 4.60% .

Further topics:

  • Weekly Comment: Draghi’s wake-up call for Italy.
  • Switzerland: National Bank in lockstep with the ECB.
  • Data outlook: Record-high gasoline prices drive US inflation; EMU industrial production treads water.
  • Market outlook: Yield overshooting to continue, EUR takes a breather.

ITALY: DRAGHI’S WAKE UP CALL

Bank of Italy Governor Draghi delivered his traditional annual speech last week (the “Considerazioni Finali”). This is the classic occasion where the Bank of Italy takes stock of the economic situation in the country, and calls attention to the most important economic policy issues. Draghi’s assessment was lucid, and he minced no words in pointing out how much still needs to be done to reform Italy’s economy. Inevitably, this was seen as a tough judgment that the steps taken by the government in its first year are insufficient—and this at a time when political tensions within the government coalition have dampened expectations of major progress on reforms.

To some extent, the timing of this hard assessment might seem surprising. Italy is enjoying very strong growth—by the standards of recent history—with real GDP rising by about 2% last year and expected to maintain the same pace this year (cf. chart).

Most encouragingly, there is evidence that this stronger growth performance is the result of a structural transformation and Darwinian selection at the micro level. As the Italian economy suffered a long period of stagnation and deteriorating competitiveness, some firms have finally repositioned themselves on higher value-added products, taken recourse to outsourcing, de-localization, and cooperation with foreign companies, invested more in research and marketing, and upgraded their human capital including at the top managerial level. Many small and medium firms have "bitten the dust"— more than 50,000 in the last five years, according to the Chamber of Commerce—but those which survived have gotten stronger.

This seems to be another “Italian miracle” of small and medium private enterprises surviving and even prospering in the face of obvious shortcomings in the government’s economic policy. We have been there before: during the past couple of decades foreign observers have often marveled at how Italy’s private sector managed to generate and support enviable living standards while a succession of coalition governments with an average lifespan of less than a year generated a rising public debt and no reforms. With strong growth and the government debating how to spend the additional tax revenue, this might be cause for optimism, confirming that somehow Italy always pulls through.

Draghi however warns that complacence might now be suicidal. Over the last several years, Italy has suffered a marked deterioration in productivity and unit labor costs compared to its main European partners (cf. chart).

Remedial action is urgently needed on several fronts:

Labor market rigidities and other structural distortions lead most firms to remain small, limiting their ability to innovate.

Insufficient competition in key public service including transport, energy and telecommunications imposes on Italian firms higher costs than those faced by international competitors; a slow legal system is a further source of uncertainty and costs.

Investment in infrastructure remains insufficient.

Public finances are a long-standing sore point: current expenditures are close to the highest levels in Italy’s post-war history, implying that the recent improvement in the fiscal balance has only been made possible by record-high tax pressure. As rising interest rates put pressure on debt servicing costs, expenditure cuts become urgent.

A pension crisis looms, and reform of the pension system remains hesitant and piecemeal.

All of this makes for a sober reality check, a clear reminder that the current upswing will not be sustainable without progress on reforms. But the most critical issue is the one that Draghi puts at the top of his priority list: education. Italy’s public spending on education is higher than the EU average, but the results are dismal. To effectively respond to the challenges of globalization, education is crucial. Thomas Friedman in his book “The world is flat” has pointed out that emerging countries are racing Europe and the US to the top, not to the bottom. The challenge for workers in Europe will increasingly be to upgrade their skills to remain in the higher echelons of a globalized food chain. There is no amount of protectionism that can insulate us from this challenge. Investing in education should be a priority for Europe, and particularly for Italy, which has consistently lagged the rest of the region. Draghi’s wake up call was loud and clear on this. Let us hope it will be heard and listened to.