No, unfortunately it was not only Mr. Berlusconi’s fault: there ‘s why Italy does not function.

as promised, I write about the situation of Italy and the option faced. The article below is  adapted from an essay presented during my EMBA.

In the past years Italy has been under the international spotlight mainly for the misdoings of the former president. I believe  attention to superficial and spectacular issues has diverted the focus away from the causes of the disturbing trajectory the country has assumed in the last decades. So, in the following, I will try to be as factual and analytic as possible to uncover the real endemic problems the country is facing.


Executive summary

This essay is written in order to provide a better understanding of the Italian macroeconomic situation to derive conclusions of main causes and constrains and to develop a clear view on the priorities for the political agenda. In order to provide some insight I will include along with the data a feedback deriving from my direct knowledge or experience. These comments do not constitute a scientific proof, however they provide, a hopefully interesting feedback and, at the same time, a confirmation or confrontation for the macroeconomic indicators.

I will privilege aspects that are often neglected by the international attention, considering the more echoed ones such as corruption, organized crime or soaring debt as the symptoms of underlying disease rather than the real issue.

The analysis will demonstrate that there are a few priorities long overlooked by the governments of Italy: structural reforms, updating of the university system and financing of political parties to mention a few ones. Furthermore, the current approach employed so far by Italy to favor the short term view to meet economic targets is becoming less and less sustainable. The country is confronted with a few scenarios discussed as conclusion of this essay.


Table of Contents

    Executive summary
    Country analysis
    Capital input
    Labor input
    Total Factor Productivity
    Technology growth
    Efficiency
    Future possible scenarios
    Business as usual
    Patchwork improvements
    Structural reforms
    Conclusions
    References

Country analysis

According to The Economist (2012a) , Italy scores 167 out of 179 average annual change of GDP per person. This poor performance, has been long debated; in synopsis of thousands of pages and man-years of broadcasts: this seems to be the problem.

However, GDP is only the effect of an underlying cause. In the following, as described in Figure 1, the Cobb–Douglas production function can be a starting point to decompose the problem into its fundamental factors and to analyze the issues in order to come to a deeper understanding of the dynamics the country is facing.

Where; Y = total production, TFP = Total Factor Productivity, K = capital stock, L = labor input, a= contribution.

Figure 1- Analysis using the Cobb-Douglas model

Analysis Cobb-Douglas model

Capital input

An analysis of Table 1, clarifies that Italy was well positioned towards the investments in capital stock for the last decade, being aligned with the average for the euro area and well before the stronger economies of Germany and Austria, only recently investments have dropped, this is a recent trend and should not be enough to cripple the economy.

Table 1- Capital stock (OECD, 2011)

Capital Stock

My practical experience, however, suggests quite a different scenario; a trip across the Northern regions would clarify to the traveller the concept; roads tend to be bumpy, repairs approximate and road works resemble more Pharaonic constructions rather than actual capital investments. The highway network stretches for more than 6600 kilometers of which only one fourth is three lanes (Autostrade, 2012).

An idea of the North-South divide is well portrayed in Figure 2, the decreasing density of the network has important consequences on development and growth. Try to follow the highway on the map to simulate the trip from Firenze (Florence) to Ancona, or even worst, the journey from Bari from Catanzaro. In both cases highway users, who pay the fee by the kilometer, are forced to follow loops and curious geometric figures.

In these cases the numbers somehow fail to capture the real status of the infrastructure; similar considerations do apply to the railroad network as Italy ranks 13th in the world (CIA, 2012), however the actual functionality the network provides are limited and unreliable.

Figure 2- Italian highway network (Autostrade, 2012)

Italian highway network (Autostrade, 2012)

Labor input

According to this indicator, Italy performs slightly above the European average, therefore no particular concern here except the observation that more developed economies such as United Kingdom tend to have a less labor input as effect of the decreasing marginal contribution. This might indicate a lower efficiency or a less advanced economy. The relatively high labor input is confirmed by experience; Italian managers take great pride talking about the long hours spent in office, often competing with their peers on who can switch off the lights. Concepts of value added or effectiveness normally not mentioned.

Figure 3- Labor input 2003 – 2010 (OECD, 2012)

 

Total Factor Productivity

The Growth Accounting theory defines, TFP as the remaining contributor of the output of a economy after labor and capital inputs have been considered. This factor is important for developed economies, as, according to a well-established assumption, the marginal product of labor and capital is a decreasing function; “it does not get any easier” (Miles, 2005:61), this in turn implies that, in order to grow, developed economies must focus on different solutions such as technology, efficiency and productivity.

Figure 4- Lack or resilience. Growth of Total Factor Productivity, per cent (OECD, 2012)

The graph in Figure 4 clarifies the key underlying issue of the Italian economy: lack of resilience. The behavior of the TFP during the past 20 years tends to present spikes of productivity during expansion phases of the overall economy and, comparatively bigger drops during contractions phases; after decreases, the recovery is not sustained up to the pre-crisis level, therefore the overall trend is sloped downward. This because the government has consistently failed to implement the necessary long-term reforms: in facing a crisis some emergency measures are taken, normally a mix of tax increase and financial gimmick, after the performance parameters are restored, institutions revert to a business as usual attitude.

Every country is hit by crisis, that is life. What matters, is how quickly they can return on their feet. The German curve, for example, presents dips during recessions however we can see a much better recovery capability; the plans tends to be sustainable as well. Similar considerations are valid for US.

Up to now we have analyzed the main components influencing the growth of an economy identifying that the Italy is plagued by some lack of effectiveness in the efforts; investments and labor input are at levels comparable to the rest of the European peers, results are however disappointing. We made an important discovery that the cause of this sluggish performance has to be searched in the TFP factor, more precisely in its main elements.

Technology growth

If we consider universities as good proxy for technological advance, the graph in Figure 5, depicts another unfortunate story of underperformance in respect of the peer group; Italy has consistently underinvested in this area, as result the academic “career” is a demeaning  experience due to lack of funds and professional development, which, in turn, forces the most dynamic and motivated researchers and professors to seek opportunities abroad; the “net brain balance” is negative for Italy as each year about 30’000 researchers leave the country only to be replaced by 3’000 foreigners colleagues (The Chronicle, 2006).

Figure 5- Squeezing stones – Expenditure on R&D as a percentage of GDP (OECD, 2011)

Expenditure on R&D as a percentage of GDP

This problem is even more complex; a direct increase in funding probably would not sort an increase in quality of the academic institutions. The other major issue is the fragmented distribution of institutions; for example the University of Turin is scattered across most of Northern Italy counting 8 locations separated by hundreds of kilometers. This must have obvious detrimental implications of the percentage of the funds which are devoted to research and teaching as a significant part of them will instead feed the administrative overheads. Moreover, small, peripheral Universities often fail to attract the best researchers and professors.

Figure 6- Everywhere and nowhere – Branches of the University of Turin

Efficiency

In the following we will highlight a few elements influencing this component and consider some well-known facts and some not well known to illustrate the main issues.

Labor productivity

It is a well-known fact that the Italian work environment is a machine designed to demotivate the high performers, otherwise lazy colleagues would look bad in comparison. Chances to be promoted are limited to the chances of your boss being retired, and even then, since nepotism is the norm, it is unlikely unless you have a raccomandazione (referral and support) from some influential figure.

The unions were successful in influencing the law and restrict the ability of firms to fire employees only in case of a “right cause” (L. 15-7-1966 n. 604 art 18 L.300/70), unfortunately magistrates consider almost no circumstances to be “right” for a company to reduce personnel; for example, a few years, ago two blue collars were caught damaging FIAT’s production equipment during a strike with the intent to block the line; the employee were fired by the company and subsequently forcefully reintegrated in their jobs by the magistrate. Similar stories repeat when employees caught stealing by the security camera of the Rome’s airport was dismissed by the department only to get their position restored by legal intervention.

As result the whole workforce is crystallized as companies are not inclined to hire for life anybody, in order to be able to cope with peaks of work companies rely on the temporary workers, paying a premium to rent-seeking agencies such as Adecco. This distortion is not helpful for the workforce either as employment conditions for temporary workers are normally not optimal.

An inadequate legislation and work practices, sunk the labor productivity to the lower positions in Europe for  the last decade (The Economist, 2011b).

Another aspect which is often cited as a source of resilience and strength is the entrepreneurship model formed by small, individually owned companies. This feature served the economy well in the past, however, there are several often not mentioned issues that now are limiting the growth: first companies are present mainly in Piedmont, Lombardy and Veneto, three relatively small regions in the North part of the country leaving the rest of the nation mostly uncovered. Second, small enterprises, concentrate wealth in the hands of the owner and employees are paid according or below the national average, which, in turn, implies less disposable income for the population and less consumption. Third owners tend not to delegate tasks thus reaching an upper limit to expansion of the enterprise marked by the hours they can work in a day. A bartender won’t open a chain of bars being engaged in running his own operations; a lawyer won’t set up studies in other cities.

Notably these firms are constrained in their growth by a regulatory failure as well; the above constitution allows derogation to the above mentioned article 18 for firms employing less than 15 workers. The rationale was to offer flexibility to small entrepreneur in order not to be constrained in the hiring process. However the unintended consequence is that a company would not scale up unless there is a strong incentive; flying under the radar is a much better option.

The result of this is a high number of interfaces and unique business models which makes the legislation over complicated and the like hood of tax evasion high.

As the work environment is not encouraging performances, why work hard if anyhow you are not going to be either fired or promoted? The most productive graduates,  therefore, escape from the country looking abroad for better career opportunities. Should this trend not be stopped, the country would find itself in less than 10 years a shortage of a competitive workforce. Italy, among the developed economies, is the only one presenting a negative migration rate for graduate students (The Economist, 2011c).

Another, plague, are lobbying activities carried on by guilds, although illegal, this practice is well established in Italy since the Middle Ages; Dante, one of the highest poets of our literature, joined the apothecaries’ guild in 1295 because of a law forcing anybody seeking a public office to join an association of craftsmen. Fast forwarding to our days, guilds, are now possibly the single biggest roadblock to any development of the county; their effectiveness in creating privileges for few at detriment of the vast majority of the population is remarkable. These lobby groups cover any part of the economy from taxi drivers to doctors and milk producers; as result a benign legislator, seeking the good of the society is constrained in any possible options as in the short run these categories would be the losers of any reform.

As an example, pharmacies in Italy are regulated and, by law, the decision to grant a permit to exercise is subject to careful considerations; pharmacies must not be too close each other to limit customer’s options. Buying common drugs as aspirins in Italy is a painful experience, when we consider over the counter drugs, the pharmacist is no different from any other shopkeeper selling, say shoes or ice creams: customer choose the product, the clerk serve the product and customer pays, however, for some reasons traced back to medieval privileges, Italian pharmacists are indeed different as they are able to avoid competition and charge high markup, an effect of this can be seen in Table 2, as the out of pocket payments for the Italian population were in 2009 among the highest in the world.

Table 2- Take my breath away – Out-of-pocket payments (households), /capita, US$ purchasing power parity (OECD, 2012)

Pocket payments for the Italian population were in 2009 among the highest in the world

The source of power of these interest groups is the fragmentation of the political forces and the lack of a center party. The major parties are relatively coherent in their votes, however they cannot reach the majority for almost any decision without the support of the small parties often accounted in the parliament as one individual. The lobby groups capture the needs of a small segment of a relatively not powerful portion of the population, for example taxi drivers or retired workers; if  these groups are successful in influencing even a few individuals in the government they virtually can decide on any matter of public interest. In the next section we will analyze in detail other aspects of the political life of the country.

Government

No, it’s not about Berlusconi, he has his share of blame namely the belief that he is above the influence of the law and of the public opinion, but definitely it is not only about Berlusconi. In the following we will focus to some less known but central facts, useful to draw some conclusions and possible priorities to address the major issues.

Political parties are financed via public money, meaning citizens support each of them by paying taxes; this implies that a red, nostalgic communist pays every year for the office of Alsessandra Mussolini, the granddaughter of the more famous Benito (1883 – 1945). If this is not bad per se; the true issue is that money is allocated not in proportion to expenses but following some obscure bureaucratic rules whose effects are described below.

In 2009 the Corte dei Conti, the Italian audit institution, published a report on public financing to political parties. The main result is reported in Table 3 and reads as follows: during the period from 1994 to 2008, political parties claimed an overall spend for electoral campaign of 468 M€ (column A) and received state contribution for 2’253 M€ (column C), with a net gain of 1’785 M€, the legislation has turned the Italian political environment into the most profitable industry of our time with a RoI of 381%, compared to the unattractive RoE of Microsoft scoring only 36,6 % (Forbes, 2012).

Table 3- Money for nothing – Expenses and refund to political parties in euros (Corte dei Conti, 2009)

Expenses and refund to political parties in euros (Corte dei Conti, 2009)

during the period from 1994 to 2008, political parties claimed an overall spend for electoral campaign of 468 M€ (column A) and received state contribution for 2’253 M€ (column C), with a net gain of 1’785 M€, the legislation has turned the Italian political environment into the most profitable industry of our time with a RoI of 381%

Another striking aspect is the longevity and attachment to power of our politicians; Andreotti (93, ninety-three) portrayed in the bottom left of Figure 7, started his political career in 1934, became prime minister in 1973, and covered afterwards many roles. After surviving untouched numerous mafia and corruption trials, he is currently covering a lifetime senator role, voting laws and reforms. Napolitano (87, eighty-seven) is the current president; unfortunately these are rather common cases.

In the same picture we can see Obama (51) and d Hillary Clinton (65). I’m not arguing that young equals better, however there must be a balance between being forever in charge and handing over just some space to the younger generations maybe just to get a refreshed view of the world. Additionally, long duration of public offices and is consistent with corruption; Figure 12 configures Italy on the first place among the developed countries in this area.

Figure 7- Immortals – Italian and American politicians

Looking back to Figure 11, we can notice another area of concern related to conflict of interest; as a matter of fact, every politician has to some extent to face it. For example Hillary is in the board of directors of many companies including Wal-Mart, however political and business roles are somehow balanced and monitored by the public opinion: if Hillary would start acting according in a biased manner the electorate would dismiss her relatively quickly. This feedback loop is missing in Italy. When some plot is uncovered, mainly by satiric TV shows, very rarely by journalist and never by governmental institutions, the reaction is only noisy indignation and immediately after, resignation.

These factor generates endless opportunity for corruption,  which, according to The Economist  (2011c), for Italy is comparable to the one in China and very well higher than Spain, France or other developed European Countries

Tax evasion

I consider this more an effect of a dysfunctional system rather than a cause. In 2009 the tax rate was 46.7% of GDP is among the highest in the OECD countries (OECD, 2011), as discussed in the beginning of this essay, infrastructure, education and political conditions are poor, the population therefore perceives no return in the money paid to the government and therefore the acceptance is low. For these reason entrepreneurs that see their revenues taken away only to foster corruption devise ever clever methods not to pay them (The Economist, 2002). Considering the opportunity cost and risks employed in these activities, possibly a lower tax rate would encourage the more citizens to contribute, theory of taxation and Laffer curve considerations do apply.

Evasion is widespread all over the country. Any patients visiting specialist knows very well threat the first questions before the payment are “are you paying in cash?” and “do you need a receipt?” if the answer is “yes” to only one of the questions, the price for the service immediately doubles, the national institute for statistics calculate that the tax evasion amount to 16% of GDP (ISTAT, 2011).

In synopsis of this analysis, we can revert to the global competitiveness report whose data for Italy are summarized in Figure 13. Consistent to our analysis, the WEF point out that the major gaps in Italy are the institutions and the innovation, followed by labor market efficiency. The major roadblocks for doing business are considered to be the government bureaucracy and high tax rates.

Figure 8 – The goverment against – World Economic Forum Competiveness indicators for Italy (2011)

 

Future possible scenarios

In the following I will define three possible forward looking scenarios for the country detailing the major implications for the economy.

Business as usual

Italy continues to navigate the storm without no major changes or even needed reforms. Targets from the European Community are incidentally met by applying hurried measures mainly resorting to accounting exercises and tax raises. Reforms are limited to the minimum and almost never implemented, this is the behavior often adopted in the past by the Italian politicians: fix the figures and let the real world following a separate de-evolution.

The solution would probably have the effect to buy more time, maybe one year or little more, without addressing any of the key issues on the European table, the country will reach a point in which the technical government would be forced to consider other options. Reputation among the international circles of Italy would fall to a minimum and the lack of confidence would limit the possibilities of the Italian firms of doing business abroad, the foreign investments and the confidence in the solvency of the country.

Patchwork improvements

The focus of this scenario are key reforms demanded by international actors such as fight organized crime, shorten bureaucracy, improve the effectiveness by re-forming the labor law ad some attempt to limit the government spend. Efforts are somehow focused but implementation is incomplete or weak; responsibilities to actually deliver end results will be shuffled back and forth between the central government and regions, not being able to reach an agreement or even an understanding on the priorities.

The international opinion would indeed be captivated at first by the renewed energy of this novel attempt. After 3 to 5 years, however the results would prove temporary; this tactic has been applied in the past with spectacular increases in TFP reported in Figure 5, only to prove not sustainable. The institutions behemoth, will be the real loser of any successful attempt to improve competitiveness as it feeds with the resources that would otherwise re-directed elsewhere, therefore the reaction of the affected actors would be either: a) openly opposing the change, as taxi drivers did in a protest when the government recently tried to raise the level of competition in the industry or, b) nullifying the effects of the regulations with some bureaucratic twist, or the tragic-comic case of the law obliging landlords to fill-in a declaration that the tenant is not engaged nor associated to any mafia activity.

Structural reforms

According to this scenario, Italy will re-invent its institutions as a pre-requisite to enact other reforms and re-gain international credibility; the task is to increase the effectiveness of the institutions and to build the platform for further reforms. This scenario calls for significant modifications of the basic rules; in particular financing political parties must change, new mechanisms to introduce transparency on the acts of individual politicians and to create a single center party, whose non-existence now render the country de facto hostage of lobby groups and small political parties which, by holding a few seats in the parliament are able to overthrown the government. Another area of need is the number of politicians in the upper and lower chamber which today amount to more than 900 politicians. Another intervention would be to open the political career to younger politicians, as an extreme measure, this can be achieved by limiting the duration of public offices or setting an age limit.

Universities must be re-organized in order to save overheads, focus efforts on research and teaching and attract and retain the best faculties. A reform of the academia is badly needed; the government should facilitate the consolidation of the institutions and create adequate housing for students, once the minimal conditions for developments are met, further funding could help the research and development of the country. As thing stands nowadays little or no effort is done in this direction, as each reform is usually limited to push more and more responsibilities to the regions and therefore to create a more dense network of institutes which are poorly financed and impossible to maintain.

These actions are a dramatic change and strong resistance is expected by the bureaucracy and lobby groups, however, a way of pursuing reforms, would be not to rush for immediate results, to fix middle term deadlines and to compensate the short term losers by means, for example, of tax breaks or other fiscal instruments, even a monetary refund could be an option considering the perspectives of maintain the current status.

Even if full results will came only in decades, the mere fact of addressing the underlying problems will provide a powerful signal to markets and international community which, in turn would react favorably and contribute to the economy, for example, by raising the confidence in the solvency of the state or investing.

Conclusions

We have integrated information from different sources considering different ages and our analysis point out that in the current status Italy is unable to reach the standards of the other developed economies due to a significant gap in institutions and infrastructure.

Forcing reforms at this stage would provide only a minor relief, as lobby groups and bureaucracy would nullify every attempt or find new ways of exploit public resources for the benefit of a restricted circle.

Italy should focus instead to badly needed structural reforms regarding the political life of the country and the effectiveness of the institutions. The current political class is too entangled into the web of personal or group interest to engage into this activity; however competent technical governments given the right amount of time and resources might have the necessary independence to complete the task.

After all, the size of market in Italy is appealing for investors and customers, a positive signal would quickly trigger good reaction form the international community; some companies are now already prospering despite all odds, the well-established cliché on Italians and on their ability to generate great, novel ideas, contain probably grain of truth as well. Adam Smith’s invisible hand is clearly present in Italy, only very well tied; we just need somebody to release it.


References

Corruption and development- Corrosive corruption, 2011c, The Economist, http://www.economist.com/blogs/dailychart/2011/12/corruption-and-development/print

Employment and labor markets: Key tables, 2011 OECD – ISSN 2075-2342, http://dx.doi.org/10.1787/888932557358

ISTAT 2011, ‘Indagine conoscitiva sulla delega al Governo per la riforma fiscale e assistenziale AC 4566’ ISTAT, Italy

Mappa Autostradale, 2012, Autostrade per L’Italia, http://www.autostrade.it/autostrade/traffico.do

Miles, David and Scott, Andrew, 2005, Macroeconomics: understanding the wealth of nations, John Wiley & Sons. 2nd ed.

Multi-factor productivity growth, 2012, OECD, http://stats.oecd.org/Index.aspx?DataSetCode=MFP

OECD Economic Outlook, Volume 2011 Issue 2 No. 90, OECD 2011, http://dx.doi.org/10.1787/888932558745

OECD Health Data 2011 – Frequently Requested Data, 2012, http://dx.doi.org/10.1787/20743904-table4

Oh for a new Risorgimento, 2011b, The Economist, http://www.economist.com/node/18780831/print

Referto Elezioni Politiche 2008, 2009, Corte dei Cont, Corte-dei-conti_Referto-elezioni-politiche-2008_16dic09.pdf

Science and technology: Key tables from OECD – ISSN 2075-843X, 2011, OECD, http://dx.doi.org/10.1787/2075843x-table1

That sinking feeling, 2012a, The Economist, http://www.economist.com/node/21538178/print

The Chronicle: Italy Suspends Brain-Drain Program, 2006 May 26. Vol. 52, Issue 38, p. A49, section

The Global Competitiveness Report 2011–2012, 2012, World Economic Forum

The ins and outs Italians are deeply anti-meritocratic, 2011c, The Economist http://www.economist.com/node/18780891/print

A double-edged shield: A new law tempts Italians to repatriate offshore money, The Economist, 2002

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