Wednesday, November 23, 2011

Is The Italian Crisis A Possible Self-Fulfilling Prophetic Negative Bubble?

Many observers are declaring Italy to be the key to whether the euro will collapse and along with it possibly most of the world economy. Having removed the near term problem from office, Silvio Berlusconi, the markets are not satisfied with the appointment of respected economist technocrat, Mario Monti, to replace him, with bond yields continuing to rise, thus threatening to bring about a crisis. What is it that Monti is or even can do to stop this?

Quite likely not a damned thing. Looking at supposed fundamentals, there should not be a problem with Italy. It is one of only four Eurozone nations that is currently running a primary budget surplus. The others are Luxembourg, Belgium, and Germany. Where is the problem?

Well, some say, aha!, look at the national debt to GDP ratio, a too high 120%. However, not only has Italy had a ratio such as this for a long time, and even been higher prevously, such as in the early 1990s, it has a much higher share of its debt domestically held, Italy has a much higher savings rate than most European nations (on the order of 17%). This would explain the NY Times story today that as long as Italians continue to hold their own debt, the euro will be saved.

What about proposals being made in Italy? One is that the retirement age be raised from 65 to 67. Maybe this should be done, but again, Italy has a primary budget surplus, and 65 is higher than quite a few other European nations have as a retirement age. And if such a "reform" is passed, it will have little near term impact on the budget balance, although maybe doing so will induce that magic effect of "raising confidence," thus bringing down the interest rates.

The other is labor market reforms, particularly to open up various professions to more entry and competition. This will be hard to pass, but I think there may be reasons for doing this, and this may well help increase the growth rate, which has been low for a solid decade, and needs some stimulus, however achieved. But, again, this is not likely to affect the budget balance at all. Why this would bring down overly high interest rates is also very unclear aside from hoping for the "confidence fairy" to suddenly appear.

That the confidence fairy has not appeared with the removal of Berlusconi is disturbing. It looks increasinigly to me that these high interest rates are simply a self-fulfilling negative bubble on Italian bonds unjustified by any actual fundamental phenomena. Even with the high interest rates, most reports suggest that Italy can manage to avoid any defaults for at least another year. It is not Greece, or even the less troubled Portugal, Ireland, or Spain. It is basically solvent. The only real threat is the high interest rates, apparently existing because of the fear of what high interest rates can do, a possible self-fulfilling prophecy, an empty, if still dangerous negative bubble.


Will said...

"This will be hard to pass, but I think there may be reasons for doing this, and this may well help increase the growth rate, which has been low for a solid decade, and needs some stimulus, however achieved."

I agree in principle with removing professional barriers to entry. But I don't see the mechanism by which doing so right now causes growth. Do you want to elaborate?

Barkley Rosser said...

No guarantee it will, but the general argument is a human capital one: lots of well educated young people being kept out of many professions where they would probably raise the productivity level, and the productivity per pay level as well, with rising production costs a major factor in Italian stagnation. As it is, many talented young people are leaving Italy.

Will said...

"As it is, many talented young people are leaving Italy."

That's an important detail. I didn't know that. It implies that what I've been telling people (following Krugman) about labor mobility in Europe might actually be false...

Here's my issue with halting "rising production costs" (I've really tried to keep it short, but I'm not good at doing this):

My support (in principle) for loosening barriers to entry is precisely that it would raise the productivity per pay level. But as I understand it, in practice this would mean reduced pay for the presently practicing professionals, as the new entrants bid down the salary in the profession (lowering the legally created rents that professionals can collect). The removal of barriers to entry would also put out of business the corrupt institutions that, for a pretty penny, help individuals to run the gauntlet and pass the barriers. As a matter of social justice, this would be great. But now the people employed by those corrupt institutions would be unemployed, and unlikely to find work. The overpaid professionals would also be spending less, and so the gain in productivity would seem to be perversely inhibiting the yield of production, making the prospect of productive investment a less appealing prospect for owners of capital.

My doubts here come very much from Keynes. Things that would be very desirable during good times, according to JMK, (free trade, confiscation and elimination of rents, &c.) may actually be harmful during bad times.

What's the mistake I'm making?