The Roots of the Italian Depression (*)

Italy is now facing its worst recession in recent history. And yet the current state is not the consequence of the European sovereign debt crisis nor of the fiscal austerity measures recently implemented, which for sure have not helped. It stems from more than a decade’s lack of effective reforms in product and labor markets that resulted, on the one hand, in ailing productivity growth, and on the other, in the decoupling of wages from labor productivity and market condition. At a time when our major trading partners, notably Germany, were introducing productivity-enhancing structural reforms, such inertia has resulted in a very large loss of competitiveness, whose consequences Italy is now paying for. Competitiveness is a simple concept but is difficult to measure (see Chinn, 2006(1)): the relative price of foreign goods relative to domestic goods. If foreign goods become more expensive than domestic goods, competitiveness rises and the terms of trade deteriorate. Different measures of competitiveness (or its reciprocal, the real effective exchange rates, REER) rely on consumer prices or unit labor costs (ULC), and use weights derived from trade shares to compute a “foreign ” goods ’ basket. I will look at ULC based REER because this index focuses on costs and its determinants, wages and.The ULC-based indexes for Italy (green line) and Germany (blue) are shown in Figure 1. Between the first quarter of 2001 and the last of 2011, unit labor cost in Italy rose by 23 percentage points more than in its trading partners (a real appreciation), while ULC’s in Germany declined by 9.7 percentage points. These numbers are impressive: so what explains the huge rise in Italian unit labor cost