Yesterday we got confirmation that Italy feel back to recession in the second quarter of the year (see more here). In this post I will take a look at three terrible ‘gaps’ – the NGDP gap, the output gap and the price gap – which explains why the Italian economy is so deeply sick.
It is no secret that I believe that we can understand most of what is going on in any economy by looking at the equation of exchange:
(1) M*V=P*Y
Where M is the money supply, V is money-velocity, P is the price level and Y is real GDP.
We can – inspired by David Eagle – of course re-write (1):
(1)’ N=P*Y
Where N is nominal GDP.
From N, P and Y we can construct our gaps. Each gap is the percentage difference between the actual level of the variable – for example nominal GDP – and the ‘pre-crisis trend’ (2000-2007).
The NGDP gap – massive tightening of monetary conditions post-2008
We start by having a look at nominal GDP.
We can make numerous observations based on this graph.
First of all, we can see the Italian euro membership provided considerable nominal stability from 2000 to 2008 – nominal GDP basically followed a straight line during this period and at no time from 2000 to 2008 was the NGDP gap more than +/- 2%. During the period 2000-2007 NGDP grew by an average of 3.8% y/y.
Second, there were no signs of excessive NGDP growth in the years just prior to 2008. If anything NGDP growth was fairly slow during 2005-7. Therefore, it is hard to argue that what followed in 2008 and onwards in anyway can be explained as a bubble bursting.
Third, even though Italy obviously has deep structural (supply side) problems there is no getting around that what we have seen is a very significant drop in nominal spending/aggregate demand in the Italian economy since 2008. This is a reflection of the significant tightening of Italian monetary conditions that we have seen since 2008. And this is the reason why the NGDP gap no is nearly -20%!
Given this massive deflationary shock it is in my view actually somewhat of a miracle that the political situation in Italy is not a lot worse than it is!
An ever widening price gap
The scale of the deflationary shock is also visible if we look at the development in the price level – here the GDP deflation – and the price gap.
The picture in terms of prices is very much the same as for NGDP. Prior to 2007/8 we had a considerable level of nominal stability. The actual price level (the GDP deflator) more or less grew at a steady pace close to the pre-crisis trend. GDP deflator-inflation averaged 2.5% from 2000 to 2008.
However, we also see that the massive deflationary trends in the Italian economy post-2008. Hence, the price gap has widened significantly and is now close to 7%.
It is also notable that we basically have three sub-periods in terms of the development in the price gap. First, the ‘Lehman shock’ in 2008-9 where the price gap widened from zero to 4-5%. Then a period of stabilisation in 2010 (a similar pattern is visible in the NGDP gap) – and then another shock caused by the ECB’s two catastrophic interest rate hikes in 2011. Since 2011 the price gap has just continued to widen and there are absolutely no signs that the widening of the price gap is coming to an end.
What should be noted, however, is that the price gap is considerably smaller than the NGDP gap (7% vs 20% in 2014). This is an indication of considerably downward rigidity in Italian prices. Hence, had there been full price flexibility the NGDP gap and the price gap would have been of a similar size. We can therefore conclude that the Italian Aggregate Supply (AS) curve is fairly flat (the short-run Phillips curve is not vertical).
The Great Recession has caused a massive output loss in Italy
In a world of full price flexibility the AS curve is vertical and as a result a drop in nominal GDP should be translated fully into a drop in prices, while the output should be unaffected. However, as the difference between the NGDP gap and the price indicates the Italian AS curve is far from vertical. Therefore we should expect a major negative demand shock to cause a drop in prices (relative to the pre-crisis trend), but also a a drop in output (real GDP). The graph below shows that certainly also has been the case.
The graph confirms the story from the two first graphs – from 2000 to 2007 there was considerably nominal stability and that led to real stability as well. Hence, during that period real GDP growth consistently was fairly close to potential growth. However, the development in real GDP since 2008 has been catastrophic. Hence, real GDP today is basically at the same level today as 15 years ago!
The extremely negative development in real GDP means that the output gap (based on this simple method) today is -14%! And worse – there don’t seems to be any sign of stabilisation (yesterday’s GDP numbers confirmed that).
And it should further be noted that even before the crisis Italian RGDP growth was quite weak. Hence, in the period 2000-2007 real GDP grew by an average of only 1.2% y/y – strongly indicating that Italy not only has to struggle with a massive negative demand problem, but also with serious structural problems.
Without monetary easing it could take a decade to close the output gap
The message from the graphs above is clear – the Italian economy is suffering from a massive demand short-fall due to overly tight monetary conditions (a collapse in nominal GDP).
One can obviously imagine that the Italian output gap can be closed without monetary easing from the ECB. That would, however, necessitate a sharp drop in the Italian price level (basically 14% relative to the pre-crisis trend – the difference between the NGDP gap and the price gap).
A back of an envelop calculation illustrates how long this process would take. Over the last couple of years the GDP deflator has grown by 1-1.5% y/y compared a pre-crisis trend-growth rate around 2.5%. This means that the yearly widening of the price gap at the present pace is 1-1.5%. Hence, at that pace it would take 9-14 years to increase the price gap to 20%.
However, even if this was political and socially possible we should remember that such an “internal devaluation” would lead to a continued rise in both public and private debt ratios as it would means that nominal GDP growth would remain extremely low even if real GDP growth where to pick up a bit.
Concluding, without a monetary easing from the ECB Italy is likely to remain in a debt-deflation spiral within things that follows from that – banking distress, public finances troubles and political and social distress.
PS An Italian – Mario Draghi – told us today that the ECB does not think that there is a need for monetary easing right now. Looking at the “terrible gaps” it is pretty hard for me to agree with Mr. Draghi.
Chris Mahoney
/ August 8, 2014There is another Italian shoe that has yet to drop: the scale of the insolvency of the banking system in relation to Italy’s debt capacity. Now, I think that it is very wise to cover this up by continuing to accrue interest on bad loans, which delays the need for a bailout. But if the ECB’s current AQR is for real (unlikely, I admit) then the banks are going to need billions in bailouts this year. Either they get bailed out and the debt ratio goes up, or they are not, and the financial system collapses.
Lars Christensen
/ August 8, 2014Chris, that is clearly very worrying. What should we expect from the rating agencies? They seems to be eager to UPgrade all the PIIGS at the moment…
dannyb2b
/ August 8, 2014Dont worry about MP. Money is neutral anyway in the long run.
Chris Mahoney
/ August 8, 2014MP was not neutral in the US 1930-33. NGDP collapsed, and mortgage defaults soared.
George Dorgan (@DorganG)
/ August 8, 2014Who tells you that NGDP in 2008 was not 20 points too high and should have increased only 20% since 2000. Implying that Italy had 20% excess inflation during a period of TFP increases caused by China and innovation (see your friend D. Beckworth paper)
Hence Italy is today back to the NGDP trend where it should have been since 2000. And the excess inflation and too high NGDP has finally created wrong allocations and unemployment.
Justin
/ August 9, 2014I’m amazed at the ability of the Italian/Spanish/Portuguese/Greek public to suffer. I’ve not heard anyone serious or important suggest the So. European countries dump the euro since 2012.
James in London
/ August 9, 2014Perhaps the only hope is that a new EZ crisis spooks the US economy too, like in 2011, forcing the US to read the monetary Riot Act again. The Banco Espírito Santo and Banca Monte dei Paschi situations could be a trigger, specific circumstances yes, but also merely the furthest out on the beach as the deflationary tide comes in – just like WAMU, Lehmans etc in 2008. Wake up ECB!
George Dorgan (@DorganG)
/ August 9, 2014Sorry, Italian median wealth is nearly the highest in wealth.
http://snbchf.snbchfcom.netdna-cdn.com/wp-content/uploads/2014/08/Average-and-Median-Wealth.jpg
The Participation rate is rising.
http://snbchf.com/global-macro/labor-participation-rate-global/
Between 2000 and 2007, salaries in these Southern countries have risen by 25%. Spanish unemployment is back to mid 1990s levels,
http://www.tradingeconomics.com/spain/unemployment-rate
Since then houses prices have risen by 150%. They have risen twice as much as in Germany.
http://snbchf.com/eurocrisis/reasons-for-the-spanish-housing-bubble/
Still today, homes in Southern Spain are worth three times more than in Eastern Germany.
Instead of generating consumption, (hyper) activity and the misleading concept of (N)GDP, Italians and many Spaniards simply saved their money and became richer.
http://snbchf.com/fx-theory/fx-rates-contrarian-investing-misleading-concept-gdp/
Just a pity for the guys who bought between 2005 and 2007.
Benjamin Cole
/ August 11, 2014The PIGS nations should withdraw from the ECB and form their own central bank.
George Dorgan (@DorganG)
/ August 17, 2014Devaluing a currency creates cheaper labor in global comparison. But a currency other than the euro provokes higher interest rates and borrowing costs for companies. This is a difficult trade-off.
Currently European leaders manage to do both. Peripheral bond yields have strongly fallen, borrowing costs are following already. At the same time they managed to slash labor costs in countries like Greece, Spain and Ireland.
This is best of two worlds: Lower borrowing costs and lower labor costs. Exactly what them makes more competitive.
One important precondition: Money and credit must contract, the best: Falling NGDP
Lars Christensen
/ August 17, 2014George, if you think the failed policies of the past five-six years in the euro “is the best” then must have been reading very odd economic textbooks. We need massive monetary easing in the euro zone to stop the debt-deflation spiral. If the ECB continues to pursue the policies that you call “the best” then we will not only get renewed sovereign debt crisis, bank crisis, financial distress, but we will also very likely get a sharp rise in political populism and extremism. We should have learned the lesson from the 1930s- Unfortunately the ECB seems to have learned little from history.