Three terrible Italian 'gaps'
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.