Italy's inflation problem

And why it has Draghi sounding the alarm about the economic effects of the war

Yesterday President Biden met Prime Minister Draghi. As Jane Foley from Rabobank observes, despite a show of unity over the issue of Ukraine, the two men had vastly different views on how it should be handled — not least because of its economic effects.

Yesterday’s visit by Italian PM Draghi to the White House was aimed at making clear Italy’s allegiance with the West.  On the day of the Russian invasion of Ukraine, Draghi had opposed excluding Russian banks from the SWIFT payments system.  This move triggered a hostile response from former European Council chief Tusk.  Some of Italy’s coalition government parties have also voiced scepticism about the impact of the war on Italy’s economy.  Draghi used his meeting with President Biden to underpin the urgent need for the allies to work on peace negotiations for Ukraine, warning that the war could bring "drastic" changes for Europe.

Why are the Italians so worried about the economy? Some may point to energy and historical trade ties to Russia. These are important. But there are underlying structural dynamics that make the issue even more pressing for the Italians.

To understand this we must look briefly at the bigger picture in Italy. The following chart shows Italy’s industrial production. It also shows the trend of industrial production up until 2000 when Italy adopted the euro.

Clearly after the euro was adopted Italy lost a lot of ground on its competitiveness. Why? Simply because Italy has long had an inflation problem. Italian unions are apt to demand higher wages and employers typically acquiese eventually.

Italy used to solve this inflation/competitiveness problem through devaluation of the lira, as can be seen in the chart below.

Once the euro was adopted, the exchange rate was fixed and the Italians could no longer devalue their currency vis-a-vis their European trade partners. This is why industrial production fell dramatically.

This raises the obvious question: what would happen if Italy experienced drastic inflation today? If it ended up being higher than its European trade partners, Italy could be in real trouble. It could see it’s competitiveness in the bloc decline even more.

Since the crisis period of 2008-11 Italy has managed to secure a trade surplus, as can be seen below.

This is a result of slow growth in the Eurozone relative to the rest of the world. This surplus refelcts net exports to the rest of the world, not to Europe. Italy remains pretty uncompetitive in Europe today.

Above average inflation would then destroy Italy’s current economic policy. The very one that Draghi himself pushed for.

So, how is it looking for Italy? As we see below, Italy’s inflation rate is currently lower than the Euro Area as a whole.

But what we really want is a trade-weighted measure. In the chart below we take the Q1 2022 CPI number for all of Italy’s major European trade partners. We then weight these trade partners relative to their trade with Italy and construct a comparative CPI measure.

On this basis, Italy still looks to be doing pretty well. But we can see why Draghi is nervous. If he takes a hardline on sanctions, he risks seeing Italy’s CPI outpace its European trade partners. If that happened his entire economic legacy would collapse.