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Open letter to Nouriel Roubini

Nouriel Roubini was the only U.S. economist who correctly predicted the crash of the American real estate market and the collapse of the global financial system based on mortgage-backed securities.

I saw Dr Roubini's Project Syndicate article in today's Sueddeutsche Zeitung. While I can agree with most of its conclusions I believe the reality in some peripheral states of Europe differs from what Dr Roubini described.

Knowing Italy well, I can tell you that the deflationary effects expected from the current austerity drive of Finance Minister Giulio Tremonti have not materialized. Today's news is that consumer spending has contracted in 2009 and 2010 by over 2 percent p.a. which might be due to rising unemployment, higher propensity to save because of the crisis, or simply because of flat incomes and inflation.

No doubt: instead of the feared deflation there is rising inflation. Why? Part of the answer is of course increased cost of energy, driven by oil prices. But in addition there is a good deal of home made inflation, as usual likely to be underestimated by ISTAT. the Italian statistics office.

How come that inflation prevails despite a vigorous (yes, really!) austerity drive?

To understand the phenomenon it is important to remember that Italy, like other Mediterranean countries, has experienced decades of inflation at least since World War II. When the euro replaced the lira, Italian mentality did not change at all. Inflation-mindedness, to coin a proper term, continued unabated. Government debt spending and commercial credit expansion provided the additional euro supply needed to balance the domestic economy’s inflationary trend with the available money supply.

As a result, wages and prices rose to the point where Italy lost most of its competitive status within the euro zone and outside. Then came the crisis and the government austerity campaign. But good old inflation-mindedness continued. Why and how?

First of all: Italian companies, individuals and public entities are accustomed to raising prices, tariffs and fees periodically, say, once a year. With the advent of the crisis and consumer restraint the reaction was not to lower prices, cut margins etc. Instead of trying to maximize sales, many companies resorted to maximizing profit per unit sold by jacking up prices, rates, tariffs, etc.

In other countries this might induce consumers to search for lower offers, to refrain from accepting the higher prices etc. Not so in Italy, a country in which prices “age”, and new prices are always higher. Inflation does not cause much concern: it is accepted like the weather. Usually twice a year, during the summer break and around Christmas, Italian media announce for the coming autumn or new year a “stangata”, a unique Italian term for a wave of price and tariff increases. The media also report how much the expected stangata is going to cost the average family annually, usually well above one thousand euro.

Stoic consumer behavior makes it easy for producers not only to raise prices but also to limit competition. A major response to austerity and weak consumption is for Italian producers and especially distributors to join forces and regulate the market to their advantage. From leading banks to supermarket chains and mafia contractors there is hardly a sector in Italy in which competition is not limited or excluded by legal and illicit means.

This showed, for instance, when during the financial crisis Italian banks – the most expensive in Europe — were scarcely affected and drew the government’s praise for having been so “cautious.” In reality, by avoiding competition they had shaped the domestic market so conveniently that they were happily exploiting their domestic customers and did not need to undertake any investment banking abroad.

An inflation-minded population combined with highly monopolistic structures, not to speak of endemic corruption and organized crime, can render even a large economy like Italy’s dysfunctional in the sense that the logic of economics does not always apply. Recommendations for how to shape economic policy in a situation under stress may be helpful in functional economies. In a dysfunctional one the recommendations might backfire and produce perverse results. In the case of Italy, floating the economy with cheap money and incentives could accelerate the inflation to the point of no return and a final cataclysm like Greece’s.

Italy is a country that needs psychiatric help to free itself of inflation-mindedness. A brief spell of detox and rehab will not suffice.


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—— Heinrich von Loesch