Italy: The Real Effects of Inflation and Disinflation

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Abstract
Italy Francesco Giavazzi and Luigi Spaventa The Italian economy has often puzzled foreign observers over the past 15 years. In the early 1970s supply shocks caused huge domestic and external imbalances which made Italy a lost cause in the view of many. But the recovery of output was stronger and the turn-around in profitability happened earlier than in other ‘healthier’ countries. In this article we attempt to interpret these developments. One important result is that, in spite of wage indexation, inflation was an effective policy instrument and disinflation was relatively painless. Without supply-side measures, however, inflation would have been neutral, at best: thanks to a non-indexed tax system, inflation provided the revenue to finance the subsidies that permitted at the same time a recovery of profits and the demand stimulus coming from a real depreciation. The costs of subsequent disinflation were low precisely because inflation and currency depreciation had boosted firms' profitability. The paper develops a close comparison with the UK experience that took off from conditions very similar to those in Italy. We argue that the success of the Italian stabilization, and its apparently superior outcome when compared with the UK, crucially depended on the timing and the sequence of the policies pursued: by raising profit margins first, and forcing adjustment subsequently, Italy never underwent the wave of plant closures observed in the UK. The role of the initial level of profits in determining the output cost of a disinflation provides a good example of hysteresis – namely the possibility that temporary fluctuations may have long-lasting effects on the economy. But there is another side to the picture: high fiscal deficits have been a permanent feature of the period and the Italian public debt has steadily mounted to record levels. We show, however, that the origins of the debt problem are quite unrelated to the policies discussed in this paper: debt has a history of its own.

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