Economic Bulletin No. 44 - 2007

Last year the performance of the world economy exceeded expectations, with a slight acceleration in output growth from 4.8 per cent in 2005 to over 5 per cent. In the United States, although the weakness in the property market affected residential investment, the expansion in household consumption showed no signs of easing and was further fostered in the second half of the year by the boost to disposable income from the decline in oil prices. The emerging economies continued to grow at a fast pace, partly thanks to the still favourable financial market conditions.
The international organizations estimate that world output growth will slow by around half a percentage point in 2007, mainly as a result of slower growth in the United States and, to a lesser extent, in the emerging countries as well. However, this should not alter the underlying expansionary trend, which is expected to gather strength as early as the second half of the year. The financial markets also appear to lean in this direction; the recent turbulence probably indicates a return of risk rating to normal levels by past standards rather than anxiety about growth. Inflationary tensions are being countered by the action of the monetary authorities.
These favourable scenarios are nonetheless threatened by the possibility of a larger than expected slowdown in residential and nonresidential investment in the United States and the persistence of an enormous US external deficit; by the danger of sudden increases in financial market volatility; and by potential rises in oil prices.
In the euro area, after a sharp and somewhat unexpected acceleration towards the end of last year, output growth in the leading countries should ease slightly to close to the potential rate of just over 2 per cent. The decline in oil prices and the appreciation of the euro helped to reduce consumer price inflation, which has been less than 2 per cent since the summer of 2006; in March expectations for the current year also dropped below that threshold. Core inflation was 1.8 per cent in the first two months of 2007. Wages continued to rise at a moderate pace despite the speed of the economic recovery. The improvement in the economic situation, the rapid growth in money and credit, and the constant risk of an upsurge in inflation have led the European Central Bank to further reduce the expansionary stimulus of monetary policy. As a result of the cyclical upturn the reduction in the public deficit of the euro area overstepped the target. OECD estimates for December set the deficit in 2006 at 2.1 per cent of GDP, against 2.4 per cent in 2005, while recent outturns for some countries indicate a larger improvement for the area as a whole. International organizations expect that further downward adjustments will become necessary in the course of this year.
In 2006 the rate of economic growth in Italy (1.9 per cent ) was the highest of the last five years, exceeding all the estimates of public and private forecasters. Output, which was driven by export demand in the last quarter of the year, jumped by over 4 per cent on an annual basis. As in the other euro-area countries, estimates indicate a slowdown in economic activity in the early months of this year, to annual growth of between 1 and 1.5 per cent. The index of firms’ confidence remained high throughout the second half of 2006, but has shown signs of slipping in the early months of this year. Recent government estimates indicate growth of around 2 per cent this year, which, as in 2006, is higher than the estimated potential rate of increase in output. The situation regarding inflation continues to be favourable.
As in the past, the stimulus provided by the most dynamic foreign markets, now not only European, made the largest contribution to overcoming the period of stagnation. the earning capacity and cash flow of non-financial corporations show a clear improvement, while short-term bank debt is accelerating sharply in response to an unprecedentedly low cost of borrowing even though official interest rates have been raised. In contrast with the past, greater labour market flexibility now allows firms to bring labour demand more promptly into line with the demand for their products, against a background of continued wage moderation.
The rapid surge in output growth could be attributed – although how far remains to be verified by future evidence – to an initial structural improvement in the ability of Italian industrial firms to cope successfully with competition at home and abroad. Indications of this can be gleaned not only from the favourable economic situation but also from the contemporaneous rise in employment and labour productivity in industry excluding construction.
The expansion in household consumption was generally moderate and slowed to less than 1 per cent on an annual basis in the last quarter of 2006. Available information does not point to any significant reversal of the trend in the early months of this year. Household confidence is improving slowly, although the continuing fluctuations reflect a still cautious attitude to spending decisions. According to preliminary estimates, in 2006 disposable income increased by around 1.5 per cent in real terms; whereas employment and unit wages made a positive contribution, the public sector effected a net withdrawal, which, partly owing to built-in stabilizers, was as large in proportion to GDP as in 2000. Household wealth, both real and financial, continued to expand, the latter particularly in low-risk investments, such as deposits and securities other than shares.
General government net borrowing rose to 4.4 per cent of GDP in 2006, compared with 4.1 per cent in 2005. Excluding two extraordinary factors that pushed up spending, it amounted to 2.4 per cent, against a forecast of 3.6 per cent at the end of September. Adjusted for cyclical effects, temporary measures and the extraordinary factors, general government borrowing fell from more than 4 per cent of GDP in 2005 to just under 3 per cent last year. The primary surplus, which was almost nil two years ago, rose to over 1.5 per cent. The improvement in the public finances was the result of a substantial increase in revenue. The incidence of taxation rose by 1.7 percentage points to 42.3 per cent, mainly due to the acceleration in output, some one-off receipts, and the measures to enlarge and recover the tax base incorporated in the package introduced at the end of 2005 and in the one launched last summer.
The net borrowing requirement amounted to 3.7 per cent of GDP, against 5.3 per cent in 2005. The gap with respect to net borrowing, excluding the two extraordinary factors, widened slightly. The debt to GDP ratio increased for the second year running, to 106.8 per cent.
Government estimates published in March set net borrowing in 2007 at 2.3 per cent of GDP, half a percentage point lower than last autumn’s target. The incidence of taxation is expected to rise to 42.8 per cent.
Thanks to the performance of the public finances it is possible to speed up the deficit-reduction process. Structural balance has to be achieved rapidly in order to make significant inroads into the public debt so that the costs deriving from the ageing of the population can be tackled in good time. While this medium-term objective is being pursued, the resources must be found to reduce the incidence of taxation, which is higher than the euro-area average and close to its historical peak, and to increase public-sector investment, which has been declining for two years but is crucial for the resumption of rapid and lasting growth in productivity and income. If these three objectives are to be achieved, primary current expenditure must be reduced without delay; it has reached 40 per cent of GDP in the last two years, exceeding even the exceptionally high levels of the early 1990s.