Explaining Italy's economic growth: a balance-of-payments approach with internal and external imbalances and non-neutral relative prices.
AbstractThirlwall's Law (Thirlwall, 1979) considers that growth can be constrained by the balance-of-payments when the current account is in permanent deficit. The Law focuses on external imbalances as impediments to growth and does not consider the case where internal imbalances emerging from budget deficits or public debt can also constrain growth. The recent European public debt crisis of peripheral countries (including Italy) shows that when internal imbalances are out of control they can constrain growth and domestic demand in a severe way. Recently, Soukiazis et al. (2013) developed a modelhenceforth the SCA model -that takes into account both internal and external imbalances and where relative prices are not neutral in the pace of economic growth. The SCA model proved to be accurate in explaining economic growth in Portugal. The aim of the present paper is to apply the SCA model to Italy and check its precision for explaining the growth path in this country. Italy is an interesting case study of a larger economy with a lack of growth in the last decade facing serious internal imbalances caused by high deficit and public debt. Our empirical analysis shows that Italy grew at a slower rate than its potential capacity due to supply constraints. Policies designed at increasing external competitiveness and lowering the costs of financing the economy are shown to be effective strategies to achieve higher growth.JEL code: C32, E12, H6, O4 Keywords: internal and external imbalances, price and income elasticities of external trade, equilibrium growth rates, 3SLS system regressions, supply constraints.
Thirlwall's law (Thirlwall 1979) considers that growth can be constrained by the balance of payments when the current account is in permanent deficit. The law focuses on external imbalances as impediments to growth and does not consider the case where internal imbalances (budget deficits or public debt) can also constrain growth. The recent European public debt crisis shows that when internal imbalances are out of control they can constrain growth and domestic demand in a severe way. Recently, Soukiazis, Cerqueira, and Antunes (2012a) developed a model-hereafter the SCA model-that takes into account both internal and external imbalances but in which relative prices do not play any role on the pace of economic growth. The aim of this paper is to extend the SCA model by relaxing this assumption and introducing explicitly relative prices into it. The model is tested for Portugal, which recently (2011) fell into a public debt crisis with serious negative consequences for growth. It is shown that our new model makes a significant improvement in explaining actual growth in Portugal. Our empirical analysis reveals that Portuguese growth is balance-of-payments constrained and that policies aimed at reducing external imbalances and changing the share of imports and exports toward trade equilibrium will help the economy to grow faster. Competitive devaluations and lower costs of financing the economy also produce an important stimulus to growth.Keywords: internal and external imbalances, price and income elasticities of external trade, equilibrium growth rates, 3SLS system regressions.
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