Explaining Italy's economic growth: A balance-of-payments approach with internal and external imbalances and non-neutral relative prices

Abstract

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 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 model – henceforth 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.