(20495331 - Review of Keynesian Economics) Causes of The Decline of Economic Growth in Italy With Special Reference To The Post-Euro Period - A Balance-Of-Payments Approach - PDF

Review of Keynesian Economics, Vol. 3 No. 4, Winter 2015, pp.
491–516
Causes of the decline of economic growth in

Italy with special reference to the post-euro
period: a balance-of-payments approach*
Elias Soukiazis, Pedro André Cerqueira,** and Micaela Antunes

Faculty of Economics, University of Coimbra and GEMF, Portugal
The aim of this paper is to investigate the causes of the poor growth performance in Italy
and the responsibility of the euro for this crisis. The theoretical approach applied is based
on the balance-of-payments constraint hypothesis (known as Thirlwall’s law), adapted to
include internal and external imbalances. Our empirical analysis shows that both the
extended model and the original Thirlwall’s law over-predict the actual growth in Italy,
suggesting that there are supply constraints that impede the economy from growing faster.
Another conclusion is that part of the decline in economic growth is explained by the loss of
competiveness during the euro period. A scenario analysis shows that a budget deficit and
public debt discipline aiming at achieving the goals of the Stability Pact are not significant
stimuli for faster growth. On the other hand, reducing the import dependence of the com-
ponents of demand, or reducing the import and increasing the export shares in the econ-
omy, are the most effective policies for fostering growth in Italy.
Keywords: internal and external imbalances, import elasticities of the components of

demand, equilibrium growth rates, 3SLS system regressions
JEL codes: C32, E12, H6, O4
1 INTRODUCTION
Thirlwall (1979) developed a simple model that determines the long-run rate of growth
of an economy consistent with the balance-of-payments equilibrium. According to this
rule, actual growth can be predicted by the ratio of export growth to the income elas-
ticity of demand for imports and this simple relation became known as Thirlwall’s law.
The law advocates that no country can grow faster than its balance-of-payments equi-
librium growth rate, unless it can continuously sustain external deficits by capital
inflows. Growth is constrained by external demand, and balance-of-payments disequi-
librium on the current account can be a serious obstacle to faster growth when it cannot
be financed by available foreign resources. A crucial implication of the model is that it
is income and not relative prices that adjust to bring the economy back to equilibrium.
* We are very grateful to three anonymous referees whose constructive comments helped
improve the paper substantially.
** This paper was written while Pedro Cerqueira was a visiting scholar at the Economics
Department of The University of Massachusetts, Amherst, receiving financial support from
the FCT grant #SFRH/BSAB/1340/2013.
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492 Review of Keynesian Economics, Vol. 3 No. 4
Thirlwall and Hussain (1982) revised the initial model, relaxing the assumption that
the balance-of-payments is initially in equilibrium. As countries can run current-
account deficits, capital inflows can be included in the model to determine the
long-term growth rate. This model has been shown to be more suitable especially
for developing countries where external imbalances can be sustained by capital inflows
that alleviate the pressure on external payments. A large number of empirical studies
emerged testing the validity of Thirlwall’s law or criticizing the basic assumptions that
it relies on. Among others, McCombie and Thirlwall (1994), Moreno-Brid (1998–1999),
and recently Blecker (2009) have made valuable contributions, discussing and criticizing
the underlying implications of the law.
The hypothesis of constant relative prices has been criticized widely in empirical
literature (see, for example, McGregor and Swales 1985; 1991; Alonso and Garcimartín
1998–1999; López and Cruz 2000). But in most studies in this field, relative prices have
been shown to be statistically insignificant and even when they show significance the
price elasticities with respect to imports and exports are very low in magnitude when
compared to the income elasticities, revealing that imports and exports are less sensitive
to price changes than to income changes. Alonso and Garcimartín (1998–1999) argue
that the assumption that prices do not matter in determining the equilibrium income is
neither a necessary nor a sufficient condition to affirm that growth is constrained by
the balance of payments. The empirical evidence seems to support that income is the
variable that adjusts to bring into equilibrium the external imbalances, implying therefore
that growth is indeed balance-of-payments-constrained (Garcimartín et al. 2010–2011).1
In addition to this discussion, Blecker (2009) stressed that it is reasonable to conclude
that the longer the time period considered, the more likely it is that relative prices remain
constant. On the other hand, increasing capital inflows can at most be a temporary way
of relaxing the balance-of-payments constraint, but they do not allow a country to grow
at the export-led cumulative growth rate in the long term. What matters in the long-term
analysis of growth is the growth of exports.
On the sustainable debt debate, Barbosa-Filho (2002) argued that as the home
country does not issue foreign currency, it can only have persistent trade deficits
by receiving a continuous inflow of foreign capital. The counterpart of unbalanced
trade is a change in the stock of foreign debt and, therefore, it has to be checked
under which conditions the unbalanced trade constraint is consistent with a non-
explosive accumulation of foreign debt.
Although Thirlwall’s model has been modified to include capital flows and foreign
debt, these studies have not considered the role of public imbalances as an additional
constraint on growth. The external imbalance considered so far in the literature
includes public disequilibrium, but the impact of the latter on overall growth has
not been analysed separately. The recent experience of some peripheral European
countries falling into public debt crisis is the motivation to deal with this issue. As
Pelagidis and Desli (2004) argue, the implementation of an expansionary fiscal policy,
aiming at strengthening growth rates and reducing unemployment, would not always
achieve the desirable objectives. It could be the case that budget deficits, financed
either by money printing or by public borrowing, will increase public debt and interest
rates, crowd out private investments, fuel inflation, and damage medium-term growth.
The answer to whether budget deficits are always desirable has many dimensions,
1. Setterfield (2012) stresses that ‘price effects’ can, at the most, influence only short-run
growth.
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Causes of the decline of economic growth in Italy: a balance-of-payments approach 493
including whether government borrowing is financing government consumption or

investment in infrastructure, whether the deficit is sustainable, and how it is financed.
On the other hand, the hesitation of many policy-makers – especially in Europe – to
rely more aggressively on fiscal policy measures in order to keep their public finances
more or less balanced may lead to the possibility of a vicious cycle between slow
growth and higher deficit rates as a result of the reduction of tax revenues.
Our paper aims at contributing to this debate by performing an alternative growth
model, in line with Thirlwall’s law, that takes into account not only external, but also
internal imbalances due to budget deficits and public debt. The reduced form of the
growth of domestic income is determined, among others, by factors related to compe-
titiveness and mismanagement of fiscal policy and public finances that could affect
economic growth negatively. At this point we should stress that our approach is some-
what related with the gap models (see Bacha 1990; Taylor 1994). Like these authors,
in addition to the external restriction we also consider that there is a fiscal restriction
that might be financed either by internal or external savings. However our approach
has some important departures from the gap models: first, the government issues
bonds to finance its deficits, and not as in Bacha’s model by seignoriage. Second,
there is no managing of the monetary aggregate by the government (as in the European
countries the monetary authority is independent from central government). Regarding
imports, we will measure the sensibility of imports to the several components of
aggregate demand and not only to investment. As for exports, these are dependent
on the growth of foreign income. In this way we can measure the potential growth
rate of a given country in comparison with the growth rates of its trade partners. In
sum, our model can be best described as an (imperfect) marriage between the gap
and the balance-of-payments-constrained growth models.
The theoretical model is tested for the Italian economy that recently faced serious
problems in financing its public debt in international financial markets. The implemen-
ted restrictive measures, monitored by the IMF, are expected to have negative
repercussions on growth in the upcoming years. Another issue to address is whether
the adoption of the euro is responsible for the decline in economic performance in
Italy. Taking all these considerations into account, the paper is organized as follows:
in Section 2 we present the theoretical growth model; Section 3 tests the model for the
Italian economy, for the whole period and the pre- and post-euro sub-periods, trying to
understand the causes of economic growth. Section 4 concludes.
2 THE GROWTH MODEL WITH INTERNAL AND EXTERNAL

IMBALANCES
We use a multi-equation model developed by Soukiazis–Cerqueira–Antunes (2012) –

hereafter the SCA model – to derive the reduced form of income growth which
depends, among other things, on internal and external imbalances. The model follows
the developments of Thirlwall’s law with two particular differences: (i) it considers not
only external imbalances (current-account deficits) but also internal imbalances emer-
ging from public deficit and debt; and (ii) it considers further the import contents of the
components of aggregate demand, measuring their impact on growth.
The SCA model is constituted by the main equations shown below, where a lower-case
letter with a dot denotes the instantaneous growth rate of a given variable.2
2. The detailed derivation is in Appendix A1.

2.1 Import equation

Contrary to the conventional specification that considers real domestic income as the main
aggregate determinant of the demand for imports, we use the components of domestic
income to explain import flows. This is in line with Palley’s (2009–2010) alternative
income–expenditure model, defining imports as the sum of imports of consumption
goods, imports of investment goods, imports by government, and imports embodied
in exports. In this way, it is possible to account properly the impact of imports on
growth, taking into account the import content of each component of demand.
We assume that relative prices do not play a significant role and that in the long run
they remain constant (the steady-state condition).3 The import function is given by:
_
m_ ¼ πc c_ þ πg g_ þ πx x_ þ πk inv; (1)
where the growth in demand for imports (m) _ depends on the growth rates of private con-
sumption (_c), government expenditures (g), _ exports (_x), and investment (inv),
_ respec-
tively. In this equation, π stands for the elasticity of each of the components of
demand in relation to imports. All elasticities are expected to be positive, as all compo-
nents of demand have import content.
2.2 Government expenditure

The long-term relationship of the growth of real government expenditures is given by:

tax wD _ tax iwB _
g_ ¼ y_ þ d − p_ 1 − − b; (2)
wG wG wG wG
where wD ¼ D=P _
Y is the public deficit ratio, d is the growth rate of public deficit, wG ¼ Y
G
B=P
denotes the public expenditure share, and wB ¼ Y the public debt to GDP ratio.
Equation (2) is derived4 from the government budget relation given by the follow-
ing identity:
Gn þ iB ¼ tax ðYPÞ þ D;
where Gn is nominal government expenditures, B is public debt,5 Y is domestic
income, P is the domestic price level, D is the public deficit, i is nominal interest
rate paid on public debt, and tax is the tax rate on nominal income. According to
this relation, public deficit exists when total current expenditures (including interest
payments on public debt) exceed the receipts obtained through taxes on domestic
money income, Gn + iB > tax*(YP).
3. The hypothesis that relative prices remain constant in the long term is a debatable assump-
tion made in some studies for the sake of simplifying the specification of the model. As we
explained before, there are studies showing that relative prices are important in international
trade and explain a substantial part of growth especially in developing countries. As an example,
Garcimartín et al. (2010–2011) attribute the slow-down of economic growth in Portugal to the
overvaluation of the domestic currency (loss of price competitiveness) when this country joined
the eurozone.
4. See Appendix A1.
5. Public debt is originated by the issue of government bonds to finance public deficit.

We have to note that the public debt (B) is a combination of both domestic (BH) and
foreign (BF) debt; that is, government bonds are held by residents and non-residents,
respectively. Likewise, the public deficit (D) can be financed internally (DH) or from
abroad (DF). Bearing this in mind, the following relations are established:
BH BF BH BF
B ¼ BH þ BF ; þ ¼ 1; ξB ¼ ; 1 − ξB ¼
B B B B
; (3)
DH DF DH DF
D ¼ DH þ DF ; þ ¼ 1; ξD ¼ ; 1 − ξD ¼
D D D D
where ξB (the percentage of public debt financed internally) and ξD (the percentage of
public deficit financed internally) are assumed to be constant in the long run,6 for sim-
plicity. The extreme case ξB ¼ 1 shows that public debt is uniquely financed by
national bond holders. Analogously, ξD ¼ 1 implies that the budget deficit is entirely
financed by domestic resources. Note that the share of debt held by foreigners is not
independent of the share of the deficit financed by foreigners. So if the share of deficit
financed by foreigners at any given time is higher/lower than the share of debt held by
them, there will be an increase/decrease over time until both are equalized. So, in the
steady state, ξB ¼ ξD .
2.3 Private final consumption and investment

From the SCA model (see Appendix A1), the growth of consumption (_c) is a function
of the growth of domestic income (_y), with εc the income elasticity with respect to
consumption:
c_ ¼ εc y_ : (4)
_ is a function of the growth of domestic

Analogously, the growth of investment ðinvÞ
income (_y) with εk the income elasticity in relation to change in capital stock:
_ ¼ εk y_ :
inv (5)
2.4 Export demand function

In this equation it is assumed that foreign income Y* is the main determinant of export
demand. It is explicitly assumed that export competitiveness is based on non-price com-
petitiveness captured by the income elasticity of the demand for exports. Therefore, we
6. Our model makes some other strong assumptions (constant relative prices, constant
demand elasticities in the import/exports functions, constant real interest rates) for the sake of
simplification and in order to determine the long-run steady-state growth rate using average
annual growth rates for the variables involved in the model. Despite this simplification our
model is flexible, as we show in our scenarios analysis, and we are free to assume any change
in the main variables and the parameters of the model and check their impact in the long-run
growth. Therefore, our model is not limited by assuming the constancy of some variables; it
is a necessary initial assumption to achieve the long-term steady-state growth rate allowing after-
wards for the building of some interesting scenarios.

assume that relative prices remain constant in the long-term analysis (the steady-state
assumption). Having this in mind, the growth of exports is defined as:
x_ ¼ εx y_ ; (6)
where x_ is the growth of real exports, y_ is the growth of real foreign income, and εx is the
income elasticity of demand for exports capturing the non-price characteristics of the
exported goods associated with quality, design, reliability, varieties, etc.7
2.5 Balance-of-payments condition

The last relation of the model is an external equilibrium condition given by the following
identity:
XP − iBF þ DF ¼ MP e: (7)
The left-hand side of the identity shows the money resources available to finance
imports (export revenues minus interest-rate payments on foreign bond holders plus
the amount of public deficit assets held by foreigners). P* is the foreign price level
and e is the nominal exchange rate. As is shown in Appendix A1, the external equili-
brium relation can be expressed as:

WD WB WM
x_ þ p_ þ ð1 − ξB Þð_y þ pÞ
_ −i ¼ ðm_ þ pÞ
_ ; (8)
WX WX WX
where wM and wX are the shares of imports and exports on income, respectively, and
the other variables are as defined previously. Substituting the growth of exports and
imports by the relations found in (1) and (6) we derive:

εX y_ þ p_ þ ð1 − ξB Þð_y þ pÞ
_ W D
WX − i WB
_ þ πg g_ þ πx x_ þ πk ιnv
W X ¼ ðπC c _ þ pÞ
_ WWX :
M
(9)
Further substitution of the growth of government expenditure (2), consumption (4),

investment (5), and exports (6) yields:

WD WB tax wD _ tax
εX y_ þ p_ þ ð1 −ξB Þð_y þ pÞ
_ −i ¼¼ πC εc y_ þ πg y_ þ d − p_ 1 − −
WX WX wG wG wG

iwB _ WM
b þ πx εX y_ þ πk εk y_ þ p_ : (10)
wG WX
The next step is to define domestic income growth and find its determinants.
7. Although we assume that the income elasticity of demand for exports captures the quality
characteristics of the produced goods we do not neglect the fact that changes in relative prices
can be related to changes in relative quality as well.

2.6 Domestic income growth

Rearranging the terms in equation (10), we derive the reduced form of the growth of
domestic income as it is shown in the SCA model (see Appendix A1):
!

εX W M −πx εX y_ þ p_ W M −1 þ ð1−ξB Þ W M −i W M −πg wG − wG − 1− wG
WX WX WD WB wD iwB tax
y_ ¼ ! :

πC εc þ πg wG þ
tax
wG − wG
wD iwB
þ πk εk −ð1−ξB Þ WD
WM −i W
WB
M
(11)
Equation (11) shows that, among other factors, the growth of domestic income is
determined by internal and external imbalances.8 Furthermore, if we assume internal
and external equilibrium (B = 0, D = 0, and X = M), equation (11) reduces to:9
ðεx − πx εx Þ_y
y_ ¼ : (12)
πc ε c þ πk ε k þ πg
Equation (12) is similar to Thirlwall’s original law, given by:
εx y_
y_ ¼ : (13)
π
The only difference is that equation (12) takes into account the import content of
exports in the numerator and the import content of other components of domestic
demand in the denominator. It would be interesting to test empirically these alternative
versions and check the difference in the prediction of domestic growth both in the pres-
ence and in the absence of internal and external imbalances.
Furthermore, from the government identity we have:

tax wD − iwB
1− ¼ ; (14)
wG wG
which allows us to write equation (11) in two alternative forms, first in terms of debt
and deficit:
!
εX W
WX
M
− πx εX y_ þ p_ WWX
M
− 1 þ ð1 − ξB Þ WWD
M
−iW
WB
M
y_ ¼ ! ; (15)

πC εc þ πg þ πk εk − ð1 − ξB Þ WD
WM −iW
WB
M
and second in terms of government spending and taxes:

!

εX W M − πx εX y_ þ p_ W M − 1 þ ð1 − ξB Þ wM − wM
WX WX wG tax
y_ ¼ : (16)
πC εc þ πg þ πk εk − ð1 − ξB Þ wG
wM − wtaxM
8. A more thorough explanation of the different mechanisms will be given after equations
(15) and (16), after taking into account the government identity restriction.
9. We are assuming that prices, real interest rates, the deficit and debt ratios are constant in
the long run. Also, tax/wG = 1.

Equations (15) and (16) show that the growth of domestic income is determined by
a ratio in which the numerator has the effect of external demand weighted by the
income elasticity of exports plus a second term that accounts for the price effect of
the external and internal imbalances, and in the denominator an aggregate of the
import elasticity of the several components of demand plus a term correcting for
internal imbalances externally financed.
Looking
at each term more carefully, the first term of the numerator in either equ-
ation is εX W WX
M
− π ε
x X y _ , saying that the effect of external demand depends on the
income elasticity of exports weighted by the X/M ratio and the import elasticity corre-
sponding to the import content of exports. So the growth rate will be higher, the greater
is the income elasticity of exports (as in the original Thirlwall’s law), but decreases if
the import content of the exported goods increases, captured by a high import elasticity
associated with the exported goods. Furthermore, the impact of the income elasticity of
WX
exports also increases with a positive trade balance, W M
. The rationale behind this is
that, the higher the trade balance the less stringent is the BoP constraint, thus allowing
for higher growth (as the country can finance its imports without having to incur
external
debt). The second term
in the numerator of equation (15) or (16),
p_ W M þ ð1 − ξB Þ W M − i W M −1 , corresponds to a price effect due to increased exter-
WX WD WB
nal
and internal imbalances. There are two sources here to consider: the trade balance
W M −1 and the primary deficit financed abroad, expressed in equation (15) by
WX

ð1 − ξB Þ WWD
M
− i WB
WM and in equation (16) by ð1 − ξ B Þ WG
WM − tax
W M . Note that the two
imbalances have contradictory effects through prices: a trade deficit will widen in
nominal terms as inflation increases, putting pressure over the external financial con-
straint and leading to a reduction in growth. However, for the government, higher
inflation will decrease the real future value of the new debt (due to the increase in
GDP) and therefore will reduce the external constraint to maintain the public deficit
and debt-to-GDP ratios constant.
In the denominator, the first three terms πC εc þ πg þ πk εk aggregate the elasticities to
import with respect to private consumption, government expenditure, and investment.
This is in fact a disaggregation of the income elasticity of imports in the original
Thrilwall’s law (πm) over the different components of demand. The final term in the
denominator
reflects the volume effect of the external financed government imbalances
ð1 − ξB Þ WWD
M
− i WB
WM in equation (15) and ð1 − ξ Þ
B WM
WG
− tax
W M in equation (16). As long
as the government is able to finance its deficit, it can incur expenses to promote internal
demand and therefore promote growth under the assumption that interest rates are not
affected. If interest rates increase, then through the second term in the denominator,
growth will decline depending on the size of the external debt-to-GDP ratio.
In the following sections we will test all these reduced forms of income growth
using data from the Italian economy.
3 TESTING THE MODEL FOR THE ITALIAN ECONOMY
3.1 Econometric methodology

The import equation (1), consumption equation (4), investment equation (5), and
export equation (6) are all estimated simultaneously to obtain the elasticities that are

needed to compute the reduced form of domestic income growth as it is expressed in

equation (11). The definition of the variables and the data sources are explained in
Appendix A2 at the end of the paper. The method used for estimating the system equ-
ations is 3SLS (Three-Stage Least Squares), as it is more efficient to capture the inter-
relation between equations and the causal and feedback effects between the
variables.10 Table A1 in Appendix A3 provides the regression results where simultan-
eity is controlled by using instrumental variables. The growth of imports, consump-
tion, investment and exports are assumed to be endogenous as well as the domestic
income. Note that the econometric estimates involve only four equations, since the
fifth equation of the model (the government spending equation) is an identity. To
reflect this, we considered that the deficit was the adjusting (and hence, endogenous)
variable, and therefore it was kept out of the instruments set. All other variables of
the system are assumed exogenous including some lagged variables, as it is explained
in Table A1.
We also regressed each of the equations individually, by 2SLS (Two-Stage Least
Squares), with the same instruments as before. The intention was to carry out some
diagnostic tests to justify the robustness of our results. The first is the Sargan statistic,
a test of over-identifying restrictions to check the validity of the instruments used in
the regressions and that the hypothesis is confirmed in all cases. The second is the
Pagan–Hall heteroskedasticity test, showing that the hypothesis of homoskedasticity
is never rejected. The third test is the Cumby–Huizinga test for autocorrelation. The
null hypothesis, which is not rejected at 5 percent significant level in all cases, is
that errors are not first-order autocorrelated. The last one is a normality test, concep-
tually similar to the Jarque–Bera skewness and kurtosis test. The null hypothesis is that
residuals from a given regression are normally distributed, and this hypothesis is not
rejected in all equations (except for investment). The results are displayed on Table A2
in Appendix A3.
3.2 Empirical results and discussion

Table 1 reports the values which are necessary for computing the growth of domestic
income in Italy. Some are estimated values taken from Table A1 in Appendix A3;
others are annual averages over the periods considered (see Appendix A2 for variable
definition and data sources).
Three different growth rates are computed and presented at the bottom of the table:
y_ a is obtained from equation (11), where internal and external imbalances are consid-
ered; y_ b is obtained from equation (12), where internal and external equilibrium is

assumed; and y_ c is obtained from Thirlwall’s law, given by y_ ¼ εxπy_ (see equation
(13)). In the latter case, it was necessary to estimate the import demand function,
m_ ¼ a þ πm y_ , by ordinary least squares (OLS), to obtain the aggregate income elasti-
city with respect to import growth.11 Additionally, we provide values of the actual
growth in the whole period (1984–2010), the pre-euro period (1984–1998) and the
post-euro period (1999–2010). We assume that the estimated parameters of the
model for the whole period are the same in the two sub-periods. The reason is that
10. For more details on the 3SLS method, see, for instance, AlDakhil (1998) and Wooldridge
(2002).
11. The import equation was also estimated with relative prices as an additional explanatory
variable, but its coefficient was not statistically significant and there was no significant change
of the income elasticity.

500
Computation of the growth rates of domestic income in Italy
© 2015 The Author

Table 1
εx πx εc πc εk πk πg r tax
1984–2010 2.554 0.508 0.817 0.823 2.161 0.415 0.093 0.039 0.427
1984–1998 2.554 0.508 0.817 0.823 2.161 0.415 0.093 0.054 0.418
1999–2010 2.554 0.508 0.817 0.823 2.161 0.415 0.093 0.022 0.448
wD wG wB ξD ξB wM wX p_ y_ wX =wM
1984–2010 0.066 0.425 1.046 0.58 0.58 0.226 0.236 0.043 0.026 1.042
1984–1998 0.095 0.419 1.015 0.58 0.58 0.198 0.213 0.059 0.032 1.077
1999–2010 0.031 0.432 1.084 0.58 0.58 0.262 0.264 0.023 0.021 1.008
1984–2010 y_ a ¼ 2:116% y_ b ¼ 1:966% y_ c ¼ 2:360% y_ ¼ 1:504%

1984–1998 y_ a ¼ 2:793% y_ b ¼ 2:327% y_ c ¼ 2:390% y_ ¼ 2:173%
Review of Keynesian Economics, Vol. 3 No. 4
1999–2010 y_ a ¼ 1:486% y_ b ¼ 1:516% y_ c ¼ 1:906% y_ ¼ 0:667%

Internal and Internal and Thirlwall’s lawa Actual growth
external external Equation (13)
imbalances equilibrium
Equation (11) Equation (12)
Notes: εx , πx , εc , πc , εk , πk and πg are taken from Table A1 (Appendix A3).
r, tax, wD , wG , wB , wM , wX , ξD , ξB , p_ and y_ are annual averages over the periods 1984–2010, 1984–1998 and 1999–2010, respectively.
a. The import equation (m_ ¼ a þ πm y_ ) was estimated by OLS to derive the aggregate income elasticity of demand for imports πm which is 2.846 for the whole period 1984–
2010, 3.325 for the pre-euro period 1984–1998, and 2.715 for the post-euro period 1999–2010.
Journal compilation © 2015 Edward Elgar Publishing Ltd

the time span is too short to allow us to implement separate regressions of the system
for two shorter sub-periods.12 The variables of the model assume their average values in
the respective periods. The aim is to investigate whether there are differences in growth
rates between the two sub-periods, thus identifying different sources of economic
growth.
Analysing the results of the computation of the growth rates for Italy shown in
Table 1, we can make the following remarks:
1. The growth rates obtained from Thirlwall’s law ð_yc Þ, given by y_ ¼ εxπy_ , over-
estimate the actual growth achieved in Italy in all periods, y_ c > y_ , and this should
be consistent with the existence of trade surpluses or at least with a balanced
trade. If we check the figures of the share of exports ðwX Þ and imports ðwM Þ,
they are similar, showing that Italy is close to a balanced economy with respect
to external trade.13 In particular, the ratio of the share ðwX =wM Þ is greater than
one in all periods (see Table 1), although it has decreased moderately in the post-
euro period. Two main conclusions can be derived from these results. The first is
that Thirlwall’s law - through equation (13) – over-predicts actual growth in
Italy, showing that the country has the potentiality to grow faster than it actually
did. The second is that Italy slightly loses competitiveness in the post-euro per-
iod and this can be part of the explanation for the anemic economic growth
observed in the last decade.
2. The growth rates computed by the SCA model – equation (12) – when internal
and external equilibrium is assumed (_yb ), also overestimate the actual growth in
Italy in all periods and lead to the same conclusions as equation (13). On the
other hand, the predicted growth rates from the SCA model are closer to the
actual rates in Italy than those obtained from Thirlwall’s law. Our estimates indi-
cate that Italy has grown more slowly than the rate allowed by the balance-of-
payments equilibrium ð_y < y_ b < y_ c Þ, and this can be taken as evidence that this
country faces supply constraints, restraining the economy from growing faster.14
The reason may be found in the gap of productive efficiency between Southern
Italy and the rest of the country (in terms of innovation, human capital, economic
infrastructures, weakness of institutional framework and the shortcomings of the
banking system). In the presence of these limitations, higher export growth may
not necessarily translate into faster output growth, if at least one of the resources
(not only labor or capital) is not supplied by the market in sufficient amounts.
Therefore, the reforms in the labor market that have been carried out through
the years, in order to bring the evolution of regional wage differentials more
in line with regional productivity differentials, should instead have been oriented
to promote R&D, education, technology diffusion, and efficiency of the financial
system (D’Acunto et al. 2004). As in other areas of the world, poor supply-side
conditions have apparently been an important constraint on export performance
12. However, this assumption is debatable, implying that the behavioral equations of the sys-
tem have not changed over time and thus the elasticities are constant.
13. The current account as a percentage of GDP in Italy was on average positive (0.249 per-
cent) in the period 1984–1998 but negative (–1.04 percent) in the euro period. The last result was
greatly influenced by the recession years of 2008 and 2009. Nevertheless, these figures are not
very far from assuming that the external trade is close to equilibrium.
14. Some previous studies obtained the same result for Italy, for instance Thirlwall (1979;
1982) for the period 1953–1976, McCombie (1985) for 1973–1980, Pattichis (2001) for
1960–1997, and Bagnai (2008) for 1960–2006.

in Italy, in large part because of the dichotomy of conditions between North and
South.
In other words, Italy’s potential growth15 (without harming the balance-of-
payments position) is higher than that actually achieved, and the explanation
for this slower growth rate can be found on the existence of supply constraints.16
As is known, once the economy becomes supply-constrained it is the supply side
that determines the level of the growth rate and not the demand side. In this case
there is a negative gap between the actual growth rate and the one implied by the
Thirlwall’s law. However, as discussed by Palley (2003), this gap should be tem-
porary as the supply or the demand should adjust in order to eliminate it. Palley
considers that it is the demand side (and not the supply side) that adjusts through
an increase in the import elasticity, reducing the demand growth rate and bring-
ing it in line with the actual growth rate. By contrast, Setterfield (2007; 2012)
argues that it is the supply side that adjusts through an increase in the productiv-
ity factor of Verdoorn’s law17 overcoming any supply constraints that the econ-
omy faces.18 Looking at the results obtained, if the mechanism explained by
Setterfield was the only factor affecting the supply side we should have observed
that the actual growth rate of Italy had converged upwards. However, the actual
growth rate was consistently below the one implied by the Thirlwall’s law,
implying that Thirlwall’s or Setterfield’s mechanisms were not effective or,
from the first to the second period, that other factors have increased the supply
constraints faced by Italy.
3. The growth rates computed by the SCA model – through equation (11) that takes into
account the internal and external imbalances – give the same insights as the previous
case. In fact, the predicted growth rates are higher than the actual rates achieved in
Italy for all periods, indicating again that the country is under supply constraints.
These computed growth rates are also slightly higher than the rates obtained from
equation (12), where internal and external equilibrium is assumed. Therefore, the
SCA model – with or without (internal and external) equilibrium – and Thirlwall’s
15. The definition of potential growth is different than that implying full capacity utilization of
factors of production. In this text we mean the growth achieved without creating balance-of-pay-
ments deficits.
16. According to the IMF (2007), ‘Italy has the most highly regulated product markets in the
EU-15, and various cross-country reviews identify excessive regulation as a continuing problem
in key sectors, accounting also for Italy’s undersized services sector and high energy prices. In
part due to these problems, Italy’s ranking in cross-country surveys of the business environment
is poor (and worsening). Significant labor market rigidities (notwithstanding important progress)
also inhibit growth by slowing labor reallocation’. Also, Forni et al. (2010) find that wages and
non-tradable price markups are higher in Italy than in the rest of Europe. They also show that a
decrease in these markups (by reducing regulation and market rigidities) would lead to a sub-
stantial increase in Italian GDP. Another supply constraint is related to total factor productivity
growth in Italy which is declining over time with the average value being 1.7 percent in 1986–
1990, 1.2 percent in 1991–1995, 0.8 percent in 1996–2000, 0.3 percent in 2001–2005, and –0.5
percent in 2006–2010.
17. The Verdoorn’s coefficient is taken from the relation between the growth of labor produc-
tivity and the growth of (industrial) output, capturing static and dynamic returns to scale due to
technical progress and innovation activities. For more details on Verdoorn’s law, see Targetti
and Thirlwall (1989, ch. 11).
18. Note that we were not able to estimate independent values for the import elasticities, owing
to the lack of data. Implicitly, we are taking the side of Setterfield by considering that the elast-
icities do not change due to differences between the implied supply and demand growth rates.

law all agree that Italy has the potentiality to grow faster (without creating balance-
of-payments problems), whenever the supply constraints are removed.
4. When we divide the whole period into the pre-euro and the post-euro sub-periods
we observe that Italy grew much slower in the latter than in the former (0.667
percent19 versus 2.173 percent). How can we justify this disappointing result
for the country’s economic performance? Is our model able to explain this radi-
cal decline in growth? The answer is yes. We have already mentioned above two
causes for the decline in economic growth in Italy in the era of the euro: the first
has to do with the loss of competiveness20 shown by the decline in the export/
import share ratio, from 1.076 to 1.008 (see Table 1) and the deterioration of the
current-account equilibrium, from a 0.249 percent average surplus before the
euro period to –1.04 percent deficit in the euro period (see footnote 7). The
second is that Italy has the potential to grow faster without harming the
balance-of-payments equilibrium, but this did not happen because of supply
constraints that are more pronounced in the post-euro period. We can clarify
this idea by checking the difference between actual growth and that predicted
by the SCA model which is higher in the post-euro period (1.486 – 0.667 = 0.819)
than in the pre-euro period (2.793 – 2.173 = 0.620).
5. Some other causes that could explain the lower growth rates in the euro period,
as Table 1 shows, are:
(a) The increase in the public debt (from 101.5 percent of GDP to 108.4 percent
on average). This result – that is, the reduction of GDP growth when public
debt increases – is because we assume that the share of public external debt is
constant. So, as total debt increases, external debt also increases, and so the
country needs to allocate more resources to pay the external debt service and
thus has to reduce internal demand and therefore growth.21 We should stress
that the prior finding is not due to a ‘debt intolerance’ (see Reinhart et al.
2003) mechanism, as that would lead to a non-linear response due to a
hike in the interest rate, which did not happen in Italy. In fact, the real interest
rate was almost the same in the two periods.
(b) The outright decline of external growth from 3.2 percent in the pre-euro
period to 2.1 percent in the post-euro period, on average. The fall in external
demand reduces the Italian exports in the foreign markets.
Summing up, we believe that there are three main directions that Italy should focus
on in order to recover economic growth: removing the supply constraints to growth
19. We have to take into account that the average slower growth rate in the euro period is heavily
influenced by the negative decline of GDP, by –1.2 percent in 2008 and –5.1 percent in 2009.
20. Two remarks must be made in this respect. The first is that around half of the total trade in
Italy is with non-European partners; therefore, variations of the nominal exchange of the euro
against the non-eurozone partners might have significant effects on the balance of payments
in Italy and therefore on its growth performance. The second is that Thirlwall’s law considers
real, rather than nominal, exchange rates, with the former being determined by the inflation
rate differentials between a country and its trade partners. Taking into account that inflation dif-
ferentials are persistent in Italy, before and after its eurozone membership, they may affect ser-
iously its external competitiveness in real terms.
21. Put another way, the external constraint gets more stringent. In Bacha’s (1990) gap model,
this would mean a smaller/bigger inflow/outflow of capital, which leads to a reduction of invest-
ment and hence of the growth rate.

(improvements in productivity); increasing external trade competitiveness; and adjust-

ing public imbalances to more suitable levels.
3.3 Scenarios to faster growth

Some scenarios can be designed that allow us to detect policies that could help Italy to
grow faster, using the SCA model with internal and external imbalances – equations
(11), (15), or (16) when relevant – for the euro period (1999–2010).
1. First of all, we can find the impact on growth by imposing different values for
the public deficit and debt using equation (15). If we set public deficit (wD) equal
to 3 percent and debt (wB) equal to 60 percent (as percentages of GDP), which
are the goals of the Stability Pact in Europe, the predicted growth rate for Italy
increases from y_ a ¼ 1:486 percent (see Table 122) to 1.564 percent, which is not
a significant improvement. Although a reduction of debt (as the deficit is basi-
cally equal to the period average) helps Italy to improve its growth performance
in the long term, this measure is not a great stimulus to growth, and is far away
from the numbers advanced by Reinhart and Rogoff (2010), when debt crosses
the 90 percent threshold rate. By contrast, if we keep debt at the current average
level and let the public deficit increase to the pre-1999 period average (9.5 per-
cent), the growth rate would increase to 1.742 percent. However this rate is not
particularly high, and reveals a very low long-run multiplier: 6 percent in deficit
leads to an increase of less than 0.5 percent in GDP growth.
2. Reducing the import sensitivity of exports (elasticity) from πx ¼ 0:533 to 0.40,
our model predicts a rise in the growth rate from y_ a ¼ 1:486 percent to y_ a ¼ 1:91
percent, and if πx ¼ 0:30 the growth rate is even higher, y_ a ¼ 2:23 percent. Hav-
ing a large import sensitivity of exports is an impediment to growth, as the
exports’ multiplier effects on income are crowded out by higher imports. Redu-
cing the import content of exports is the appropriate policy to achieve higher
growth in Italy. We have to notice, however, that living in a global economy
where production is organized around international value chains, what is impor-
tant is not importing too much in order to produce exports, but ensuring that
the transformation of imported components into exports contains enough value-
added. In international markets, most exports embody a substantial share of
imported components, but in terms of gains it is important that the value
(price) of exports embodying imported components is sufficiently higher than
the value (price) of those imported components.
3. Growth rates in Italy are also sensitive to import contents of other components of
demand like consumption and investment. Reducing the import sensitivity of
consumption from πc ¼ 0:545 to 0.40 and that of investment from πk ¼ 0:475
to 0.30, the predicted growth rate obtained from the SCA model increases in
the 1999–2010 period from y_ a ¼ 1:486 percent to y_ a ¼ 2:146 percent, which
is a significant improvement. Therefore, policies aiming to reduce the import
dependence of the elements of demand can be a good strategy for fostering
economic growth in Italy.
4. Increasing the share of exports by two percentage points (from 26 percent to
28 percent), the obtained growth is y_ a ¼ 1:77 percent, or alternatively reducing
the share of imports by only two percentage points (from 26 percent to 24 percent),
22. The growth rate predicted by equations (11), (15), and (16) are virtually identical.

the predicted growth is even faster, of about y_ a ¼ 1:90 percent. A combined policy
with the aim of reducing the import share to 24 percent and increasing the export
share to 28 percent (with a surplus on trade) yields an even faster growth rate,
around y_ a ¼ 2:21 percent. Therefore changing the structure of the shares of
imports and exports is the appropriate way to achieve higher growth in Italy.
These hypothetical scenarios clearly show that the most effective policy to achieve faster
growth in Italy is related to the external sector, either through an effort to obtain a positive
net trade or to lower the import content of the components of demand. This is in line with
the balance-of-payments equilibrium approach supported by Thirlwall’s law.
4 CONCLUDING REMARKS
The aim of this study was to apply an alternative growth model in line with Thirlwall’s
law that takes into account both internal and external imbalances. The important con-
tribution of the model is that it discriminates the import content of aggregate demand
and introduces public deficit and debt measures as determinants of growth. The
reduced form of the model shows that growth rates can be obtained in three alternative
ways: (i) assuming internal and external imbalances (the so-called SCA model);
(ii) assuming that public finances and current-account external payments are balanced;
and lastly (iii) the growth rate predicted by Thirlwall’s law. The SCA growth model is
tested for the Italian economy to check its accuracy.
The equations constituting the SCA model are estimated by 3SLS to control the
endogeneity of regressors and to obtain consistent estimates. Growth rates are estimated
for the whole period 1984–2010 and also for the pre- and post-euro periods. The
empirical analysis shows that growth rates obtained by the SCA model and Thirlwall’s
law over-predict actual growth in Italy in all periods considered, providing evidence
that Italy grew slower than the rate compatible with the balance-of-payments equil-
ibrium hypothesis. According to the interpretation of this hypothesis, the causes for
the slower economic performance can be found on supply constraints that obstruct
the economy from growing faster. Another important finding is that Italy’s economic
growth is much slower in the euro period and the main explanation may lie in the loss
of competitiveness in this period. Other factors that possibly contributed to the decline
of growth are higher public deficits and debt, higher taxes, and high public
expenditure.
Some scenarios are implemented to detect policies that could foster economic
growth in Italy. It is shown that imposing the Stability Pact measures related to fiscal
discipline (3 percent budget deficit and 60 percent public debt as percentages of GDP)
are not significant stimuli for higher growth. Policies aiming at reducing the import
contents of the components of demand or reducing by only two percentage points
the import share and increasing by the same amount the export share in the economy
are the most effective policies to promote economic growth in Italy.
The key factor is making the economy more competitive internally (through the
reduction of the import content of the components of demand) and externally through
an export-led strategy. Thirlwall has suggested many strategies to improve export com-
petitiveness by increasing the income elasticity of the demand for exports. He further
explains that this elasticity captures the non-price characteristics of the goods produced
associated with quality, design, post-sale services, product variety, renovation, and
diversification, among others, which he called the supply characteristics of the

produced goods. All policies aiming to improve these supply characteristics imply
developing strategies at the firm level to produce goods that are attractive both in
domestic and foreign markets. Analysing a firm’s strategy with export orientation is
not the scope of our paper as this topic is well developed in the literature. At the gov-
ernment level, a strategy could be to encourage the production of tradable goods with
high elasticity of demand in international markets.
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APPENDIX A1
In the derivations of the model we omitted, for ease of exposition, the subscript t when all
the variables in the same equation refer to the same time period.
A1.1 Import equation
M ¼ αC πc Gπg X πx Invπk
Taking logs and deriving with respect to t we get:
m_ ¼ πc c_ þ πg g_ þ πx x_ þ πk inv:
_
A1.2 Government expenditure

The government balance identity is:
Gn þ iB ¼ tax ðPYÞ þ D with Gn ¼ GP;

where Gn is the nominal government expenditure and equal to GP (the real expenditure
times the price level).
Replacing Gn and deriving with respect to time:

dY
ðdG=dtÞP þ ðdP=dtÞG þ iðdB=dtÞ ¼ tax P þ tax ðdP=dtÞY þ ðdD=dtÞ:
dt
Multiplying and dividing by the relevant variable in order to obtain growth rates we get:

dG G dP P dB B dY Y dP P dD D
P þ G þi ¼ tax P þ tax Y þ
dt G dt P dt B dt Y dt P dt D
⇔
ðg_ þ pÞPG
_ þ iBb_ ¼ tax PYð_y þ pÞ _ þ Dd: _
Dividing the whole equation by (PG), we get:
iB _ PY D _
g_ þ p_ þ b ¼ tax _ þ
ð_y þ pÞ d:
PG PG PG
ðPY Þ
B
D=PY
If we define: GY ¼ wG ; PG
B
¼ PG=PY ¼ wwGB ; PG
D
¼ PG=PY ¼ wwDG , we get equation (2):

tax wD _ tax iwB _
g_ ¼ y_ þ d − p_ 1 − − b:
wG wG wG wG
A1.3 Private final consumption and investment

The final consumption of households is a function of total disposable income and the
yields obtained by holding government bonds:
ε
C¼ ð1 − taxÞ þ rwBH Y c ;

where tax is the tax rate on income, r is the real interest rate,23 wBH is the ratio between
BH and the level of income Y, and εc is the income elasticity of consumption.
Taking logs, it gives:

logðCÞ ¼ εc log ð1 − taxÞ þ rwBH Y ¼

¼ εc log ð1 − taxÞ þ rwBH þ logðYÞ ¼

¼ εc log ð1 − taxÞ þ rwBH þ εc logðYÞ:
Assuming constancy of tax, r and wBH , the first parcel of the final expression is a
constant. So, deriving in order to time:
d logðCÞ d logðYÞ
¼ εc ;
dt dt
which gives:
c_ ¼ εc ð_yÞ:
The private investment function is derived from the flexible accelerator model, first
suggested by Goodwin (1951) and Chenery (1952), where gross investment (denoted
by Invg) in period t is given by:
Invgt ¼ λ ðK dt − Kt−1 Þ þ δKt−1 ;
where Kd is the desired amount of capital stock, K is the effective capital stock in the
economy, λ is the speed of adjustment, and δ the depreciation rate.
The desired capital stock is assumed to be a function of domestic income (Y ) and
the real interest rate (r), defined as:
K d ¼ Y εKd r εrd ;
where εKd and εrd are the elasticities of desired capital stock with respect to income and
real interest rate. Replacing the last equation in the previous one and taking variations at
t, we get:24
dðInvg Þ dðλK d Þ dðλY εKd r εrd Þ dðY εKd Þ εrd dY

¼ ¼ ¼λ r ¼ λεKd Y εKd −1 r εrd :
dt dt dt dt dt
dY
Since dt
Y ¼ y_ , then:
dðInvg Þ
¼ λεKd Y εKd r εrd y_ ¼ λεKd K d y_ :
dt
23. We consider it to be constant in this model.

24. Considering that Kt–1 is given at period t and that the real interest rate is fixed.

Dividing by Invg :
dðInvg Þ
. .
Invg ¼ λεKd Invg y_ :
dt
Kd
dðInvgt Þ= dt
K dt
Setting εK ¼ λ Invgt
εKd and Invgt
_ the growth rate of investment is
¼ inv,
given by:
_ ¼ εK y_ :
inv
Therefore, investment growth is a function of the growth rates in domestic GDP.
A1.4 Export demand function

Considering that the export function is given by:
δx
εx P e
X ¼ βY ;
P
taking logs and deriving through time (considering that relative prices are constant),
we get:
x_ ¼ εx y_ :
A1.5 Balance of payments

From the balance of payments:
XP − iBF þ DF ¼ MP e:
Deriving with respect to time:

dX=dt P þ dP=dt X − i dBF =dt þ dDF =dt ¼ dM=dt P e þ M dðP eÞ=dt :
Rearranging the above expression:

dX=dt dP=dt dBF =dt dDF =dt
XP þ PX − iBF þ DF
X P BF DF

dM=dt
dP e=dt
¼ MP e þ MP e:
M P e
ð dX=dtÞ
Replacing X by x_ and doing the same for the others:
x_ XP þ pPX
_ − iBF b_ F þ d_F DF ¼ mMe
_ þ ðP _ eÞMP e:
Dividing the equation by XP and assuming that P*e/P = rer. Considering that the
real exchange rate is constant (not necessarily the law of one price), then the growth
rates ðP _ eÞ and p_ are equal. Dividing the above equation by PX:
BF _ DF P eM P eM
x_ þ p_ − i b F þ d_F ¼ m_ þ p_ :
PX PX PX PX

Simplifying:
BF _ DF P eM
x_ þ p_ − i b F þ d_F ¼ ðm_ þ pÞ
_ : (A1)
PX PX PX
We have considered that the share of foreign-financed debt and deficit is

equal and given by:
BF ¼ ð1 − ξB ÞB
:
DF ¼ ð1 − ξB ÞD

Note also that: dBF =dt ¼ ð1 − ξB Þ dB=dt .
dBF =dt
Dividing both terms by BF: BF ¼ ð1 − ξB Þ dB=dt
BF .
And replacing BF ¼ ð1 − ξB Þ B we get:
dBF =dt _ _
¼ ð1 − ξB Þ dB=dt
BF ⇔ bF ¼ b:
BF
The same happens for the growth rate of the deficit.
So equation (A1) becomes:
ð1 − ξB ÞB _ ð1 − ξB ÞD P eM
x_ þ p_ − i b þ d_ ¼ ðm_ þ pÞ
_ :
PX PX PX
B=ðPYÞ P eM ðP eMÞ=PY

And as B
PX ¼ PX=ðPYÞ ¼ W
WB
X
and PX ¼ PX=PY ¼W
W X , so we get:
M
WB _ WD _ WM
x_ þ p_ − ið1 − ξB Þ
b þ ð1 − ξB Þ d ¼ ðm_ þ pÞ
_ :
WX WX WX
Note that the steady state (share of debt over GDP and the deficit as share of GDP
are constant) implies:
b_ ¼ d_ ¼ y_ þ p:
_
So the balance-of-payments equation becomes:
WB WD WM
x_ þ p_ − ið1 − ξB Þ _ þ ð1 − ξB Þ
ð_y þ pÞ _ ¼ ðm_ þ pÞ
ð_y þ pÞ _ :
WX WX WX
Rearranging:

WD WB WM
x_ þ p_ þ ð1 − ξB Þð_y þ pÞ
_ −i ¼ ðm_ þ pÞ
_ :
WX WX WX
Replacing x_ , m_ by their expressions derived before:

WD WB WM
_ −i _ þ pÞ
¼ ðπC c_ þ πg g_ þ πx x_ þ πk inv _ :
WX WX WX

Also x_ , inv,
_ g_ and c_ their expressions derived before:

WD WB
_ −i ¼
WX WX

tax wD _ tax iwB _ WM
¼ πC εc y_ þ πg y_ þ d − p_ 1 − − b þ πx εX y_ þ πk εk y_ þ p_ :
wG wG wG wG WX
Replacing b_ ¼ d_ ¼ y_ þ p_ we get:

WD WB
_ −i ¼
WX WX

tax wD tax iwB
¼ πC εc y_ þ πg y_ þ _ − p_ 1 −
ð_y þ pÞ − _ þ πx εX y_
ð_y þ pÞ
wG wG wG wG
WM
þ πk εk y_ þ pÞ
_ :
WX
Rearranging:

WD WB
_ −i ¼
WX WX

tax wD iwB tax
¼ πC εc y_ þ πg y_ þ − _ − p_ 1 −
ð_y þ pÞ þ πx εX y_
wG wG wG wG
WM
þπk εk y_ þ pÞ
_ :
WX
A1.6 Domestic income growth

WX
First, multiply the last equation by WM :

WX
WX WD WB
εX y_ þ p_ _
þ ð1 − ξB Þð_y þ pÞ −i ¼
WM WM WM WM

tax wD iwB tax
¼ πC εc y_ þ πg y_ þ − _ − p_ 1 −
ð_y þ pÞ þ πx εX y_ þ πk εk y_ þ p:
_
wG wG wG wG
Isolate y_ in the right-hand side:

WX WX WD WB wD iwB
εX y_ − πx εX y_ þ p_ þ ð1 − ξB Þp_ −i − πg −
WM WM WM WM wG wG

tax tax wD iwB
p_ − p_ 1 − − p_ ¼ ¼ πC εc y_ þ πg y_ þ − y_
wG wG wG wG

WD WB
þ πk εk y_ − ð1 − ξB Þ −i y_ :
WM WM

Collecting terms, we get:

WX WX WD WB wD iwB
εX − πx εX y_ þ p_ þ ð1 − ξB Þ −i − πg −
WM WM WM WM wG wG
! !
tax tax wD iwB
− 1− −1 ¼ πC εc þ πg þ −
wG wG wG wG
!
WD WB
þ πk εk − ð1 − ξB Þ −i y_ ;
WM WM
which gives equation (11):

εX W
WX
þ ð1 − ξB Þ W WD
−iWWB
− πg wwDG − iwwG − 1− wG
B tax
−1
y_ ¼
M M M M
:
πC εc þ πg wtaxG þ wwDG − iw
wG
B
þ πk εk − ð1 − ξB Þ WWD
M
−iWWB
M
If we plug in the government identity, that can be written as:

tax ðD − iBÞ
1− ¼
wG PG
or by dividing the numerator and denominator of the right-hand side by PY:

tax wD − iwB
1− ¼
wG wG
then:
0 ! !
zfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflffl}|fflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflffl{
︷

εX W
WX
M
− πx εX y_ þ p_ WX
WM þ ð1 − ξB Þ W M − i W M − πg wG − wG − 1 − wG
WD WB wD iwB tax
−1
y_ ¼ ! ! .

πC εc þ πg tax
wG þ wD
wG − iwB
wG ︸ þ πk εk − ð1 − ξB Þ WWD
M
− i WB
W M
zfflfflfflfflfflfflfflfflfflfflfflfflffl}|fflfflfflfflfflfflfflfflfflfflfflfflffl{
1
So the final equation in terms of debt and deficit (equation (15)) is:

εX W
WX
− π x ε X y_ þ _
p W
WX
−1 þ ð1 − ξ B Þ W
WD
− i WB
W

M M M M
y_ ¼ :
πC εc þ πg þ πk εk − ð1 − ξB Þ W M − i W M
WD WB
Also, from the government identity we have:

tax ðD − iBÞ wG − tax ðD − iBÞ wG − tax ðD iBÞ=PY
1− ¼ ⇔ ¼ ⇔ ¼ ,
wG PG wG PG wG PG=PY

which means that:

wG − tax W D − iW B
¼ :
wG wG
wG
Therefore, multiplying both sides of the equation by wM we get:
WD WB wG tax
−i ¼ − :
WM W M wM wM
We can also write the final equation in terms of government spending and taxes,
equation (16):

εX W
WX
−1 þ ð1 − ξB Þ wwMG − wtaxM

M M
y_ ¼ :
πC εc þ πg þ πk εk − ð1 − ξB Þ wwMG − wtaxM
APPENDIX A2
A2.1 Description of the variables and data sources
• m_ t Annual growth rate of real imports – imports of goods and services at 2000
prices (national currency; annual percentage change).
• c_ t Annual growth rate of final private consumption – private final consumption
expenditure at 2000 prices (national currency; annual percentage change).
• x_ t Annual growth rate of real exports – exports of goods and services at
2000 prices (national currency; annual percentage change).
• k_ t Annual growth rate of investment – gross fixed capital formation at 2000
prices (national currency; annual percentage change).
• y_ t Annual growth rate of real GDP – GDP at 2000 market prices (national cur-
rency; annual percentage change).
• p_ t Annual growth rate of price deflator – GDP at market prices (national cur-
rency; annual percentage change).
• wG Share of government’s expenditure on GDP – total expenditure; general
government (percentage of GDP at market prices; excessive deficit
procedure).
• wD Share of government’s deficit on GDP – net lending (–) or net borrowing
(+); general government (percentage of GDP at market prices; excessive
deficit procedure).
• wB Share of government’s debt on GDP – general government consolidated
gross debt (percentage of GDP at market prices; excessive deficit proce-
dure). It excludes interest rate payments on debt.
• wM Imports of goods and services at current prices (national accounts) –
percentage of GDP at market prices.
• wX Exports of goods and services at current prices (national accounts) –
percentage of GDP at market prices.

• tax Share of government’s revenues on GDP – total current revenue; general gov-
ernment (percentage of GDP at market prices; excessive deficit procedure).
• i Nominal long-term interest rates (percent).
Data on m_ t , c_ t , x_ t , k_ t , y_ t , p_ t , wG, wD, wB, wM, wX, tax and i were taken from European
Commission (2011).
• g_ t Annual growth rate of government’s expenditure. Computed by the
authors from data on general government expenditure (millions of ECU
up to 31 December 1998, and millions of euros from 1 January 1999),
available on Eurostat - Government Accounts, http://epp.eurostat.ec.
europa.eu/portal/page/portal/statistics/search_database (extracted on 12
December 2011) and information on p_ t .
• y_ Annual growth rate of real foreign income (OECD countries), excluding
Italy. The rates were computed by the authors, using data obtained from
OECD. StatExtracts http://stats.oecd.org/Index.aspx (extracted on
15 December 2011).
APPENDIX A3
Table A1 The 3SLS estimation of the structural model, Italy, 1984–2010

Coefficient Std error t-stat p-value R2 F-stat p-value
Imports growth
constant 0.271 0.844 0.32 0.749 0.795 27.2 0.000
c_ t 0.544 0.516 1.06 0.294
g_ t 0.115 0.111 1.03 0.305
x_ t 0.533 0.112 4.74 0.000***
k_ t 0.475 0.188 2.52 0.013**
Consumption growth
constant 0.359 0.278 1.29 0.201 0.586 52.96 0.000
y_ t 0.830 0.114 7.28 0.000***
Investment growth
constant –1.690 0.562 –3.00 0.003*** 0.742 83.49 0.000
y_ t 2.163 0.237 9.14 0.000***
Exports growth
constant –3.214 1.366 –2.35 0.021** 0.583 34.51 0.000
y_ t 2.520 0.429 5.87 0.000***
Notes:
Endogenous variables: m_ t , c_ t ; k_ t ; x_ t , y_ t .
Exogenous variables: y_ t ; y_ t−1 ; WG;t ; WG;t−2 ; WD;t−2 ; WB;t ; WB;t−2 ; taxt ; it ; p_ t ; p_ t−1 ; p_ t−2 ; k_ t−2 ; g_ t−2 ; c_ t−3 ; g_ t .
* Coefficient significant at the 10% level;
** coefficient significant at the 5% level;
*** coefficient significant at the 1% level.

516
Table A2 The 2SLS estimation of each equation of the structural model, Italy, 1984–2010
Coefficient Std error t-stat p-value Sargan test Heteroskedasticity test AR(1) test Normality test
© 2015 The Author

Growth of imports
constant 0.385 0.972 0.40 0.696 χ213 = 16.831 χ217 = 13.012 χ21 = 1.572 χ22 = 0.52
c_ t 0.757 0.624 1.21 0.238 p-value = 0.207 p-value = 0.735 p-value = 0.210 p-value = 0.770
g_ t 0.069 0.135 0.51 0.612
x_ t 0.432 0.135 3.20 0.004***
k_ t 0.562 0.228 2.46 0.022**
Growth of consumption
constant 0.500 0.296 1.69 0.104 χ216 = 19.004 χ217 = 18.822 χ21 = 0.547 χ22 = 2.33
y_ t 0.736 0.126 5.84 0.000*** p-value = 0.269 p-value = 0.339 p-value = 0.460 p-value = 0.311
Growth of investment
constant –1.542 0.588 –2.62 0.015** χ216 = 20.962 χ217 = 17.368 χ21 = 3.356 χ22 = 11.6
y_ t 2.065 0.250 8.26 0.000*** p-value = 0.180 p-value = 0.430 p-value = 0.067 p-value = 0.003
Review of Keynesian Economics, Vol. 3 No. 4
Growth of exports
a
constant –3.868 1.357 –2.85 0.008*** χ21 = 0.195b χ21 = 1.4415 χ22 = 3.61
y_ t 2.789 0.443 6.30 0.000*** p-value = 0.659 p-value = 0.230 p-value = 0.164
Notes:
Endogenous variables: m_ t , c_ t ; k_ t ; x_ t , y_ t .
Exogenous variables: y_ t ; y_ t−1 ; WG;t ; WG;t−2 ; WD;t−2 ; WB;t ; WB;t−2 ; taxt ; it ; p_ t ; p_ t−1 ; p_ t−2 ; k_ t−2 ; g_ t−2 ; c_ t−2 ; c_ t−3 ; g_ t .
* Coefficient significant at the 10% level;
** coefficient significant at the 5% level;
*** coefficient significant at the 1% level.
a. The last equation is an OLS regression; there is no Sargan test.
b. The heteroskedasticity test on the last equation is a White/Koenker NR2 test statistic. The Breusch–Pagan/Godfrey/Cook–Weisberg test points to the same conclusion:
χ21 = 0.189; p-value = 0.6634.
Journal compilation © 2015 Edward Elgar Publishing Ltd


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Review of Keynesian Economics, Vol. 3 No. 4, Winter 2015, pp.

Causes of the decline of economic growth in

Elias Soukiazis, Pedro André Cerqueira,** and Micaela Antunes

Keywords: internal and external imbalances, import elasticities of the components of

JEL codes: C32, E12, H6, O4

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including whether government borrowing is financing government consumption or

2 THE GROWTH MODEL WITH INTERNAL AND EXTERNAL

We use a multi-equation model developed by Soukiazis–Cerqueira–Antunes (2012) –

2. The detailed derivation is in Appendix A1.

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2.1 Import equation

2.2 Government expenditure

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2.3 Private final consumption and investment

_ is a function of the growth of domestic

2.4 Export demand function

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2.5 Balance-of-payments condition

Further substitution of the growth of government expenditure (2), consumption (4),

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2.6 Domestic income growth

and second in terms of government spending and taxes:

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3 TESTING THE MODEL FOR THE ITALIAN ECONOMY

3.1 Econometric methodology

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needed to compute the reduced form of domestic income growth as it is expressed in

3.2 Empirical results and discussion

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Computation of the growth rates of domestic income in Italy

© 2015 The Author

1984–2010 y_ a ¼ 2:116% y_ b ¼ 1:966% y_ c ¼ 2:360% y_ ¼ 1:504%

1999–2010 y_ a ¼ 1:486% y_ b ¼ 1:516% y_ c ¼ 1:906% y_ ¼ 0:667%

Journal compilation © 2015 Edward Elgar Publishing Ltd

via Tbilisi Open Teaching University

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(improvements in productivity); increasing external trade competitiveness; and adjust-

3.3 Scenarios to faster growth

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A1.1 Import equation

A1.2 Government expenditure

Gn þ iB ¼ tax ðPYÞ þ D with Gn ¼ GP;

A1.3 Private final consumption and investment

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Invgt ¼ λ ðK dt − Kt−1 Þ þ δKt−1 ;

dðInvg Þ dðλK d Þ dðλY εKd r εrd Þ dðY εKd Þ εrd dY

23. We consider it to be constant in this model.

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A1.4 Export demand function

A1.5 Balance of payments

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We have considered that the share of foreign-financed debt and deficit is

And replacing BF ¼ ð1 − ξB Þ B we get:

B=ðPYÞ P eM ðP eMÞ=PY

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A1.6 Domestic income growth

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