Why Italy’s Economy Stopped Growing

For the past quarter-century, Italy’s economy has been nearly stagnant – not because of trade shocks, bad government, labor market problems, or lack of technology advancements, but because of a management style that is holding the country back, finds research co-authored by finance professor Bruno Pellegrino at the University of Maryland’s Robert H. Smith School of Business.

Pellegrino and Luigi Zingales of the University of Chicago study Italy’s productivity problem in “Diagnosing the Italian Disease” – a working paper for the National Bureau of Economic Research. The paper was recently highlighted in a Bloomberg opinion piece. The scholars looked at why Italy’s economy abruptly stopped growing in the mid-1990s, a plight that has proved both puzzling and at odds with standard economic growth theories.

The researchers used sector-level and firm-level data to root out the block on Italy’s productivity. In looking at industry sectors in the European Union, they were able to rule out several possible explanations: It wasn’t due to lack of capital accumulation, nor did it stem from trade shocks following the introduction of the euro or China’s entry into the World Trade Organization. There was no major institutional turmoil to explain the decline, considering that, in 1996 and the following decade, Italy saw low and stable interest rates and inflation, as well as the longest-lasting government since WWII.

Pellegrino and Zingales shifted focus to the competitive landscape of the mid-1990s – what happened then? – and zeroed in on the technology revolution. By 1995, IT was taking off. But firms in Italy weren’t fully capitalizing on the rise – not because they hadn’t invested in technology, but because they didn’t have the right managers and employees in place to implement it.

The researchers used World Economic Forum expert surveys to analyze how different countries were recruiting and promoting managers. They found that productivity grew faster in tech-intensive sectors in countries where firms were more likely to select, promote and reward people based on merit. They ranked countries based on their meritocracy score, and Italy ranked last. The countries that scored highest for meritocracy (Sweden, other northern European countries, the United States, Japan) also saw the biggest bumps in productivity, thanks to the technology revolution.

In Italy, firms often use cronyism and nepotism to decide who gets ahead. Before the rise of technology, this management style didn’t hurt Italy’s economy, say the researchers. But as IT took off, this widespread practice of rewarding loyalty over skill kept its economy from growing – costing the country between 13% to 16% in productivity growth.

Using response data from a large survey of European manufacturing firms, Pellegrino and Zingales constructed a firm-level measure of meritocratic management practices that reflected a firm’s actual organizational practices. In Italian firms, a boss’s family members or cronies are most likely to move up the ladder.

“Using our data, we confirm the stylized fact that Italian firms are particularly likely to select and reward their managers based on loyalty and connections, rather than performance,” the researchers write.

So why has Italy lagged behind its counterparts in the adoption of meritocratic management practices? The researchers say it’s because loyalty-based management seems to have greater benefits in Italy than in other developed countries.

“Among developed countries, Italy stands out for its patronage-based banking sector, its inefficient legal system, and the diffusion of tax evasion and bribes,” write Pellegrino and Zingales. “Thus, a reasonable explanation is that, at the onset of the [technology] revolution, Italy found itself with a managerial class that was perfectly suitable for its domestic environment, but incapable of taking full advantage of the newly available technologies.”

Pellegrino and Zingales stop short of prescribing a cure for the problem, pointing out that in Italy, there are tradeoffs for more meritocratic management styles.

“Given this conundrum and the fact that country’s institutions are intrinsically hard to change, it appears that Italy serves as a cautionary tale of the importance of building institutions that aren’t simply appropriate at one historical juncture, but that are also attuned to the pace of technological progress.”