Can we learn from the “Italian Miracle” Formula?
In the 1960s, while the Italian economy was booming, such to talk of “The Italian Economic Miracle”, IRI – Istituto per la Ricostruzione Industriale S.p.A. – was among its most important factors. The IRI, (Institute of Industrial Reconstruction) was a conglomerate owned by the Italian government and inherited by the Great Depression period. By the 1960’s it was growing at rates that were more than double those of the national economy and it was once the largest non-oil producing company in the world outside the United States. It had stakes in a multitude of sectors of the Italian economy, ranging from infrastructure and manufacturing to telecommunications.
This experience of the IRI contains some valuable precedents and lessons for policy makers today in the midst of the extreme economic difficulties.
When the 1929 market crash initiated the worldwide depression of the 1930s, few countries were as adversely affected as Italy, even though this propagated with a certain delay. Italian banks had a history of purchasing substantial interests in Italian industry, and when those industries began to fail it appeared that the nation’s banking system might well collapse. The Fascist government of Benito Mussolini created IRI in January 1933 to bail out Italy’s three largest banks, Banco di Roma, Banca Commerciale, and Credito Italiano. As a result, wrote Stuart Holland in: The State as Entrepreneur. New Dimensions for Public Enterprise: The IRI State Shareholding Formula, “the new state holding company found itself responsible for major proportions of the main industrial and service sectors in the economy.”
During the years of its intense growth, IRI behaved unlike any corporation seen before. Because it served the interests of the state, it did not have to concern itself with short term profits. Thus IRI could sink millions of lire into enterprises, like steel and road building that private companies shied away from. The effect of such government investment was to create markets in which other companies could then compete, thereby expanding the economy as a whole. The U.S. government was using tax-breaks and incentives, but their situation was different, so Italy employed IRI. Not only did IRI create economic markets, it did so in areas thought to be most beneficial to the country as a whole or in areas of strategic importance.
It is crucial to remember that IRI avoided the pitfalls of most state-run businesses. The problem with most state-run businesses, especially in the formerly communist countries, was that there were few incentives to be productive or efficient. Thus, state-run companies often became notorious for mismanagement, creating unnecessary jobs and spending public money unwisely. IRI avoided these drawbacks by creating a level of distance between itself and its subsidiary holding companies. IRI’s subsidiaries were put in a position to behave as if they were private enterprises; they were encouraged to be entrepreneurs, while the small core of IRI management acted as investors, backed by the financial might of the Italian government. While IRI was 100 percent government owned, the subholdings were not, and thus these subholdings could attract private investment as well. And so they did.
When IRI was working well, it combined the dynamism of entrepreneurial capitalism with some sort of social guardianship and long term forward looking common purpose. The success that IRI had in the 1950s and 1960s, during what was dubbed: “The Italian Economic Miracle”, made it the model for governmental involvement with industry around the world. In the 1960s, Great Britain, France, Australia, Canada, Sweden, and West Germany all initiated programs that were based at least in part on the IRI formula of mixed state/private investment formula.
Many European countries, particularly the UK, were looking at the “IRI’s formula” as a positive and effective example of a proper state participation in the economy. It was better than the straightforward “nationalization” because it allowed a direct cooperation between public and private capital. Many of the companies of IRIs’ group had mixed capital, partly from public government, partly from private investors. Many of IRI’s enterprises were listed and the bonds issued by IRI to finance its own companies were massively subscribed by savers.¹
Here are the main functions of the newly proposed Institutes for Economic Reconstruction:
1.Be of immediate support to companies in strategic sectors of the economy; prevent their collapse, avoiding catastrophic impacts by taking over preferred shares, (a midway instrument between shares and bonds with no voting rights), taking control only where strictly necessary.
2.Acquire stakes in small and medium size businesses (SMEs) to protect them for being indirect contagion casualties, facilitate their financing, their international development plans.
3.Acquire preferred stakes in new enterprises with strong growth prospects, to promote new technologies, new inventions, more exports to BRICs, vital sectors of the economy …
4.Act as a traditional institutional investor in search of long term returns, acquiring assets domestically but also abroad, restoring confidence and stabilizing markets in coordination with the necessary general economic reforms of each of the western countries.
5.Defy fears that external SWFs investment reasons are other than portfolio diversification and that by investing in other countries they could take control of crucial national interests, or could influence other sovereign states. Consider co-investments with SWFs with the aim of contributing to a globally coordinated stabilization effort.
Yet, let us analyze the core of this hypothesis in details with the help of Modern Portfolio Theory. We like to demonstrate that, in addition to the results that must be produced by a much needed fiscal stimulus (and infrastructures spending), and by flexible monetary policies, a third factor to be deployed in their conjunction, should be the organization and presence of the state in certain companies or sectors of the economy. Very much like a modern and more refined version of the historical I.R.I., Institutes for Economic Reconstruction (IRE) need to be created grouping the forced rescue effort stakes and developing specific investment choices in a selected cluster of enterprises. The benefit of the mix of “State/Private Co-Investment Formula” can be quantified and explained. Thus it can be utilized in a more precise and effective way. Let us recall the Capital Asset Pricing Model. CAPM describes the relationship between risk and expected return and it can be used in pricing of any security or asset.
The general idea behind the CAPM is that investors need to be compensated in two ways: time value of money and risk. The time value of money is represented by the risk free (rf) rate in the formula and compensates the investors for the use of the money in any investment over a period of time. The other half of the formula represents risk and calculates the amount of compensation the investor needs for taking on additional risk. This is calculated by taking a risk measure (beta) that compares the returns of the asset to the market over a period of time and to the market premium (řm-rf).
The CAPM says that the expected return of a security or a portfolio equals the rate on a risk-free security plus a risk premium. If this expected return does not meet or beat the required return, then the investment should not be undertaken. The security market line plots the results of the CAPM for all different risks (betas) creating the so called ‘Efficient Frontier’, a line created from the risk-reward graph, comprised of optimal portfolios.
Now, the big problem facing this depressionary period is that there is strong general reluctance to undertake any investment at all. There is widespread fear. The risks are perceived to be too high; a vicious “Trust Crunch” circle is generated, and that brings to a compression and ultimately to the freezing of any exchange in the economy. If the blood stops circulating even the healthiest individual will eventually die. The banks stop lending, even to themselves; consumer confidence plummets at its lowest, panic spreads across and creates damage to fundamentally sound businesses. The above curve gets flatter and it moves more and more to the extreme right of the graph. This deadly spiral must be “unlocked”!
The Value of the “State/Private Co-Investment Formula”: the ‘Sovereign Alpha’
The implementation of a proper “State/Private Co-Investment” formula allows reducing enterprise risks, guarantees a long term view horizon, reestablishes trust and confidence in the markets for investments to take place, gives a positive boost to all of the firm’s constituents, and thus decreases risks. The presence of such a ‘Strong hand’, enhances the value of a company for all the parties involved: employees, management, suppliers, customers, shareholders, bondholders, financing banks, insurers, regulators, local administrators. The positive impact reverberates also into other companies of the same sector, creates a compounding positive virtual circle, a psychologically positive impact into the entire system.
This dynamic effect will make possible a much needed improvement of the efficient frontier shown in the graph above, thus creating new economic value. It will be the ‘liquid’ able to restart the engine of growth and prosperity and also to correct those ‘devious unbalances’ that lead us in this situation. The impact of the “State/Private Co-Investment Formula” is obviously of superior significance in periods of deep dislocation and depression like those we are currently going through. Historical examples show also that where there is a public presence, growth is even faster than the market average at times of expansion. Last but not least, history reminds us that the most important element will be, much further down the line, a proper ‘exit strategy’ for the public money. This is a relevant aspect but it can be addressed later on.
What is the value of restarting the economic engine? This is certainly very high now. Yet, how to evaluate and analyze the impact of the “State/Private Co-Investment Formula”? Let us use “Alpha” to explain. This is a technical term that has its roots in financial theory and in the recent years it has been ‘claimed and chased’ excessively by too many investment managers. The basic is that to analyze the performance of an investment we must not only look at its return but also at its risk. If we compare two companies both generating an 8% return, a rational investor will want to buy the stock of the less risky one.
Thus, Alpha is a technical risk ratio and a measure of performance on a ‘risk-adjusted basis’. Alpha takes the volatility (price risk) of a certain assets and compares its risk-adjusted performance to an average market value (e.g. a benchmark index). The excess return of the assets relative to the return of the average value is the asset’s alpha. It is the additional rate of return of an asset (or security, or portfolio) in excess of what would be predicted by an equilibrium model like the capital asset pricing model (CAPM).
Now, the “simple organization and presence” of the government in a certain company increases the size of its Alpha, or it could be the only Alpha component of its return. Because of the positive effect that a stable presence of the State creates, especially in such a depressionary period, it automatically brings over value to an enterprise and to all of its constituents: shareholders, bondholders, employees, management, suppliers, public in general, lenders and insurers. The overall perception of that firm improves and that has a positive impact on the results generated. Obviously the public intervention is also synonym of a certain rigorous evaluation criteria, of a long term commitment, of sound management and market practices, of a guarantee of ethical values and possibly future support if needed.
Furthermore, a renewed formula of the Italian I.R.I., a new breed of western Sovereign Fund which I call Institutes of Economic Reconstruction (IER), can be viewed exactly as a portfolio manager, having to allocate capital among different selection of enterprises and industrial sectors. Let us assess this value creation in a formal way using the CAPM theory.
I call ‘Sovereign Alpha’ the part of the company’s (or portfolio of companies) extra value generated simply by the organization and presence of the State among the shareholders.
Other things being equal, a purchase of a stake from the National government diminishes the enterprise risk, enhances the probability of returns, gives stability to the business, and the value of this equation becomes positive. The company is therefore earning excess returns by virtue of the “State/Private Co-Investment Formula”.
To be noted that this ‘Sovereign Alpha Generation Process’ can take place in two separate occasions which interact in a compounding dynamic. First, at the company individual level. This is produced by the simple organization or presence of such a “strong hand” as the national government among the shareholders. Second, at the economy macro level, given the combined impact of all of the stakes co-owned by the public entity, by the consequence of the collective psychological reassurance, and then indirectly by the effect of a positive moral suasion.
The IER holding company can also be viewed as a fund manager and similarly, if successful in allocating its asset among best performers and diversifying risks accordingly, generating return higher than the market. If the first assumption proves to be true, the second can also be true as the sum of all the alphas. The second Alpha generation level can also benefits from the diversification effect, from the compensation of sector risk, and from the fact that the government size and position can effectively give an advantage in investing in areas where returns can only be generated by long term and particularly large investments.
The value generated by these asset allocation strategies will also improve because the allocation process itself is made easier by the presence of a “strong hand” that reduces fears and uncertainties. And we know that asset allocation is the most important factor in successful value creation and preservation. From the case study of IRI, we see that when the Italian economy was growing 8%, IRI was growing more than double that.
The stronger the depression, the higher is value of the “State/Private Co-Investment Theory”. Same was for the Great Depression and for other similar historical periods. After all the creation of “Sovereign Alpha” does not just come automatically, but it is also be the result of a selection and an enhancement process; the enterprise will have to improve its values and standards, requirements, conditions, and keep them that way.
Can we learn form the “Italian Miracle”? “Yes, We Can!”
If IRI chemistry allowed to flourish the unstoppable Italian art of making do with what available; if that formula allowed the unfolding of the fantastic creativity of the Italians and their relentless ‘trial and error’ mentality that brought to life world icons like Ferrari or Espresso, Versace and Armani,… up to the helicopters currently used by the USA President and much more, think what a similar formula could do to revamp a United America and the western economies today. Not only the historical comparables match, but the advantage of available technology and knowledge make possible a more effective and controlled use of the “State/Private Co-Investment” formula. Yet, time is of the essence.
A new breed of Sovereign Wealth Funds, the Institutes for Economic Reconstruction (IER), based on the “State/Private Co-Investment” formula with the crucial goal of reestablishing confidence in each of the national markets, and restarting the much needed economic growth, appears to be the only way forward and a viable one. Not Von Hayek but not really Keynes either. It is going to be a balanced, comprehensive approach, a real generator of modern value.
This approach not only will benefit the individual enterprises which receive the participation from the State, but it will also generate a positive crucial impulse to the global economy, increasing overall market returns and reducing risks. Last but not least, ethical and sustainable growth considerations will be able to receive a reasonable place in a much needed restructuring of the world order. Markets will come out different from this crisis but ultimately stronger.
We have the means, the expertise, and now a good impending necessity to make it happen.
“A pessimist sees the difficulty in every opportunity; an optimist sees the opportunity in every difficulty”.