Welfare State Crisis Pulling Europe Deeper into the Hole

As I reported two weeks ago, Spain is the next welfare state in Europe to crumble under the burden of its own overspending. Today the Irish RTE News reports on yet another indication of just that. The Spanish government is having increasing trouble borrowing at affordable interest rates:

Spain’s borrowing rate nearly doubled in a short-term debt auction as investors fretted over the euro zone’s determination to deal with its debts. And Italy raised nearly €3.5 billion in a short-term bond sale today but at sharply higher interest rates amid fresh concerns over the euro zone outlook, the Bank of Italy said. The Spanish treasury said it raised €1.933 billion but the timing could hardly have been worse, with financial markets slumping on concern that Europeans are wavering in their commitment to austerity.

The problem is not their wavering commitment to austerity. The problem is their commitment to austerity. Austerity means something very simple: spending cuts – which are good if done the right way – and tax hikes – which are always bad. When a country combines bad spending cuts with higher taxes, the effect is devastating. The higher taxes drain the free economy for resources that could have been used by the private sector to spend, invest and create jobs; the cuts in spending withhold even more money from the economy than is usually lost when government operates “as usual”. Government spending is an inefficient way to produce services and should therefore be replaced with private solutions, but at least the money is coming back into the economy. Under austerity government cuts away inefficient spending but does not allow the private sector to replace it with free-market solutions.

Austerity makes the burden of government go from bad to worse. The response from the private sector is further depression of investments, consumption and employment. Since austerity is a response to a recession, the policies aimed at alleviating a recession actually deepen and worsen the very problem they were supposed to solve. Not surprisingly, the Spanish economy is in even worse shape now than it was before, and it is getting increasingly difficult for the Spanish government to raise enough taxes to close their budget gap. Furthermore, when the austerity policies depress the private sector, they hurl more people into government dependency:

Spain has promised to cut its public deficit – the annual shortfall of income compared to spending – to 5.3% of gross domestic product in 2012 and just 3% of GDP in 2013. Last year it had allowed the deficit to hit 8.5% of GDP – 2.5 percentage points over target. Desperate to meet its targets, the government approved €27 billion in fiscal tightening in its 2012 budget, in addition to an earlier round of tax increases and spending cuts amounting to €15.2 billion. But analysts say those targets will be harder to reach as tax income declines and welfare costs rise because Spain is back in recession just two years after emerging from the last downturn. Spanish GDP fell by an estimated 0.4% in the first quarter of 2012 after a 0.3% decline in the last three months of 2011, the Bank of Spain said yesterday. Spain, whose unemployment rate at the end of 2011 was already the highest in the industrialised world at 22.85%, suffered a further 4% year-on-year drop in employment in the first quarter of 2012, the Bank of Spain said.

There is even more evidence in Europe of what panic-driven budget cuts can do to a country. Greece went into austerity mode in 2009, and since then the country has suffered badly under its own policies. Its repeated rounds of bad spending cuts and even worse tax increases have pushed the economy even deeper into its perpetual recession. Therefore, the latest GDP forecast on the Greek economy comes as no surprise:

Greece’s economy will contract a deeper than expected 5 percent this year, the country’s central bank chief said on Tuesday, piling more pressure on to a citizenry already battered by crippling austerity and record joblessness. The projection topped a previous forecast the central bank made in March, when it projected the 215 billion euro economy would contract 4.5 percent after a 6.9 percent slump in 2011. Twice bailed-out Greece is in its fifth consecutive year of recession. Speaking to shareholders at the central bank’s annual assembly, George Provopoulos, also a European Central Bank Governing Council member, urged strict adherence to reform and fiscal adjustment commitments Greece has agreed with its euro zone partners, saying they were needed to return the economy to sustainable growth.

And predictably, the macroeconomic illiterates who populate various influential institutions around the world want Greece to take another dose of the wrong medicine:

Athens is under pressure to apply more fiscal austerity to shore up its finances as part of a new rescue package agreed this year with its euro zone partners and the International Monetary Fund (IMF) to avert a chaotic default. Its continued funding under the 130 billion euro package will hinge on meeting targets. … Greece is set to pick a new government on May 6, with the two main parties in the current coalition seen barely securing a majority in parliament, according to the latest opinion polls. Whoever wins will have to agree additional spending cuts of 5.5 percent of GDP, or worth about 11 billion euros for 2013-2014, and gather about another 3 billion from better tax collection to keep getting aid, the IMF has said.

There is only one solution to this problem, and that is to structurally reform away the welfare state. Austerity policies are aimed at preserving the welfare state by shrinking it to fit inside ever shrinking government revenue. But since the welfare state is the original cause of the crisis, this means that government preserves the very mechanisms that drove the economy into the ditch in the first place.

When Sweden went through an austerity program in the 1990s the economy lost eight percentage points of employment and has never recovered. Its employment rate is, in other words, permanently eight percentage points lower than it was before the austerity program. The saving grace for the Swedish economy was its enormous exports: multinational corporations were able to get their wheels going by selling abroad on markets not depressed by austerity, and thus pull in enough tax revenues to save the government from complete collapse. But the long-term effects of the ’90s are still hanging over Sweden – essentially, the only lasting result is a combination of the world’s highest taxes and a government operating, for the most part, at third-world standard. Greece and Spain do not have the same saving mechanisms in their economies, which means that they will take an even harder beating by austerity than Sweden did.