In the last quarter of the 20th century large parts of the world lifted themselves out of poverty. China and India are the best known but far from the only examples. Countries like Malaysia, Indonesia, Vietnam and Korea elevated themselves to a standard of living that for most of the population meant life in the global middle class. The Soviet sphere collapsed and allowed hundreds of millions of people from Saxony to Sakhalin to pursue happiness unhindered by government.
Now the prosperity train is slowly making its way through the African continent. Its effect is still marginal, but global corporations have discovered pockets of economic environments in Africa where they can actually set up operations with reasonable prospects of stability and profit.
While this is happening, the old industrialized parts of the world have mismanaged their prosperity. Latin America offers a split image with Argentina and Venezuela sinking into the holes of socialism while Chile and Brazil are examples of economic progress. The United States is still an economic superpower but has over the past 25 years allowed its government to grow irresponsibly large. It is still manageable and we are moving forward economically, but not at the pace we could.
Europe is the black sheep of the industrialized family, having squandered its prosperity for the sake of income redistribution. While Europe has not yet sunk into abject poverty, and probably never will, the continent has entered a stage of economic stagnation that it will take a very long time to get out of. In fact, the European economy is beginning to resemble some of the less oppressive countries in the Soviet sphere – not in terms of political oppression, but in terms of the destructive presence of government in the economy. Europe has, partially and unintentionally but nevertheless destructively, adopted the static statism that characterized countries like Poland, Czechoslovakia and Hungary before the Iron Curtain came down.
The stagnant nature of the European economy and the slower-than-capacity growth rates in the United States and Canada are all self inflicted. The fatally erroneous belief that government has a productive role to play in the economy inhibits the creation of prosperity in parts of the world where, fundamentally, the conditions for creating prosperity are better than anywhere else. This structural mismanagement of some of the world’s wealthiest economies have ramifications far beyond their own jurisdictions. By keeping their economies from growing, Europe’s political leaders hold back demand for products from countries on the verge of climbing out of poverty. By holding back the forces of prosperity, America’s political leaders prevent the creation of a surplus that otherwise could provide funds for development and investment projects in developing countries.
Instead of unleashing the prosperity machine we know as capitalism and economic freedom, governments in Europe and North America spend far too much time trying to preserve their welfare states. When their government-run entitlement programs promise more than taxpayers can pay for, they resort to growth-hampering austerity measures, aimed not at reducing the presence of government in the economy but at saving the very structure and philosophy of the welfare state. The result, again, is stagnation and industrial poverty.
The First World’s obsession with the welfare state thus prevents the proliferation of prosperity to parts of the world still struggling in poverty. By means of economic freedom, nationally and globally, the relatively wealthy can help the poor toward a better life. This cannot be stressed strongly enough; if accounts of the demerits of the welfare state are not enough to turn our political leaders in favor of economic freedom, then perhaps a new report on global poverty can help. Published by an organization called ATD Fourth World, Challenge 2015: Towards Sustainable Development that Leaves No One Behind provides a painfully direct account of abject poverty around the globe. The authors do not exhibit any deeper understanding of what causes poverty, but the parts of the report that tell the story of poverty from the “ground level” are definitely worth reading.
More than that, they provide a stark contrast to the destructive policies used in Europe and North America to preserve the welfare state. Instead of raising taxes and putting more of our own people on welfare, we owe it to the rest of the world to maximize our creation of prosperity. We can only do that by relieving our own population of the shackles of artificial redistribution. With more wealth, higher incomes and a growing standard of living we will have more money to trade with developing countries, as well as more surplus to donate to and invest in productive development projects in the poorest parts of the world.
Economic freedom has elevated billions of people from abject poverty to a respectable standard of living. It has elevated millions into true prosperity, and thousands upon thousands to almost unlimited wealth. It can do the same for those still in poverty. All it takes is that we in the most prosperous nations of the world sort out our priorities and responsibilities.
Today my book Industrial Poverty: Yesterday Sweden, Today Europe, Tomorrow America is officially available. You can order it directly from the publisher or through Amazon. An ebook version is on its way out, too, but why wait when you can get the real thing now?
In his foreword, Cato Institute senior fellow Michael Tanner writes:
Larson provides convincing evidence that the welfare state, and misguided policy choices by Europe’s governments, turned a regular recession into a systemic economic crisis. During the seemingly prosperous first years of the European Union, few people could foresee the problems ahead, and even fewer viewed these developed countries as struggling with a form of poverty. However, during this stubborn economic recession, GDP growth in many European countries slowed (or even stopped), private consumption stalled, government spending surged, and unemployment rates among the young increased. This book helps us to better understand the current situation facing Europe today, one far more complicated than the austerity versus stimulus dichotomy that is so often imposed.
And that is the most important point I hope readers will take away from this book. Europe’s crisis is not just a recession – it is the result of decades of bad policy compounded slowly into an ultimately unbearable burden for the private sector. There is plenty of evidence for this. Europe’s decline during the Great Recession is not new, but the logical continuation of four decades of slow but inevitable stagnation. The U.S. economy is on a similar, but more recent trajectory and still has the dynamics to recovery (albeit modestly) from the recession.
With slower growth it becomes more difficult for Europeans (and Americans) to increase, and eventually maintain their high standard of living. Stagnant economies also produce less surplus that can be used for aid to poor nations, either through government or through charitable donations. Trade also suffers negatively, hitting primarily low-income nations first.
Another side of economic stagnation with global repercussions is high, persistent unemployment. More than one in five young men or women in the European Union is unemployed. Overall unemployment remains stubbornly above ten percent. While the United States is experiencing declining unemployment rates, job growth is still far from as strong as it normally would in a recovery. With unemployment remaining high, it becomes increasingly difficult for Europe to provide opportunities for immigrants from poorer parts of the world.
With the two largest economies in the world tentatively on a path to long-term stagnation, the consequences for the rest of the world could be serious, especially in terms of the ability to provide disaster relief, aid and development funds. This paper suggests that the long-term stagnation is the fault of the industrialized countries. Given that the people of the prosperous nations of the world have a moral obligation to help those in abject poverty, it is immoral to fail to address the cause of long-term stagnation.
In other words, what is happening in Europe is not just a matter for the poor 500 million souls who live there, but for the rest of the world. It is of vital importance to all of us that Europe today, and the United States very soon, get their macroeconomic act together and remove the hurdles to growth and prosperity that the welfare state has created.
Yes, the welfare state. It is the root cause of Europe’s many problems. Their crisis is, to put it plainly, self inflicted. Over its more than half-century long life, the welfare state has fundamentally transformed large parts of the economic landscape. It has changed work incentives by means of both taxes and entitlements. Income-security programs, much larger in Europe than in the United States, have weakened people’s motives for participating in the workforce. The redistributive nature of the income-tax system discourages entrepreneurship and the pursuit of high-end professional careers.
Self determination and innovation are replaced by sloth and indolence.
This is a new perspective on the European crisis, a perspective that I spend my entire book explaining. The usual question “why isn’t anyone else saying this?” is easily answered: it is only recently that we have access to enough information, enough economic data, to piece together a hypothesis about the welfare state’s long-term effects on its host economy. Especially in view of the Great Recession it is now possible to study broader economic trends and the long-term macroeconomic effects of the institutions that constitute the welfare state. In this new wealth of information, a pattern is emerging, suggesting that while the welfare state can have short-term positive effects on economic growth, its long-term effects are undeniably negative.
In particular, it now appears to be possible to identify a “point of no return” beyond which the welfare state pushes an economy over the line, from the realm of GDP growth into perennial stagnation.
For more on that, and for more on what life looks like under Industrial Poverty, buy my book today!
As I keep saying, there are no reasons for Europe’s households and entrepreneurs to be optimistic about the future. Therefore, they are not going to spend more money. They are going to drive their economy into the deep, long ditch of deflation, depression and permanent stagnation.
Eurozone private business growth slowed more than expected in August, despite widespread price cutting, as manufacturing and service industry activity both dwindled, a survey showed on Thursday (21 August).
This is an important, but hardly surprising measurement of what is really going on in the European economy. When buyers do not respond positively to price cuts, it means either of two things:
- They cannot afford to increase spending; or
- They are so pessimistic about the future that they hold on for dear life to whatever cash they have.
A less likely explanation is that they speculate, planning their purchases for a future point in time when prices are expected to be even lower. For this to be true there would have to be other signs of improving economic activity, signs indicating that, primarily, households can afford to spend money in the first place. But the European economy does not exhibit any such signs.
First of all, the cuts in entitlement programs may have wound down with some austerity measures coming to an end. But there is only a partial austerity cease-fire, with Greece, Spain, Italy, France and Sweden continuing contractionary budget measures. Austerity measures designed to save the welfare state in the midst of an economic crisis inject a great deal of uncertainty among consumers, as they can no longer trust the welfare state with keeping its entitlement promises. More of household earnings is used to build barriers against an uncertain future, causing consumer spending – the largest item in the economy – to stall or fall.
So long as austerity remains a threat to the European economy, consumers are going to hesitate.
Secondly, employment is not growing. People’s outlook on the ability to support themselves in the future is not improving. Youth unemployment is stuck at one quarter of all young being unemployed, total unemployment is almost at eleven percent and neither is budging. So long as there is no improved prospects for jobs, those who have jobs will not feel increasingly secure in their jobs, and the large segments of the population who are out of work have no more money to spend than what government provides through unemployment benefits (often hit by austerity).
Third, the European Central Bank may be flooding the euro zone with cheap money, but that is not going to help increase economic activity. Its negative interest rates on bank deposits only leaves liquidity slushing around in the banking system, making banks increasingly desperate to put the money to work. But because of the two aforementioned problems there has been no net addition of demand for credit in the European economy. While the liquidity makes no good difference in the real sector, it may find its way into financial speculation. That is a different and troubling story; the point here is that monetary policy is completely exhausted and can no longer help move the economy forward. Since the fiscal policy instruments of the European economy are entirely devoted to government-saving austerity, there is no clout left in the economic policy arsenal. The Europeans are left to fend for themselves, mired in uncertainty and stuck having to fund the world’s largest government.
In other words, there is no reason to be surprised by the lack of demand response to declining prices. There are, however, a lot of reasons to be worried about Europe’s future. Euractiv again:
Economic growth ground to a halt in the second quarter, dragged down by a shrinking economy in Germany and a stagnant France … Markit’s Composite Purchasing Managers’ Index (PMI) will provide gloomy reading for the European Central Bank (ECB), suggesting its two biggest economies are struggling like smaller members. Based on surveys of thousands of companies across the region and a good indicator of overall growth, the Composite Flash PMI fell to 52.8 from July’s 53.8, far short of expectations in a Reuters poll for a modest dip to 53.4.
Technically, any index number above 50 means purchasing managers are still expanding purchases. However, since the second-order trend is negative – the increase is flattening out – it is only a matter of a little bit of time before the PMI index itself goes negative. Shall we say three months? The Euractiv story gives good reasons for that:
Markit said the data point to third-quarter economic growth of 0.3%, matching predictions from a Reuters poll last week. “We are not seeing a recovery taking real hold as yet. We are not seeing anything where we look at it and think ‘yes, this is the point where the eurozone has come out of all its difficulties’,” said Rob Dobson, senior economist at Markit.
Again, an economist whose thinking is upside down. The right question to ask is not when the European economy is going to recover. The right question to ask is: what reasons does the European economy have to recover in the first place? In the emerging deflation climate, and with the economy stuck in the liquidity trap where monetary policy is completely impotent, Europe’s households and entrepreneurs have no reasons to change their current, basically depressed economic behavior.
Deflation is the most worrying part of their crisis. Says Euractiv:
Consumer prices in the eurozone rose just 0.4% on the year in July, the weakest annual rise since October 2009 at the height of the financial crisis, and well within the ECB’s “danger zone” of below 1%. Worryingly, according to the composite output price index firms cut prices for the 29th month – and at a faster rate than in July. … Also of concern, suggesting factories do not expect things to improve anytime soon, manufacturing headcount fell at the fastest rate in nine months.
This is not a protracted recession. This is a new normal, a state of permanent stagnation.
A state of industrial poverty.
My book Industrial Poverty: Yesterday Sweden, Today Europe, Tomorrow America will be officially available as hardcopy and e-book on September 10. This book basically asks a two-step question: Has the industrialized world entered a state of permanent economic stagnation? If so, is the state of stagnation self-inflicted?
I suggest that the answer is affirmative on both accounts. The consequence is dire for the two largest economies in the world:
- Europe is stuck in a depression that is leaving one in five young man and woman with no other option than to live off welfare;
- While the U.S. economy is improving, it is a recovery that leaves a lot to be wished for, primarily in terms of job creation and economically sustainable consumer spending.
The United States will continue to move, slowly, in the right direction, but without structural reforms to end large entitlement systems it will be very difficult to achieve more than 2-2.5 percent growth per year. That is just about enough to maintain a constant standard of living on an inter-generational basis.
A growing number of economists are expressing concerns about what will come after the Great Recession. One of them is Stanley Fischer, the number two guy at the Federal Reserve. From the New York Times:
Sounding a somber note even as the economic outlook in the United States brightens, the Federal Reserve’s No. 2 official acknowledged on Monday that global growth had been “disappointing” and warned of fundamental headwinds that might temper future gains. … Stanley Fischer … noted that although the weak recovery might simply be fallout from the financial crisis and the recession, “it is also possible that the underperformance reflects a more structural, longer-term shift in the global economy.” In a speech delivered on Monday in Stockholm at a conference organized by the Swedish Ministry of Finance, Mr. Fischer also conceded that economists and policy makers had been repeatedly disappointed as the expected level of growth failed to materialize.
My book is timely, in other words… To be perfectly honest, the reason why “economists and policy makers had been repeatedly disappointed” during the Great Recession is precisely that they do not primarily think in structural – or institutional – terms. One reason is the over-reliance on traditional econometric methods, which work well so long as there is no major upset to the overall structure of the economy. Another reason is the downgrading of genuine economic theory: today’s average graduate student in economics probably will never read an original text by theory-based scholars like Keynes, von Mises, Hayek, Lerner, Harrod or even Milton Friedman. Today’s academic economics puts the cart before the horse, deciding what tools to use first and then finding a list of problems those tool may apply to. What does not make the list is not of interest.
This is, obviously, an exaggerated stylization, but it is not more than that. Instead of using methodology that asks how soon the European economy will return to business as usual, economists need to begin to ask what reason, if any, the European economy has to return to full employment and growth. I have made my contribution. Stanley Fischer is opening for the same type of non-traditional analysis. Here is what he said, directly from the Federal Reserve website:
[The] Great Recession is a near-worldwide phenomenon, with the consequences of which many advanced economies–among them Sweden–continue to struggle. Its depth and breadth appear to have changed the economic environment in many ways and to have left the road ahead unclear. … There has been a steady, if unspectacular, climb in global growth since the financial crisis. For example, based on recent IMF data from the World Economic Outlook, which uses purchasing power parity weights, world growth averaged 3percent during the first fouryears of the recovery and as of July was expected to be 3.4 percent this year. The IMF expects global growth to reach 4 percent next year–a rate about equal to its estimate for long-run growth. This global average reflects a forecast of steady improvement in the performance of output in the advanced economies where growth averaged less than 1 percent during the initial phase of the recovery to an expected 2-1/2 percent by 2015.
Again, the best we can hope for is growth that – as I explain in my book – keeps our standard of living from a continuous decline. But let us also keep in mind that if we are going to expect Europe to grow by 2-2.5 percent next year, a minor miracle has to happen. A true end to welfare-state saving austerity would be a big step in that direction, but so far we have not seen more than verbal commitments to that. But even as this European version of austerity ends, it will take quite a while before the economy will recover. Confidence, like Rome, is not built in a day, and therefore I predict that Fischer will be too optimistic about Europe.
As we return to Stanley Fischer, he stresses the tepid nature of the global recovery:
With few exceptions, growth in the advanced economies has underperformed expectations of growth as economies exited from recession. Year after year we have had to explain from mid-year on why the global growth rate has been lower than predicted as little as two quarters back. Indeed, research done by my colleagues at the Federal Reserve comparing previous cases of severe recessions suggests that, even conditional on the depth and duration of the Great Recession and its association with a banking and financial crisis, the recoveries in the advanced economies have been well below average.
Which is yet more evidence that my argument that this is a structural crisis is valid. But not only that: the structural crisis is of a kind that traditional economics has not yet grasped. The culprit is the welfare state, the depressing effect of which slowly emerged up to four decades ago. However, unlike other long-term trend suggestions, such as the Kondratiev cycle, my hypothesis about the welfare state has a realistic microeconomic underpinning. More on that at some other point; for now, back to Stanley Fischer:
In the emerging market economies, the initial recovery was more in line with historical experience, but recently the pace of growth has been disappointing in those economies as well. This slowing is broad based–with performance in Emerging Asia, importantly China, stepping down sharply from the post-crisis surge, to rates significantly below the average pace in the decade before the crisis. A similar stepdown has been seen recently for other regions including Latin America. These disappointments in output performance have not only led to repeated downward revisions of forecasts for short-term growth, but also to a general reassessment of longer-run growth.
Does the welfare-state explanation apply to the emerging economies as well? In some cases the answer is yes, with South Africa and Argentina as leading examples. I am not familiar enough with the Chinese economy to be able to tell what role the welfare state plays there, but I would be surprised if their talk from time to time about fighting social stratification has not led to an expansion of a government-based redistribution system.
But it really does not matter if the Chinese are expanding their welfare state, or are wrestling with a financial bubble. Neither is going to change the European economy, which – as we go back to the New York Times story – is showing yet more signs of perennial stagnation:
A report on Monday by the Organization for Economic Cooperation and Development warned that German economic growth might be slowing. Germany has been one of Europe’s rare bright spots, continuing to prosper even as countries on the periphery like Greece, Portugal and Spain struggle after the debt crisis of 2010-12.
Let’s take a closer look at that report on Friday. For now, let’s just note that it is good to see that more and more economists are taking a broader, less conventional look at the economy. Just as I do…
As I explained last week, the American economy is pulling ahead of Europe. One major reason why this is happening is that our welfare state, big and onerous as it is, has not quite yet grown to the point where it brings the private sector to a grinding halt. Our consumers and entrepreneurs still have enough breathing room to pursue happiness and prosperity.
It is a safe bet that Europe will continue to slide behind. More evidence of this is in this Euractiv.com report:
Germany, France and Italy have agreed on closer cooperation in the areas of energy, transport and digital infrastructure. At a meeting in Berlin on Wednesday (July 30), German Minister of State for Europe Michael Roth, French State Secretary of Europe Harlem Désir and Italian State Secretary of European Affairs, Sandro Gozi agreed on the shared goals. In an explanatory paper, the three Europe ministers emphasised the importance of bridging investment gaps. “It is necessary that we fully exploit existing instruments like the EU structural funds, loans from the European Investment Bank and project bonds,” said Roth. But it is also important to be ready to test new, suitable instruments – regardless whether public or private, he added.
The prevailing political doctrine, in other words, is that more government spending is needed in Europe. The only problem the statists have is that they do not know how to fund that new spending, and that is perhaps the only silver lining in this. After the tax hikes that came with the past few years of austerity, Europe can catch its breath for a while.
This emphasis on government spending is part of a trend that gained momentum with the socialist gains in the EU elections in May. Consequently, it is not surprising that, according to Euractiv, these European politicians…
also emphasised the desire to more strongly address high youth unemployment in many EU member states. Europe should not be reduced to a functioning internal market and a common currency, Roth explained. “Europe is also, and above all, a community of values and solidarity.” Germany, France and Italy have set common goals of fulfilling targets for sustainable growth and improving employment opportunities, said Roth. Above all, this applied to the younger generation, he added.
By using terms like “values” and “solidarity” instead of “freedom” and “opportunity”, Europe’s political leaders declare again that government is the key player in bringing the continent’s economy out of its perennial slump. When government designs policies based on “values” it means imposing ideas of income redistribution on taxpayers, who are then asked to give up some of their money for someone who has not earned it. When government pursues “solidarity” it wants to eradicate differences between individuals in terms of economic outcomes. Jack’s hard work should not give Jack more than what Joe can achieve through sloth and indolence.
There is another interesting angle to this. Euractiv again:
To free up new sources of cash, the European Commission would like to expand project bonds for large infrastructure projects. According to the Commission, these funds will be granted to private investors such as banks and pension funds to support cross-border infrastructure like power grids, roads and railways. The credit quality of loans will be improved through the acquisition of guarantees.
As I have explained numerous times on this blog, a major component of the so called financial crisis was the early and rapid credit decline of Europe’s welfare states. In the years leading up to the crisis, financial institutions in Europe had rapidly expanded their investments in European government debt. As the credit worthiness of those welfare states fell, so did the solidity of bank portfolios. Spanish, Irish, Portuguese, French, Italian and – not to forget – Greek treasury bonds were reduced from practically no credit risk to more or less junk status. As a result, bank balance sheets tumbled, and a real financial crisis emerged – not as a cause of the economic crisis, but as a result of it.
Now governments in Europe want private investors to once again trust them with their money.
Apparently, Europe has learned nothing from the crisis. Instead both voters and political leaders demand more of the very same economic ingredients that caused the crisis in the first place: entitlements, high taxes and unsustainable welfare states.
Europe has turned into an economic wasteland. So long as its politicians keep protecting the welfare state at any cost, the European continent will sink deeper and deeper into perennial industrial poverty.
As an institutional economist I focus my research on the role that institutions and policy structures play in our economy. It is a fascinating niche in economics, and when combined with macroeconomics it becomes one of the most powerful analytical tools out there. So far, over the past 2.5 years, everything I have predicted about the European crisis has turned out to be correct; my upcoming book Industrial Poverty makes ample use of institutional economics and macroeconomics to show why Europe’s crisis is far more than just a protracted recession.
In economics, the institutional methodology is often pinned against econometrics, the mainstream methodological favorite. I don’t see it that way – econometrics has its place in economics – but the mainstream of the academic side of economics has given econometrics a far bigger role than it can handle. This has led to over-confidence among econometricians which, in turn, has led to a downplay or, in many cases, complete disregard for the benefits that other methodologies bring. The worst consequence of this over-reliance on econometrics was the multiplier debacle at the IMF, with serious consequences for the Greek economy. (How many young Greeks are unemployed today because their government implemented austerity policies based on IMF miscalculations?) A wider, better understanding for economic institutions and their interaction with the macroeconomy could help mainstream economists a long way toward a deeper, more complete understanding of the economy and, ultimately, toward giving better policy advice.
As an example of how institutional analysis can inform more traditional analysis, consider this interesting article on the European crisis by Economics Nobel Laureate Michael Spence and David Brady, Deputy Director of the Hoover Institution:
Governments’ inability to act decisively to address their economies’ growth, employment, and distributional challenges has emerged as a major source of concern almost everywhere. In the United States, in particular, political polarization, congressional gridlock, and irresponsible grandstanding have garnered much attention, with many worried about the economic consequences. But, as a recent analysis has shown, there is little correlation between a country’s relative economic performance in several dimensions and how “functional” its government is. In fact, in the six years since the global financial crisis erupted, the US has outperformed advanced countries in terms of growth, unemployment, productivity, and unit labor costs, despite a record-high level of political polarization at the national level.
This is true, and as I demonstrate in Industrial Poverty, a major reason for this is that the American economy is not ensnared in a welfare state like the European. We still lack a couple of major institutional components that they have: general income security and a government-run, single-payer health care system. That said, the U.S. economy is not exactly performing outstandingly either:
Yes, we are currently in better shape than Europe, but we are also doing worse than ourselves 20, 30 or 40 years ago.
Let’s keep this in mind as we continue to listen to Spence and Brady – their discussion about political dysfunction is actually tied to the role of the welfare state in the economy:
[In] terms of overall relative economic performance, the US clearly is not paying a high price for political dysfunction. Without dismissing the potential value of more decisive policymaking, it seems clear that other factors must be at work. Examining them holds important lessons for a wide range of countries. Our premise is that the global integration and economic growth of a wide range of developing countries has triggered a multi-decade process of profound change. These countries’ presence in the tradable sector of the global economy is affecting relative prices of goods and factors of production, including both labor and capital.
And the government structures that aim to redistribute income and wealth within a country. High-tax economies lose out to low-tax economies. The Asian tigers have generally held tax advantages over their European competitors, but they have also held advantages on the other side of the welfare-state equation as well. By not putting in place indolence-inducing entitlement systems they have kept their work force more shaped toward high-productivity labor than is the case in the old, mature welfare states of Europe.
Why does the welfare state not change, then, in response to increased global competition? After all, Japan, China, South Korea and other Asian countries have been on the global market for decades. Enter the political dysfunction that Spence and Brady talk about. Unlike the United States, there is almost universal agreement among Europe’s legislators that the welfare state should be not only preserved but also vigorously defended in times of economic crisis. This has been the motive behind the European version of austerity, with the result that taxes have gone up, spending has gone down and the price of the welfare state for the private sector has increased, not been reduced as would be the logical response to increased global competition.
It is not entirely clear what kind of American political dysfunction Spence and Brady refer to, but if it has to do with fighting the deficit, they are absolutely on target.
In fact, probably without realizing it, Spence and Brady make an important observation about the long-term role of the welfare state:
Relatively myopic policy frameworks may have worked reasonably well in the early postwar period, when the US was dominant, and when a group of structurally similar advanced countries accounted for the vast majority of global output. But they cease working well when sustaining growth requires behavioral and structural adaptation to rapid changes in comparative advantage and the value of various types of human capital.
If understood as a general comment on the institutional structure of an economy, this argument makes a lot of sense. So long as the traditional industrialized world only had to compete with itself, it could expand its welfare states without paying a macroeconomic price for it. Gunnar Myrdal, Swedish economist and a main architect of the Scandinavian welfare-state model, confidently declared back in 1960 that the welfare state had no macroeconomic price tag attached to it. Back then, it was easy to let government sprawl in every direction imaginable without any losses in terms of growth, income and employment. That is no longer possible.
Spence and Brady then make this excellent observation of the American economy:
What, then, accounts for the US economy’s relatively good performance in the post-crisis period? The main factor is the American economy’s underlying structural flexibility. Deleveraging has occurred faster than in other countries and, more important, resources and output have quickly shifted to the tradable sector to fill the gap created by persistently weak domestic demand. This suggests that, whatever the merit of government action, what governments do not do is also important. Many countries have policies that protect sectors or jobs, thereby introducing structural rigidities. The cost of such policies rises with the need for structural change to sustain growth and employment (and to recover from unbalanced growth patterns and shocks).
The move of resources from the domestic to the foreign-trade sector is visible in national accounts data as a rise of gross exports as share of current-price GDP from 9.1 percent in 2003 to 13.5 percent in 2013. Furthermore, actual growth numbers for exports relative private consumption reinforce the point made by Spence and Brady: from 20087 to 2013 private consumption has increased by 15 percent in current prices, while gross exports have increased by more than 22 percent. For every new dollar Americans doled out on cars, food, haircuts and motel nights, foreign buyers added $1.50 to what they spend on our products.
However, let us once again remember that the adaptation of the American economy should be viewed against the backdrop of a smaller welfare state. As I have discussed on several occasions, European countries are also making big efforts at increasing exports. They are not as lucky in using foreign sales as a demand-pull mechanism for restarting their economies. One reason, again, is the rigor oeconomicus that the welfare state injects into the economy.
Spence and Brady also compare the United States to a number of other countries, noting that:
Removing structural rigidities is easier said than done. Some stem from social-protection mechanisms, focused on jobs and sectors rather than individuals and families. Others reflect policies that simply protect sectors from competition and generate rents and vested interests. In short, resistance to reform can be substantial precisely because the results have distributional effects. Such reform is not market fundamentalism. The goal is not to privatize everything or to uphold the mistaken belief that unregulated markets are self-regulating. On the contrary, government has a significant role in structural transitions. But it must also get out of the way.
In short – and my words, not theirs: reform away the welfare state. Its detrimental influence actually stretches deeper than perhaps Spence and Brady recognize: it does indeed protect large sectors from competition by simply monopolizing them. Health care is a good example, with a government monopoly spilling over on medical-technology products. Another good example is income security, where many European countries have de facto monopolized every aspect from parental-leave benefits to retirement security. Education is a third example, where the United States, despite its heavily socialized K-12 system has a very strong private sector for academic education. This sector is almost entirely absent in many European countries.
Again, it is good to see a different approach to economic analysis than the traditional one based on econometrics and often irresponsibly simplified quantitative analysis. In a situation like the European crisis, it is very important for economists and other social-science scholars (Brady is a political scientist) to broaden the analysis and focus on such variables that rarely change. Among those are economic institutions such as the welfare state, and the political and economic incentives at work in Europe to preserve it, even in the face of mounting global competition.
The European crisis still seems to confuse the continent’s policy makers. After having believed for several years that austerity would both save the welfare state and increase growth, they have now slowly began walking away from the EU’s constitutionally required government deficit and debt rules. Instead, there is now growing belief in government spending as the remedy for the persistent crisis.
For the most part, the debate now seems to gravitating toward the question of how much government stimulus is needed. If the continent is indeed in a recovery mode, as some suggest it is, then there is not this big need for more government spending.
It is understandable that some believe there is a recovery under way. According to Eurostat, GDP for the EU as a whole grew by an inflation-adjusted 1.5 percent in the first quarter of 2014, over the same quarter of 2013. This is an increase from the last quarter of 2013 (1.0 percent) and in fact the fourth quarter in a row with improving growth numbers.
Technically, this represents a recovery. However, in no way does this mean that Europe is out of the crisis. To see why, let us compare GDP growth rates for EU-28 during the 2009-10 spurt to the one that started in 2013:
|Q2 2009||Q3 2009||Q4 2009||Q1 2010||Q2 2010|
|Q1 2013||Q2 2013||Q3 2013||Q4 2013||Q1 2014|
Early on in the Great Recession, the European economy made a rapid recovery and kept growing at more than two percent per year for four quarters straight. The rate slowly fell, though, and by the second quarter of 2011 growth was once again below two percent. By the end of that year it was below one percent, and down into negative territory in Q2 of 2012.
But should not a growth spurt count as a definitive recovery? Are not four quarters of improvement enough, especially if followed by a year of growth above two percent?
There is some merit to that argument. The problem is that the growth rates discussed here are not the kind of rates that normally would constitute a recovery, let alone a growth phase of a business cycle. Europe is in a structural crisis, which means that its growth rate is permanently lower than it was before. This is now becoming painfully evident in Eurostat’s national accounts data.
It has now been six years since the Great Recession began. For the entirety of the crisis that we have seen so far, namely 2008-2013, the average inflation-adjusted annual GDP growth rate for the European Union is a depressing -0.1 percent.
This is despite the aforementioned growth spurt.
Compare that to the six preceding years, 2002-2007: 2.4 percent. And that covers the back end of the Millennium Recession. Going back yet another six-year period to 1996-2001, we include the opening and trough of that recession, and still come out with 2.8 percent per year!
To further emphasize the structural nature of the European crisis, let us look at a long-term trend in growth. The following figure illustrates GDP growth in the EU as a six-year moving average. Starting in the fourth quarter of 2001 the average begins by covering the 1996-2001 period. The average is quarter-based to give as detailed an image as possible:
The red trend line conveys a chilling message of structurally driven decline. In order to get Europe out of this decline and persistent crisis, economists must re-write their own books on macroeconomics. Surely, the conventional relative-price based advice from accomplished economists such as Michael Spence is still valid: a reduction in the cost of production in Spain vs. other exporting countries will eventually bring about a boost in exports. But as I have pointed out on several occasions, when that boost happens, such as in Germany or Sweden, it has very little influence on GDP growth as a whole. Modern foreign trade in industrialized economies is an isolated activity as many inputs are imported from elsewhere.
But more importantly, the presence of the welfare state throws a heavy, wet blanket over the economy. Austerity, as practiced in Europe in recent years, has added insult to injury by means of even higher taxes and even more perverted economic incentives.
As Michael Spence points out in the aforementioned article, it does not help Europe’s most troubled economies to share currency with Germany. This prevents the exchange rate adjustment needed to reflect global relative production costs. But the conventional macroeconomic wisdom also tends to downplay the growth-hampering effect that welfare states, and welfare-state saving austerity policies, have on GDP.
Spence actually opens for a recognition of this problem in another article together with political scientist David Brady. They acknowledge that modern Western governments have difficulties unifying all their policy goals, including income redistribution. However, Spencer and Brady do not go into more depth on the role that income-redistributing policies may play in causing the downward growth trend illustrated above. Their choice not to do so is understandable – their focus is elsewhere – but it also reflects somewhat of a conventional wisdom among economists: income redistribution and its institutional form, the welfare state, is just another sector of the economy.
It is not. It is the overweight on the private sector that is slowly but inevitably destroying the prosperity of the West. For more on that, stay tuned for my book Industrial Poverty. Out soon!
There is no better macroeconomic “health indicator” for an economy than private consumption. Not only is it the largest part of GDP, but private consumption also reflects well the overall sentiment of households. Since households are important spenders, taxpayers and workers all baked into one type of economic unit, the growth rate of private consumption is the best quick-check “wellness test” of an economy. (A more detailed understanding of the shape of an economy obviously requires a more detailed macroeconomic and microeconomic analysis.)
Since I have recently reported on how the European economic recovery has not materialized, I figured it would only be fair to perform a quick-check macroeconomic “wellness test”. Alas, I pulled private consumption data from Eurostat, and I made sure to get inflation-adjusted figures based on a price that is relatively distant in time. (If the index year is close in time there can be growth distortions based on the mere proximity to “year zero”.) I also selected quarterly data, which is not commonly used for this purpose. My motivation, though, is that if the quarterly data is not seasonally adjusted it allows for a more frequent communication of household sentiments.
You would expect this type of data to be available from every EU member state for every quarter you might want it. I often encounter that attitude from consumers of public policy research: somehow they assume that every piece of statistical information anyone could ever want is readily available within two clicks into the internet. That is not the case, though, and the reason is simple. Quality statistical material requires careful data collection, according to detailed and very rigid collection methods; it requires methodologically rigorous processing according to standards defined not just for this piece of information, but for every comparable piece of information in the world.
There are other methodological restrictions on statistical information that contribute to the production cost. We should actually take this as a sign of quality for the data we have access to; I always get suspicious when scholars claim to have produced large sets of quantitative information in short periods of time – it often leads to bombastic conclusions that later prove to be little more than a house of cards built on clay feet.
Anyway. Back to the European economy. For reasons of high quality standards and therefore reasonably high production costs for national accounts data, not every EU member state reports the kind of consumption data analyzed here. Figure 1 below reports real private consumption growth in 24 EU member states from 2002 through 2013:
The growth rates, again, are inflation-adjusted rates per quarter, over the same quarter the year before. This means that the blue line reports a rolling annual growth rate, updated quarterly. As such it helps us pinpoint business cycle swings with good accuracy. The most obvious example is that private consumption nosedives in the second quarter of 2008: after having averaged an acceptable two percent per year from 2003 through 2007, private consumption literally came to a standstill over the next five years. From 2008 through 2012 the average growth rate was zero percent.
The difference may not seem like much, but for two reasons it would be wrong to draw that conclusion. First, a one-percent reduction in private consumption equals a decline in spending worth a bit over two million jobs in the EU-28 economy. This does not mean that two million Europeans automatically lose their jobs if households cut spending by one percent – the economy is more dynamic than that. But it does mean that if private businesses lose sales over a sustained period of time they cannot afford to keep all of their employees. At the macroeconomic level this eventually translates into, roughly, two million jobs per one percent private consumption (measured in current prices).
In other words, even seemingly small fluctuations in household spending can have major effects on the economy.
Secondly, sluggish private consumption means that the economy is not evolving. If the growth rate falls below two percent, then at least in theory consumers are no longer improving their standard of living. I explain in detail how this works in my book Industrial Poverty (out August 28); a very brief explanation is that it takes a certain level of sustained spending to maintain one’s standard of living. As products get better and other factors affect the quality of our consumption, we have to grow our outlays by a certain minimum rate just to make sure we keep our standard of living intact.
For the first half of the 12 years reported in Figure 1, households in the 24 selected EU member states managed to maintain their standard of living; on the other hand, for the second half of the period they did not maintain that standard. With an average growth rate of zero (adjusted for inflation) the theoretical loss of standard of living was two percent per year.
In addition to creating unemployment, this protracted sluggishness in household spending is a long-term prosperity downgrade for Europe’s consumers. What is even worse is that there are still no signs of a return to higher growth rates. While 2013 saw an average .8 percent growth in the EU-24 we discuss here, that came on the heels of ytwo years of negative growth (-0.6 percent). There was a similar, and bigger, uptick in 2010 (1.5 percent) that proved to be an anomaly compared to the two years before and after.
Furthermore, data for the first quarter of 2014, which is available for 20 of the 24 EU member states, shows a rise in inflation-adjusted private consumption in three countries only. While it is good to see a rise in Greece and Spain, which have been the hardest hit by the crisis (Austria is the third) this is far too isolated and far too small to be the turnaround many economists have hoped for.
More importantly, this is where the use of quarterly data can spook the careless observer. Spanish private consumption, which is up by 3.1 percent in the first quarter of this year, has a pattern of growing every other quarter. Since it was down 1.3 percent in the last quarter of 2013, this only means that the economy is on track with its historic path (which, sadly, means zero growth over the 16 quarters in 2010-2013). The rise in Greek private spending is part of a similar pattern, coming on the heels of a 2010-2013 average of -1.1 percent.
Bottom line, then, is that European households are unwilling or, more likely, unable to unleash that spending spree the European economy needs so badly. This should not surprise any regular reader of this blog, but it will in all likelihood be a surprise to those who live in the illusion that big government and the welfare state are the blessings that prosperity is built from.
I have explained on numerous occasions that the European economy is not at all in recovery mode. Jobless numbers are frighteningly bad, the long-term trend is still pessimistic, GDP growth is so slow that there is a credible deflation threat hanging over Europe, the OECD recently wrote down its growth forecast for the global economy, including the EU. All in all, Europe is a slow-motion economic disaster.
Now British newspaper The Guardian reports of yet another dark cloud over the European economy:
The eurozone’s fragile economic recovery suffered a setback in the first quarter after slower-than-expected growth. The combined currency bloc scraped together growth of 0.2% between January and March, in line with growth in the previous quarter but disappointing expectations of 0.4% growth.
This amounts to 0.8 percent for the entire year, which is deeply insufficient to turn around the European economy. The best you can say about this growth figure it is yet another indicator that my forecast of Europe being stuck in long-term stagnation is correct. This long-term stagnation is not a recession – it is a new era for the European economy.
There was a huge divergence in fortunes, with Germany growing at the fastest rate of all 18 countries, with gross domestic product increasing by 0.8%. It followed 0.4% growth in Europe’s largest economy in the previous quarter. The pace of recovery also accelerated in Spain, with growth of 0.4% outpacing a 0.2% increase in GDP in the previous three months.
I have explained before that the German economy is growing because of its strong exports. The gains from the exports industry do not spread to the rest of the economy, as is evident from paltry domestic spending figures for the German economy. The same is, in all likelihood, true for the Spanish economy, whose national accounts I will take a look at as soon as time permits.
When exports drive a country’s GDP growth, the country is not in a sustained recovery. The only way a sustained recovery can happen is if private consumption and corporate investments increase together. That is not yet happening in Germany, and it is certainly not happening in Spain.
At the bottom of the pile was the Netherlands, which suffered a shock 1.4% contraction in GDP, reversing 1% growth in the previous quarter. Portugal’s economy shrank by 0.7%, following growth of 0.5% in the final three months of last year. The French and Italian economies were also dealt a blow, with zero growth in France and a 0.1% contraction in Italy in the first quarter. It followed 0.2% growth and 0.1% growth in the fourth quarter of 2013.
Stagnation, for short. And the only remedy that Europe’s political leaders seem to be able to think of is to print even more money, to saturate the economy with liquidity and to thus depreciate the euro vs. other major currencies. But with the Federal Reserve continuing its Quantitative Easing policy and the Chinese facing major problems in their financial sector it is entirely possible that the attempts at eroding the value of the euro will be neutralized by similar attempts from two of the world’s other major central banks. That in turn will put a damper on exports and rob the Europeans of even the illusion that their GDP will at some point start growing again.
At the end of the day, the fact that this negative news disappoints so many people in Europe is yet another indicator that my new book, Industrial Poverty, out in late August, is badly needed.
It is no secret to readers of this blog that Europe’s political leadership is entirely out of touch with the real life conditions that people live under in Europe. The reckless fiscal policies imposed on member states by the EU leadership over the past 4-5 years have damaged the living conditions and the future prospects of perhaps as many as 200 million people in Europe. In 19 EU member states, youth unemployment exceeds 20 percent, while in at least two it is between 19 and 20 percent. In 7 member states it exceeds 30 percent, with three countries – Croatia, Greece and Spain – seeing more than half of their young go unemployed.
This is nothing short of a social and economic disaster, unfolding in slow motion without much media attention. Sometimes, though, Europe’s political leaders get an attention spurt and decide that they want to do something about that disaster. The latest fad is some sort of “social protocol” that is supposed to monitor and (in theory) initiate policies against the worst exhibits of the unfolding disaster. Euractiv.com reports:
As the European Commission prepares to issue its first-ever social policy recommendations in the framework of the strengthened European Semester of economic policy coordination, there are lingering questions as to what the whole process will actually achieve, with critics branding it a “communications exercise”. As announced last October, the EU executive will publish its assessment by next month on five “key social indicators”, together with its usual macro-economic recommendations. Poverty, inequality, household income, employment rates and youth joblessness will all come under scrutiny as part of the social monitoring process.
So now, after five years of destructive austerity policies with higher taxes and spending cuts; policies that have driven unemployment to depression levels in many countries; after five years of trying to balance government budgets in the midst of sharply rising demand for poverty relief entitlements and tax base erosion; the EU now starts wondering how people are doing in Europe.
Back to Euractiv:
This “scoreboard for employment and social indicators” is one of the “new tools to build the social dimension of the Economic and Monetary Union (EMU)”, the Commission says. It was launched in an attempt to strengthen the social dimension of the EMU as governments across Europe were feeling the backlash of austerity policies decided in the midst of the sovereign debt crisis. “The new scoreboard of key employment and social indicators shows that we have high income inequalities in some member states and the data also shows increase in the differences of income inequalities amongst the member states of the Eurozone, between the core and the periphery. Persisting and increasing socio-economic divergence is a problem for a monetary union,” said Laurence Weerts, who is responsible for the social dimension of the EMU in the office of László Andor, the EU Employment Commissioner.
There was a vast economics literature available back when they started planning the currency union, showing that the euro zone did not meet the criteria of an optimal currency union. It would have been easy for the Eurocrats to avoid the problems caused by putting together a sub-optimal currency union – all they would have had to do was to, well, keep the national currencies.
But more importantly, the depression-level social problems in countries like Greece, Spain and Portugal would never have come about if the EU had not forced those member states to accept the EU-ECB-IMF version of austerity. Greece, as we know, lost one quarter of its GDP to austerity. One quarter. In the past six years unemployment in the 15-64 age group has tripled in Greece (it was 27.7 percent in 4th quarter of 2013) and Spain (26.1) and doubled in Italy (12.9) and Portugal (16.1). Youth unemployment, i.e., the age group 15-24, tripled in Spain (from 18.1 percent in 4th quarter of 2007 to 55.1 percent in 4th quarter of 2013), almost tripled in Greece (from 22.6 percent of 57 percent), doubled in Portugal (16.8 to 35.7) and almost doubled in Italy (23.2 to 43.5).
It is almost impossible to imagine that the EU leadership understands how their policies actually created this economic disaster. Yet, so long as they maintain their current policy priorities, where a balanced government budget is more important than any other policy goal, there will be no improvement of the situation for the perhaps 100 million Europeans whose livelihood critically depends on the welfare state. If instead the EU decided to get the welfare state out of the way, if they did away with the taxes that feed the welfare state and discourage entrepreneurship, they would quickly (by macroeconomic standards) see an improvement in the living conditions of those who are now on the dole.
However, that is probably not going to happen. The EU leadership is so stuck in its view of what is good and bad policy that its only idea of how to get the European economy going again is to depress wages. This, of course, means more people will depend on government just to survive the month. Euractiv again:
Belgian Green MEP, Philippe Lamberts, a member of the committee on economic and monetary affairs, welcomed the announcement in principle but says he doubts the recommendations will be taken into account. “I hope there will be country specific recommendations aimed at reducing inequalities. The problem is that they would be in contradiction with the usual Commission recommendations which say that we need to make the labour market more flexible, to reduce the power of social interlocutors, which clearly means putting a downward pressure on wages. If the Commission is to introduce recommendations to reduce inequalities, it would contradict itself,” Lamberts said. To really deliver on the social dimension, the Commission would need to “change directions” which “it won’t”, Lamberts said.
Two forces depress wages in Europe: high unemployment and large immigration of low-or-no skilled labor. Both forces are currently at work, which effectively means that Europe’s welfare states are going to get more clients. This in turn means that there is even less of a chance that Europe will be able to avoid a future in the economic wasteland where stagnation rules, people live in industrial poverty and there is no hope for a better future.
Think that can’t happen? Wait until late August when my book Industrial Poverty is out (Gower Applied Research). You will never see Europe the same way again.