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.
Here is the first in a four-part series on austerity, its theory, its application and its consequences:
The United States of America is a wonderful country to live in. Contrary to the laments of most of my conservative and libertarian friends, this country is still among the most free and opportunity-friendly places on Earth. Americans are strong individuals, they are friendly yet have a lot of integrity, they celebrate winners and have compassion for losers. There is less racism here than in Europe, and we are more prosperous than they are, and deep down in the fertile soil of Middle America, the roots of freedom and democracy stand firm even when the political storms rage viciously through the legislative hallways of our country. Our constitution, while twisted and tweaked and bent and stretched, is still working.
Our deeply rooted sense of individuality – as opposed to individualism – and freedom is currently helping America through one of the toughest periods in her almost 250-year long history. This country is the last place on Earth where totalitarianism would take over. But our freedom, prosperity and peace are at least to some degree dependent on what is going on in the rest of the world.
This is why in the 20th century the United States established itself as a global power. Throughout most of that time, Europe has been a major scene for our foreign policy and military engagements. A big reason is that Europe has long been, and still is, a central stage for the fight against totalitarianism.
With the rise of totalitarian nationalism in primarily Germany, Italy and Spain in the 1920s and ’30s, Europe became the world’s most important battle ground between freedom and tyranny. Freedom won the war, but once the bullets had stopped flying a more polished version of the values that drove Hitler, Mussolini and Franco to power began setting roots in Western Europe. The idea of collectivism, which is in the DNA of Naziism and fascism, is also prevalent deep into the segments of European politics that are generally considered democratic. The notion that government can and should shape a nation, socially, culturally and economically, has taken seemingly more palatable forms than the swastika.
Today, nationalists no longer use the sense of patriotism as their first and foremost voter recruitment tool. The new gateway to nationalism is the welfare state.
More on that in a moment. First, a quick look back at how nationalism – and totalitarianism – is once again able to rise to political prominence in Europe.
In 1960, in one of the most revealing books on the subject, titled Beyond the Welfare State, Swedish economist Gunnar Myrdal explains how the idea of central economic planning without political dictatorship has conquered Western Europe and is slowly but relentlessly replacing Capitalism as the prevailing economic model. The welfare state, for short, would soon spread its intellectual tentacles across the Atlantic and peacefully defeat the American free-enterprise system. Myrdal was partly right: with considerable help from John Kenneth Galbraith’s Economics and the Public Purpose and The New Industrial State the American left made a major effort during the 1960s and ’70s to establish the European notion of collectivism and indicative economic planning as the new normal for the New World.
They never quite succeeded. The Obama administration represents the last effort of the collectivist left to “fundamentally remake” America (as Obama put it during his campaign). But while the welfare state is finally reaching its peak as a socio-economic model here in the United States, the Europeans are holding on to it for dear life. The entire fiscal struggle during the Great Recession has been about saving Europe’s ailing welfare states with every means possible – even at the expense of years of declining GDP, at the cost of 30, 40, 50 and even 60 percent youth unemployment. Ill-designed austerity, motivated not by a desire to shrink big government but to save it, has taken more from people in the form of higher taxes and given less back.
Instead of conceding that the welfare state is a lost cause; instead of repealing the welfare state and giving economic freedom a chance; the political leadership in Europe has doubled – no, tripled – down in their defense of collectivism, high taxes, income redistribution, entitlements, socialized health care and deep, stifling regulations of the labor market.
In countries with the biggest, most intrusive governments this has resulted in a dangerous political backlash. When voters feel betrayed by the government that promised to take care of them cradle to grave, and there is no alternative there presenting a case for economic freedom, voters turn their back on the established political institutions that gave them the welfare state. Those institutions also happen to be parliamentary democracy. Feeling that parliamentary democracy has let them down and left them out to dry, both financially and politically, large groups of voters are now turning to another form of collectivist parties.
The modern totalitarians.
When the European welfare state swept through Western Europe in the ’50s and ’60s its collectivist principles appealed to people whose cultural background was a straight line from late Medieval collectivism through undemocratic monarchies to the nationalist movements of the early 20th century. Europe may have been the birthplace of the concept of the individual, but the continent never quite unleashed what they had discovered. Unlike America, the roots of Europe’s political culture are still firmly in the notions of nationalism, collectivism and – almost for a century now – the welfare state. It was a smooth transition for Europe to go from nationalism to the welfare state: instead of being part of an ethnically, racially or culturally defined group along nation-state lines, the Europeans became part of a mildly Marxist dichotomy between taxpayers and entitlement recipients.
While the technical difference is considerable, the cultural difference is minor. The individual shrinks and crawls in under the group banner, hoping that the group will care for him. By giving legislative power to political parties that promise more entitlements, Europe’s voters have reaffirmed and reinforced the collectivist principles that guide the welfare state.
Those collectivist principles, however, are easily transferrable, from the welfare state onto another collectivist vehicle. Now that the welfare state has proven, beyond a shred of a doubt, that it can no longer keep its entitlement promises, Europe’s voters have begun listening to the old nationalist tunes again.
The difference between today’s nationalists and those that ultimately paved the way for Naziism and fascism after World War I, is that today they know how to use the welfare state to appeal to people. Every nationalist party in Europe, from the Danish People’s Party and the Swedish Democrats to the far uglier Front National in France, Fidesz and Jobbik in Hungary and Golden Dawn in Greece, promises to preserve the welfare state in one form or another. They have learned to capitalize on people’s frustration with the failing welfare state. But instead of rightly pointing out that the statist economic model is flawed, the modern nationalists – and especially the totalitarians among them – have projected the blame onto centrist, social-democrat and liberal political parties. Ultimately, this blame falls on parliamentary democracy itself.
So far, only the outer rim of the modern nationalist surge has pointed finger squarely at parliamentary democracy. However, as Golden Dawn, Jobbik and similar parties gain ground, antipathy toward the parliamentary system will grow. France will be one of the key battle grounds between nationalism and parliamentarism: if Le Pen follows in the early footsteps of her father it is entirely possible that her rise to the presidency in 2017 could mark the beginning of the end of De Gaulle’s Fifth Republic. If the radicals in her movement set the tone, the new France that would emerge – the Sixth Republic – could become a catalyst for a new, broad nationalist surge across Europe.
There are already movements around the continent hard at work to create a fascist “Gross-Europa”. They are probably not going to gain more than marginal political influence, at least not in the near future. But it is important to remember that a decade ago, the idea of a President Le Pen in France was laughable. Furthermore, the idea of a resurrection of European communism was ridiculed. I know, because I warned about it in an article in Front Page Magazine back in 2006 and got more than a few sarcastic comments from more established “thinkers”. Even a cursory look at the results in the EU Parliament election in late May shows how frighteningly right I was back then.
And I did not even consider that nationalism would be a competing force. But with two competing, and growing, totalitarian movements now procreating in Europe’s political landscape, the continent is facing a dark future. Independently, these movements will reinforce Europe’s collectivist culture and cling to its dying welfare state for as long as they can, and then some. Most of all, they are going to use it to entice people into crossing the line, from parliamentary democracy into a totalitarian political system Europe has supposedly left behind it.
Using the welfare state as an economic gateway drug, the modern totalitarians are going to try to reshape the continent that, for a century, has been America’s most costly foreign-policy problem. Given that both the nationalists and the communists now rising to political prominence are negative, in some cases outright hostile, toward America, that foreign-policy problem may soon come back knocking on the doors of the U.S. State Department – and the Pentagon.
In a great article in the Wall Street Journal, former vice president Dick Cheney and his daughter, former senatorial candidate Liz Cheney, explain how Obama’s failures on the foreign-policy front are transforming the Middle East into a new major headache for America. They are correct, but it is crucial for America’s future that our foreign policy does not overlook the radical transformation taking place in Europe right now.
Europe’s political leaders are showing more and more signs of discomfort – not to say emerging panic – over an economic crisis that just won’t go away. My diagnosis is that this is a permanent crisis, brought upon Europe by its fiscally obese and unsustainable welfare state. (Make sure to get my book Industrial Poverty when it comes out August 28!) By consequence, it is therefore not possible for Europe to get out of the crisis unless they first roll back and eventually fully dismantle their welfare state.
Not everyone agrees. As the EU Observer reports, the social affairs commissioner of the EU – compare him to the U.S. Secretary of Health and Human Services – is getting mighty frustrated with the crisis and calls for a restoration of the welfare state:
The EU’s social affairs commissioner on Friday (13 June) lashed out at the EU’s response to the economic crisis. Lazlo Andor, in a speech delivered in Berlin, said debt-curbing policies designed to resolve the sovereign debt crisis have wrecked Europe’s social welfare model. “Austerity policies in many cases actually aggravated the economic crisis,” he said.
Has he been sneak-peeking on this blog? Apparently, because he cannot have read my articles in full. If he had, he would know that there are two answers to his frustration over austerity and the crisis. On the one hand, yes, the spending cuts have slashed entitlement programs and made it tougher to get by on government handouts. On the other hand, though, the current European austerity model has raised taxes on businesses and households. This has stifled economic growth and thus made it harder for people to get out of their government dependency.
The reason for this is that austerity, as designed and carried out during the crisis in Europe, has had the purpose of balancing the government budget – even at the cost of depressed private-sector activity. Other forms of austerity, applied back in the late 20th century, had other goals, among them to inspire growth in the private sector. The difference is monumental for the outcome of an austerity strategy.
Europe has been under the statist version of austerity, the purpose of which is to balance the government budget and therefore restore fiscal sustainability in government. The reason for this, in turn, is that as Europe’s political leaders designed a response to the crisis, it never occurred to them that the very existence of a welfare state could have something to do with the crisis.
Back to the EU Observer:
He described the EU’s economic and monetary union (EMU) as flawed from the start, forcing troubled member states to make deep cuts in the private and public sectors via internal devaluation. “Internal devaluation has resulted in high unemployment, falling household incomes and rising poverty – literally misery for tens of millions of people,” he said.
This is a technical level of macroeconomics. What Commissioner Andor is saying is actually that Greece would have been better off when the crisis began if they had been able to devalue their own currency – the drachma – vs the Deutsch mark. However, that is a way to grossly simplify the problem: the argument rests on the assumption that Greece fell into a depression because of bad terms of trade vs. Germany. But the fact of the matter is that Greece was in trouble for years before the outbreak of the Great Recession, with deficit and debt problems resulting not from insufficient exports capacity (which is what Commissioner Andor alludes to) but from a vast system of entitlement programs that promised a lot more to their recipients than taxpayers could afford.
The EU Observer again:
[The] EMU is gripped by a social and economic paradox. “On the one hand, we introduce social legislation to improve labour standards and create fair competition in the EU. On the other hand, we settle with a monetary union which, in the long run, deepens asymmetries in the community and erodes the fiscal base for national welfare states,” he said.
There you go. No blame on the welfare state, all blame on admittedly dysfunctional EU institutions. But the role of the EU did not become acute until the economic crisis had escalated to depression-level conditions in some southern EU states. It was not until the Troika (EU-ECB-IMF) went to work in 2010-11 that the venom of ill-designed austerity went to work deep inside the economies of Greece, Spain, Portugal and Italy. By then, the crisis had already started, it had escalated and caused runaway unemployment and rampant deficits.
So long as Commissioner Andor persists in believing that the welfare state is the victim, not the culprit, in this crisis, the crisis will prevail.
Commissioner Andor’s complete ignorance on this item is revealed as the EU Observer story reaches its crescendo:
A possible way out, he says, is to disperse some money from national coffers through so-called “fiscal transfers” between member states using the euro. Some of the pooled money would be used, in part, to fund a European Unemployment scheme to better prop up domestic demand, says Andor.
How many entitlement programs, and how many levels of government, do you have to involve before government expansionists understand that pouring more gasoline on the fire is not going to put out the flames?
Europe is now officially in the liquidity trap.
Even though this gives me plenty of reason to say “See I Told You So”, I prefer to note that this is a thoroughly bad thing for businesses and households in the euro zone.
The ECB may have a positive intent with this, but the only thing it has achieved is to cement a fundamental imbalance in the euro-zone economy. That imbalance is a structural excess supply of liquidity. This is what happened in Japan in the ’90s, when what was then the world’s third largest economy got stuck in a state of economic stagnation for so long that the country basically lost an entire generation to dependency on parents and whatever social welfare they have there.
The significance of the ECB overnight rate move cannot be understated. The ECB is one of the world’s four most important central banks (together with the Bank of England, the Federal Reserve and the Bank of China). By nailing its interest rates not to the floor, but to the ceiling of the basement, the ECB has officially capitulated on the monetary policy front.
This is huge. Before we get into just how huge this is, let us listen to a couple of astute observers, whose points illuminate the practical side of the issue. First, Ambrose Evans-Pritchard from the Daily Telegraph:
The way we are going, the whole world will end up with zero interest rates or some variant of quantitative easing before long. Such is the overwhelming power of deflation in countries with burst credit bubbles. Such too is the implication of a global savings rate that has spiralled to an all-time high of 25pc of GDP, starving the world of demand.
There you go. While Evans-Pritchard is wrong about the root cause of QE (I will explain this in a moment) he nails it right on the head about aggregate demand. Lack of demand is, in turn, driven by overarching pessimism among businesses and households, a pessimism that translates into a net reduction of spending in the economy. To quote Lord Keynes (General Theory, Chapter 16):
An act of individual saving means — so to speak — a decision not to have dinner to-day. But it does not necessitate a decision to have dinner or to buy a pair of boots a week hence or a year hence or to consume any specified thing at any specified date. Thus it depresses the business of preparing to-day’s dinner without stimulating the business of making ready for some future act of consumption. It is not a substitution of future consumption-demand for present consumption-demand, — it is a net diminution of such demand. Moreover, the expectation of future consumption is so largely based on current experience of present consumption that a reduction in the latter is likely to depress the former, with the result that the act of saving will not merely depress the price of consumption-goods and leave the marginal efficiency of existing capital unaffected, but may actually tend to depress the latter also. In this event it may reduce present investment-demand as well as present consumption-demand.
And that is precisely what has happened in Europe. While the American economy seems to continue its sluggish recovery after a hiccup in the first quarter, the European economy is sinking even deeper into the stagnation quagmire. Neither businesses nor households want to spend. They choose to save instead, which increases liquidity levels in the banking system. Banks in turn signal excess liquidity to the ECB, which now has responded by saying “don’t come to us with your money – lend it out instead”. But so long as households and businesses remain pessimistic and prefer to save, not spend, they will not demand more loans from Europe’s financial institutions.
As I pointed out back in April, interest rates in Europe have been on the downslope for at least three years now, without generating a macroeconomic restart. There have been isolated pockets of recovery, such as in the Spanish and Portuguese exports industries, but overall the European economy remains at a standstill. The problem is not lack of liquidity – the problem is lack of confidence.
Somewhere, the ECB knows this, but they are not the ones who can restore it. Yet as Evans-Pritchard suggests, their sub-zero interest rate policy is an expression of a desperate desire to do the impossible, namely use monetary policy in a liquidity-saturated economy to restore business confidence:
The chief purpose is to drive down the euro, an attempt to pass the toxic parcel of incipient deflation to somebody else. The ECB is expected to map out future purchases of asset-back securities, “unsterilised” and intended to steer stimulus with surgical precision towards small businesses in what amounts to light QE. This is not yet the €1 trillion blitz already modelled and sitting in the ECB’s contingency drawer.
But that is the next step. And, again, the ECB’s commitment to buy treasury bonds from any troubled country, at any time, at any amount, is de facto a standing commitment to start QE at the drop of a hat.
One more point from Evans-Pritchard:
In China the new talk is “targeted monetary easing”, with the first hints of outright asset purchases. Railways bonds have been cited, and local government debt. The authorities are casting around for ways to keep the economy afloat while at the same gently deflating a property boom that has pushed total credit from $9 trillion to $25 trillion in five years.
Which, again, de facto puts all three major global currencies in the QE zone. So far only the euro has reached liquidity-trap territory, but its fate is a stark warning to other central banks to put a foot down at some point when it comes to saturating the economy with liquidity – in other words, printing money day and night.
This is truly desperate stuff. That nearly six years after the collapse of Lehman Brothers, Europe is still belatedly trying to address the twin afflictions of deflation and economic depression tells you as much about the political paralysis that grips the euro area as about the severity of the crisis.
Yes. However, I am not sure Warner knows exactly what that political paralysis consists of. Europe needs deep, far-reaching structural reforms in order to get its economy going again. The key content of those reforms must be the gradual, but eventually complete dismantling of the welfare state. This will not only eliminate the heavy tax burden on Europe’s private sector, but also open up large sectors of the economy for free-enterprise entrepreneurship. Both these effects will generate GDP growth way beyond what today’s political leaders in Europe – and, frankly, in America – can imagine.
Such reforms would also pave the way for a restoration of sanity in monetary policy. Today’s vastly excessive supply of money, both in Europe and in the United States, is related to big, structural government deficits. In a way, government has established a third funding arm for its expenditures: in addition to taxes and borrowing from the general public, Europe’s and America’s welfare states have learned to work with their central banks to create an ongoing funding opportunity for government outlays. Central banks print money, buy treasury bonds and thereby allow welfare states to survive – theoretically in perpetuity – even as they max out taxes and their credit rating with the general public.
In other words, the purpose behind money supply under a welfare state is broader and more complex than in a free-market economy. In the latter, all the central bank does is provide a base for liquidity in the economy; in the former, the central bank adds to its liquidity commitments a “funding buffer” for big government. Since big government slows down economic growth, over time the tax base cannot keep up with the growth in entitlement spending that is symptomatic for the modern welfare state. As a result, money supply grows faster to provide compensating funding. When the economy makes a serious downturn, as it did a good five years ago, this slow replacement of money supply for taxes to fund the welfare state accelerates.
Eventually, money supply becomes impotent. Unless fiscal policy picks up the slack; unless legislators make the necessary reforms; the central bank will hit the point of zero interest rate. From there, it only has two ways to go: back or down in the negative-interest basement.
The ECB chose the latter.
Welcome to the liquidity trap, Europe. Enjoy the stay, because it is going to be long. A Japanese Decade long.
While Europe is struggling with the outcome of the European Parliamentary elections and the United States in a macroeconomic limbo after the first-quarter GDP growth shock, countries in other parts of the world face similar economic challenges. This shows that the systemic economic problems in, primarily, Europe and, secondarily, the United States are not confined to those old, mature welfare-state economies. Other countries could learn a great deal from their experiences, but we can also learn one important lesson from them, namely that the problems plaguing Europe and America are indeed systemic and not somehow unique experiences.
South Africa is a case in point: a country run by radical socialists whose policies are slowly destroying the economy. Last year I pointed to South Africa’s growing stagflation problem, which fundamentally is caused by the ANC government’s stubborn commitment to the welfare state. Since then the inflation-unemployment problem has grown worse. Premier South African publication Business Day reports:
Last week, President Jacob Zuma was inaugurated and his new cabinet announced. Their task is to implement the National Development Plan, which targets annual growth of 5.4%, and “radical socioeconomic transformation policies and programmes”. Their task is urgent. Figures this week revealed that the economy had contracted for the first time since the 2008/09 recession.
Last year I explained that the National Development Plan, with its slew of new entitlements handed out left and right,
is yet more evidence that the ANC is determined to drive South Africa into the ditch, and then have the elephant of big government stomp her to into a pile of trash. … More tax-paid educational programs that won’t lead to any new jobs, because in order to pay for them the government has to put yet more hate taxes on the “rich”. This crushes small businesses, which are almost without exception the best job creators in any economy. And since nothing is being done about the corruption in the country, except talking about it, larger corporations are unlikely to want to expand their operations in South Africa. As a result, the young who are lured into these new ANC-proposed programs – if they ever become reality – will get an education they can’t use. Their frustration with their government may be postponed, but it will be exacerbated by the years that the young feel they wasted on a useless education. … The National Development Plan shows clearly that with the ANC in power, things are only going to deteriorate. But hopefully it will also be the motivator for the political opposition to begin formulating a common-sense alternative. South Africa deserves better than socialism.
The Plan also talks at great length about promoting “ownership among historically disadvantaged groups”, in other words about keeping racism alive two decades after the death of Apartheid. Furthermore, there are large sections about reducing income differences – called “income inequalities” in the Plan – which is nothing more than the same old ideological leftovers that Europe’s welfare states have been regurgitating for the better part of a century now. Income redistribution is a safe way to discourage people from working: the free entitlement reduces efforts by those considered to be entitled by government; the taxes that pay for those entitlements discourage higher-income earners from working. In both ends the tax base shrinks and more people end up eligible for increasingly unaffordable entitlements.
In short: the National Development Plan is a recipe for a Scandinavian welfare state in South Africa. Bad, bad idea.
In fact, the idea is even worse now than it was a year ago, given South Africa’s macroeconomic ailments. The Business Day again:
When searching for explanations for the first-quarter drop in GDP of 0.6%, it is clear that local domestic factors dominate. Newspaper headlines focus on the collapse in mining output, dragged down by a platinum strike and a drop in manufacturing output amid weak demand, and rising costs. But growth in the services sector, which expanded at an annualised rate of 1.8% in the first quarter this year, is also subdued. This highlights underlying weakness in domestic demand. Consumer spending is slowing amid sluggish job creation, waning credit growth, rising inflation and low confidence levels.
That was a good summary of South Africa’s macroeconomic problems. Adding a full-fledged Scandinavian welfare state to this mix is like pouring high-octane gasoline on a fire.
I fear that the ANC is not going to listen to such warnings, but instead charge ahead with their entitlement expansion. The only way they can pull that off, even in the short term, is by printing money faster – another thoroughly bad idea in an economy with up to 40 percent unemployment.
Business Day again:
The country’s tight electricity supply will hang over growth prospects until constraints are eased. At the same time, inflationary pressure is on the rise. CPI accelerated to 6.1% in April, breaching the Reserve Bank’s inflation target 3%-6% range. Producer prices also accelerated to an annual 8.8%, which implied further upside price pressures in the months ahead. HSBC expects CPI to rise above 6.5% later this quarter, which will put more pressure on Reserve Bank governor Gill Marcus to deal with the challenges associated with this enveloping stagflationary malaise.
Which, again, I warned about more than a year ago.
There are other knock-on effects of this weak growth. For one thing, it is likely to undermine tax revenues, while the stoppages in the platinum sector will suppress exports. The country’s twin deficits — the fiscal deficit and current account deficit — are likely to deteriorate in this environment, and the near-term outlook could be clouded by more poor data, whether from mining and manufacturing production, retail sales, international trade, or GDP growth in the second quarter.
How is the ANC government going to fund its deficit? With stagflation de facto already in place it is unlikely that foreign investors will have the confidence needed to invest in South African Treasury bonds. This effectively forces government to ask the Reserve Bank to print money to fund the deficit.
This does not necessarily mean accelerating inflation over night. But with zero growth and inflation already in place, it could have that effect sooner than in other economies (such as the euro zone where they are currently trying to fend off deflation).
That said, there are some mitigating circumstances. For example, some of the depressing growth numbers in the South African economy are due to single-sector events. Explains Mail & Guardian business reporter Thalia Holmes:
South Africa’s gross domestic product (GDP) has shrunk for the first time since the 2009 recession, decreasing by 0.6% in the first quarter of the year, and causing analysts to scale back their predictions of upcoming interest rate hikes. The nominal GDP at market price during the first quarter of 2014 decreased by R2-billion from the last quarter to R874-billion. This marked a sharp change in direction from last quarter’s GDP growth of 3.8%. South Africa’s fall in productivity was largely due to a huge loss of output in the mining and quarrying industry, which decreased by almost 25%. “Economic activity in the mining and quarrying industry reflected negative growth of 24.7%, due to lower production in the mining of gold, the mining of other metal ores [including platinum] and ‘other’ mining and quarrying [including diamonds],” said the report from Statistics South Africa (Stats SA).
Nevertheless, an economy has the structure it has. If it depends heavily on one industry, such as mining, then all its residents, businesses and households alike, as well as government will have to pay the price for that dependency. If anything, this is a wake-up call to the ANC government to get serious about promoting private-sector growth on a broad scale, to pursue industrial diversification through deregulations, tax cuts and ironclad protection of property rights.
Unfortunately, I don’t see this happening so long as their focus is on the National Development Plan.
And just to make matters a bit worse, Thalia Holmes continues:
However, Nedbank observed in an emailed note that “the economy’s fragility was on display in most other sectors too. Manufacturing output dropped sharply.” Output in the sector declined by 4.4% from last quarter. Investec group economist Annabel Bishop attributed the slowdown to “work stoppages caused by strike action and electricity constraints”. Nedbank added that “the pace of activity in most of the services industries also slowed to the low single digits. The only rays of light came from construction and agriculture, where output rose by annual rates of 4.9% and 2.5% respectively over the quarter.” At the same time, the South African Reserve Bank has released a report indicating that the country’s Leading Business Cycle Indicator has continued to decline. The leading indicator, which predicts trends in the economy, was down by -2.36% in March from the same time last year, following a similar -2.7% decline in February.
As the Business Day story pointed out, consumer spending plays a big role in this. The combination of high unemployment and high inflation is venomous to consumer spending. Add to this that many analysts in South Africa seem to expect the Reserve Bank to raise interest rates soon, and the outlook for the country’s economy is even more pessimistic. Higher interest rates discourage consumer-directed installment credit, which will hold back consumers on both the housing market and the market for cars and similar big-ticket durables. This spills over into small businesses, which are often run on basically the same terms as family finances.
South Africa’s problems are structural. The country has earned a reputation for being unreliable, and the reputation has reached such momentum that Japanese car manufacturer Nissan recently decided to choose Nigeria instead of South Africa for its African production expansion.
When you lose out to Nigeria, you know you are in trouble…
I wish I could express great hopes for South Africa, but so long as the ANC keeps pursuing their welfare-state dream and keep trying to push it onto an already struggling private sector, things can only go downhill.
If, on the other hand, the ANC abandoned its socialist delusions and actually started governing for the future, South Africa would have enormous potential.
Anyone who has had even a minimum of experience trying to balance a check book knows that if you first define the food you want to buy, the car you want to drive, the house you want to live in and the clothes you want to wear, and then look for a job to pay for those expenses, you are very likely going to end up with an acute overdraft on your checking account. Anyone who has ever run a business knows that if you hire the number of people you want, buy the inventories you want and hire the facilities you like, and then start trying to sell products to get the revenue that those costs require, you are almost certainly going to go belly-up.
The welfare state does not confine itself to the same realities as private citizens do. Its MO is the exact opposite of how the real world works. It makes promises to a select group of citizens and then forces another group of citizens to pay for those promises – regardless of whether or not the latter group can afford it. The promises are made in the form of “defined benefits”, in other words government first decides to give away a certain amount of money (welfare checks, housing subsidies, food stamps) or specific services (education, health care, child care) and then, once the package of entitlements is in place, starts looking for a way to pay for it.
This upside-down approach sets up the welfare state for some big trouble. It also has terrible long-term consequences for all of us. When the entitlement programs go online they reduce work incentives among large layers of the population. So do the taxes created to pay for those entitlement programs. Fewer people work to feed themselves fully, while fewer people work fully out to build wealth or create businesses.
So long as the welfare state is small, focusing its entitlement programs only on those who are really needy, there is only a marginal loss of economic activity. The lack of a visible macroeconomic price tag on this small welfare state encourages government expansionists to pursue more entitlement programs with higher taxes.
At some point, though, the growing welfare state inhibits enough productive economic activity to create serious problems with growth and prosperity. What was initially a tolerable balance between tax revenues and entitlement spending soon becomes an unsustainable imbalance: slower economic growth leaves more people entitled to support from the welfare state; slower economic growth produces fewer decent-paying jobs, leaving more people entitled to support from the welfare state; more support from the welfare state discourage people from pursuing decent-paying jobs, eventually reducing supply of such jobs.
To complete the imbalance: slower economic growth reduces the stream of tax revenue needed to pay for the ever-growing output from the welfare state’s entitlement programs. A structural imbalance emerges where government expansionists pursue ever higher taxes and the private sector quietly winds down its operations, or moves them overseas.
Latin America has seen plenty of this, with Argentina as the absolutely best example. In the period from circa 1920 through the 1950s, Argentina was a flourishing economy with among the highest standard of living in the world. There were years when Argentina attracted more immigrants from Europe than the United States. Then the welfare state came and the rest is history.
A history that the current Pope should have learned. He was, after all, cardinal of Buenos Aires before rising to the Holy See. Unfortunately, learning from history is apparently not a prerequisite for rising through the ranks of the Catholic church. The Associated Press reports:
Pope Francis called Friday [May 9] for governments to redistribute wealth to the poor in a new spirit of generosity to help curb the “economy of exclusion” that is taking hold today. Francis made the appeal during a speech to U.N. Secretary-General Ban Ki-moon and the heads of major U.N. agencies who met in Rome this week. Latin America’s first pope has frequently lashed out at the injustices of capitalism and the global economic system that excludes so much of humanity, though his predecessors have voiced similar concerns.
What is injust about an economic system where every individual can find work at his own best ability, or start a business, build a career on nothing but his own merits? What is unjust about an economic system that does not come with long bread lines, where consumers can make independent choices what they want to eat, where they want to live, how much they want to save for their own future? What is unjust about an economic system where people can give to charitable causes regardless of their faith, and regardless of the faith of the recipient? What is unjust about an economic system where people can choose their own doctor, what school their children should attend and how much they want to save up for their own retirement?
What is wrong with an economic system where you get to keep the proceeds of your hard work, where the farmer who spends that extra hour out in the field can put better food on his children’s dinner plates? What is wrong with an economic system where the poor do not have to be poor for the rest of their lives, but can work their way up from despair to independent wealth?
Back to the Associated Press story:
On Friday, Francis called for the United Nations to promote a “worldwide ethical mobilization” of solidarity with the poor in a new spirit of generosity. He said a more equal form of economic progress can be had through “the legitimate redistribution of economic benefits by the state, as well as indispensable cooperation between the private sector and civil society.” Francis voiced a similar message to the World Economic Forum in January and in his apostolic exhortation “The Joy of the Gospel.” That document, which denounced trickle-down economic theories as unproven and naive, provoked accusations in the U.S. that he was a Marxist.
My mother grew up poor. My grandfather, who had six years of school to lean on, worked as a logger and built a small farm big enough to provide the very, very basics of what his family needed. They set aside money so they could move to a mining town where my grandfather hauled iron ore a thousand feet under ground while grandmother raised seven children to be strong, independent, proud and ambitious. My mother once explained what set their family aside from many other families living under the same conditions:
“We didn’t have time to complain about how poor we were. We were too busy doing our homework.”
So there is your priority. Either you invest in yourself, pursue opportunities and build your life – or you sit at your kitchen table day and night complaining about how your neighbor drives a better car than you do.
The Associated Press again:
Francis urged the U.N. to promote development goals that attack the root causes of poverty and hunger, protect the environment and ensure dignified labor for all. “Specifically, this involves challenging all forms of injustices and resisting the economy of exclusion, the throwaway culture and the culture of death which nowadays sadly risk becoming passively accepted,” he said.
And of course the Pope does not spell out what he believes are the root causes of poverty and hunger. If he pursued those “root causes” he would have to address the fact that the poorest nations on Earth are also run by corrupt, ruthlessly selfish dictators who steal from their own people. Or does the Pope see no difference between the government systems of, on the one hand, the United States, Canada, Western Europe, Australia and Japan and, on the other hand, the Democratic Republic of Congo, North Korea, Zimbabwe, Somalia and the Central African Republic?
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.
Since January 2012 I have been practically the only analyst pointing to how deeply flawed economic analysis combined with irresponsible political preferences turned an economic recession in Europe into a depression. In late 2012 IMF economists began hinting that the economic analysis behind crisis policies was not entirely up to standard. In January 2013 the IMF followed up with a formal, very good analysis explaining how they had contributed to the errors.
The IMF paper – a rare but highly respectable academic mea culpa – should have caused a fundamental change of course in fiscal policy in Europe. Sadly, that did not happen. Some rhetoric has been spread around in recent months by EU and national political leaders seeking to distance themselves from the absolutely disastrous consequences of the past few years of austerity, but in reality they have neither changed their policy preferences nor adopted new political goals.
They still have not realized the depth of the errors in their own understanding of the crisis, or what to do about it.
My book about the crisis is due out in August. In the meantime, here is another contribution, reported by Euractiv.com:
In his new book, Philippe Legrain, a former adviser to European Commission President José Manuel Barroso, says European leaders are responsible for the record-high unemployment and rock-bottom growth afflicting the EU. At the height of the euro zone debt crisis, with Portugal’s economy nearing collapse, the European Commission told the government in Lisbon that it had to slash wages if it was ever going to boost competitiveness and grow again. Portugese shoemakers – one of the economy’s main export sectors – steadfastly ignored the advice and found a way to bounce back while actually increasing workers’ pay. It is just one of many examples Philippe Legrain, a former adviser to Commission President José Manuel Barroso, cites in a new book that argues policymakers misdiagnosed the crisis and ended up prescribing the wrong medicine to resolve it.
I’m curious to see if Mr. Legrain drills down to the core of the crisis problem, namely the welfare state. I doubt he does, based on this wage-setting example. The crisis was not really about wages, at least not in the private industry. Private businesses operate in the free realm of the economy. If they set the wrong prices, they go out of business. Evidently, the Portuguese shoe manufacturers had not priced their products wrong.
Let’s see what else Mr. Legrain has to say:
He was an adviser from 2011 until resigning in March of this year, so was involved at some of the most critical moments. “The Portuguese basically said, ‘We’re not going to do that’, and they went upmarket instead,” said Legrain, the author of “European Spring: Why our Economies and Politics are in a Mess”, which is published on April 24. “They are now selling more expensive designer shoes and their exports are soaring – wages and employment have risen,” he said. “That shows in a nutshell how policy was misguided.”
Again, what do you expect of a private business? That they operate on free-market terms (and are allowed to do so by lawmakers and tax-paid bureaucrats). If you have a low-cost production facility and you think you can produce something with higher margins with that same production facility, then obviously you go ahead and do it. It is the same philosophy that Korean car manufacturer Hyundai used when they introduced their new Azera, Genesis and Equus luxury models.
The dicey part is if you can produce with the quality needed for a higher market segment. Hyundai has been able to pull it off (just look at their Equus – it has got to be one of the best looking, best built cars in the world) and, in the other end of the manufacturing world, Portugal’s shoe makers have apparently been able to do it.
But again, this is not the real story of the European crisis. Let’s hope Mr. Legrain has more than this to add. It does not look like it:
Instead of recognising that the crisis was principally the fault of a banking sector run amok, [Europe's political] leaders focused on the excessive debts of Greece, Ireland and Portugal, effectively seeing the problem as fiscal rather than financial. That led policymakers to enforce a strict regimen of budget cuts, tax increases and lower wages in an effort to improve competitiveness and make exports comparatively cheaper.
Oh, dear… First of all, this was not a financial crisis, no matter how many people say so over and over again. Secondly, austerity as designed and executed in Europe from 2010 and on – culminating but not ending in 2012 – aimed to save the welfare state by making it fit into a smaller economy. “More affordable” as someone aptly described it.
Even when Mr. Legrain touches upon the government debt issue, he misses the target by a mile:
While Legrain acknowledges that Greece, with debts greater than its GDP and a budget deficit of 6.5% of output in 2008, was facing mainly a debt crisis rather than a banking one, he says the solution chosen by Europe was wrong. Rather than renegotiating or writing down much of that debt, the Commission, the International Monetary Fund and the European Central Bank pushed through two hard-to-swallow bailout programmes totalling more than €200 billion that left Greece’s economy shattered and just as indebted. Unemployment now stands at 26% and debt is expected to peak at 170% of GDP. Social unrest is bubbling.
His prescribed solution is even worse than his analysis:
“Greece’s debts should have been restructured in May 2010,” said Legrain. “Instead, we have had a lurch towards self-defeating austerity and now have much more centralised fiscal controls, which are inflexible and undermine democracy.”
So called “debt restructuring” means writing down or writing off debt. That is dangerous and reckless. It is dangerous because it means a government walks away from a contract between itself and a private citizen – a bank or a family who has invested in Treasury bonds instead of, for example, buying stocks. It is reckless because it sets a precedent that could eventually stretch into the private sector: if debtors can just write off what they owe someone, a large chunk of the private-property/private-contract dimension of our modern economy is fatally wounded.
This last point is a bit of a stretch, but deliberately so. According to this Euractiv article about Mr. Legrain’s book, all that he has to offer as a solution to Europe’s crisis is that they should have written off debt four years ago, and that the EU should not have handed out certain types of advice to private businesses. This is a very shallow analysis of a problem that runs deep into the European economy – so deep, in fact, that it cannot be solved without a major restructuring of that economy.
In fairness to Mr. Legrain I am going to order a copy of his book. But if this article accurately represents his work, I’m happy to say my book is more relevant than ever!
Of all the countries around the world that have tried to embrace the European welfare state, Argentina is perhaps the most tragic example. From the 1920s through the 1950s the Argentine economy was one of the strongest in the world, and there were years when Argentina attracted more immigrants from Europe than the United States did. But what could have become a formidable economic powerhouse caved in to the ideas of the welfare state. As the economy began declining, social and economic stability evaporated and Argentina suffered decades of political turmoil.
The long-term suffering of the Argentine people, and of many other South American countries, is a stark warning to today’s Europeans: their continent could become the same tragedy in the 21st century that South America was in the last century. Unfortunately, the Europeans refuse to hear the warning bells from recent history, so we might just as well pile on yet another story, on top of the ones already published about the crumbling Argentine economy and what brought it down. This one is from Bloomberg.com:
Argentina reduced government subsidies on natural gas and water by an average 20 percent in a bid to narrow the largest fiscal deficit in more than a decade. The government could save as much as 13 billion pesos ($1.6 billion) and will use proceeds to cover utility company costs and finance social spending, Economy Minister Axel Kicillof and Planning Minister Julio De Vido said today at a press conference in Buenos Aires. The cuts won’t apply to industrial users.
And the reason for the big deficit?
President Cristina Fernandez de Kirchner has boosted social spending since taking office in 2007 and left utility rates largely unchanged amid average annual inflation of about 25 percent, straining the finances of power distribution companies and leading to periodic blackouts.
If you live in California (which, thank my tax God, I don’t) you recognize this behavior. Back in the ’90s the state of California wanted to compassionately make sure that everyone could always pay their utility bills. So they regulated the price that utility companies could sell power for to households, but imposed no price regulations on the market where utility companies buy power from power producers. As a fourth-grader could have figured out, if the regulated price in the retail end was too low, on average utility companies would be buying power at a market price that exceeded the retail price they could charge.
The result? Rolling black-outs, no investments to improve either power production or power delivery, and in the end mounting costs for everyone in the back end when the entire power infrastructure needed massive upgrades anyway. (It did not help that California at the time was falling for the global warming delusion and chasing low-cost, fossil-based fuel out of the state.)
Now, Argentina finds itself in the exact same situation. But even more importantly, the Argentine government’s focus on entitlement spending is a stark parallel to Europe. Utility price regulation, which varies from country to country in Europe, is just another form of welfare-state intervention into the private sector. When coupled with the general plethora of entitlement programs that normally comes with welfare states, the subsidy becomes just another entitlement.
As Argentina demonstrates, this has consequences when government runs into fiscal trouble. Just like every welfare state the Argentine version combines spending determined by political preferences with revenues determined by a private sector, i.e., struggling entrepreneurs and tax-burdened consumers. Entitlement spending has a strong tendency to outgrow its revenues – in fact, I am working on an article for an academic journal defining a law that shows that welfare-state entitlement programs inevitably outspend their revenue – but politicians favoring the welfare state never realize that this is actually happening. Inevitably, therefore, they run into deficit problems, but since the politicians do not see this coming they are caught by surprise and react with fiscal panic.
There are three ways that fiscally panicking politicians can respond:
1. Buy time. This means, borrowing as much as they can. When they cannot borrow any more money by flooding the world with their Treasury bonds, they print money and have the central bank buy the Treasury bonds instead. If this happens in an economy with a stable financial system and a limited system of cash entitlements, the money printing will not cause high inflation. If on the other hand cash entitlements are comparatively important for daily consumer spending, then printing money to fund them opens a dangerous transmission mechanism for the money supply to cause high inflation.
2. Raise taxes. No longer a viable option, other than marginally. There is a fair amount of research that shows that voters in both Europe and North America grew tired of constantly rising taxes already back in the 1970s. Since then, an increasing share of the growth in government spending has been deficit-funded. The same is true in Argentina.
3. Cut spending. Since most politicians in our modern welfare states want to preserve the welfare state one way or the other, they do not want to eliminate entitlement programs. But when tax revenues do not grow as fast as they would want it to they are forced to downsize the welfare state to fit within a tighter revenue framework. This means chipping away at entitlements that people have gotten used to and based on which they plan their family finances.
For common-sense minded economists and politicians this means a good opportunity to prudently reform away the welfare state. “Just cutting spending, damn it” is not the way forward, but a structurally sound phase-out model can do wonders.
Leftists, on the other hand, go even deeper into panic. Bloomberg.com again:
Argentina, which has subsidized utilities since 2003, wants to cut aid from about 5 percent of gross domestic product to 2 percent of GDP and make higher income earners pay more for their utilities, Cabinet Chief Jorge Capitanich said March 12. “In 2003 the need for subsidies was clear,” Kicillof said in reference to the period after the nation’s $95 billion default and economic crisis. “Argentina isn’t ending subsidies, just redistributing them.” For Argentine households, the increase in their gas bill may rise as much as 161 percent for the biggest consumers and 306 percent for water bills, according to a presentation distributed by the Planning Ministry.
“The Planning Ministry”… Why not just adopt the Soviet acronym GOSPLAN and get it over with? Humor aside, though, it is worth noting that the families who are now hit with enormous price increases still have to pay the same amount of taxes as before.
The way out, again, is not to restore the subsidies. The way out is to end the entitlement programs and return purchasing power to the private sector so that those who have grown dependent on government can actually support themselves. This, of course, won’t happen in Argentina. What will happen there instead is that consumers now will respond by cutting spending elsewhere, thus reducing economic activity in general. This has repercussions for the tax base, which again will take government by surprise. And the entire process is repeated, with the difference that it starts from an already lower level of economic activity.
Europe is not in as bad a shape as Argentina is. But if they continue down the current path of using spending cuts and tax increases to save the welfare state in tough times, they will perpetuate their own crisis – and thereby perpetuate the need for spending cuts and tax increases.
The end station? An economic wasteland where children grow up to be poorer than their parents. That is, in effect, where Argentina is today, and has been for a long time. Sweden has been there for a good two decades and other European countries are beginning to see that same economic wasteland on the horizon.