Tagged: The Welfare State

The Unsustainable Welfare State

With crawling speed, awareness is spreading across Europe that something has gone wrong – terribly wrong – with their economy. The latest to raise his eyes above the mainstream horizon is Jonathan Portes, director of the British think tank National Institute of Economic and Social Research. In a recent interview with Euractiv.com, Portes explained that Europe’s leaders have completely misunderstood the nature of the current crisis:

http://c.brightcove.com/services/viewer/federated_f9?isVid=1&isUI=1

The problem for Portes is that he lists among the challenges for Europe that it needs to find a way to fund its welfare state. But the welfare state is precisely the problem for Europe. The welfare state is what eventually tipped a regular recession over the edge into a permanent, structural crisis. Surely, the welfare state was aided in its amplification of the crisis by misguided, ill-designed austerity policies. But the European economy was suffering from a structural imbalance, forced upon it by the welfare state, long before the financial crisis began.

We should not glean too much from Portes’s short statement, but it is probably not an exaggeration to conclude that he is looking for a sustainable funding model for the European welfare state. The problem is that no such model exists. In order for the welfare state to be fiscally sustainable, neither its funding model nor its entitlements can have any effect on the tax base from which the welfare state gets its revenue. This “exogenous” view of the welfare state has been thoroughly refuted, both by reality and by a long tradition of research.

There is only one solution to the European crisis, and that is to phase out the welfare state – to privatize education and health care and to return income security to the individual taxpayer. No more, no less, will save Europe.

Ebola and Socialized Health Care

When government creates a spending program, it also makes a promise to taxpayers. So long as the sum total of those promises is small and government limited to protecting life, liberty and property, we have good reasons to believe that government can deliver on its promises. However, the more promises government makes, the fewer of those promises it will be able to keep. As government promises reach into income redistribution and services like health care, the distance between promise and provision grows into a chasm.

That chasm has opened up across Europe. As millions upon millions of Europeans have discovered, a broken government promise is not just a theoretical construct. It is harsh reality. First they were lured into dependency on government by lavish promises of being taken care of, then government walked away from its promises  – and did so without offering people a route to an alternative.

The price is paid by the people. As government fails to deliver as promised, and taxes and regulations supporting the government monopoly all remain in place, people have nowhere else to go but down. A permanent blanket of stagnation slowly descends upon the economy and a new form of industrial poverty replaces prosperity and a bright future.

This is, again, not just theory. It is harsh reality. When government asks people to trust it, and then fails to provide that trust, even ebola can slip through the cracks of the crumbling tax-funded promises. A story from the New York Times offers a chilling example:

The case is particularly worrisome to health experts because Spain is a developed country that is considered to possess the kind of rigorous infection control measures that should prevent disease transmission in the hospital. Although the Ebola epidemic has killed hundreds of doctors and nurses in West Africa, health officials in Europe and the United States have reassured the public repeatedly that if the disease reached their shores, their health care systems would be able to treat patients safely, without endangering health workers or the public.

The story also suggests:

While the risk to hospital workers is thought to be far lower in developed countries, the infection of the Spanish nurse, along with the missteps in dealing with Ebola in Dallas, exposes weak spots in highly praised defense systems.

There is a major difference between the American and Spanish cases. In Dallas, health care workers approached the patient under the assumption that the U.S. government was right when, back in July, it assured Americans that there was no real risk that ebola would ever spread to the United States. Trusting their government, the health care professionals in Dallas used their professional skills as they have been trained, assuming that the people in charge of keeping our country safe were doing their job as promised.

Once the ebola case had been confirmed, however, our health care system, which still to a large degree is private and therefore has plenty of resources, went to work and contained what could have become a very serious outbreak.

Spain is a different case altogether. To begin with, the country has a virtually open border to northern Africa, with migrants coming daily across the narrowest stretch the Mediterranean. It is comparatively easy to travel from the epicenter of the ebola outbreak to the southern coast of Spain. But more importantly, the Spanish health care system, unlike the American, has suffered major spending cuts in the last few years. In December last year The Economist observed similarities between cuts in government health monopolies in Greece and Spain, with the Greek cuts leading to…

dramatic increases in HIV, mental illness, TB and the return of malaria. Greece made its cuts two years earlier than Spain did, so their impact became evident sooner. But the situation in Spain is just as worrying, warns Helena Legido-Quigley of the [London School of Hygiene and Tropical Medicine], who fears that if the government doesn’t change course soon, similar outbreaks could very well happen in Spain.

Specifically, The Economist notices, Spanish health care spending…

was reduced by 13.7% in 2012 and by 16.2% in 2013 (including social services). Some regions imposed additional cuts as high as 10%. As a result a significant part of the Spanish population is excluded from basic health care, which could in turn lead to public-health problems for the entire population.

As part of the 2012 cuts, the Spanish government reduced tax subsidies for medicine, a measure that was also used in Greece. The effect of these cuts is that many people simply do not get the medicine they have been prescribed – since there are no private alternatives, people are locked in to a defaulting government monopoly. Because of the high taxes needed to fund the welfare state, few Spanish families have enough money to pay privately for what they have already paid for through taxes.

With resources at hospitals being tightened, access to health care rationed and a culture of austerity spreading through the entire health care system, it is not out of the realm to ask to what extent Spain is at risk of an ebola outbreak because its government made a promise to its people that it cannot afford to keep. As an example, the New York Times story cited earlier reports that in order to treat one single ebola patient, a hospital in Madrid turned an entire floor into a sealed-off isolation unit. In a health care system with tight resources, that means the hospital has to move numerous other patients to other units or even other hospitals. This in turn means increasing the number of patients per room, or (as in Sweden) putting patients in storage rooms, lunch rooms, corridors or even patient lunch cafeterias.

In a private health care system, the supply of resources is dynamic. It depends on the public need for health care and is funded through a multiple of sources, such as insurance plans, out-of-pocket payments and charitable donations. Competition and patient choice guarantee that, over time, there is always provision of health care for all patients.

By contrast, in a government health monopoly resources are static and rigidly dependent on how much taxes the legislature can squeeze out of the private sector. If, in theory, health care were the only thing government provided, it may not be an unbearable burden to taxpayers. However, a single-payer government health monopoly is the crown jewel of the welfare state, and therefore adds up to an excessive tax bill for the private sector.

The effect is inevitably a long-time economic decline and the kind of welfare-state crisis that Spain is now experiencing. The pressing question now is: can a rationed government health monopoly protect a modern, industrialized nation from a deadly disease?

A Note on Poverty

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.

Sweden at the Crossroads

Sweden holds a national election on Sunday, September 14. The current parliamentary majority, a center-right coalition called The Alliance, is set to lose its majority. A three-party group of red-and-green socialists is expected to come in a few parliamentary seats short of majority, leaving the next prime minister and his cabinet dependent on nationalist, self-proclaimed “socially conservative” Swedish Democrats.

Not a lot has been said about the election outside of Sweden. This is unfortunate, because the country that American liberals used to tout as their role-model society is on the brink of a social and economic disaster up and above what any European country has experienced since the military coups in Greece and Portugal in 1967 (not counting the Balkan War).

I have covered Sweden in scattered articles, and my new book Industrial Poverty has an entire chapter on the crisis of the Swedish welfare state. However, time constraints have precluded me from analyzing the situation there in more detail on this blog. Therefore, I am grateful that the Economist reports on the pending election and its consequences. Unfortunately, the reporting is not entirely accurate:

For a decade Sweden could plausibly claim to be Europe’s most successful economy. Anders Borg, the (formerly pony-tailed) centre-right finance minister since 2006, likes to trot out numbers for his time in office: GDP growth of 12.6%, a rise in gross disposable incomes of almost 20%, a budget moving into surplus and a public debt barely above 40% of GDP.

I have no idea where they get these numbers from. But I also do not see what is so impressive with them. A GDP growth of 12.6 percent in eight years is less than 1.5 percent per year if you factor in the compounded growth effect. According to Eurostat National Accounts data, GDP growth has averaged just over 1.3 percent per year since the center-right government won the 2006 election. Private consumption has increased a bit faster, but only at the expense of a doubled debt-to-income ratio for Swedish families. In 2000 the debt-to-income ratio was approximately 90 percent; ten years later it had doubled. (By comparison, the U.S. debt-to-income ratio topped out at 140 percent before the Great Recession began.) In my new book Industrial Poverty, which has an entire chapter on Sweden, I adjust consumption growth for a constant debt ratio. The result is a staggering loss of spending (you will have to buy the book to get the details…) which shows that the only reason why the Swedish economy has grown a bit faster than the EU average over the past decade is that Swedish families have accumulated a lot more debt.

In fact, from 2006 to 2012 household debt as share of GDP grew by 22 percent, faster than in two thirds of EU countries. By 2012 Swedish households are the seventh most indebted in the EU; an extrapolation of the 2006-2012 trend would place Sweden among the top five in 2013 (for which no complete data has been reported yet).

Debt-driven growth is not the way forward, especially since the debt drive is based on an out-of-control real estate market. Swedes have access to mortgage loans that only cost them interest payments, and the Swedish central bank has the most aggressive in the EU – after the ECB – in pushing more cash out into the economy. Long story short: there is nothing to brag about in the Swedish economy.

The only sector that is thriving in Sweden is the exports industry. They, on the other hand, are increasingly operating as an isolated sector from which little more than tax revenue trickle down.

The Economist again:

[The center-right government] has overturned Sweden’s old image as a high-tax, high-spending Socialist nirvana. Twenty years ago public spending took an eye-watering 68% of GDP; today the figure is heading to 50%. Although the tax burden remains high by international standards, top rates have been cut, as have corporate taxes. Taxes on gifts, inheritance, wealth and most property have been scrapped.

This is a bad case of statistical trickery. The reason why government spending reached two thirds of GDP in 1994 is that the country’s GDP had been contracting for three years at that time, that unemployment exceeded 15 percent and that there had been no major cuts in income security programs. During the three years that followed that 1994 figure government spending was cut by an equivalent of five percent of GDP. That would be $850 billion here in the United States.  Later, the Swedish government laid off one fifth of the employees in its socialized health care system. Replacement ratios in income security systems were pushed down from 90 percent of your current income to 50 percent in the worst case and nowhere more than 80 percent. Student-to-teacher ratios grew in public schools and the number of hospital beds per 100,000 citizens was reduced to the lowest level in the European Union.

If you make such heavy spending cuts you will no doubt see a decline in the ratio of government spending to GDP.

On the tax side, the Economist perpetuates the mythology that Sweden has cut its top income tax rates. In 2013 the top rate was still 60 percent, a figure that anyone can find who is willing to examine Swedish tax tables. What has been cut is the tax burden at the lower end: Sweden now has its own version of the American Earned Income Tax Credit. However, its effect has been the same as the EITC, namely to increase the discouraging marginal effect in the income tax system. While it is cheaper to live on a low income, the price tag on a promotion or an education has risen significantly.

Ignoring reality on the ground in Sweden, the Economist is surprised that Swedish voters seem ready to hand government over to the green-socialist left. Needless to say, the magazine struggles to explain the predicted election outcome:

Although the polls have narrowed sharply in the closing days before the September 14th election, all the signs are that Swedes will toss out the centre-right alliance in favour of a centre-left government led by the Social Democrats. … Inequality has risen fast, as almost everywhere—but Swedes care about this more than most. Mr Reinfeldt boasts of the creation of 300,000 private-sector jobs, yet unemployment is stubbornly high at almost 8%, and far worse among immigrants and the young.

The number for job creation is flat wrong. According to Statistics Sweden, quarterly workforce data, a total of 227,000 jobs have been added to the Swedish economy from first quarter of 2007 to first quarter of 2014. Of those jobs, only 47 percent are full-time permanent positions. The rest are temporary, primarily low-wage service jobs. Furthermore, youth unemployment – which government has tried to manipulate down – persists around 25 percent, which is close to the EU average.

With all this in mind, there is no doubt that Sweden is better off today than it would have been under a left-wing government over the past eight years. The social democrats and their prospective coalition partners – the greens and an unapologetic communist party – have promised to raise a slew of taxes as soon as they get into office. Among the more controversial proposals is to return the payroll tax for young workers from its current rate of ten percent to the normal rate three times higher. It is difficult to estimate what the actual effect of this would be on the Swedish labor market, but the attempts made thus far point to 10-20,000 lost jobs for people between high-school age and 25.

Again, Sweden would be better off under the current Alliance government, but it is, frankly, not very difficult to provide better policy than socialists whose idea of growth and prosperity is a higher tax bill. What Sweden truly needs is a turn in the libertarian direction, with major reforms to dismantle the welfare state. Such reforms would start with privatization of the country’s anorectic health care system, proceed with a strengthened – and truly private – school choice system, then privatize the country’s costly and inefficient income security system, and top it all off with a major tax reform that would cut the current world’s-highest tax burden in half.

Such reforms, however, will have to wait until there are true libertarians in Sweden’s parliament. And that won’t happen over night.

Industrial Poverty – New Book!

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!

ECB Weakens EU Growth Forecast

Analysts are grasping for explanations of why the European economy has once again stalled. The European Central Bank, which has lowered its forecast for GDP growth in the euro zone, suggests that this weakening is not part of a trend, but an aberration from a trend:

First, activity in the first quarter was subject to an unusual upward effect from the low number of holidays (as the entire Easter school holiday period fell in the second quarter) and from the warm winter weather that had boosted construction. Neither of these upward effects in the first quarter was sufficiently captured by seasonal or working day adjustment. As they unwound in the second quarter, this dampened growth. Second, negative calendar effects related to the more than usual number of “bridge days” around public holidays in many euro area countries may have reduced the number of effective working days in May, a factor that was not captured by the working day adjustment.

I have a lot of respect for the macroeconomists at the ECB, but frankly, this is below what we should expect of them. Calendar days and weather always vary – some claim that the bad performance of the U.S. economy in the first quarter of this year was due to the unusually cold winter. In reality, that growth dip was more than likely the result of businesses trying to adjust to the impact of Obamacare. By contrast, the slow growth numbers in the European economy are part of a trend of economic stagnation. A 30,000-foot review of what the European economy looks like is a good way to become aware of that trend.

The profession of economic has to some degree drifted away from the bigger-picture thinking that characterized its earlier days in the 20th century. While econometrics is important, there is too much emphasis on it today, drawing attention away from longer, bigger trends and the kind of institutional changes that characterize Europe today. Based on this broader analysis, my conclusion stands: Europe is not going to recover until they do something fundamental about their welfare state. Or, more bluntly: so long as taxes remain as high as they are and government provides entitlements the way it does, there is no reason for the productive people in the European economy to bring about a recovery.

The problem with short-sighted, strictly quantitative analysis is that it compels the economist to keep looking for a reason why the economy should recovery, as if it was a law of nature that there should be a recovery.

This problem is reflected in the ECB forecast paper:

Regarding the second half of 2014, while confidence indicators still stand close to their long-term average levels, their recent weakening indicates a rather modest increase in activity in the near term. The weakening of survey data takes place against the background of the recent further intensification of geopolitical tensions (see Box 4) together with uncertainty about the economic reform process in some euro area countries. All in all, the projection entails a rather moderate pick-up in activity in the second half of 2014, weaker than previously expected.

It would be interesting to see the results of a survey like this where the questions centered in on the more long-term oriented variables that focused on people’s ability and desire to plan their personal finances. I did a study like that as part of my own graduate work, and the results (reported in my doctoral thesis) were interesting yet hardly surprising. When people are faced with growing uncertainty they try to reduce their long-term economic commitments as much as possible. This results in less economic activity today without any tangible commitment to future spending.

Since I do not have the resources to study consumer and entrepreneurial confidence in Europe at the level the ECB can, I cannot firmly say that people in Europe today feel so uncertain about the future that they have permanently lowered their economic activity. However, my survey results corroborate predictions by economic theory, and the reality on the ground in Europe today points in the very same direction. In other words, so long as institutional uncertainty remains, there will be no recovery in Europe.

The ECB does not consider this aspect. Instead they once again forecast a recovery, just as assorted economists have done for about a year now:

Looking beyond the near term, and assuming no further escalation of global tensions, a gradual acceleration of real GDP growth over the projection horizon is envisaged. Real GDP growth is expected to pick up in 2015 and 2016, with the growth differentials across countries projected to decline, thanks to the progress in overcoming the fragmentation of financial markets, smaller differences in their fiscal policy paths, and the positive impact on activity from past structural reforms in several countries. The projected pick-up in activity will be mainly supported by a strengthening of domestic demand, owing to the accommodative monetary policy stance – further strengthened by the recent standard and non- standard measures – a broadly neutral fiscal stance following years of substantial fiscal tightening, and a return to neutral credit supply conditions. In addition, private consumption should benefit from a pick-up in real disposable income stemming from the favourable impact of low commodity price inflation and rising wage growth.

A key ingredient here is “smaller differences in … fiscal policy paths” and “a broadly neutral fiscal stance”. This means that the ECB is expecting an end to austerity policies across the euro zone, an expectation that has been lurking in their forecasts for some time now. But austerity has not ended, nor have the budget deficit problems that brought about austerity. The austerity artillery is not as active now as it was two years ago, but it has not gone quiet. France, e.g., is currently in a political leadership crisis because of the alleged need to continue budget-balancing measures.

France also indicates where the fiscal trend in Europe is heading. If the radical side of the French socialists could have it their way they would chart a course back to big-spending territory. But they would also couple more spending with even higher taxes, in order to avoid conflicts with the debt and deficit rules of the EU Stability and Growth Pact. While technically a “neutral” policy, the macroeconomic fallout would be a further weakening of the private sector – in other words a further weakening of GDP growth.

Another aspect that the ECB overlooks is the effects of the recalibration of the welfare state that has taken place during the austerity years. I am not going to elaborate at length on this point here, but refer instead to my new book where I discuss this phenomenon in more detail. Its macroeconomic meaning, though, is important here: the recalibration results in the welfare state taking more from the private sector, partly in the form of taxes, and giving less back in the form of lower spending. As a result, the private sector is drained, structurally, of more resources, with the inevitable result that long-term GDP growth is even weaker.

None of this is discussed in the ECB forecast paper, which means that we will very likely see more downward adjustments of their growth forecasts in the future.

There would be no problem with the ECB’s erroneous forecasts if it was not for the fact that those forecasts are used by policy makers in their decisions on taxes, government spending and monetary supply. The more of these “surprising” downward corrections by forecasters, the more of almost panic-driven decisions we will see. Alas, from EUBusiness.com:

The European Central Bank cut its forecasts for growth in the 18-country euro area this year and next, and also lowered its outlook for area-wide inflation, at a policy meeting on Thursday. The ECB is pencilling in gross domestic product (GDP) growth of 0.9 percent in 2014 and 1.6 percent in 2015, the central bank’s president Mario Draghi told a news conference. “Compared with our projections in June, the projections for real GDP growth for 2014 and 2015 have been revised downwards,” he said. The bank said inflation was expected to be 0.6 percent this year — a lower rate than the 0.7 originally forecast, Draghi said.

And therefore, the ECB decided to cut its already microscopic interest rates. Among their cuts is a push of the overnight bank lending rate further into negative territory, so that it now stands at -0.3 percent. But all these measures, aimed at injecting more cheap credit into the European economy, will fall as flat on their bellies as earlier interest-rate cuts. The problem is not that there is not enough liquidity in the economy – the problem is, as mentioned earlier, that the European economy suffers from institutional and structural ailments. Those are not fixed with monetary policy. Yet with the wrong analysis of the cause of the crisis, Europe’s policy makers will continue to prescribe the wrong medicine and the patient will continue to sink into a vegetative state of stagnation and industrial poverty.

Right and Wrong about Europe

Last Friday I explained that Europe appears to be on its way back to Big Spending country. One major reason is that the policies practiced so far during the Great Recession have proven to be sorely inadequate. Another reason is that Europe suffers from a bad case of conventional wisdom, the default position of which is that there is nothing more important in the economy than the welfare state. As a result, when austerity policies, specifically designed to save the welfare state, fail to do just that while also failing to reignite the economy, voters and political leaders turn to erstwhile solutions such as more government spending. Led there by conventional wisdom, not solid analysis, they are certain to only do more harm to an already ailing patient.

In this situation, clear and crisp crisis analysis is more important than ever. That is the only way to a working solution to the crisis. Unfortunately, the road to such solutions still runs through analytical neighborhoods where arguments about what cause the crisis sprawl in all directions. My blog article from last Friday quoted one example, Dan Steinbock of the India, China and America Institute. This week, Steinbock continues his contribution in the EU Observer::

In the United States, the global financial crisis was unleashed by real estate markets and the financial sector, which caused a dramatic contraction and massive mass unemployment.

That is a superficial explanation. The root cause was a fundamental misinterpretation of a macroeconomic trend. From the late 1970s through the Millennium recession the swings in the American business cycle gradually became weaker. This has been interpreted as a shift to more stable growth, which policy makers in the United States used as a basis for liberalizing the country’s credit markets. One part of this liberalization was an expansion of subprime mortgage lending, a reform that makes sense if the expectation is high GDP growth and as a result high growth in disposable income, then the risks associated with subprime lending are well contained. The debt-to-income ratio would not reach alarming levels, perhaps not even grow at all.

There was just one problem. The trend that was interpreted as growth stabilization was also a trend of weakening growth. In the 2000s the American economy grew at about half the pace of the ’90s. This led to a relative weakening of the ability of American households to keep up with debt payments. Therefore, it is incorrect to say that this was a financial crisis – it was a macroeconomic crisis that was mismanaged and misinterpreted by key political leaders.

It is important to keep this in mind, because it has consequences for how to get the U.S. economy out of the Great Recession. Steinbock lauds the Obama administration for its “stimulus package”, which…

included spending in infrastructure, health and energy, federal tax incentives, expansion of unemployment benefits and other social welfare provisions. It boosted innovation and supported competitiveness.

Frankly, there is no evidence of this. The bulk of the money spent through the American Recovery and Reinvestment Act went to fill revenue gaps in existing government spending programs, at the federal level as well as in the states. This borrowed money may have prevented a massive tax increase, which would have been the other conventional-wisdom option, but it certainly did not expand spending. On the contrary, what was a temporary jump in GDP growth during the stimulus spending, but as soon as it was over the growth rate reverted to pre-stimulus levels. It was not until late 2013 that the very first signs of some sort of recovery were visible. That recovery, though, which is still continuing, is far weaker than it should have been. Why? More on that in a moment. For now, back to the EU Observer, where Steinbock claims that the United States…

was able to rely on common fiscal and monetary policy. When one state got into trouble, it could turn to others for support. Of course, the crisis supported some states and hurt others, but the common institutions worked.

I have worked for state-based think tanks for eight years now, and I have carefully studied state fiscal policy for at least as long. To be perfectly honest, I have no idea what Steinbock is talking about here.

Let’s continue to listen to him, though. Maybe he makes more sense when he turns to discussing Europe:

When the 2008/9 crisis hit Europe, the core economies relied on their generous social models, but structural challenges were set aside. That ensured a timeout but boosted threats. In spring 2010, the crisis was still seen as a liquidity issue and a banking crisis. So Brussels launched its €770 billion “shock and awe” rescue package to stabilise the eurozone. As the consensus view grouped behind Brussels, I argued that the rescue package was inadequate and the austerity policy too strict. Further, it ignored multiple other crisis points. And it was likely to result in demonstrations and violence in southern Europe.

While he is correct about the political fallout of the crisis, he is far too vague on the economic variables that drove the European economy into the ditch. As I explain in my book Industrial Poverty (order your hard copy now or get your ebook version very soon!) the cause of the European crisis is to be found in the structure of the welfare state. This structural ailment is present in the American economy as well, though not as pronounced, but it explains why the Western economies experienced a growth slowdown in the 1980s (EU) and on the heels of the Millennium Recession (U.S.).

So long as the structural problem remains, there will be no recovery in the European economy. The United States has been able to recover despite the weight of government, an aspect that Steinbock misses. He does, however, make a good point about mistakes made by the European Central Bank:

[The] European Central Bank (ECB), led by its then-chief Jean-Claude Trichet, moved too slowly and hiked rates instead of cutting them. When the ECB finally reversed its approach, precious time and millions of jobs had been lost. Subsequently, Trichet’s successor, Mario Draghi, cut the rates and pledged to defend euro “at any cost.” Markets stabilised, but not without huge bailout packages, which divided the eurozone.

Trying to stuff as many explanations as possible of Europe’s perennial crisis into the same article, Steinbock then proceeds to point in many different directions at the same time:

As Barroso and his commissioners began to argue that “the worst was over,” Brussels hoped to reinforce the trust in euro and the EU and deter the rise of the eurosceptics. But hollow promises resulted in a reverse outcome. What’s worse, both Brussels and the core economies failed to provide adequate fiscal adjustment amidst the global crisis and the onset of the eurozone debt crisis, which made bad mass unemployment a lot worse and continues to penalise demand and investment. Further, neither liquidity support nor recapitalisation of the major banks has mitigated the worst insolvency risks in the region. Unlike in the US, many European economies, including Nordic ones, also continued to cut their innovation investments, thus making themselves even more vulnerable in the future. As the crisis spread to Italy and Spain, which together account for almost 30 percent of the eurozone economy, bailout packages could no longer be used. Rather, structural reforms became vital but since they were seen as a political suicide, delays replaced urgency.

Reduced spending on “innovation” is not nearly as important an explanation of the crisis as the structural fiscal imbalances of the welfare state. It is important to separate what matters from what does not matter. Otherwise, one cannot provide solutions to those who are in the position to put them to work.

A Recipe for Economic Stagnation

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.

An Institutional Analysis of the Crisis

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:

LB 7 28 14 2

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.