For the people who live in the European Union, daily life offers challenges in the form of zero growth, high unemployment, lack of opportunity and a gloomy outlook on the future. For a macroeconomist, however, the EU is a formidable experiment that must not be left undocumented. The union was constructed based on the European tradition of welfare statism, right when the welfare state as a socio-economic construct was beginning to show clear signs of macroeconomic ailment. For unknown reasons – though probably ideological preferences played a good part – the architects of the EU misinterpreted the symptoms of macroeconomic ailment such as persistent budget deficits. They saw them as expressions of irresponsible budget policies and therefore institutionalized budget-balancing guidelines for member-state fiscal policies. Those guidelines became the EU’s own constitutional balanced-budget requirement, also known as the Stability and Growth Pact.
The Stability and Growth Pact was created essentially to secure the fiscal sustainability of the European welfare state. The problem is that the welfare state in itself is not fiscally sustainable. A wealth of literature (which I am currently working my way through as part of my next book project) and a plethora of compelling data together convincingly show that the welfare state is in fact the fiscal venom that causes governments to go into structural deficits. So far, though, the political leaders of the European Union have not understood that their practice of the Stability and Growth Pact – known as statist austerity – has driven the European economy into a permanent recession. Their governments, consuming up to half of GDP, are subjected to spending cuts and in turn subject the private sector to higher taxes, which in turn causes the private sector to contract its activity or at the very least keep it constant.
As statist austerity causes GDP to stagnate, the welfare state’s budget problems are exacerbated. More people request assistance from its entitlement programs, while fewer people pay taxes. The budget problems that statist austerity was aimed at solving – again in order to make the welfare state look fiscally sustainable – actually cause a new round of budget problems. In response, austerity-minded governments tighten the fiscal belt yet another notch.
All in order to make the welfare state more affordable to a shrinking economy. In other words, saving the welfare state is the prime directive of European fiscal policy.
American fiscal policy has a different purpose. It aims to help the economy grow and lower unemployment. Granted, far from everything that comes out of U.S. fiscal policy is helpful in that respect, but at least the basic course of direction is right. Therefore, when representatives of the United States Treasury look at Europe and try to figure out what on Earth is going on over there, it is hardly surprising that some eyebrows go up and some foreheads are wrinkled.
The United States warned Europe on Thursday (9 April) against relying too much on exports for growth, and urged officials to make more use of fiscal policy, saying stronger demand was essential. In its semiannual report on foreign-exchanges policies to Congress, the US Treasury Department gave a preview of the positions it will press on foreign policymakers during next week’s International Monetary Fund meetings in Washington. The world cannot rely on the United States to be the “only engine of demand,” the report insisted. It urged nations to use all tools available to accelerate growth and not rely only on their central banks to boost recovery.
Before we get to the accolades, a technical comment. Exports is also “demand”, though from foreign buyers. The Treasury economists should know better and use the term “domestic demand”.
Now for the accolades. It is refreshing and reassuring to see that the Obama administration’s Treasury understands how the economy works. This is not a sarcastic comment – this is a genuine word of appreciation. Europe, by contrast, is filled to the brim with economists and other fiscal-policy decision makers whose actions and decisions prove that they have basically no comprehension of macroeconomics whatsoever. An economy is driven by its demand side: household spending and business investments from the private side, and government spending. Since consumer spending is 65-75 percent of a well-functioning economy, the confidence and prosperity of the general population is quintessential to the survival, growth and prosperity of any nation.
Furthermore, businesses invest because they ultimately will sell something to the general public. Therefore, confident households create confident businesses. A strong, forward-looking economy spends 15-20 percent of GDP on business investments.
Without growth in these two private-sector spending categories, there will be no growth in the economy as a whole. The economists of the U.S. Treasury know this, and they operate based on this basic, common-sense macroeconomic knowledge. Their criticism of Europe’s governments for not understanding the same thing is highly valid and echoes, in fact, what I have been saying on this blog for three years.
But there is one more aspect to this that the Treasury economists have not brought up – at least not as quoted by Euractiv. Let’s get back to their story:
The report singled out Europe’s biggest economy, saying “stronger demand growth in Germany is absolutely essential, as it has been persistently weak.” The US Treasury argues that policy makers in the euro area need to use fiscal policies to complement the monetary stimulus that the European Central Bank is providing. … While growth in Europe has shown some recent signs of picking up, the region remains the sick man of the global economy.
The problem for the Europeans is that they cannot do this. They cannot use fiscal policy to stimulate aggregate demand, because if they do they have to abandon statist austerity. Welfare states would again be allowed to go into deficits.
There are many reasons why the Europeans cannot let that happen. The first and most immediate reason is called “Greece”. The EU is in a very tense showdown with the socialist Greek government over repayments of loans – loans that in turn were given as part of EU-enforced statist austerity. If the EU now abandoned its austerity policies, the Greeks would rightly ask “what about us??” and the 25-percent drop in GDP that followed the harsh implementation of statist austerity in the country.
Another reason for the EU to stick to its austerity guns is the long-term concern for the welfare state’s fiscal sustainability. The Europeans are almost unanimously behind their welfare states and they are willing to sacrifice enormously for their ideologically driven big government. They have convinced themselves that the welfare state is not, has not been, and will not be the cause of their macroeconomic ailment. Therefore, they will try as best they can to defend the indefensible, namely the fiscal sustainability of the welfare state; that defense will take priority over any measures to help the private sector grow and thrive.
For these reasons, and others, there is no hope for a growth-oriented fiscal policy in Europe.
Apparently, the realization that something is structurally wrong is beginning to set in on some key policy makers. Euractiv again:
Speaking ahead of next week’s meetings, IMF managing director Christine Lagarde also warned that global recovery remained ‘moderate and uneven’ with too many parts of the world not doing enough to enact reforms even as risks to financial stability are rising. Mediocre economic growth could become the “new reality,” leaving millions stuck without jobs and increasing the risks to global financial stability, she insisted.
Ms. Lagarde and others interested in the systemic roots of this growth crisis are more than welcome to read my book Industrial Poverty about the structural problems in the European economy.
Again, it is encouraging to see American government officials notice and basically correctly analyze the differences between Europe and the United States. What is needed now is that those officials speak up about why the Europeans are ailing, and what the consequences will be for them and the world economy if they insist on protecting their welfare states at all cost.
Perhaps a President Rand Paul can take it up a notch…
Two years ago Caritas, the charity arm of the Catholic church, published a study of the socio-economic effects of the European crisis. They reported:
The prioritisation by the EU and its Member States of economic policies at the expense of social policies during the current crisis is having a devastating impact on people – especially in the five countries worst affected – according to a new study published today by Caritas Europa. The … failure of the EU and its Member States to provide concrete support on the scale required to assist those experiencing difficulties, to protect essential public services and create employment is likely to prolong the crisis.
Their report presented…
a picture of a Europe in which social risks are increasing, social systems are being tested and individuals and families are under stress. The report strongly challenges current official attempts to suggest that the worst of the economic crisis is over. It highlights the extremely negative impact of austerity policies on the lives of vulnerable people, and reveals that many others are being driven into poverty for the first time.
This was, again, two years ago. Since then, things have gotten worse, which Caritas reflects in its 2015 study of the European crisis. Sadly, the report not only accurately presents the socio-economic disaster in southern Europe, but it also makes requests for a bigger welfare state.
Starting with the effects of the crisis, Caritas points to widespread cuts in income-security entitlements and health care, especially in the worst-off countries like Greece, Italy, Rumania, Portugal and Cyprus:
[From] 2011, social expenditure declined … and social challenges have grown further during the second dip of the recession … for example, in a number of countries the number of long-term unemployed losing their entitlements has increased, the level or duration of benefits has been reduced, eligibility rules have been tightened to increase incentives to take up work and this has also led to excluding beneficiaries from some [entitlement programs].
The study also criticizes the hand of austerity that has been particularly heavy on southern Europe:
[The] policy of requiring countries with the weakest social protection systems to impose fiscal consolidation and successive rounds of austerity measures within very short timetables is placing the burden of adjustments on the shoulders of those who did not create the crisis in Europe and are least able to bear the burden.
[Austerity] policies pursued during the crisis in Europe and the structural reforms aimed at economic and budgetary stabilisation have had negative effects with regard to social justice in most countries
This is the problem facing Europe in the next few years. An economic crisis hit; governments responded by slashing welfare-state entitlements and raising taxes; people respond by getting angry – not over the crisis, but over lost entitlements. As a result, socialist parties are gaining strength from Paris to Lisbon, from Athens to Madrid, pushing an agenda of restored entitlements. Caritas reinforces this movement by suggesting that “social justice” – a politically undefinable concept – should be the guideline for post-austerity policy.
A battle cry for more social justice is a battle cry for higher taxes and more income redistribution. Or, as Caritas puts it, “the impacts [of austerity] have not been shouldered equally”. If by “equally” they mean “spread out evenly across the citizenry”, then yes, they are entirely correct. But the reason for this is – obviously – that only a select segment of the population receives entitlements from the welfare state. That is the very reason for the welfare state’s existence.
Caritas and other advocates of social justice would respond that this is a moot point: those who earn the least cannot afford lose the entitlements they have. Others have money, they contend.
If the argument about the frugality of welfare-state entitlements were applied to the United States, it would not stand up to scrutiny. Michael Tanner and Charles Hughes have proven this beyond the shadow of a doubt. Things are a bit different in Europe, though, as Caritas actually show in their study. However, this does not mean that austerity could have been executed differently. More burden on those who do not receive entitlements automatically means higher taxes; as I show in my book Industrial Poverty austerity based on tax increases has even worse macroeconomic effects than austerity biased toward spending cuts. This means, in a nutshell, that if austerity had been profiled according to some “social justice” scale, it would have deprived even more Europeans of jobs and entrepreneurial opportunities.
Plain and simple: Europe must not fall for the temptation of “social justice”. It must charter a course away from collectivism and government “solutions”. The way to the future goes through fundamental, structural reforms toward a permanently smaller government.
The answer to the question whether or not Greece will stay in the euro will probably be given this week. New socialist prime minister Tsipras is not giving the EU what it wants, jeopardizing his country’s future inside the currency union:
Talks between Greece and eurozone finance ministers broke down on Monday with an ultimatum that Athens by Friday should ask for an extension of the current bailout programme which runs out next week. Greek finance minister Yanis Varoufakis said he would have been willing to sign off on a proposal made by the EU commission, which was more accommodating to Greek demands, but that the Eurogroup offer – to extend the bailout programme by six months – was unacceptable. The battle is about more than just semantics. EU officials say Greece cannot cherrypick only the money-part of a bailout and ignore the structural measures that have to be implemented to get the cash. “If they ask for an extension, the question is, do they really mean it. If it’s a loans extension only, with no commitments on reforms, there is an over 50 percent chance the Eurogroup will say no,” one EU official said. Failure to agree by Friday would leave very little time for national parliaments in four countries – notably Germany – to approve the bailout extension. It would mean Greece would run out of money and be pushed towards a euro-exit. … As for the prospect of letting Greece face bankruptcy to really understand what’s at stake, an EU official said “there is no willingness, but there is readiness to do it”.
The mere fact that there is now official talk about a possible Greek exit from the euro is a clear sign of how serious the situation is. It is also an indication that the EU, the ECB and the governments of the big EU member states have a contingency plan in place, should Greece leave the euro.
My bet is that Tsipras is gambling: he wants out of the euro, but with a majority of Greeks against a reintroduction of the drachma he cannot go at it straightforwardly. He has to create a situation where his country is given “no choice” but to leave. This is why he is negotiating with the EU in a way that he knows is antithetical to a productive solution.
The reason why Tsipras wants out is simple: he is a Chavista socialist and wants to follow in the footsteps of now-defunct Venezuelan president Hugo Chavez. That means socialism in one country. (A slight rephrasing of the somewhat tarnished term “national socialism”.) In order to create a Venezuelan-style island of reckless socialism in Europe, Tsipras needs to get out of the euro zone.
Should he succeed, it is likely that other countries will follow his example, though for different ideological reasons. However, there is more at stake in the Greek crisis than just the future of the euro zone. Tsipras is riding a new wave of radical socialism, a wave that began moving through Europe at the very depth of the Great Recession. Statist austerity was falsely perceived as an attempt by “big capitalism” to dismantle the welfare state. It was not – quite the contrary: statist austerity was a way for friends of big government to preserve as much as possible of the welfare state.
However, socialists have never allowed facts to get in the way of their agenda. And they certainly won’t let facts and good analysis get in the way of their rising momentum. What started mildly with a socialist victory in the French elections in 2012 has now borne Tsipras to power in Greece and is carrying complete political newcomers into the center stage of Spanish politics. But this new and very troublesome wave of socialism is not stopping at member-state capitals. It is reaching into the hallways of EU politics as well. As an example, consider these words on the Euractiv opinion page by Maria João Rodrigues MEP, Vice-Chair of the Socialists and Democrats Group in the European Parliament, and spokesperson on economic and social policies:
The Greek people have told us in January’s elections that they no longer accept their fate as it has been decided by the European Union. For those who know the state of economic and social devastation Greece has reached, this is only a confirmation of a survival instinct common to any people. The Greek issue has become a European issue, and we are all feeling its effects.
This is a frontal attack on EU-imposed austerity, but it is also a thinly veiled threat: unless Europe moves left, the left will move Europe.
Back to Rodrigues:
European integration can only have a future if European decisions are accepted as legitimated by the various peoples who constitute Europe. Decisions at European level require compromises, as they have their origins in a wide variety of interests. But these compromises must be perceived as mutual and globally advantageous for all Member States involved, despite the commitments and efforts they entail. The key question now is whether it will be possible to forge a new compromise, enabling not only to give hope to the Greek people, but also to improve certain rules of today’s European Union and its Economic and Monetary Union.
This should not be misinterpreted as a call for return of power to the member states. The reason why is revealed next:
We need a European Union capable of taking more democratic decisions and an Economic and Monetary Union which generates economic, social and political convergence, not ever-widening divergence. If Europe is unable to forge this compromise, and if the rope between lenders and borrowers stretches further, the risks are multiple: financial pressures for Greece to leave the euro; economic and social risks of continued stagnation or recession, high unemployment and poverty in many other countries; and, above all, political risks, namely further strengthening of anti-European or Eurosceptic parties in their aspiration to lead national governments, worsening Europe’s fragmentation.
The fine print in this seemingly generic message is: more entitlement spending to reduce income differences – called “economic and social convergence” in modern Eurocratic lingo – and a central bank the policies of which are tuned to be a support function for fiscal expansion. The hint of this is in the words “If the rope between lenders and borrowers stretches further”: member states should be allowed to spend on entitlements to reduce income differences, and if this means deficit-spending, the ECB should step in and monetize the deficits.
Rodrigues offers yet another example of the same argument:
[Many of] Greece’s problems were aggravated by the behaviour of the European Union: Firstly, it let Greece exposed to speculative market pressures in 2010, which exacerbated its debt burden. Secondly, when the EU finally managed to build the necessary financial stabilisation mechanisms, it imposed on Greece a programme focused on the reduction of the budget deficit in such an abrupt way that the country was pushed into an economic and social disaster. Moreover, the austerity measures resulted in a further increase of Greece’s debt compared to its GDP.
It is apparently easy for the left to look away from such obvious facts as the long Greek tradition of welfare-state spending. But that goes with the leftist territory, so it should not surprise anyone. More important is the fact that we once again have an example of how socialists use failed statist austerity to advocate for even more of what originally caused the crisis, namely the big entitlement state. They want to turn the EU and the ECB into instruments for deficit-spending ad infinitum to expand the welfare state at their discretion.
To further drive home the point that what matters is the welfare state, Rodrigues moves on to her analysis of Greece:
What Greece needs now is a joint plan for reform and reconstruction, agreed with the European institutions. This plan should replace the Troika programme, while incorporating some of its useful elements. Crucially, it should foresee a relatively low primary surplus and eased conditions of financial assistance from other eurozone countries, in order to provide at least some fiscal room for manoeuvre for the country. In return, the plan should set out strategic reforms to improve the functioning of the Greek economy and the public sector, including tax collection, education, employment and SMEs services as well as ensuring a sustainable and universal social protection system.
There is no such thing as a “sustainable and universal social protection system”. When Europe’s new generation of socialist leaders get their hands on the right policy instruments they will turn all government-spending faucets wide open. Deficits will be monetized and imbalances toward the rest of the world handled by artificial exchange-rate measures (most likely of the kind used by now-defunct Hugo Chavez).
If this new wave of socialism will define Europe’s future, then the continent is in very serious trouble.
A short-term measure of the strength of the momentum will come later this week when we will know whether or not Greece will remain in the currency union. Beyond that, things are too uncertain to predict at this moment.
There have been many attempts at predicting which way Greece is going to go under the new socialist government. Most of the voices heard thus far seem to agree that Prime Minister Tsipras will not seek a confrontational course against the EU. That is, however, a mistake. This is a man who considers now-defunct Venezuelan president Hugo Chavez a political hero. Tsipras is also a former communist (though being a former communist and at the same time a fan of now-defunct Hugo Chavez is a matter of political semantics) whose training in politics and – to the extent it exists – in economics is fully governed by those ideological roots.
It is only logical that he continues to raise the volume vs. Brussels. Alas, from Euractiv:
Greek Prime Minister Alexis Tsipras laid out plans on Sunday (8 February) to dismantle Greece’s “cruel” austerity programme, ruling out any extension of its international bailout and setting himself on a collision course with his European partners at a summit in Brussels later this week. In his first major speech to parliament since storming to power last month, Tsipras rattled off a list of moves to reverse reforms imposed by European and International Monetary Fund lenders; from reinstating pension bonuses and cancelling a property tax to ending mass layoffs and raising the mininum wage back to pre-crisis levels.
There are two reasons to take this man seriously. The first has to do with his admiration of now-defunct Hugo Chavez. Fans of so called Bolivarian socialism – the ideological niche Chavez carved out for himself and his project to destroy Venezuela – truly believe in the idea of socialism in one country. They are not ideologically or intellectually opposed to “going at it alone”: on the contrary, it would be entirely in line with their thinking to try to repeat in Greece what now-defunct Hugo Chavez did in Venezuela. This means, as I have explained several times before, that Tsipras and his party, Syriza, would be more than happy to try to turn Greece into a European Venezuela.
In addition to terrible economic consequences, this would mean cutting some key economic and political ties between Greece and the EU. A termination of EU-imposed austerity and a reintroduction of the drachma are high on that list.
The second reason to take Tsipras seriously will be revealed in just a moment. First, back to Euractiv:
Showing little intent to heed warnings from EU partners to stick to commitments in the €240 billion bailout, Tsipras said he intended to fully respect campaign pledges to heal the “wounds” of the austerity that was a condition of the money. Greece would achieve balanced budgets but would no longer produce unrealistic primary budget surpluses, he said, a reference to requirements to be in the black excluding debt repayments. “The bailout failed,” the 40-year-old leader told parliament to applause. “We want to make clear in every direction what we are not negotiating. We are not negotiating our national sovereignty.” In a symbolic move that appeared to take direct aim at Greece’s biggest creditor, Tsipras finished off his speech with a pledge to seek World War II reparations from Germany.
In effect, that means writing off German loans. But wait – there is more. Let’s continue with the Euractiv article and listen to the political arrogance of Prime Minister Tsipras:
Tsipras ruled out an extending the bailout beyond 28 February when it is due to end. But he said he believed a deal with European partners could be struck on a so-called “bridge” agreement within the next 15 days to keep Greece afloat. “The new government is not justified in asking for an extension,” he said. “Because it cannot ask for an extension of mistakes.” Athens – which is shut out of bond markets and will struggle to finance itself without more aid quickly – plans to service its debt, Tsipras said. “The Greek people gave a strong and clear mandate to immediately end austerity and change policies,” he said. “Therefore the bailout was first cancelled by its very own failure and its destructive results.”
This is quite a high-pitch rhetoric to come from a man whose country cannot function without foreign aid. But herein lies the second reason why it is important to take Tsipras seriously and assume that he means every word he says. From EU Business:
A Greek exit from the euro would see the euro collapse like a house of cards, Finance Minister Yanis Varoufakis warned in comments that triggered a spat with Italy. “Greece’s exit from the euro is not something that is part of our plans, simply because we believe it is like building a house of cards. If you take out the Greek card, the others will collapse,” Varoufakis said in an interview with Italian public broadcaster RAI that was aired on Sunday.
Here is the strategy behind the Greek finance minister’s rant. As PM Tsipras tells the EU, the ECB and the IMF that austerity is over, he flags up that Greece will now begin its long walk out on the left flank. he is now at a point where he can start implementing his long-held dream of a communist, or at least Bolivarian socialist, paradise in Greece. The EU-ECB-IMF troika has very limited resources to put up against the Greeks unilaterally ending austerity – their most formidable weapon would be to kick Greece out of the euro.
Theoretically, the Greek government would not mind that, but they want it to happen on their terms. They want to tell Europe that “you can’t kick us out, because we quit”. That is a risky strategy – they can only push Brussels and Berlin that far – so to increase the likelihood that Greece holds the aces here, finance minister Varoufakis reminds the European leadership what chaos would erupt if they kicked Greece out.
This is a very high-stakes game, for both parties. The first skirmish will be over Greece’s participation in the currency union, with my bets being on Tsipras unilaterally pulling Greece out. That may make him look strong, but in the end Greece will lose. It is their economy and their people who will be subjected to a European version of the Bolivarian socialist paradise that now-defunct Hugo Chavez created.
Earlier this week I explained how Europe has, institutionally, set itself up for a long-term decline in growth. The Stability and Growth Pact should take a lot of blame for this, as it comes with a built-in bias in favor of contractionary fiscal policy. But it is not just any type of contractionary policy that is favored by the Stability and Growth Pact: it is contractionary policy aimed at balancing the government budget – regardless of all other policy goals.
To be clear, there are two types of contractionary fiscal policy:
- So called “statist austerity” aims at balancing the government budget with the explicit or implicit purpose to keep government spending programs as intact as possible under tighter economic conditions;
- So called “free market austerity” where the goal is to shrink government spending with the explicit purpose of permanently reducing the size of government.
The two forms employ different policy strategies. Statist austerity can include tax increases; the balance between spending cuts and tax hikes is determined primarily by practical and political considerations. These considerations typically supersede economic analysis: the execution of statist austerity typically takes place over a short period of time and upon short notice, such as looming panic among global investors over a government’s believed ineptitude in balancing the budget.
Free market austerity, on the other hand, aims solely at permanently shifting the balance between the private sector and government. This can be achieved if and only if:
a) government spending is permanently reduced; and
b) taxes are reduced proportionately to the reduction in spending.
As a result, the combination of changes in taxes and spending is entirely different than what is required under statist austerity. In terms of outcomes, the effects of free-market austerity on GDP growth are radically different from the effects of statist austerity: under the latter government actually increases its net claim on the economy, while under the former the private sector is given ample opportunity to expand.
By dictating budget-balancing requirements, the Stability and Growth Pact de facto mandates statist austerity in Europe. The logical outcome of this should be a long-term decline in GDP growth. There is lots of economic theory to draw on for this conclusion.
The growth rate reported in this figure is of the sliding-average kind (without a forecasting side), which shifts focus from periodic observations to trend observations. As the polynomial (third order) trend line indicates, the long-term path is unequivocally downward. In addition, growth peaks get weaker and shorter.
Perhaps the best evidence of the connection between the Stability and Growth Pact and this long-term trend can be found in the downturn after 2010. Annual growth in the fourth quarter of 2010 was 2.2 percent; a year later it was 0.2 percent and by Q4 2012 euro-zone GDP was shrinking by a full percent. It did not return to growth until the latter half of 2013, and then only at tepid rates below half a percent.
In fact, over the past three years – 12 quarters – euro-zone GDP growth has only been above one percent one single quarter. That was in Q1 2014. For Q3 2014 it expanded by a tiny 0.8 percent on an annual basis.
The relation between the institutional structure and the long-term decline in GDP growth is one of the most important reasons why I have come to the conclusion that Europe is stuck in a state of permanent economic stagnation – a state of industrial poverty – which it will not recover from until it reforms away its institutional barriers to a real economic recovery.
In December I took a first look at the European Commission’s “Report on Public Finances”, with the intention of returning to this important document later. It has been almost a month, longer than I expected, but here we are.
In my first review of the report I explained that the strict focus by Europe’s political leadership on government finances has led to a systemic error in their fiscal policy priorities:
Austerity, as designed and executed in Europe, was aimed not at shrinking government but making it affordable to an economy in crisis. The end result was a permanent downward adjustment of growth, employment and prosperity. In order to get their economy out of this perennial state of stagnation, Europe’s leaders need to understand thoroughly the relations between government and the private sector.
This is a kind of prioritization that has guided European fiscal policy for two decades now. Under the Stability and Growth Pact, EU member states in general are forced to adopt a fiscal policy that inherently has a contractionary – austerity – bias. But it is not the kind of austerity that reduces the size of government. It is the kind that tries to shrink a budget deficit in order to keep government finances in good order and save the welfare state from insolvency.
So long as contractionary fiscal policy – austerity – is focused on balancing the budget and saving the welfare state, it won’t reduce the size of government. For that, it takes specifically designed austerity measures. Those measures are indeed possible, even desirable, but they cannot be launched unless government is allowed by its own constitution to prioritize less government over a balanced budget.
Unfortunately, the Stability and Growth Pact does not permit that member states prioritize shrinking government over budget balancing. Instead, the Stability and Growth Pact forces them to always pay attention to deficits and debt, but never worry about running too large surpluses. Part A of the Pact caps government deficits at three percent of GDP and debt at 60 percent of GDP. At the same time, there are no caps on budget surpluses; since a surplus is excess taxation, and since excess taxation drains the private sector for money in favor of a government savings account, this means that governments can drain the private sector for all the money it wants to without violating the European constitution.
Unlike a budget surplus, which is contractionary in nature, a budget deficit is, at least in theory, always stimulative. However, by capping deficits the European constitution restricts the stimulative side of fiscal policy, while at the same time leaving the contractionary end unrestricted.
In addition to the technical aspects of this contractionary bias, there is also the political mindset that is born from a legislative construct of this kind. Lawmakers and elected cabinet members – primarily treasury secretaries – are concerned with avoiding deficits, thus quick to resort to contractionary policy measures, but pay little attention to the need for counter-cyclical policies. Over time, this political mindset becomes “one” with the Stability and Growth Pact to the extent where parliaments do not think twice of passing budgets that impose harsh contractionary measures in order to balance a budget.
Think Europe in 2012. And read chapters 4a and 4b in my book Industrial Poverty to get an idea of how deep roots in Europe’s legislative mindsets that this “gut reaction” bias toward contractionary measures has actually grown.
With its contractionary bias, Europe’s fiscal policy has permanently downshifted growth in Europe. This in turn has perpetuated the budget problems that said contractionary policies were intended to solve. It left the European economy fragile and frail, vulnerable to a tough recession. All it took was the downturn in 2008-09 with its spike in deficits – and once the fiscal-policy gut reaction kicked in, there was nowhere to go for Europe other than into the dungeon of budget-balancing contractionary measures; statist-driven austerity; mass unemployment; and perpetual budget problems.
Never did Europe’s leaders think twice of trying to actually release its member states from the shackles of the Stability and Growth Pact. Never did they think twice of permitting a widespread downward adjustment of the size of government.
The Commission’s “Report on Public Finances” cements this statist approach to contractionary fiscal policy. It has an entire section that suggests further collaboration and coordination among EU member states on the fiscal policy front. So long as the Stability and Growth Pact remains in place, such coordination would be a thoroughly bad idea. All that such coordination would accomplish is to cement statist austerity as the prevailing “fiscal policy wisdom” ruling the economy that feeds 500 million people.
I will return in more detail to this report. In the meantime, do take a minute and read my paper Fiscal Policy and Budget Balancing: The European Experience. It is part of a five-paper series of discussion papers on the ups and downs of a balanced-budget amendment to the United States constitution.
The truth about the European economic crisis is spreading. The latest evidence of this growing awareness is in an annual report by the European Commission. Called “Report on Public Finances”, the report expresses grave concerns about the present state as well as the economic future of the European Union. It is a long and detailed report, worthy of a detailed analysis. This article takes a very first look, with focus on the main conclusions of the report.
Those conclusions reveal how frustrated the Commission has become over Europe’s persistent economic stagnation:
The challenging economic times are not yet over. The economic recovery has not lived up to the expectations that existed earlier on the year and growth projections have been revised downwards in most EU Member States. Today, the risk of persistent low growth, close to zero inflation and high unemployment has become a primary concern. Six years on from the onset of the crisis, it is urgent to revitalise growth across the EU and to generate a new momentum for the economic recovery.
Yet only two paragraphs down, the Commission reveals that they have not left the old fiscal paradigm that caused the crisis in the first place:
The aggregate fiscal picture for the EU and the euro area is now considerably more favourable, thanks to the commendably large consolidation efforts made in the past. … this has allowed Member States to slow the pace of adjustment. The aggregate fiscal stance is now expected to be broadly neutral in 2014 and 2015, both in the EU and the euro area. This will reduce one of the drags on growth and should therefore be welcomed.
If Europe is ever to recover; if they will ever avoid decades upon decades of economic stagnation and industrial poverty; the government of the EU must understand the macroeconomic mechanics behind this persistent crisis. To see where they go wrong, let us go through their argument in two steps.
a) “The aggregate fiscal picture for the EU and the euro area is now considerably more favourable, thanks to the commendably large consolidation efforts made in the past.” There are two analytical errors in this sentence. The first is the definition of “fiscal picture” which obviously is limited to government finances. But this is precisely the same error in the thought process that led to today’s bad macroeconomic situation in Europe: government finances are not isolated from the rest of the economy, and any changes to spending and taxes will affect the rest of the economy over a considerable period of time. The belief that government finances are in some separate silo in the economy led to the devastating wave of ill-designed attempts at saving Europe’s welfare states in 2012.
Austerity, as designed and executed in Europe, was aimed not at shrinking government but making it affordable to an economy in crisis. The end result was a permanent downward adjustment of growth, employment and prosperity. In order to get their economy out of this perennial state of stagnation, Europe’s leaders need to understand thoroughly the relations between government and the private sector.
b) “The aggregate fiscal stance is now expected to be broadly neutral in 2014 and 2015, both in the EU and the euro area. This will reduce one of the drags on growth and should therefore be welcomed.” Here the Commission says that if a government runs a deficit, it causes a “drag” on macroeconomic activity. This is yet another major misunderstanding of how a modern, monetary economy works.
Erstwhile theory prescribed that a government borrowing money pushes interest rates up, thus crowding out private businesses from the credit market. But that prescription rested on the notion that money supply was entirely controlled by the central bank; in a modern monetary economy money supply is controlled by the financial industry, with the central bank as one of many players. Its role is to indicate interest rate levels, but neither to set the interest rate nor to exercise monopolistic control on the supply of liquidity.
A modern monetary economy thus provides enough liquidity to allow governments to borrow, while still having enough liquidity available for private investments. In fact, it is rather simple to prove that the antiquated crowding-out theory is wrong. All you need to do is look at the trend in interest rates before, during and after the opening of the Great Recession, and compare those time periods to government borrowing. In a nutshell: as soon as the crisis opened in 2008 interest rates plummeted, at the same time as government borrowing exploded.
This clearly indicates that the decline in macroeconomic activity was not caused by government deficits; it was the ill-advised attempt at closing budget gaps and restore the fiscal soundness of Europe’s welfare states that caused the drag. And still causes the drag.
In other words, there is nothing new under the European sun. That is unfortunate, not to say troubling, but on one front things have gotten better: the awareness of the depth of the problems in Europe is beginning to sink in among key decision makers. What matters now is to educate them on the right path out of the crisis.
There is a lot more to be said about the Commission’s public finance report. Let’s return to it on Saturday.
Belgium is one of Europe’s most troubled welfare states, though its problems have been overshadowed by the macroeconomic disasters along the Mediterranean. Its fiscal problems are older than most EU member states, and it was the first country to attract sociological interest based on the fact that there were families – regular working class families – where three generations were perennially unemployed.
Today, Belgium is attracting interest because of a new report from the International Monetary Fund. The EU Observer reports:
The Belgian government is planning “many welcome measures to address the critical macroeconomic challenges facing the Belgian economy”, but it can do more, the International Monetary Fund (IMF) said on Monday (15 December). On the same day Belgian unions organised a general national strike, the IMF presented its findings from a ten-day mission to the country. “The planned reforms of social security and budgetary measures are a step in the right direction”, the IMF wrote.
As with other welfare states in Europe, Belgium suffers from disturbingly low growth. As a result, tax revenues cannot keep up with entitlement spending and the budget deficit becomes structural. GDP growth has been as disappointing in the Belgian economy over the past few years as it has elsewhere in Europe (annual growth rates, reported quarterly):
The Great Recession took a big toll on the Belgian government’s finances. Its budget went from a 156 million euro surplus in 2007 to a 19.1 billion euro deficit in 2009, equal to 5.6 percent of GDP.
From there, the deficit has declined slowly but steadily, reaching the EU’s magic three-percent of GDP mark in 2013. Due to the almost clinical absence of GDP growth, the decline has been accomplished by means of welfare-state saving austerity. As the EU Observer explains, these policies are likely to continue, with some tax reshuffling to spice it up:
The centre-right government of Charles Michel, the first coalition without socialists since 1988, started work in October. It plans spending cuts and increasing the pension age from 65 to 67 by 2030. However, the IMF says that Belgium should also reform its tax system. … when it comes to labour tax, Belgium ranks top with a rate of over 40 percent. The IMF suggests that labour tax should be lowered and compensated with a higher tax on capital.
As the figure above clearly shows, there is no recovery under way in Europe. Belgium is no exception, which makes the IMF advice a problematic ingredient in the Belgian fiscal policy mix. More than anything, Belgium needs tax cuts, not a redistribution of the tax burden. It also needs massive, structural reforms to its welfare-state entitlements system, encouraging work and discouraging indolence. None of this is on the horizon, which makes it a safe bet to predict that the Belgian economy will not return to historic growth levels in the foreseeable future.
Whenever government creates an entitlement, it makes a promise to its citizens. The promise is defined in terms of a cash value, or an in-kind service of a certain quality; in terms of duration and of who is, or can become, eligible.
Over time, people adjust their lives to these promises. They come to rely on government being there for them when it really matters, and therefore stop – or never start – saving for contingencies such as unemployment or major health care expenses. Their incentives to stop providing for unforeseen events are reinforced by the taxes that go toward paying for government’s promises.
There you have it, in a nutshell: the welfare state.
In the early years of its existence, the welfare state provided for people with relative ease. Many adults still lived by the old creed of keeping current expenses moderate in order to have enough in the bank for most of what life could throw at them. Taxes were also relatively moderate, allowing people the cash margins to do the saving they still thought they needed.
Over time, though, it became harder and harder for government to keep its welfare-state promises. The incentives structure that government had created began sinking in to the fabric of the economy. Not only did people cut down on their savings, thus relying more on the welfare state, but they also responded to the higher taxes by working less.
Dependency on government increased while independence decreased. This created a trend where the ability of government to pay for its promises was slowly but inevitably eroded. The cost of its promises crept upward, beyond what the creators of the welfare state had originally imagined; work disincentives eroded tax revenues, also beyond what the architects of the welfare state had pictured.
In the early 1970s most of Europe’s welfare states hit a point where the cost of the welfare state began rising above what the private sector of the economy could afford. Various accommodating measures were taken, varying from higher taxes and benefits cuts – as in Denmark – to supply-side tax cuts aimed at accelerating growth in tax revenue – as in Sweden. (Notably, the Reagan tax cuts were coupled with seven-percent-per-year federal spending growth, a clear indication that the supply-side policies were there to fund government, not part of a strategy to reduce the size of government.) But these were merely stopgap measures; inevitably, the welfare state overwhelmed the private sector with its entitlement costs, its high taxes, its incentives toward a lifestyle of government dependency.
The crisis of 2008 was the straw that broke the camel’s back. Europe’s welfare states plunged into the dungeon of economic stagnation and began their march into a new era of industrial poverty.
For more on that part of the story, see my book on the European crisis. For now, though, there is another aspect of the crisis of the welfare state that deserves attention. In response to the overwhelming cost of the welfare state, most of Europe’s countries have resorted to a kind of austerity not yet known to Americans. They cut government spending and raise taxes not to reduce the size of government, but to resize their welfare states to slim-fit them into a smaller economy (make them more “affordable” as Michael Tanner so aptly put it in his foreword to my book). The metrics for whether or not austerity has succeeded have nothing to do with how the private sector is doing – they are all focused on whether or not the welfare state will survive.
The primary measurement of survivability is whether or not the budget deficit has been reduced.
In order to get there, though, most European governments have had to cut deeply into their welfare state programs. That would be fine under the right circumstances – if people were given tax cuts corresponding to the spending cuts and thus a chance to buy the same services on a private market. But in the European, statist version of austerity, reduced spending means cutting the size of government without giving more room to the private sector. As much as this sounds like a contradiction in terms, consider the fact that while spending is reduced, taxes remain high or go up even higher.
As a direct result of this statist version of austerity, government breaks its promises to its citizens, and does it on many fronts at the same time. This is now statistically visible.
Broadly speaking, welfare-state spending consists of two parts: cash benefits and in-kind benefits. The latter is health care, elderly care, child care and similar services. Both these two categories can then be subdivided into means-tested and non-means tested benefits.
When a government is faced with the need to cut spending, and its motive for cutting spending is to save as much as possible of the welfare state, it will make its cuts based on two criteria:
- what cuts will give the most bang for the political and legislative effort; and
- what cuts will stir up the least political protests among voters.
These two criteria do not always work in tandem, and it varies from country to country, from government to government, which one weighs more heavily. However, as a general rule it is easier to cut in-kind benefits than cash benefits: while people see the reduction in cash benefits immediately, it takes a while for them to experience the reduced quality or availability of services such as health and child care.
We can see this rule at work in Europe. In countries that have been hit hard by statist austerity, there were tough cuts to in-kind benefits spending (Eurostat data; changes to annual total spending; current prices):
By contrast, countries that have not suffered as hard statist austerity measures:
Now compare the cuts to in-kind benefits in “austerity countries” to what they did with cash benefits:
What is the lesson from all this? There is, again, the broader, long-term lesson of a future in economic stagnation and a life in industrial poverty. But already today there are tangible consequences felt by citizens whom welfare statists often refer to as “vulnerable”. They have first been lured into dependency on government, then – when austerity strikes – they are left without access to services monopolized by government.
When the welfare state breaks its promises, having the right to health care is one thing; getting health care when needed is a totally different matter.
Yankees baseball legend Yogi Berra coined the proverbial phrase “It ain’t over ’til it’s over”. That is certainly true about the European economic crisis. This past week saw a crop of bad news from the Old World. Nothing very dramatic – and certainly nothing that should surprise regular readers of this blog – but nevertheless bad news. In this first of two parts, let’s look at a report from the EU Observer:
The eurozone appears to have come back onto the markets’ radar amid low inflation, poor economic news from Germany, and Greece’s bailout exit plans. Greece’s long-term borrowing costs went above 8 percent on Thursday (16 October) – their highest for almost a year – as investors took fright at the fragile political situation in the country. The government in Athens has tried to shore up popular support by suggesting it will exit its bailout programme with the International Monetary fund more than a year early.
There is an important background here. The bailout program had three components:
1. The Greek government will do everything in its power to combine a balanced budget with protecting as much as possible of its welfare state against the economic depression;
2. In return for the Greek government’s tax increases and spending cuts, the International Monetary Fund, the European Union and the European Central Bank provided loans that kept the Greek government afloat cash-wise;
3. The only metric used to measure the success of bailout policies is the stability of a balanced government budget.
If GDP did not grow, if unemployment was at 30 percent, if more than half the young in Greece had no job to go to… none of that mattered. As a result, there has been no structural improvement of the Greek economy; government has not reduced its burden on the private sector – quite the contrary, in fact. Welfare systems have been reduced, but higher taxes have prevented welfare recipients from transitioning into self sufficiency.
As a result, the social situation in Greece is almost unbearable. The political reaction has come in the form of a surge for parties on the extreme flanks of the political spectrum. In my book Industrial Poverty I explain in detail what happened in Greece, what brought the country down from the heights of European prosperity to permanent stagnation. Today, sadly, the country is little more than a macroeconomic wasteland.
It is with this in mind that one should approach the news that Greece is considering leaving the bailout program. The coalition government is under enormous pressure to save the nation itself, to keep parliamentary democracy in place and to inject some sort of life into the economy. If they fail either of two extreme political movements will take over – the Chavista communists in Syriza or the Nazis in Golden Dawn.
International investors know this and are understandably scared. In their mind the bailout is the least of available evils; in reality, as I explain in my book, the attempts at balancing the budget and saving the welfare state in the midst of the crisis are the very policies that keep Greece from recovering; weak signs of a minor recovery earlier this year have yet to materialize into anything other than the “beaten dog” syndrome often following protracted periods of austertiy.
This is the very reason why Greece is now considering leaving the bailout program. They cannot continue forever to try to muddle through with an economy deadlocked in depression and a democracy so fragile that it has brought the first Nazis into a parliament in Europe for the first time since World War II.
However, as the EU Observer explains, the Greek government is caught between a rock and a hard place – as are other hard-hit euro zone economies:
But the recent announcement spooked investors, unconvinced that Greece can stand alone. Long-term borrowing costs also jumped in the weak periphery states, Spain, Italy, and Portugal. The market jitters – while not comparable to the height of the eurozone crisis in 2011 and 2012 – come as the eurozone’s main economies are once again at odds over policy responses.
France also belongs on that list, primarily for its typically European attempt at leaving the bailout program. Its government tried to leave the bailout path for a left turn into the quagmire of government expansionism. Thinking that more government spending, on top of the largest government spending in the world, could in fact bring about a recovery, the French socialists who won the 2012 elections scoffed at the EU balanced-budget rules and went full speed ahead with their government-expansionist agenda.
Two years later that agenda has hit a brick wall. Massive tax increases, supposed to pay for some of the new government spending, have only resulted in an exodus of brain power and entrepreneurship. The French GDP is standing more still than the Eiffel Tower.
In fact, the EU Observer notes,
France and Italy are fighting a rearguard action for more flexibility saying budget slashing will condemn them to further low growth. Paris is on collision course with both Berlin and the European Commission after having indicated that it wants an extra two years to bring its budget deficit to below 3 percent of GDP. Italy, meanwhile, has submitted a national budget for 2015 which brings the country to the edge of breaking the rules.
The French challenge to the budget-balance rules compounds the uncertainty emanating from the talks in Athens about a Greek bailout exit. It is more than a theoretical possibility that at least one of these countries leaves the euro zone in the next two years, and does so for a combination of political and economic reasons. That would be an institutional change to the European economy – and really the global economy – of such proportions that no traditional quantitative analysis can render justice to a forecast of its effects. It is therefore entirely logical that global investors are growing more uncertain and as a result demand higher risk premiums.
As the icing on the uncertainty cake, informed investors know that Marine Le Pen may very well become France’s next president. If she wins in 2017 her first order of business is in all likelihood going to be to exit the euro zone and reintroduce the franc. On the one hand that could be an “orderly” exit; on the other hand it would have ripple effects throughout the southern rim of the euro zone to the point where the very future of the common currency is in grave danger.
In summary: mounting uncertainty about the future of the euro is being mixed with growing uncertainty about the macroeconomic performance of the member states of the currency union.
Stay tuned for the second part about the bad news out of Europe.