Slow Economic Growth is a Crucial European Problem-Becker

Both Europe’s short-term and long-term economic futures do not look bright. The need to bail out Greece, and possibly also Spain, Portugal, and Italy is the immediate problem, but the fundamental problems go much deeper. Relatively rapid economic growth will cure many budgetary imbalances since the challenge is not the size of government debt per se, but its size relative to GDP. A faster growing economy can tolerate sizable growth in government spending as long as the growth rate of its debt is no faster than the rate of growth of GDP.

Unfortunately, large government spending and rigid economies, the European approach, tend to both increase the growth rate of government debt, and at the same time lower the growth rate of GDP. As a result, the prospects for rapid growth in most European economies, and for getting government debt under control, are dim unless major reforms are introduced into their welfare state, labor markets, regulatory framework, and other government policies.

Europe needs high income and other tax rates in order to finance its system of early retirements and generous pension benefits, especially among its large numbers of government employees, its liberal unemployment benefits, easy access to welfare payments to support unmarried mothers, the care of children, and many other government subsidies. Edward Prescott has shown (see e.g., his “Why do Americans Work so Much More than Europeans”, Federal Reserve Bank of Minneapolis, Quarterly Review, 28, July 2004) that higher marginal tax rates account for a significant part of the difference in employment, earnings, and hours worked between the US and the main European countries. High tax rates reduce both the level of income at any moment and the rate of growth of income over time.

 

Very low European birth rates contribute to the difficulty in financing generous support of the elderly since fewer men and women of prime working ages are available to be taxed to support the growing number of retirees, although the greater education, and hence greater productivity, of each young European partly but not fully compensates for having fewer young workers. The substantial increase in life expectancy is an enormous benefit of modern medicine and of greater knowledge about healthy personal care. However, longer expected lifetimes have greatly raised pension and health burdens in most European countries since their retirement ages have not increased in proportion to the growth in years lived of older persons.

The rigidities imposed by a single currency, the euro, will continue to cause frictions and difficulties for countries in the European Monetary Union. Part of the problem, as in the current Greek crisis, is the separate fiscal regimes of member countries.  But budgetary deficits and reckless borrowing are not the only forces that create tensions within a common currency. Some countries using the Euro will at times experience severe shocks to their economy that create unemployment and deficits in their foreign trade accounts. Economically weaker countries with own currencies usually respond to such shocks by devaluating their currency, as Greece frequently did in the past when it had the drachma.

Devaluation is not available to individual countries within the euro monetary union. They have to adjust to bad shocks to their individual economies either through increased unemployment, reduced wages, or migration of some unemployed workers to countries that are doing better. These adjustments are difficult for Greece, Italy, Spain and other weak members of the EU because their labor markets are inflexible, and because many workers in these countries are reluctant to migrate elsewhere, partly because they would give up generous benefits.

States of the US also have a common currency, and also face state-specific shocks since they specialize somewhat in different commodities and services. However, the difficulties states face in adjusting to their economic shocks are reduced by the much greater flexibility of US than European labor markets, and the willingness of many unemployed Americans to move to states that are doing well.

Apropos of comparisons between US and Europe, the US faces many of the same problems as Europe, but generally they are in a more muted form. The US has more flexible labor markets, lower marginal tax rates, fewer invasive regulations, a smaller welfare state, higher birth rates, greater immigration, more rapid incorporation of immigrants into the general economy, greater encouragement to starting new businesses, greater competition, and many other economic advantages. Nevertheless, the US has large fiscal deficits, and large health care and retirement obligations that will be growing rapidly over time.

To manage effectively a growing federal government debt, it is essential that the growth in entitlements be reduced, in part by raising the age of retirement and of access to Medicare. It is also crucial that government policies encourage more rapid economic growth of the American economy. Unfortunately, this is not true of many policies proposed or implemented during the past 18 months. These include, among many others, higher income taxes on corporations and on persons with bigger incomes, government regulation of pay, especially the pay of executives, health care “reform” that will raise, not lower, government spending on healthcare, special subsidies to various unproven green technologies, so-called job creation bills that create few jobs per dollar spent, and more aggressive anti-trust actions against successful companies, such as Google. These and other policies will reduce US economic growth at a time when faster growth is more necessary than ever.

 

Comments

[IntuitiveEconomics]

Another very striking comparison between Europe and the US is that the average European is much more educated compared to the average American and thus should, in theory, be more productive (given equal incentives, that is). Actually I would argue that Europeans are overall the best educated people in the world.

Thus the equations of prosperity boil down to:

US: Mediocre people + Cowboy individualism = Most prosperous nation in the world
Europe: Most competent people + Collectivism and Welfare State (dis)incentives = Mediocre prosperity.

New America: Mediocre people + Collectivism and Welfare State (dis)incentives = (Any guesses?)

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[Jim]

I hear many well heeled Americans saying, "Why work?" and looking for ways to change to a Less competitive lifestyle and speaking ill of the public's understanding of current events, economic and otherwise. I don't know if they are correct or not but the chorus is certainly getting louder.

[IntuitiveEconomics]

As I said, I’m not an economist. However, as a scientist, I become very skeptical at the prevailing European belief that the continent’s economic woes and deteriorating competitiveness can somehow be fixed without removing the European public’s fundamental disincentives to production. After all, economic technicalities aside, even a non-economist understands that economic prosperity more or less boils down to total average per capita production of goods and services. So, though not an economist, I strongly suspect that there are no perpetual machines of prosperity in economics either.

Have the fundamental incentives to produce in Europe changed? No. Why? Because the European welfare state environment makes a citizen’s standard of living only loosely coupled to individual exceptional productivity, whether the superior productivity potential comes from higher raw intelligence, higher individual competence in general, or simply harder work.

With the most important baseline elements in life such as education, health, retirement, etc. being very similar for everyone (i.e. only loosely connected to individual productivity) few Europeans find much attraction to the extra effort required to engage in exceptional work. Especially when the larger part of any extra compensation associated with exceptional work undertaken is confiscated to provide the above baseline elements to others.

In such a muted incentive environment, most Europeans naturally choose to funnel their creativity into less economically productive but un-taxable activities (eg. being poorer but doing more yoga, spending more time at the beach, paying more attention to their looks etc). These activities may also enhance the standard of living of people engaging in them, but otherwise offer little benefit to society at large, unlike, say, inventing IPads or advancing medicine,

Sure, in the short term, the effects of growing at 2% vs. 4% are not that striking. However, in the mid to long term, the relentless compounding nature of economic growth severely restrains the standard of living for slow growth countries. Realizing that and convincing voters to act accordingly at the polls is a very difficult task.

Even absent highly progressive tax rates, marginal happiness already decreases with increasing income. Thus the incentive to produce already decreases with increasing income. The very progressive European tax rates with top tax rates kicking in at barely 2-4 times the average income, greatly increase aversion towards the greater effort required to engage in exceptional work.

So, the bottom line is: Will Europe remove its disincentives to engage in high value work and grow at a pace comprable to the 4% worldwide average? The answer is, most likely, no. Therefore Europe’s economic marginalization seems inevitable.

[Jim]

And ours.

[James Roberts]

I have two main comments--first, that these arguments seem to me to be "deja vu all over again," meaning that that are pretty much the same (basic) arguments made against a common US currency among the states in our past. The single currency should and will survive, precisely because its framework provides a means for member states--and their people--to address the problems, while still enjoying the benefits--as we have since a single currency was introduced--of the single currency and the rapidly integrating economies.

Second, the arguments presented spring more from an ideological position than anything else--government intervention is bad, pension benefits are excessive, etc. Most of these arguments are simply not supported by the data--especially when they are investigated at the country and sub-national levels. Few countries in Europe use either a collectivist system or exist as "welfare states." An in-depth look at the health care expenditures of the US v. European countries would immediately show the enormous--and I emphasize enormous--savings in the European systems.

Likewise with the labor markets: That they differ from the US labor markets (and there are quite a few--n.b., the Californian market v. e.g., the Georgia market) does not make them "rigid," it makes them different. Making them conform to the US model would be so disruptive as to swamp any putative benefits of the shift. Can you say "massive unemployment?" Moreover, the European countries would lose what benefit they have of their existing labor markets, which are abundant.

No doubt there need to be some changes. That need exists in all economies at every moment. It does not follow that ideologically-driven prescriptions, bereft of sufficiently rigorous data analysis, would be the right approach.

[Edith Bodnar]

I lived half of my life in Europe (and have finished a university there), then, I moved and I am living as the second half of my life in the US (and I finished a university here as well). I am in a good position to compare these two -- Europe and US.
Yes, I believe that the European people have a surplus in education and in a historically more stable community-based social strucutre compared to the American system. I also do believe that this surplus will give the needed support to Europe in surviving the global crisis. (think how much Europe, as a community went through during the past milenea...)

[Gordon Longhouse]

My concern is that here is a perfectly good crisis for Europe and they will miss out on taking advantage of it vide the Japanese.

In Oz we had our crisis in the early nineties. Eighteen months of economic shrinkage or nil growth, the near collapse of two major banks (out of four we have in total) and stratospheric unemployment.

The result was that antiquated corporate regulation (both the laws and the institutions that enforce them) were brought up to date as was banking regulation (laws and institutions though the institutions needed another 10 years and the collapse of an insurance company to the learn that laws don't enforce themselves and "light touch" is no touch.

The central bank, which played a role in that recession, was given independence of a sort in that it was told to seek an inflation target of 3% per annum.

Likewise Asian countries such as Indonesia and Korea used the Asian crisis to reform their banks, free their currencies and (begining in the case of Indonesia) to get rid of patronage networks.

Korea is now a market economy with the bubble wrap off. Its economy almost has a "new car" smell.

Indonesia is still a work in progress. It has recognised that corruption has to go but that the transition will be difficult until the government is in a position to pay public servants a decent wage.

In terms of crisis Indonesia is a text book case of not letting one go to waste.

When the tsunami hit Aceh ("ACHAY") province in December 2004 (and it hit harder there than anywhere else) Indonesia recognised a crisis that could be an opportuntiy. Aceh had an on-going insurgency against the government) during this period that absorbed both resources and the attention of the government trying to suppress it.

The Indonesian government acted to ensure that foreign aid (including from the US Marine Corps) got to where it was needed and was not used to support patronage networks that plague that country. The eventual result was that it was able to come to an agreement to end the insurgency, which seems to have held.

The point is that crises can be good. They draw attention to what is wrong in a society and give a society the incentive to fix the problems as soon as possible. Thing is, that the urgency of a crisis is easily dissipated (vide Japan again) and what needs to be done has to await losers consenting to it.

I regret that this will be lost in the European crisis and that they will not do the necessary. For one thing the IMF is being kept at arm's length. I don't carry a torch for the IMF but they are useful as an external target for rage that might be directed internally and sometimes as a means of pointing out the obvious. (Not always. They directed the Indonesian government to cut spending even though their crisis was a banking and corruption crisis and the Indonesian budget was in balance).

There are obvious problems with Europe that have been revealed by this crisis. Unfortunately it seems that no one has considered these problems in any detail before the crisis. There is no agenda that has been created that has recognised the problems of Europe and has proposed steps to resolve them prior to the crisis taking place.

What this means is that Europe may be able to temporise and postpone, at least for a while, as Japan did with economic stagnation as a result.

[Apostolos Rigas]

Just as simple as that: If Europe's problem was the competitiveness one, then it would not have a trade surplus with its trade partners, notably the US. Unlike the US, Europe does not face twin deficits. What has to be done though in Europe, it is a mild and slow adjustment of public expenses in lower levels as the recession gives place to stable economic growth. Just have a look at the history of the economic crises when the governments cut their spendings in a reckless way.

[IntuitiveEconomics]

Though perhaps competitiveness can be a somewhat subjective issue, here is a ranking of competitiveness:
http://www.imd.ch/research/publications/wcy/upload/PressRelease.pdf
(The US had been in the 1st place since 1993 but was demoted to 3rd this year. Harbinger of the vicious cycle of decline having started ? )

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