The European malaise

The long run effects of big government

I am seeing a lot of American triumphalism, due to our recent outperformance of other developed economies. Check out this tweet:

My own view is that some of this is overstated. When I travel to places like Europe, Japan, Canada and Australia, I see lots of things they do better than the US. Indeed even China (with a per capita GDP on par with Mexico) is vastly superior to the US in things like subways, high-speed rail, safe streets. Overall, I still greatly prefer conditions in the US to China, but there is more to life than GDP/person. On the other hand, economic performance is not a trivial issue, so it’s worth considering why the US seems to be moving even further ahead of its closest competitors.

Twenty years ago, it was often said that the divergence in GDP/person reflected a greater European preference for leisure, and that their labor productivity was similar to the US. I don’t believe that was ever entirely true (as higher European unemployment was disproportionately among the less productive), but it’s certainly not true today. Here’s the FT:

US labour productivity has grown by 30 per cent since the 2008-09 financial crisis, more than three times the pace in the Eurozone and the UK. That productivity gap, visible for a decade, is reshaping the hierarchy of the global economy. Economic growth in the Eurozone has been a third of the US’s since the pandemic, and output is set to expand by just 0.8 per cent this year, according to the IMF.

My framework for thinking about economic development is sketched out in a paper I did back in 2008, right before the Global Financial Crisis pulled me back into monetary economics. In The Great Danes, I argued that socialism had two components, statism and egalitarianism. Statism involved economic policies such as barriers to entry, price controls, nationalization of industry, and distortionary taxes. Egalitarianism involved various forms of social insurance, and/or redistribution of income. I defined neoliberalism as free markets plus egalitarianism, with Denmark being the best example and Greece the worst (in the developed world).

My empirical work showed that during the neoliberal era from 1980 to 2005, countries with stronger “civic virtue” moved more rapidly toward free market policies. This is because the political system in these countries is more idealistic, less dominated by selfish rent seekers, and thus was better able to shift course when it became widely apparent in the 1980s that statism was a flawed policy regime.

[Here’s one way to think about civic virtue. When people are asked: “Is it acceptable to take government benefits to which you are not entitled?”, the Danes are the most likely to say no.]

Thus after 1980, intelligent people in both Greece and Denmark began to see that statism needed reforming, but the Danes were able to move far more aggressively than the Greeks, where reform was blocked by powerful special interest groups. In recent decades, high civic virtue countries have tended to be more free market, while more corrupt countries have tended to be more statist. That was less true prior to 1980, because for many decades after the Great Depression, even idealistic people thought statism was best.

So what’s happened since I wrote that paper back in 2008? This is from The Economist:

I follow European affairs fairly closely, but even I was surprised to see this data. At one time, Sweden had the largest welfare state in Europe. Even in 2019, it was still above average. But if these figures are correct, government spending in Sweden has fallen slightly below the European average. So what’s going on?

During the 1970s and 1980s, it became increasingly obvious that statism was not working very well. But this did not lead policymakers to adopt a small government model. Instead, they reduced regulations but maintained a welfare state. After all, the Nordic countries were still doing pretty well with a model that combined free markets and extensive social insurance. (Sweden trimmed spending somewhat, but maintained a big welfare state.)

Beginning in the 2010s, however, a number of southern European countries experienced fiscal problems, due to a combination of four factors:

1. Use of the euro

2. Overly tight ECB monetary policy

3. Excessive budget deficits

4. Poor economic performance on the supply side

[Before America readers begin gloating, recall that we are experiencing similar fiscal irresponsibility, a fact that is somewhat hidden by our otherwise strong economy and independent monetary policy.]

The article I took this graph from has the following headline and subhead:

France stares into a “colossal” budgetary abyss

A fragile new government must try to plug the hole. Fast

The headline explains the problem, and the subhead explains the political barriers to solving the problem. France is obviously spending too much (57% of GDP). No one can convince me that the French public could not get by just fine with a Swedish-sized welfare state, spending 49% of GDP. (And IMF data suggests that both Denmark (45%) and Norway (39%) have even lower spending.)

So why don’t they fix the problem? As always, economics is downstream of politics, and politics is downstream of culture. French politics is in a sort of death spiral. Each election sees the far right gain more strength, and every attempt to fix their economic problems makes the right even stronger.

At this point, an American conservative might think “What’s wrong with Le Pen gaining power in France, it would be great if she came in and fixed the socialist mess.” But the far right in Europe is not like the traditional Republican party of Ronald Reagan; they are big government statists. They are both nationalistic and mildly socialist.

You might think, “Given France’s precarious fiscal situation, who could possibly oppose a minor reform like raising the retirement age from 62 to 64?” (Which would still be lower than the retirement age in most other countries.) It turns out that lots of people are opposed:

There is growing concern in the corridors of power in France that a fractious parliamentary debate over pension reform plans is playing into the hands of far-right leader Marine Le Pen, who is eyeing the 2027 presidential election, sources say.

Faced with a growing debt pile swollen further by the COVID pandemic, French President Emmanuel Macron is trying to push through changes he says are vital to plugging a projected deficit in the pension system and saving it from collapse.

But after more than a month of heated debate on the bill in the lower house, which failed to review all of the legislation before a Friday deadline, polls suggest Le Pen's strategy of non-obstructive opposition is winning over public opinion.

Think of it this way. Intelligent people in Denmark, Sweden, France and Italy all see the need to restrain public spending, but only the Nordic countries have a political system where it is possible to implement that policy.

Of course, it’s easy for a libertarian like me to blame Europe’s recent malaise on ever bigger government. Perhaps this is just motivated reasoning. So let’s consider some other hypotheses. Europe is not the only area lagging behind the US, countries like Canada and Japan face similar problems. Perhaps it’s not so much that Europe is doing poorly, rather that the US is doing exceptionally well.

Here’s my best guess as to why Europe is lagging behind, starting with structural factors:

To some extent, Europe (and Canada and Japan) has concentrated on the wrong set of industries. The US has focused on things like high tech, media, energy, and of course services. We still have a sizable manufacturing sector in traditional areas like autos and steel, but it’s a smaller share of our economy than in many other developed economies.

Not only is traditional manufacturing less of a growth area than high tech or services, it’s also facing much stronger competition from rising Chinese firms such as BYD. I rode in an inexpensive electric BYD during a recent trip to China, and was stunned by the quality of the car—it felt like a luxury car.

[Of topic, but if these cars were allowed into the US market, they would immediately seize a significant market share. Lots of conservatives I speak with think EVs only sell due to help from the US government. Actually, if you removed the current subsidy, and removed the trade barriers, Chinese EVs would flood the US market.]

How about tech? This graph in the FT article shows how China is crowding out other developed countries in innovative companies (but not the US!):

(The biggest dark blue country is Japan.)

So is the recent US outperformance merely due to luck? Is it because we have a large domestic market, and tech firms just happened to locate here due to network effects? That’s part of the story, but I don’t believe it’s the whole story. Tyler Cowen recently linked to a post by Pieter Garicano explaining how European regulations make it very expensive to finance new startups. We have a better regulatory regime.

Furthermore, there’s actually very little evidence that “size matters” for an economy. For instance, when you look at per capita GDP (in PPP terms), the US is the only large population country in the top 18:

Some of those are special cases, including tax havens (Luxembourg, Ireland) and oil rich countries (Norway, UAE). But not all of the richest countries are tax havens; some have highly productive industry (Switzerland, Denmark, Taiwan, Netherlands, Sweden). The evidence is pretty clear that having a small domestic market doesn’t prevent a country from having a relatively high per capita GDP.

When I look beyond the tax havens and oil producers, I see at least weak evidence that richer developed countries either have relatively low government spending (the US, Singapore, Switzerland, Taiwan, Australia), a relatively free market (Denmark, Singapore, Switzerland, Australia, Taiwan, US), or a bit of both (Netherlands.)

Sweden’s political system seems to have enough cohesion that they were able to pull back from the fiscal abyss. So far, France’s more polarized system has been unable to do so.

At the moment, the US seems somewhere in between these extremes. Like France, we have a polarized political system, where at least a portion of the right is becoming more populist on economics. But small government conservatives still have more clout in the GOP than they do within the French far right. In addition, our ability to borrow is greater due to the fact that we have our own currency.

BTW, the importance of the “exorbitant privilege” associated with the dollar’s reserve currency status is wildly overrated. The fact that we are able to borrow at a few basis points less than other developed economies is of trivial importance. We are still on an unsustainable fiscal path in the long run, as even debt that is never repaid must still be serviced.

I do not claim that the preceding points offer a complete explanation of what’s gone wrong in Europe. So let me throw out another hypothesis. Perhaps big government naturally gets less effective over time.

Think about the two components of leftist economics: statism and redistribution. Perhaps redistribution doesn’t immediately erode the work ethnic; rather it gradually degrades over time. And perhaps regulation continues to build up over time, becoming a force that increasingly reduces economic flexibility. Is there any evidence for this? I think so:

1. Communism seemed to get worse over time. In the 1950s, the Soviet Union was doing well. But by the 1980s it was doing poorly. When I was young, North Korea was richer than the South. Now it’s far poorer. Cuba and Venezuela are becoming increasingly dysfunctional.

2. Left-wing big cities in blue states seem increasingly poorly governed. That reality is somewhat hidden by the fact that they have strong sectors like tech and finance. But in parts of blue states that lack those benefits (downstate Illinois, upstate New York, and California’s Central Valley), the economy has done especially poorly. And even in the richer areas of New York and California, Nimbyism has dramatically reduced housing construction, fracking, and many other economic activities.

3. The malaise that we see in most of Europe is noticeably less apparent in developed places with smaller government, such as Switzerland and Singapore. And like the US, those two places have absorbed lots of immigrants without the creation of pockets of mass unemployment. Might a big welfare state contribute to things like Paris’s segregated banlieues, where many people do not work?

I am skeptical of any single explanation for the European malaise. But it might be helpful to frame the problem in a broader sense then simply US vs. Europe:

1. Why are relatively capitalist countries like the US, Singapore, and Switzerland doing somewhat better than marginally less capitalist areas like the EU and Japan? And why has the gap seemed to widen in recent years?

2. Why are the more statist areas of southern European doing more poorly than the more free market areas of northern Europe? And why is the fiscal situation so much worse in southern Europe?

Those questions seem a bit more precise, more helpful in directing out attention toward plausible answers.

PS. I did an interview with Russ Roberts on industrial policy.

Here’s Titian’s The Rape of Europa, the finest painting in the Western hemisphere: