It is high time for Europe’s political leaders to get their act together. The EU is trapped in economic stagnation with no end in sight.
In their flash estimate for the second quarter of this year, Eurostat reports that the GDP for the 27 member-state EU grew by an inflation-adjusted 0.46% over Q2 in 2022. This is down from 1.06% in the first quarter and 1.6% in the last quarter of 2022.
In the meantime, the American economy grew by an equally adjusted 2.56% in the second quarter. The ‘raw’ growth number, which I reported on yesterday, is even higher at 2.7%; since we do not yet have the ‘raw’ data from Eurostat, we will have to make do with the adjusted numbers.
The contrast between the European and American economies becomes so big that I frankly do not understand why there is no debate about it in Europe. The difference on the inflation side is also big, with America at 2.97% in June and the euro zone at 5.3% for July (new U.S. numbers are due out next week). Unemployment is at 6.4% in the euro zone, way above the American rate of 3.6%.
In category after category, the European economy is behind its American rival. As I explained back in January 2022, this is not a new phenomenon; to illustrate the stark contrast between the two economies, let me repeat the experimental approach to growth disparity that I introduced in that article. In Figure 1 below, you put $100 into two different bank accounts in January 1996. One of the accounts is called ‘U.S.’ and the other ‘EU-27’. The interest paid on the account is equal to the year-on-year growth rate in the respective economies:
Figure 1
Sources of raw data: Bureau of Economic Analysis (U.S.), Eurostat (EU-27)
This difference should be an alarm bell to every member of the European parliament, as well as to lawmakers in the several member states of the EU. As of the second quarter this year, the EU-27 bank account would have had a balance of $572.26. The U.S. account, by contrast, would have stood at $1,275.43.
In other words, in the past 27 years, the U.S. economy has grown 2.2 times more than the European economy has.
Obviously, the EU did not exist in its current configuration back in 1996, so this comparison is a bit artificial. However, the 27 European countries that today constitute the EU did indeed exist, and most of them have formed a cohesive economic area for most of that time. Therefore, the comparison to the United States is valuable as an illustration of how differences in economic structure and economic policy can have a major impact on an economy over time.
Figure 1 is also an illustration of the potential for prosperity and a brighter economic future that lies ahead, if the peoples of Europe choose to pursue it.
To this point, there is a practical dimension to the difference illustrated in Figure 1. Personal income grows at rates that are usually very close to GDP growth rates. Therefore, Figure 1 can be used as a proxy for how much personal income Europeans lose relative to their American peers. For every €1,000 of income growth that Europeans have earned over the past 27 years, they could have earned €2,229 if their economy had grown on par with the U.S. economy.
Over time, this difference becomes substantial, and visible to the naked eye. Anecdotally, Americans own 71% more passenger vehicles than Europeans do, and homes are bigger in America than they are in, e.g., France and Germany. There are major differences in health-care access, with the American health care system offering faster and more comprehensive access than European health care systems do.
However, the differences go beyond the apparent standard of living: it spills into the ability of government to fund the welfare state. When the gross domestic product grows at slow rates, the revenue that funds government also grows slowly. By contrast, most government spending in modern European welfare states is defined by politically and ideologically motivated entitlement programs, the spending on which is independent of GDP.
The inevitable result is a constant fight against budget deficits. Unfortunately, governments often respond to the challenge of deficits by raising taxes, which also happened in Europe in the last decade. Figure 2 has the story, reporting taxes and government spending in the EU-27 as a share of GDP. The blue function, G/Y, represents spending, while the red one, T/Y, represents taxes:
Figure 2
Source of raw data: Eurostat
Phase 1 is the upstart phase of the euro. It is also the phase when the EU and the currency union within it work pretty much as intended: to facilitate economic integration between the several member states. It is an economically relatively tranquil period. As for government finances, the most noteworthy event is the gradual decline in the spending-to-GDP share, G/Y. It is a combination of growth in GDP and restraint in spending; in the first years of this millennium, some member states were still trying to adjust the size of their governments to the criteria spelled out in the Stability and Growth Pact.
Phase 2 begins with the Great Recession, a short but deep decline in economic activity. One of its more persistent consequences was that it opened up massive deficits in the budgets of many European governments. We see that in Figure 2 as the sharp rise in the spending-to-GDP ratio: while GDP shrinks, governments across the EU are forced to rapidly increase outlays. A sharp rise in unemployment transforms tens of millions of workers from taxpayers to benefits consumers.
In response to the rapid growth of budget deficits, most European governments resort to austerity policies to limit the damage done by the budget gaps. This does not work very well on the spending side, as evidenced by the persistently high G/Y ratio, the reason being the welfare-state driven increase in entitlement spending.
Austerity has a more visible effect on the tax side, where taxes went up from 44.7% of GDP in 2008—the last year before the recession—to 46.6% in 2014. This may not sound like much of an increase to argue about, but it equals €107 billion per year in extra taxes. This is money that would have stayed in the private sector, had taxes remained unchanged relative GDP. There, the money would have been used to raise the growth rate of the European economy.
Phase 3 represents a return to relative tranquility for the European economy. It also represents a shift in austerity policies from tax increases to spending restraint. This has a noticeable effect on the European economy:
- In 2011-2014, the recovery phase after the deep recession, EU-27 GDP grew by 0.7% per year, adjusted for inflation;
- In 2015-2018, the growth rate increased to 2.3% per year.
The higher GDP growth rate coincides with a gradual reduction of the G/Y ratio and a stabilization of the T/Y ratio. The latter ratio remains higher than it was in phase 1, but its depressing effect on economic activity is to some degree mitigated by the slow reduction in the former ratio.
This means, plainly, that government outlays were gradually reduced relative to the economy as a whole, and that the reduction happened in such a way that it did not directly harm the economy. Spending reductions that are done under austerity tend to cause a decline in economic activity, as those who use government services and receive entitlement benefits have to seek other means to obtain the services and the cash that government provided. When, on the other hand, government spending is reduced because the growing economy reduces dependency on tax-paid benefits, the relative decline in public-sector outlays is not directly harmful to the economy.
Given the moderately good growth rate of 2.3% per year in 2015-18, it is reasonable to conclude that on balance, the reduction in the G/Y ratio was of the latter, less harmful kind.
It is important to keep in mind that these are all general observations of the performance of the EU-wide economy; with 27 members in the union, there are of course differences in how they conduct their fiscal policy. Again, with reference to Figure 2, of the 23 countries for which Eurostat reports public finance data consistently from 2002 to 2023, 16 had higher taxes as share of GDP in phase 3 than in phase 1. By contrast, only nine have a higher spending-to-GDP ratio.
In other words, the fiscal policy conducted in the EU through the first 20 years of this century has profoundly changed the presence of government in the economy. Europeans in general pay more for their governments, but they do not get more for those taxes.
If Europe wants a stronger-growing economy, a reduction of the size of government must be at the top of the legislative to-do list. There must be focus on bringing down high taxes, which means that the EU itself must take a back seat and keep its hands off the European economy. Tax policy generally falls under the jurisdiction of member states; the best the EU can do is to pledge not to pursue EU-level taxes, and to relax EU-wide tax harmony rules. The latter is an important instrument toward creating tax competition among EU member states. The sky is the limit when the 27 members of the union are liberated from tax harmonization rules and other fiscal-policy restraints imposed by the EU.
When the states are given total freedom to configure their tax systems and their government spending as they see fit, there is no limit to what Europe can accomplish.
