Some things are complicated. Building a spaceship to take people to Mars is complicated. Brain surgery is complicated.
Economics, on the other hand, is not complicated. It is, in fact, rather simple, although it does not always come across that way. Economists have a habit of making the simple complicated, for no other reason than, well, to make it complicated.
Among the simple, apparent facts in the world of economics is that big government is bad for economic growth. The higher taxes are, and the more of our common resources that government spends, the more slowly the economy will grow.
If growth slows down during a recession, we really have nothing to worry about, but if it stays low for an extended period of time, we have a problem. When an economy stops growing, standard of living stops evolving. The markets for new ideas—new solutions to all kinds of problems new and old—narrow down and make more and more inventions unaffordable.
A long period of economic stagnation eats its way into the economy in all kinds of ways. The consequences make their way into all corners of our society. The auto industry sells fewer cars and therefore slows down the development of better, safer, and environmentally more friendly vehicles. Households see their incomes stagnate, forcing them to spend less on everything from food and electricity to vacations and new homes.
There are less resources available for medical research, slowing down our progress toward curing new diseases.
In a nutshell, economic stagnation hurts us all. There are fewer jobs where people can support a family, or even themselves. People who graduate from university have fewer job opportunities to choose between. The wealthy find fewer opportunities to make productive investments, leading to unsustainable speculation in, e.g., stocks and real estate.
Government has less tax revenue but needs to spend more: with stagnant household incomes, more people are trapped in full or partial dependency on social welfare programs.
Europe has a big growth problem
Slow growth in the European economy is nothing new, and certainly nothing that is limited to recessions. Covering the period from 2002 through 2019, Figure 1 reports real, annual GDP growth for the European Union in its current 27-state configuration. The EU rarely reaches 3% growth and is struggling just to top 2% per year. This trend has become more accentuated in the past 10-12 years:
Figure 1
Source of raw data: Eurostat
It is essential with 3% real growth for an economy to make solid forward progress, i.e., to create enough resources for all to see their standard of living grow, and for quality of life to evolve. However, the 2% threshold is even more important: when the economy grows at a slower pace than that over time, it does not generate enough economic resources to improve the standard of living of its population.
In a manner of speaking, life becomes frozen in time. The practical meaning of this for the general public is that when they replace their cars, their furniture, their home electronics, even their clothes, they do it with an equivalent product, not something that improves their quality of life. Children grow up to lead a life no more prosperous than that of their parents.
Life in an economy that cannot break the 2% growth barrier is a life in industrial poverty. We enjoy all the conveniences of a life with industrial production of goods and services (yes, services can also be industrialized!) but our standard is frozen in time. There is no room for quality improvement in any one part of our lives—without at least the same amount being sacrificed in another part.
The so-called green transition is a good example: in order to afford a new energy system, stagnant European economies have to lower their expectations in many other parts of the economy. One exhibit of this is in highly unaffordable electricity bills and higher taxes for businesses and households; another exhibit is the government money that goes toward ‘green’ energy subsidies while spending in other areas is kept at inadequate levels.
It is bad enough that Europe was experiencing inadequate growth before the 2020 pandemic. Things have not gotten better since then. During the pandemic years of 2020 and 2021, the EU economy grew at exactly zero percent per year on average. The impressive annual growth rates above 10% in 2021 were simply compensatory for equally dramatic losses during the artificial economic shutdown in 2020.
In 2022 and the first quarter of this year, the EU economy has grown at an average rate of 3.1% per year. This may seem healthy, but it is the only economic growth that Europe as a whole has experienced since the last quarter of 2019; if spread out through the pandemic years, the growth rate is only a tepid 1.2% per year. Furthermore, the growth rate is tapering off, from 4.4% in the second quarter of last year to a minuscule 1.1% in the first quarter of 2023.
All in all, after the upheaval caused by the pandemic-related artificial economic shutdown, Europe is now back to its disappointing macroeconomic business-as-usual. Some countries are doing better, with a notably large number of the better performers being located outside the euro zone. Among them is Hungary, which achieved a real annual growth rate of 2.3% from 2020 through the first quarter of this year. This is not surprising, given Hungary’s long streak of strong economic performance; in 2015-2019, the Hungarian economy grew at 4.1% per year, making it one of only six to rise above the 4% level.
As we will see in a separate review in the coming weeks, the Hungarian economic performance is particularly impressive given that it is a full-scale industrialized economy. Other members of the 4%+ growth group have reached those exceptional levels of economic expansion due to a highly specialized economic structure:
- Cyprus has a volatile, service-based economy that, so to speak, rises and falls with the tides of tourism and agriculture;
- The Irish economy is dependent on exports at almost bizarre levels not unlike those of oil-exporting Arab countries;
- Malta, which due to its size can be considered a ‘special economic case’ together with Luxembourg.
Sadly, for every country that reached 4% real annual growth back in 2015-2019, the EU also had at least one country that fell below 2%: Austria (1.85%), Belgium and Finland (1.8%), Germany (1.7%), France (1.6%), Italy (1%), and Greece (0.8%).
Europe has a big government problem
These numbers are notably disappointing, given that the period from 2002 through 2019 was a strong growth period for the global economy. The EU as a whole only reached 2.2% per year, while the euro zone came in a hair below 2%. These numbers effectively tell us that Europe as a whole is stuck in an economic quagmire where there is no evolution of the standard of living and no thriving environment for industrial entrepreneurship. What capital formation there is in the economy only keeps it afloat at the current, overall standard of living.
This is a depressing thought, and it does not get better when we look for insights into Europe’s economic stagnation among the plethora of institutions that are funded by the European Union. For the most part the ‘Eurocracy’ appears to lack interest in elevating Europe out of its current stagnation.
The cause of this sluggish growth is indisputable: big government. Its negative influence on the economy comes in three forms, two of which are easily visible in economic statistics: spending and taxes. (The third form, regulations, is tougher to illustrate statistically, but that does not mean it should be ignored.) Figures 3a and 3b report the GDP share of, respectively, government spending and taxes, and the real rate of economic growth. The quarterly data covers all the current 27 EU member states from 2002 through 2019 (again to avoid pandemic-related disturbances).
Due to the large number of observations, the data is divided into deciles. The 10% of the observations that have the largest ratio of government spending—an average of 58% of GDP—are grouped together in the first decile, i.e., the first green column. The dot on the blue line that corresponds to this group shows that the average GDP growth rate for this group is -0.1%, in other words a marginal economic decline.
By contrast, the decile with the smallest government, averaging 31.6% of GDP, experienced the strongest GDP growth rate, on average: 6.5% per year.
Figure 3a
Source of raw data: Eurostat
Regardless of which way we read Figure 3a, the result is unequivocally the same: big government means a stagnant economy. If we want the economy to grow at least at 2%, we need to keep government spending below 45% of GDP. That level, again, will only guarantee a minimum of economic progress over time; to secure solid progress, we need growth to exceed 3% per year. To do that, though, we have to keep government spending below 40% of GDP.
We see a similar pattern when we replace government spending with taxes; the blue columns represent the tax-to-GDP ratio while the line representing GDP growth is now green:
Figure 3b
Source of raw data: Eurostat
The impact of taxes is a bit tougher than the impact of government spending. Here, the 3% growth rate needs a tax-to-GDP ratio in the 35-37% bracket, while 2% growth requires taxes to stay below 43%.
Reforms to shrink government
Again, these are general numbers that work as benchmarks for policy makers. Individual countries can deviate from them depending on their economic structures, their regulatory policies, and their currency status (non-euro vs. euro member). However, none of these factors will be of any material consequence over time if government sizably exceeds the thresholds illustrated here.
The one question that lingers behind all these numbers is: what can we do about big government? There are many individual pieces to an answer to this question, such as the European People’s Party’s concept of the “social market economy“. This concept, which has roots dating back to the 1970s, distinguishes a conservative welfare-state project from both socialism and libertarianism.
At the principled level, it is important to eliminate, or at least downplay the influence of the concept of ‘inequality’ on conservative policy making. Welfare states based on the unending fight against inequality are all abysmal failures, in Europe as well as in America.
In terms of specific policy issues to put non-inequality reforms to work, there are solutions emerging, primarily in the area of retirement reform. Last year, the Heritage Foundation, an American think tank, published an interesting idea for reforming Social Security, the federal retirement-benefit program. There are other interesting examples from countries that have done better than average in keeping pension systems fiscally manageable.
The last point is important: it is easy to prove that socialist welfare states, i.e., those that are geared toward fighting economic ‘inequality’, are more at risk of fiscal crises than welfare states focused on promoting conservative values. In effect, the former type of welfare state is permanently less affordable to taxpayers than the latter type.
There is more to be said about conservative policy reform. Stay tuned!
