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The Hurdles to European Prosperity by Sven R. Larson

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The Hurdles to European Prosperity

In 2021, Europe gradually opened up again after the pandemic and the economy began its journey back to normality. It is almost there: by the end of last year the euro-zone economy was operating at 98.6% of the level at which it was operating in pre-pandemic 2019 (adjusted for inflation). The EU as a whole was back to 99.1% of 2019 levels. 

This seems like an impressive rebound, but it dwarfs next to the American economy, which in 2021 was 5.8% bigger than it was in 2019, again adjusted for inflation. 

America has held an economic edge over Europe for the past 20 years. In 2000-2009, the U.S. economy averaged 1.8% real annual economic growth, compared to less than 1.4% in the euro zone. In 2010-2019, the U.S. pulled further ahead: 2.25% vs. 1.4% for the 19 euro-zone countries. 

If the euro zone had kept up with America from 2010 to 2019, its economy would have been an inflation-adjusted 8.7% bigger than it actually was. With U.S. growth rates since 2000, the euro-zone economy would have been almost 30% bigger in 2019. 

While impressive, the American edge is not so much thanks to New World excellence as it is a matter of Europe holding itself back. There is no doubt that the U.S. economy is structurally more dynamic of the two, but those advantages have been evaporating with growing government. 

To fund its expanding welfare state, U.S. Congress has run perennial budget deficits for half a century. When those deficits emerged in the late 1960s and became chronic in the 1970s, they first served as a fiscal stimulus helping to fund the growing American welfare state. However, as government expanded, the economy needed increasingly outrageous doses of deficit spending to keep growing. 

With the pandemic, the U.S. finally crossed a line where its debt became so big that it now faces the imminent threat of a major fiscal crisis.

Stagnation by design

While America’s leading politicians slowly learn that you can’t cheat the basic laws of economics forever, their European peers are having the opposite problem. Europe has an even bigger government than America, but over the past two decades they have done everything in their power to avoid runaway budget deficits. The combination of excessive government spending, averaging close to half of GDP since the euro was minted, and strict adherence to a balanced budget, Europe has ended up in perennial economic stagnation. 

What the Americans have pushed in front of them, the Europeans are already standing in, waist deep.

No doubt, Europe needs to get its economy growing. But how? 

Some European leaders are looking for an answer, with French President Emmanuel Macron at the forefront. While trying to avoid his own re-election campaign, Macron has made at least one bold statement in terms of economic policy. If given a second term, Macron will implement a so-called green investment plan worth €50 billion. 

For all intents and purposes, this is really the only economic-policy measure that the French people have to look forward to under five more years with Macron. He harbors a similar dream for Europe as a whole, a dream that many others seem to share. But is a massive investment plan for so-called renewable energy really the way to get Europe’s economy growing?

The answer is negative. There is a much better alternative, but before we get there, let us first look at why green-energy investments will do nothing for the future prosperity of the European continent. 

A massive investment in so-called green energy will require a substantial expansion of public debt. The hurdle in Macron’s way is known as the Stability and Growth Pact (SGP) which, enshrined as it is in the EU Constitution, is designed to help economic growth. It supposedly does so by limiting the negative impact of government borrowing on the cost of credit in the economy. 

As the aforementioned GDP growth numbers show, the SGP has not delivered. On the contrary, it has actually contributed to holding back the European economy. Two decades with a common currency and constitutionally enforced fiscal responsibility have left Europe noticeably poorer than it evidently could have been. 

This fact is slowly dawning on Europe’s political leadership, which has started a conversation about reforming the SGP. In order to give EU governments room for extraordinary spending during the pandemic, the EU suspended the SGP until 2023. Anticipating its reactivation, according to euronews.com, the finance ministers of the euro zone met in Brussels in January for a discussion on the future of the Pact. 

A much-needed conversation

Part of their goal seems to be to give room for a Macron-style investment plan, but the conversation about the SGP is long overdue. It was made clear during the Great Recession a decade ago that the European Union suffered from some key flaws in terms of its fiscal and monetary policy structure. The disaster in Greece, best likened to a macroeconomic massacre, is the most notorious piece of evidence, but there are less ominous ones. Portugal is trapped by the SGP in “a Gordian knot of conflicting policy goals:” 

  • On the one hand, the government wants to expand its welfare state and spend more money on economic redistribution; 
  • On the other hand, since reducing the size of government is not considered ideologically correct, the Portuguese are stuck in economic stagnation under the debt and deficit rules of the SGP.

Germany is another example. During her long tenure as Chancellor, Angela Merkel wanted her country to stand as a shining example of fiscal responsibility. She strengthened the federal government’s finances in line with SGP requirements, but she did so in good part by increasing the burden on German taxpayers. She exacerbated the growth-hostile effects of her high taxes by leaving untouched the problem with inflation-driven tax hikes, known in Germany as “cold progression.”

The consequences of combining big government with the SGP show themselves everywhere in Europe. The French economy grew at 1.46% in 2000-2009 and 1.42% in 2010-2019. Being forced into fiscal austerity during the recession of 2009-2011, French taxes gradually pushed past 46% of GDP. In the last few years, the Fifth Republic has given Sweden and Denmark a run for the title as the hardest-taxed economy in the world. 

Other countries, forced by the SGP into extreme fiscal austerity, were left even deeper in the hole. As I reported on December 20th:

It is evident that Europe still suffers from the last economic crisis: the countries that took the hardest austerity beatings during the Great Recession have barely recovered the jobs lost. It took Portugal six years, from the start of the recession in 2009 to 2015, until they had returned to the same employment rate. Spain and Italy needed another year, while in Greece an even smaller percentage of the population is working today than they were in 2009.

But will a reformed, or even permanently suspended Stability and Growth Pact give Europe a chance to grow and thrive?

No, it won’t. Big government is the most formidable force holding back economic growth, especially when they fund their spending by means of taxes. 

Figure 1 is admittedly a bit complex, but the information it reports is important enough that it merits the complexity. Please give it some time and let the information sink in. The figure compares real economic growth to the tax share of GDP in 28 European countries from 1996 through 2018. This makes for a total of 644 observations, which are divided into deciles. Each column shows the average tax-to-GDP for its decile, e.g., 55% (left axis) for Decile I. The blue line, in turn, shows the average real GDP growth rate for that decile (right axis), e.g., 2.8% for Decile VI. As the columns get shorter, we observe lower taxes (left axis); as we observe lower taxes, we see GDP growth increase (right axis):

Figure 1

Source of raw data: OECD

But would not more public spending, especially on investments, without higher taxes be beneficial to the European economy? Does not America show that this combination is the way to go?

Renewables: a bad idea

Again, the answer is no. First of all, as the American example teaches us, sustained deficits buy a country time, and when that time runs out, the bill comes due anyway. Second, once government has expanded beyond a certain size, its weight on the economy is heavy enough to hold back growth, even if part of the spending is funded by government. That level is marked by the dashed line in Figure 1: once government spending or taxes exceed 40% of GDP, the economy slows down permanently

In other words, unless the member states of the EU generally reduce the size of their governments, they cannot expect a suspension of the Stability and Growth Pact to elevate their economic growth. However, there is a third reason why the combination of more debt and investments in so-called renewable technology is a bad idea.

In order to generate economic growth, investments must permanently improve the productivity of the economy. The productive capital of a factory allows workers to assemble and ship out more products per hour; a faster computer program allows a customer-service agent to process more inquiries; improved pharmaceutical products heal more patients faster, allowing them to return to work and be productive. 

Public investments work the same way. If government builds a new highway where safety is high enough to allow free speed, travelers will cut down on travel time and get to work faster. Trucks delivering goods will arrive sooner, reducing the cost of delivery. A more productive power plant can generate more megawatt-hours out of a given source of energy; an airport with a longer runway allows larger passenger planes, increasing the productivity of airlines operating the airport.

When a private business borrows money to make an investment, it goes ahead if the balance between expected new revenue exceeds the credit cost. Public finance should work the same way: if government borrows €1 billion to build a new highway, the project makes economic sense if the increase in expected tax revenue exceeds €1 billion. 

That, at least, is the founding principle for public finance. It is not always adhered to. In fact, most of the deficits we see in government finances these days are the result of political expediency: it is easier to simply hand off the cost of government spending to unborn generations who cannot have a say on the matter, than for us to take responsibility.

Investments in so-called renewable energy certainly fall into this non-productive category. They do not make energy production more efficient; if anything, wind and solar plants have demonstrated the economic and engineering advantages of large-scale, traditional power production. Furthermore, their only substantive selling point is that they prevent alleged negative consequences of an alleged manmade change in the planet’s climate. 

Even if we assume that humankind can affect the climate by means of the emissions of a naturally occurring compound of carbon and oxygen, the purported consequences of such emissions are highly dubious, if not outright false. Furthermore, the scientific case for manmade climate change is weak at best, non-existent at worst,  with key climate statistics pointing in the opposite direction

Regardless of whether we make the reasonable assumption that there is no manmade global warming, or if we hold the door open for it but acknowledge the highly speculative nature of its alleged consequences, the conclusion is the same regarding public investments in so-called renewable energy. We have no reason to believe, by even a remotely calculable rate of probability, that the investments will prevent any negative events in the future. Therefore, we cannot assign any calculable return to the investment.

All that remains is a pile of new debt, which we have no new economic activity that can be used to pay for it. We are simply poorer, without any identifiable positive effects to motivate it. 

Rather than sinking further into debt to maintain current, high levels of government spending, it is time for Europe’s leaders to fundamentally reconsider their economic and social policies. It is time for them to adopt an entirely new program for economic prosperity.

In a coming article, I will make my contribution: a plan for how to take the European economy out of its current state of stagnation. 

Sven R. Larson is a political economist and author. He received a Ph.D. in Economics from Roskilde University, Denmark. Originally from Sweden, he lives in America where for the past 16 years he has worked in politics and public policy. He has written several books, including Democracy or Socialism: The Fateful Question for America in 2024.

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