May 30, 2010
Slow Economic Growth is a Crucial European Problem
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.
Europe's Long-Term Economic Woes—and America's
Europe's current economic crisis is being attributed to its having a common currency but no common fiscal authority. It's as if the United States had no Treasury Department, and a state that had borrowed heavily from banks in other states got into serious financial trouble, like Greece. It could not reduce its debt burden by devaluing its currency (and thus repaying its debts to the banks in other states in cheaper dollars), which would have the further benefit of stimulating exports (by enabling the same amount of foreign currency to buy more U.S. products) and discouraging imports (because it would take more dollars to buy products denominated in a foreign currency). The state could not expect to receive any transfer payments from other states, and the federal government would not be authorized to transfer money to the state (remember that I'm assuming that the federal government has no Treasury Department). So the state probably would default on its bank debt ("restructure" the debt is the current euphemism), and this might bring down the banks that had made the loans that were now in default.
That is the current economic situation, with Greece taking the place of the defaulting state, and the European Union taking the place of the U.S. government, in my hypothetical example. And the situation will be resolved, one way or another. One way would be by a default, perhaps accompanied by a bailout of banks whose solvency is endangered by the default. Another way would be by Greece's abandoning the euro in favor of its own currency, And a third way would be by fiscal measures ("austerity") that would restore the government's solvency.
The current European economic crisis is thus the product of an encounter between a defective institutional structure (a common currency but no common fiscal authority) and an overindebted member state of the supranational institution. These problems are solvable in a variety of ways, including by dropping the euro or creating an EU fiscal authority, comparable to our Treasury Department, as well as by a default or austerity measures. But the financial crisis is short term and tends to mask Europe's longer-term economic problems, well discussed in a recent article in the New York Times: "Europeans Fear Crisis Threatens Liberal Benefits," May 22, 2010, www.nytimes.com/2010/05/23/world/europe/23europe.html?pagewanted=1&hp.
The basic problem is often said to be the conjunction of an aging population, low birthrates, and extravagant social welfare benefits (mainly pensions, early retirement, and publicly subsidized health care). For example, these benefits consume 31 percent of the Gross Domestic Product of France—twice as much as such benefits consume of the U.S. GDP (these are 2005 figures). But I think we need to dig deeper for a satisfactory explanation.
It is true that improvements in health care (including nonmedical preventive measures such as diet and exercise) are increasing longevity, but they are also increasing (along with the decline in manual labor as a percentage of all work) the age at which people are no longer healthy or fit enough to work. And it is true that birthrates are very low in most of Europe, which increases the percentage of old people, but that of course is not because of some biological impairment of European fertility. Nor would low birthrates matter much if Europe were more welcoming than it is to immigration, because immigrants tend to be young.
The major cause of Europe's long-run economic problems is political, though the political is in turn shaped by cultural factors, including historical memory; maybe the best way to describe the major cause of the problems is Europe's "political culture." Government has greater prestige in Europe than in the United States and (a related point) socialism retains substantial support in Europe; individualism, with related notions such as self-reliance, freedom to fail, entrepreneurship, the "self-made" man, and the Horatio Alger story do not grip the public imagination of many Europeans. Government in Europe employs a higher percentage of the working population and engages in more redistribution of income, resulting in high taxes to fund retirement at earlier ages than in the United States, generous pensions and family leave, unemployment benefits generous enough to discourage work, and medical care. Lavish redistribution of wealth in turn entails barriers to immigration, lest the social safety net become an immigration magnet. Unions are strong in Europe, and they push up wages and (worse) encourage featherbedding, short hours, and other inefficient practices. Unions of government workers are especially pernicious, as they reinforce the natural tendency of government to overpay its employees because they are voters as well as employees. A third of the Greek work force is government-employed, for example, and much of it appears to be both overpaid and underworked relative to employees in the private sector.
Because socialist policies reduce economic efficiency, European countries (with some exceptions, notably Germany) have difficulty competing in foreign markets with China, Indian, Brazil, and other rapidly growing economies, and so have difficulty maintaining a positive trade balance. And because tax rates in Europe are already very high, government deficits cannot easily be reduced by raising taxes. The aging of the population increases the demand for public spending, and the demand can be met only by increased borrowing, which is also necessary to close the gap between exports and imports.
European economic stagnation and public overindebtedness is in short mainly a political problem, resulting from a swollen and still rapidly expanding demand for government services. It is a political problem rooted in cultural factors summed up in the word "statism," in contrast to American individualism, as designations of dominant political ideologies. This is an oversimplification but seems to me to get at the heart of the difference between European economies and the U.S. economy.
Many of the same economic pathologies that plague Europe plague us, but less seriously. We have an aging population, though it is due mainly to increasing longevity rather than to a low birthrate, for our birthrate is close to the replacement level and immigration brings us over the replacement level; there has been an ominous increase of late in hostility to immigration but this may be a byproduct of the economic crisis and so may pass when the crisis passes. Many of our public employees are overpaid and underworked, but only 8 percent of our labor force is employed by government (federal, state, and local), and this includes our military personnel (almost 1 percent of the labor force), who do not appear to be either overpaid or underworked. We have an alarming public debt, swollen by unfunded spending programs in both the Bush and Obama Administrations (the new health care reform is, realistically understood, unfunded) and by the decline in tax revenues as a result of the economic downturn. But as long as the U.S. dollar remains the dominant international reserve currency (which means that it is used in many transactions in which there is no U.S. party), the demand by foreign central banks for the dollar will remain very high and the resulting volume of U.S. money held abroad will enable us to continue borrowing abroad at low or at least moderate interest rates.
But if we continue running huge deficits, continue being unable politically either to cut spending significantly or raise taxes significantly, continue adding huge new spending progams, continue increasing the ratio of elderly to young, continue raising the minimum wage and promoting unionism, turn protectionist, resist immigration, and become even more deeply involved in military operations, we too may eventually go the way of Europe, even the way of Greece. Nowhere is it written that the United States can never decline.