May 18, 2016

Industrial Poverty: The European Wasteland

My 2014 book about the European crisis (which I shamelessly market here on this blog) actually discussed an important topic: the long-term consequences of a large, burdensome welfare state. I was inspired to write the book by the Great Recession, but also the fact that Europe, unlike the United States, for a long time has been trending toward economic stagnation.

The thesis of my book was that Europe has left the era of growing prosperity of the mid-20th century. That was the era when children almost certainly would grow up to live a more prosperous life than their parents. It worked for two, maybe three generations. Then Europe left that era and entered a new one where the future of the growing generation is considerably more pessimistic than it was during the era of growing prosperity.

I dubbed this new era "industrial poverty" (which was also the title of my book). The term has both a rhetorical meaning and testable analytical content. Rhetorically, it distinguishes an era of stagnation in a developed nation from the living conditions in developing nations, but also from the experience from a developed nation with a strongly growing economy.

The poverty of a developed nation with a stagnant economy consists of two parts: the stagnation itself and what it does to the future prospects of the growing generation; and the fact that stagnation freezes the technological level at which people live. To understand the latter point, it is helpful to study the lives that people lived for decades and generations in Communist Eastern Europe. There, in the 1950s people had access to indoor plumbing, heating and electricity, basic appliances, mass transit and the opportunity to buy basic furniture, clothes and groceries (though the supply of the last few items was sketchy at times in Eastern Europe and from time to time disastrous in the Soviet Union).

In the 1980s, the last decade of the Soviet empire, supplies of all these basic consumer items was a bit more reliable but still of the same basic standard as it had been 30 years earlier. The kids who were born in the 1950s and had their own children in the 1980s enjoyed almost entirely the same actual standard of living as their parents did. Technological progress in consumer market products and housing was basically non-existent.*

In the Soviet empire this complete economic standstill was the result of heavy-handed central economic planning in combination with an almost universal ban on private property. Economies based on free markets are not supposed to run into long-term stagnation like the period that Europe is in now. Yet that is precisely what has happened in Europe.

There are five criteria for whether or not a country is in a state of industrial poverty. Measured over a ten-year period, each one of them gives an indication of where a country is economically; taken together they determine whether or not a country has entered a state of industrial poverty:

Variable 1: Consumption growth. This variable matters because - as I explain in the book Industrial Poverty - when a nation's private consumption grows at less than two percent per year its population is, on the whole, not making any advances in standard of living. It takes a two-percent annual growth rate to just keep current standard of living intact.

In the ten-year period 2006-2015 only eight of the 28 member states of the European Union averaged consumption growth in excess of two percent:

Romania 3.83%
Poland 3.28%
Bulgaria 2.70%
Lithuania 2.68%
Latvia 2.63%
Slovakia 2.25%
Estonia 2.10%
Sweden 2.04%

It should be noted, though, that Sweden climbed above the two-percent threshold only because of exorbitant household debt levels. With a debt-to-disposable income level of 180 percent, Swedes are so deeply in debt that many international financial analysts have sounded the alarm over their economy. A lower debt level with everything else unchanged would reduce consumption growth substantially below two percent.

At the bottom of the list is, unsurprisingly, Greece. Their consumption growth average for the period is -1.66 percent.

Variable 2: Exports share of GDP. From a macroeconomic perspective, exports are only there to pay for a nation's imports. From a free-market perspective, it is none of any government's business whether I buy an AUDI  or a Cadillac (though, frankly, anyone who has driven a CTS with the 3.6 V6 would be a fool to buy an AUDI instead...). Nevertheless, an imbalance between exports and imports can tell us a great deal about the underlying structure in an economy.

If imports exceed exports over time, and the economy is "big enough" to be industrially diversified, then there are good reasons to find out why the country's own private sector cannot provide what people need.

By contrast, if gross exports (not deducting imports) take up a dominant part of GDP it means that the country's workforce is spending more time and resources satisfying the needs of people in other countries than in their own country. Again, since a free-market system over time would eradicate the global-trade differences between nations (other than those that depend on natural resources and other structural variables) when a country's economy is dominated by exports it is a sign that the domestic sector is too weak to constitute a viable market for the nation's private businesses.

If so, the logical question is: why? Leaving the answer to the astute reader, let me report the EU member states where exports exceeded 50 percent of GDP in 2006-2015:

Austria 51.7%
Denmark 51.7%
Latvia 52.0%
Cyprus 53.3%
Bulgaria 55.8%
Switzerland 65.4%
Lithuania 66.8%
Slovenia 68.0%
Czech Rep.69.1%
Netherlands 74.3%
Estonia 76.6%
Belgium 79.5%
Hungary 82.8%
Slovakia 84.5%
Ireland 101.6%
Malta 145.3%
Luxembourg 184.8%

Again, Sweden is hanging on by a whisker, with exports at 47.3 percent of GDP for the period.

Variable 3: Consumption share. Unlike exports, consumption is an intrinsically good purpose of economic activity in general. At the end of the day, all production leads to the satisfaction of the needs of an individual human being, near or afar.

So long as private consumption constitutes 50 percent or more of GDP, the economy is in acceptable health. For the ten-year period studied here, only a small group of nations did not pass this test:

Czech Rep. 48.5%
Denmark 47.5%
Sweden 46.0%
Ireland 45.6%
Netherlands 44.3%
Luxembourg 32.9%

Variable 4: Government revenue share. One of the most interesting findings I report in my book is that GDP growth starts slowing down notably once the government share of the economy exceeds 40 percent. Why this number is the threshold is less interesting than why: up to that point the private sector can cope with the burden that taxes and other government charges impose upon them; they can still expand their activities, though far from as much as they could if they were free to do so without a government burden on their shoulder.

Beyond the 40-percent mark, however, the government burden becomes so onerous that the private sector simply chooses to stagnate its activities, invest in only the most sure-footed, profit-safe operations and move everything else to lower-tax jurisdictions. Because of this change in corporate strategy the economy as a whole grows more slowly.

Alas, the EU member states where the government burden, measured as total government revenue, exceeds 40 percent:

Croatia 42.1%
Portugal 42.4%
Netherlands 43.2%
Greece 43.5%
Slovenia 43.7%
Luxembourg 43.7%
Germany 43.9%
Hungary 45.7%
Italy 46.4%
Austria 48.8%
Belgium 50.2%
France 51.1%
Sweden 51.5%
Finland 53.4%
Denmark 54.8%

Variable 5: Youth unemployment. The youth is the nation's future. If they cannot get a foot in the door of the economy, they will not be able to replace the existing workforce. If they cannot do that they will be more of a burden on the economy than an asset to it. Again for reasons explained in the book, a nation that persistently keeps 20 percent or more of its young unemployed will slowly decline and become poorer over time.

The problem of large youth unemployment is widespread in Europe:

Bulgaria 20.9%
Belgium 20.9%
Ireland 21.4%
Lithuania 21.4%
Romania 21.5%
Cyprus 21.7%
Sweden 22.4%
Latvia 22.6%
Hungary 22.8%
France 22.8%
Poland 23.7%
Slovakia 28.6%
Portugal 29.0%
Italy 30.4%
Croatia 35.3%
Greece 38.9%
Spain 39.6%

So, then, what countries qualify as industrially poor? To be fair, the exact methodology for answering that question is still in the works. Preliminarily, though, half of the 28 EU member states are in the danger zone of becoming industrially poor. While not a single EU country so far scores a perfect 5, i.e., showing up in all five categories, six of them are very close to doing so, scoring 4. Another eight countries are in the danger zone with a score of 3:

IP score
Belgium 4
Denmark 4
Hungary 4
Ireland 4
Luxembourg 4
Netherlands 4
Austria 3
Cyprus 3
Czech Rep. 3
France 3
Greece 3
Italy 3
Portugal 3
Sweden 3

Again, this is still a crude measure that will require more work. For example, it is entirely possible that it would be more reasonable to use a weighted index, with the dynamic variable of consumption growth weighing more heavily than the structural variables (the "GDP share" ones).

That said, the phenomenon of industrial poverty is real, it is dangerous and without a new direction for Europe's fiscal policy, it is very likely where the continent will find itself in the near future.

A follow-up article will analyze where the United States and Canada are in comparison to Europe.

*) A curious little anecdote to highlight this point. While Western auto manufacturers abandoned the two-stroke engine for the much more efficient and powerful four-stroke system, some manufacturers in the Soviet Empire kept churning out two-stroke powered cars. One of them, Wartburg, was located in East Germany. At one point in the 1970s the question came up at the Wartburg factory whether or not to shift to four-stroke engines. Since the factory was owned and operated by the Communist Party the issue had to go all the way up through the party bureaucracy to the Polit Bureau (the highest authority within the party). After considering the issue carefully the Communist leaders decided that the East German people did not need the luxury of a four-stroke engine in their cars. As a result, the Wartburg factory kept producing cars, up to the very end of Communist rule, with essentially the same design and the same technology as they had back in the 1950s.

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