June 17, 2016

End of the Government Credit Line, Part 2

For decades, Europe's welfare states have continued to grow despite a long-term trend of economic stagnation in the economies that feed those welfare states. The weakening trend of GDP growth began in the 1970s, at a point in time when the European welfare state had reached its point of maturity. It offered comprehensive, tax-funded, often single-payer health care; universal K-12 schooling, often with government-run universities monopolizing or dominating academic education; pre-K child care and elderly care on government's tab; and last but not least: elaborate income-security systems providing both poverty relief (welfare, unemployment and pensions), income redistribution (progressive income taxes) and redistribution of consumption (child benefits, housing subsidies).

At first the growth slowdown was thought to be a passing problem related to the first oil crisis (1973-74) or the second oil crisis (1979). However, as the 1980s unfolded with its 7+ percent annual expansion of global trade, the lower growth rates in Europe in general - and in Sweden in particular, being as it was the epitome of the welfare state - began taking a toll on the fiscal solvency of Europe's welfare states. Debt levels increased steadily as temporary borrowing turned into a permanent source of government funding. Over the 40 years from 1965 to 2005 every European-Union member state increased its debt-to-GDP ratio, in many cases dramatically.

When the Great Recession hit, the welfare states that were already deep in debt had much smaller margins to operate with in order to fund their entitlement programs. Deficits had already become the third rail of government funding, in addition to taxes on the flow of economic activity (income, consumption, investments, foreign trade) as well as economic stocks (productive capital, financial securities, real estate). The result was a landslide of credit downgrades and credit "watches", raising dramatically the cost of borrowing for Europe's over-indebted welfare states.

Now, more than four years after hitting the trough of the Great Recession, the indebted welfare state should have been on its way to stronger solvency. That is, if the debt problem had been anything other than a permanent, structural problem.

Rising growth rates across Europe should have taken the continent's myriad of entitlement programs out of red ink. Debt-to-GDP ratios should have fallen thanks a firm recovery.

Yet this has not happened. Instad, Europe is faced with a new macroeconomic phenomenon, not accounted for in standard academic literature: reduced debt is now the enemy of strong GDP growth. 

Why is this? Please be patient with an answer (although for the impatient reader I recommend a shortcut.) First, we need to take a look at the phenomenon and understand its macroeconomic mechanics. 

Let me start with a brief little table showing the inflation-adjusted GDP growth rate in the euro zone and the debt-to-GDP ratio in the same zone. The data covers almost 20 years, from the third quarter (Q3) of 1997 through the fourth quarter (Q4) of 2015. The data is then divided in to four almost equally long periods.* The result is intriguing:

GDP growth
Debt ratio
Q3/97-Q1/02 3.33% 80.3
Q2/02-Q3/06 1.62% 88.6
Q4/06-Q2/11 1.00% 103.1
Q3/11-Q4/15 0.54% 98.7
Sources: Eurostat (GDP growth) and Bank of International Settlements (Debt ratio).

The first period covers the end of the strong-growth era in the 1990s and the Millennium Recession; the second period stretches from the end of the Millennium Recession through the recovery and the return to more "normal" economic conditions; the third period begins at the top of the last business cycle and ends right as the recovery from the Great Recession begins; the fourth period is entirely about Great Recession recovery.

The first three periods exhibit a traditional relationship between growth and the debt ratio. There is a gradual slowdown in GDP growth and, expectably, the debt ratio rises. In the fourth period, however, the opposite relation appears to be true. 

A closer examination of the data in the third and fourth periods help explain the new phenomenon:

In the third period - the light and dark brown lines - the rise in the debt-to-GDP ratio (dashed line) correlates with a decline in GDP growth (solid line). When GDP growth picks up again the debt ratio stabilizes and declines, though not by much. 

The fourth period exhibits an oddly different pattern. The decline in the debt ratio happens while GDP growth is shrinking. Prior to this fourth period, as described by the third-period functions, the debt ratio had gone from rising to be stagnant. The decline is therefore a new trend that can easily be related to a change in fiscal policy. 

That change is the highly coordinated campaign of austerity that engulfed Europe during the toughest years of the Great Recession. The purpose was to reduce the burden of the welfare state by downsizing it to what a smaller tax base could afford. The means were spending cuts and tax increases. 

The effect, however, was not what austerity proponents suggested. GDP growth declined during the worst of the austerity period - just as the macroeconomic textbook says - but the return to growth that followed once most of the austerity pressure was lifted, was hardly impressive at all. It has taken the euro zone three long years, 12 quarters, to climb from the bottom growth rate during the austerity period back to the highly unimpressive two percent it was at when austerity first set in.

By comparison, as the brown growth line shows, when growth declined for the same countries during the beginning of the Great Recession, it took only seven quarters - less than two years - for those countries to return to previous growth. 

What does this mean?

Two things. First, austerity has not made a difference for the better for the European economy. It does not help to point to the continued decline in the debt ratio; does my dog feel better today because I was beating it, or because I stopped beating it? The debt ratio decline after austerity is simply the function of the rise in growth. 

It is important to point this out because austerity as the Europeans practice it has nothing to do with reducing the size of government. The purpose is strictly to make the welfare state more affordable, to ride out a macroeconomic storm and keep as much of government in place as possible.

Secondly, the welfare state can no longer be combined with high growth. The euro zone is incapable of reaching growth rates in excess of three percent. In the past 74 quarters - essentially the life span of what we know as the euro zone - its annual growth rate has only exceeded three percent in 12 quarters. The last time was in Q4 of 2007. As mentioned, the recovery that began in 2011 has seen an extremely low growth average and shows that it is virtually impossible for the euro-zone economy to reach growth rates above two percent.

All the growth-dampening structures of the welfare state are weighing down on the private sector, such as general income insurance programs, sloth-inducing entitlements, marginal income taxes that punish work and benefit leisure. In addition to the burden of these programs, austerity itself has drastically increased the cost of the welfare state to the private sector. This cost increase is the combined effect of higher taxes and lower levels of spending in the entitlement systems:

  • Suppose that, in year 1, GDP is 100,000 euros, the welfare state spends 40,000 euros and thus takes in 40,000 euros in taxes; its cost to the private sector is now 40,000 euros, or two thirds of the 60,000-euro total production value of the private sector;
  • A recession reduces GDP by five percent to 95,000 euros; welfare state spending increases to 42,000 euros, assuming increased cost for unemployment benefits and other recession-related entitlements; at the same time, tax revenue remains 40 percent of GDP, in this case 38,000 euros;
  • In order to close the budget gap of 4,000 euros, the legislature passes a budget that increases taxes to 44 percent, hoping to get 42,000 in tax revenue.

Nothing has changed on the spending side; the increase in outlays was simply the welfare state delivering on its promises to take care of the unemployed. The problem for the individual taxpayer, and eventually for the economy as a whole, is that the welfare state no longer costs him 40 cent of every euro he makes - but 44 cent. Its price has increased by ten percent, while the product it delivers is exactly the same as before.

The extra ten percent that the welfare state now costs must come from somewhere. Regardless of whether taxpayer reduce savings or consumption outlays, the end result will be less money for the private sector (for business investments or sales of products to households).

The price increase is less drastic if it comes in the form of spending cuts. Nevertheless, ultimately those cuts have similar effects on the economy as a whole: when taxes pay for less of their children's education (school lunches, textbooks, extra-curricular activities, school buses) households have to pay for those services themselves - without getting anything new for that money.

As the price of the welfare state goes up, the private sector is depressed further. Together with the growth-depressing features that are inherent to the welfare state, austerity thus prevents - or preempts - the European economy from permanently returning to growth levels at, let alone above, three percent.

As growth is depressed at a permanently low level, welfare states continue to run deficits. Those deficits, again, become a permanent part of welfare-state funding. This, in turn, means a perennial increase in the debt-to-GDP ratio (with the decline seen recently in the euro zone being an anomaly rather than the break in a trend) whereupon credit ratings decline.
The spiral of rising debt, falling credit rating and slow-to-no growth rates eventually brings about the end of the credit line for Europe's welfare states. Europe's political leaders know that this day is coming. They have been desperately fighting to stay away from it, but not with the right measures. Soon, they will pay a very heavy economic and social price for their political and economic state of denial. 
*) The total period is 74 quarters long. Since 74 is not divisible by four, two of the four periods are 18 quarters long and two are 19 quarters long.

No comments:

Post a Comment