End of the Government Credit Line, Part 3

In the first two installments of this article series I explained that the budget problems in, primarily, the European welfare states are caused by a combination of long-term decline in GDP growth and unending spending. The spending problem, in turn, is caused by a more than a little stubborn refusal among political leaders to reform away the welfare state, or even parts of it.

It is hard to blame those who are reluctant to entitlement reforms. The welfare state itself is the root cause of the economic decline, yet it is also a formidable political lock-box, almost impossible to remove without major political and social consequences. 

Almost, but not completely impossible. The reforms that will save Europe - and eventually the United States - from perennial economic decline will require courage, fortitude, persistence and humility on behalf of the politicians leading the way. I will leave the search for such courageous men and women to others; what matters here is to explain the economics of why we are on the long-term path to stagnation and decline. 

The welfare state consists of two parts, both of which exercise a depressing effect on macroeconomic activity: entitlements discourage work, encourage sloth and indolence and thereby reduce both workforce participation and private wealth-building; high taxes also depress labor supply, but they also depress current private spending and thereby affect both the supply side and the demand side of the economy.

Over the past two generations the welfare state has gone from being something that the private sector could handle and cope with, to being such a burden that private businesses shift from expanding activities in welfare states to expanding in other parts of the world. What remains within the jurisdictions of the welfare states is essentially stale industrialism with a static future, little to no rise in incomes and practically no net job creation. 

The only reasonable conclusion is that the Western world must rid itself of the welfare state. If that does not happen our welfare states will eventually run out of credit. In fact, the combination of what are now undoubtedly perennial deficits, equally perennially high taxes and slow growth will send the welfare states of the Western world to the end of their credit line in a few short years. 

The problem is that any policies designed to reform away the welfare states must be designed in such a way that they address the purpose and method of the welfare state. It does not help with reforms that make entitlement programs less burdensome to the private sector; the reforms must lift the entire burden off the shoulders of the taxpayers. 

To make this happen, we first have to understand - again - the purpose and the method of the welfare state. Its purpose, as spelled out by prominent welfare-state proponents such as the three economists Gunnar Myrdal of Sweden, Stuart Holland of Britain (whom I had the privilege of taking a class from in graduate school) and John Kenneth Galbraith of the United States, is to minimize and eventually eliminate differences in the standard of living between citizens. 

Unlike more revolutionarily minded people further to their left, Myrdal, Holland and Galbraith (and others who shared their world view) proposed peaceful progress from a world of relatively limited government to one where income difference no longer mattered. Their preferred method was taxation and entitlements, in other words the welfare state. 

Did they succeed? Yes, they did. This table compares GINI coefficients in 2014 before and after social transfers:

	Before	After
EU-28	51.8	30.9
Euro-19	51.9	31.0
Belgium	47.6	25.9
Bulgaria	50.8	35.4
Czech Rep.	45.0	25.1
Denmark	53.1	27.7
Germany	57.7	30.7
Estonia	50.9	35.6
Ireland	53.9	30.8
Greece	61.0	34.5
Spain	50.9	34.7
France	49.7	29.2
Croatia	48.6	30.2
Italy	49.1	32.4
Cyprus	46.7	34.8
Latvia	50.3	35.5
Lithuania	51.8	35.0
Luxembourg	48.0	28.7
Hungary	52.9	28.6
Malta	44.1	27.7
Netherlands	45.8	26.2
Austria	47.8	27.6
Poland	47.9	30.8
Portugal	60.4	34.5
Romania	51.0	34.7
Slovenia	44.3	25.0
Slovakia	42.8	26.1
Finland	47.5	25.6
Sweden	55.0	25.4
Britain	54.0	31.6

Source: Eurostat

In other words, the welfare state makes a big difference in how income is eventually distributed in the economy. In some countries, such as 1Sweden and Denmark, the GINI coefficient falls by about half when the welfare state has had its say. In fact, in 18 of the EU's 28 member states the welfare state reduces the GINI coefficient by more than 40 percent. 

This redistribution comes at a price: very high taxes. Figure 1 correlates the reduction in the GINI coefficient, measured on the right vertical axis, with the tax burden (total tax revenue as precent of GDP) measured on the left vertical axis:

Figure 1

Source: Eurostat

The higher the taxes needed to pay for the welfare state, the more slowly the economy grows. As the economy grows more slowly, more people are left with low incomes, or no incomes of their own, thus having to rely on the welfare state more heavily, and for a longer part of their lives. The more people who become net takers of money from the welfare state, the fewer people are net payers into the system. 

As the imbalance between net payers and net takers continues to grow, the welfare state relies more heavily on deficits to finance its entitlements. Growing deficit reliance thrusts the welfare states right into the finishing stretch of their credit line. As borrowing continues, even grows, while GDP growth slows down or stalls entirely, the debt-to-GDP ratio accelerates to alarming levels. 

There is only one way to get the West out of the trap set by the welfare state: to end the welfare state by means of free-market reforms. The welfare state is part of the structure of our modern economies, and any reforms must be of the same ambition as the welfare state: to alter the structure of our modern economies. Here are some ideas on how to get that done.