August 10, 2016

Structural Consequences of the Welfare State

Last week I wrote about the Sovietization of money, explaining how the obsession with various kinds of quantitative easing is slowly destroying our monetary system. My point was not based in hawkish monetarist theory, nor in Austrian theory of intertemporal interest rates. No, it was simply a conclusion based on common-sense macroeconomics and liquidity theory as developed by, among others, John Maynard Keynes and Arthur Okun.

Today, let me elaborate on this point. The reason why we have irresponsibly easy monetary policies from all the world's major central banks is simple: government spending. Almost every industrialized economy is struggling with budget deficits, and the reason is invariably the welfare state. For a good 40 years now the Western economies have experienced slow growth and persistent budget deficits. In fact, deficits are so pervasive today that they have become a third form of funding government, as permanent as taxes and fees. 

This is of course bad for many reasons, one being the inescapable correlation between deficits and GDP growth. Take a look at this chart over the U.S. economy and the balance of the federal budget (columns represent five-year annual averages):

Figure 1
Source: United Nations National Accounts Database.

The almost-balance period of the late 1990s is a notable anomaly. As compelling as it is, the most important story here is that of how the long-term downward trend in growth is paired with a long-term trend toward larger deficits. As soon as GDP growth shifts down below four percent per year, deficits drift up in excess of four percent per year. 

There are two reasons why this happens. The first is that lower growth means tax revenues grow more slowly. This, of course, directly affects budget deficits - given spending. Which brings us to the second reason for the deficits. Government spending is in nature independent of tax revenues: it is not determined by available tax revenue, but by the fiscal value of the promises that government has put out through entitlements. 

Furthermore, many entitlements are constructed to be counter-cyclical, with spending increasing in recessions and - in theory - declining in times of strong growth and full employment. This of course compounds the deficits in recessions, but the long-term trend of weaker GDP growth has in turn led to a situation where the growth periods no longer yield strong enough expansion in tax revenue to eradicate deficits. 

Where, then, does this long-term growth-decline trend come from? I have claimed for a few years now that it correlates statistically, and matches theoretically, the long-term negative influence of the welfare state. While the long story is told in my 2014 book Industrial Poverty, the short story is that entitlements erode workforce participation, thereby weakening growth, and high, redistributive income taxes discourage professional excellence, entrepreneurship and career-building. When taken together these two effects permanently depress workforce participation and offer the economy fewer cutting-edge contributions from high-skill workers. 

High taxes also affect businesses in general. There is a compelling statistical correlation between the downshift in GDP growth and the tax ratio of an economy exceeding 40 percent of GDP. This means, generally speaking, that so long as taxes are below this ratio businesses can adapt, accommodate and adjust to the tax burden. It still affects them negatively but they are able to cope and still operate and even expand (though I urge all of you macroeconomics nerds out there to take a closer look at the nature and composition of gross fixed capital formation for economies with a tax ratio above about 35 percent). 

However, once taxes exceed a certain point, which I would suggest is 40 percent of GDP, it is no longer possible for private businesses to cope. They do not shut down, but they also do not expand like they did before. Large corporations, with enough resources to be able to make such choices, will seek out new locations abroad for production and expansion. Smaller businesses will stagnate where they are, avoid expansion and more often than not become the endeavor of one savvy or eccentric entrepreneur. When he wants to retire, he sells the business to a larger corporation.

Over time, this leads to a stale industrial structure. The Nordic countries are excellent examples of this, but the phenomenon is far from isolated to them. European countries in general exhibit the same tendencies of industrial stagnation; just look at what businesses have topped the stock exchanges for the past 50 years.

Then compare that list to the United States.

This is not to say we do not have the same problem. We do. The Obama administration has made life increasingly difficult for small businesses, with everything from environmental regulations to the taxes that came with Obamacare. Our combined corporate tax rate is uncompetitive; a main reason why businesses still choose the United States is that our labor-based taxes are comparatively low (as are our energy prices). However, further reforms increasing the cost of labor - such as a national paid-family-leave program - will invariably weaken our private sector and bring us much closer to the stale industrial structure of other oversized welfare states.

As the welfare state slowly but inevitably increases its burden on the private sector, the economy will inescapably drift into the macroeconomic wasteland of stagnation, high unemployment and withering prosperity. We are not there yet, but we are close, and the only way to change course is to start the long, hard work of dismantling the welfare state. 

The challenges to such a course change are formidable. First and foremost, the addition of deficits as a permanent funding source for government - significantly reinforced by irresponsibly lax monetary policies such as quantitative easing - to some degree decouples legislatures from taxpayers. Instead of having to restrict their spending to what taxpayers believe they can afford, and what taxpayers are willing to tolerate in the form of lending (buying treasury bonds), our elected officials now literally have their own monetary printing press. Their lack of understanding of the long-term consequences of QE-driven government spending is as big as their urge to get that spending out the door.

Secondly, there are ideological hindrances that no man should under-estimate. In my conference paper Is Life After the Welfare State Possible? I analyze the depth of the ideological commitment to the welfare state, not only among its devoted supporters but also among conservatives. The conclusion is that our modern-day political environment is so dedicated to the ideological core of the welfare state, namely redistribution of income and consumption, that there is no obvious place to begin the unraveling of unsustainable entitlements. Rather the fight has to start at the intellectual level, with focus on the issue of economic redistribution itself. 

That is not to say these challenges cannot be overcome. We can overcome them. And we must, for simple, undeniable macroeconomic reasons. The Western world, which has been leading the rest of the global community into the era of modern prosperity, is allowing its manic obsession with economic egalitarianism to trap itself in stagnation and industrial poverty. In a couple of generations, European children will be growing up to a life where they can only dream of the standard of living that their great grandfathers enjoyed.

If we do not pay attention, we will put the United States on the same track, just a generation or two behind.  

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