Germany and the two-tier EU

Plans for a fiscal-stimulus programme will open old wounds.

TARRIC BROOKER

17th October 2019

Ever since the Eurozone debt crisis began in 2009, Germany, as the most powerful EU member state, has consistently asserted that austerity is the only way forward for deeply indebted EU nations. If such nations want to revive their economies, so the reasoning goes, they have to get their budget deficits under control.

In the years since the Eurozone crisis broke, member states on the southern periphery have undergone varying degrees of social upheaval and political turmoil as a result of EU-enforced austerity policies. Indeed, with EU citizens growing tired of cuts to everything, from government-pension payments to essential health services, populist political parties, such as Italy’s Five Star Movement (M5S) and Greece’s Syriza, have ridden into government on the back of anti-austerity messages that have resonated strongly with their electorates.

In recent months, however, Germany has encountered economic problems of its own. Its manufacturing sector has entered recession and analysts predict that the slowdown in growth may drag the German economy as a whole into recession by the end of October.

Given the potentially severe effect of the slowdown on the German economy, there have been growing calls from within Chancellor Merkel’s own ruling coalition, and across the political spectrum, for the deployment of a fiscal stimulus programme to insulate the economy from the impending downturn. There are even suggestions the programme is already in play.

Berlin certainly has the means to run a large government stimulus programme. After five years of budget surpluses, and one of the lowest levels of sovereign debt in Western Europe, it has built a substantial fund ready for just this sort of eventuality.

But for the citizens of southern Europe still reeling from almost a decade of austerity enforced by the European Commission, the European Central Bank (ECB) and the International Monetary Fund (IMF), German politicians’ claims that ‘we are different’ are likely to ring hollow.

To many observers of German or EU politics, Berlin deploying a government stimulus is rather the non-event. Which it is. No rules are being broken, EU or otherwise. A nation as wealthy and powerful as Germany is obviously going to try to protect its economy.

But in a Europe that has become increasingly divided by austerity, accusations of a ‘two-tier’ EU are likely to grow even louder. After all, Germany is planning on doing what it has told poorer EU members they cannot do: spend vast sums of public money.

Italy, for example, is in recession. And the Italian government isn’t allowed to protect its economy in the same way as the German government can, due to EU regulations on budget deficits. Berlin’s actions, therefore, will only rile the economically weak members of the EU.

Yes, the EU is meant to be a union of equals. But Germany, as the preeminent political and economic power in the EU, has continued to drive policy on everything from Eurozone debt to the response to the ongoing migrant crisis. As a result, it isn’t hard to understand the anger and frustration of those nations that didn’t sign up to consistently follow wherever Germany led.

German plans for a stimulus programme ought not to be a problem. But in the context of an austerity-ravaged Eurozone they could quite easily become one.

https://www.spiked-online.com/2019/10/17/germany-and-the-two-tier-eu/

Our timid chancellor fell for the discredited groupthink that Brexit is bad for growth

If the Autumn Statement was a court of law, and the OBR was in the dock, it wouldn’t be long until the prosecuting barrister got the OBR to admit that its numbers were an assumption in the short term and a guess thereafter.

Wednesday 23 November 2016 8:15pm
Graeme Leach

The “2 per cent forever” growth forecasts are based on a complete blank
as to where the economy will be in the future (Source: Getty)

The latest GDP forecasts from the OBR made me laugh.

If the Autumn Statement was a court of law, and the OBR was in the dock, it wouldn’t be long until the prosecuting barrister got the OBR to admit that its numbers were an assumption in the short term and a guess thereafter.

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The downward revisions in 2017 and 2018 are based on little more than assumption. As I’ve discussed a number of times in this column, the behaviour of broad money supply growth over recent months suggests that, at worst, the UK economy was flat-lining and, more likely, is strengthening not weakening. But the group-think which says Brexit equals weaker growth is alive and kicking in the OBR, hence GDP forecasts (well assumptions) of 1.4 per cent growth in 2017 and 1.7 per cent growth in 2018.

Read more: Brexit: Unequivocally good for the UK economy in the short and long term

Even though the idea that Brexit means downturn has been thoroughly discredited over recent months, we’re expected to believe it will still happen over the next two years, because of lower trade flows, lower investment and lower net inward migration. The problem with this view is that, when you look at the underlying data used by the OBR, business investment as a proportion of GDP is flat. It’s not collapsing.

The “2 per cent forever” growth forecasts for 2019 onwards are based on a complete blank as to where the economy will be by then. The obvious get-out is to use estimates of underlying potential output growth and hope for the best, which is exactly what the OBR has done.

Forecasts from 2019 onwards are about as clear as a sandstorm. History teaches that the error on the public finance projections is around 1 per cent of GDP per annum i.e. 1 per cent a year from now, 2 per cent after two years etc. In other words, by 2020-21, the public finances could be 5 per cent of GDP higher or lower than projected today, with around half the gap due to GDP error and the other half due to errors in the projections of the public finances.

Read more: Hammond was right to focus on productivity as key to post-Brexit success

The real structural problem facing the UK economy is not Brexit, but the size of the state. It’s now 10 years since the global financial crisis struck the economy and yet in 2016-17 we’re likely to have the largest deficit – at 3.5 per cent of GDP – of all the G7 economies, with the exception of Japan. The new chancellor has relaxed the fiscal rules with regard to the structural deficit and public debt and does not appear inclined to push the public spending to GDP ratio sharply lower.

He could have given out a strong signal that Britain is open to the world for business, by announcing a commitment, phased in over the next decade, to reduce the rate of Corporation Tax to 10 per cent. A commitment to 15 per cent five years from now would have been a big step forward as well.

Read more: Hammond has gifted Britain a third decade of gross fiscal irresponsibility

Unfortunately, he’s looking down the wrong end of the telescope. Instead of looking at the opportunity to combine Brexit with vigorous supply-side reform, we’ve had the same old story that Brexit will undermine growth and tax receipts and so there’s no room for manoeuvre.

The good thing in the Autumn Statement was the announcement of improvements to infrastructure investment, but even here there are problems. There are literally thousands of small infrastructure projects which could make a big difference to congestion on our roads, but resources remain skewed towards big ticket infrastructure projects.

http://www.cityam.com/254324/our-timid-chancellor-fell-discredited-groupthink-brexit-bad

Trump, May et al must cut government to get growth

As Trump prepares for power, America, Britain and the whole world must understand that smaller government vastly increases societal wealth for all, as new research shows. Trust in free markets not failed bureaucrats

Milton Friedman knew the path to widespread wealth

Daniel J. Mitchell

On 12 November 2016 10:44

Now that Donald Trump has been elected, one of my main goals will be to convince him and his team that it would be wrong to leave government spending on autopilot (and it would be even worse to spend more money and increase the burden of government!).

Since Trump semi-endorsed the Penny Plan, I don’t think this is a hopeless quest. But it will be an uphill battle since populists have a “public choice” incentive to appease interest groups.

But we have a very powerful weapon in this battle. It’s called evidence.

And now there’s even more data on our side. The Institute for Economic Affairs in London has just published an excellent new book on fiscal policy. Edited by Philip Booth, Taxation, Government Spending, & Economic Growth is must reading for those who want to understand the deleterious impact of the modern welfare state.

The IEA’s Director General, Mark Littlewood, explains the goal in the book’s foreword.

"The authors of this monograph have taken a rigorous and data-driven approach to discovering and documenting the size of the state and how government spending and regulation affect the wider economy. But, most importantly, they have undertaken a major and original statistical analysis of the economic costs of high taxes and, equally importantly, which taxes cause the most economic harm."

The most depressing part of the book is contained in Chapter 3. As you can see from Table 7, the burden of government used to be rather modest in western nations. Indeed, I’ve made the point that it was during the era of small government that the western world became rich.

But now look at the numbers. Pay special attention to the period between 1960 and 1980, which is when the welfare state exploded in many of the countries (aided and abetted by the value-added tax).

But let’s not cry about unfortunate historical developments.

It will be more productive if we measure the harm so we can educate policy makers about the need for spending restraint.

And the book is filled with lots of useful information in that quest. In Chapter 4, David Smith explains the interaction between fiscal policy and economic performance, noting that excessive government not only reduces the level of economic output, but also the future growth rate.

"…increased governmental consumption appears to reduce national output. This is likely to be because the resources diverted to supply such expenditures would be better employed in the private sector. In particular, the evidence from international cross-section and panel-data studies suggests that almost all increases in the share of governmental expenditure in GDP lead to a near one-for-one reduction in the share allocated to private capital formation. This under-capitalisation takes the economy onto a lower, but parallel, growth path according to ‘neo-classical’ growth models but leads to an additional permanent reduction in the growth rate in the context of a ‘post-neo-classical endogenous-growth’ model."

He provides a micro-economic explanation for why various government activities hinder growth (I offer eight reasons in this video, by the way).

"Transfer payments are likely to reduce economic growth in various ways, not least because of the supply-side effects of the taxes necessary to finance them. Unlike with government investment, there is unlikely to be any offsetting effect on growth. These have grown rapidly over the last century. Transfers in the form of pensions and other payments to people at older ages are likely to reduce saving in the private sector and fixed capital formation. However, the most potentially counter-productive public expenditure appears to be paying means-tested welfare benefits to the population of working age.

"These reduce potential GDP because of their impact in reducing the supply of labour to the private sector, which exacerbates the effect of the taxes necessary to finance them. …there has been a big increase in government spending over the last 100 years. However, within the government spending envelope, there has been a particularly large increase in those items that damage the economy most while those items that tend to have a beneficial effect on growth or which damage the economy least have been reduced."

In other words, he’s saying that not only is government too big. He’s also pointing out that much of the spending is seemingly designed to impose economic damage by discouraging the productive use and allocation of labor and capital.

I also like that he explains that the real problem is spending, not just red ink (a point I often make, but not always successfully, when talking to politicians).

"…statistical evidence that suggests that the negative effects of higher taxes and budget deficits on private activity are identical in the long run and quite similar in the short term. This confirms that the primary issue is the size of state spending compared with national output and that the choice between tax and bond finance is a secondary consideration. Ultimately, government spending is financed either by taxes levied now or deferred taxes."

He then reviews some of the research on the “Rahn Curve.”

"…it is reasonable to ask whether there are ‘growth-maximising’ or ‘welfare-maximising’ levels of government expenditure. …The growth-maximising share of government spending in GDP was some 20–25 per cent of GDP. This was based on the fact that ratios in this range were typical of the fast growing South East Asian ‘Tiger’ economies, countries such as Japan and Korea in their high growth phases, and even Australia, Canada and Spain in the 1950s. This indicative range should probably be revised down to some 18.5–23.5 per cent, using current (June 2016) UK definitions."

Incidentally, I like and dislike what he wrote in this section.

I like it because the obvious conclusion is that the burden of government is excessive in both the United States (37.9 percent of GDP according to OECD fiscal data) and the United Kingdom (43.3 percent of GDP). And we can use this data to argue for much-needed spending restraint.

But I don’t like the above passage because I think the growth-maximizing size of government is well below 20 percent of GDP. As I’ve previously explained, academic researchers are constrained by the lack of data for small-government economies.

So when they crunch numbers (relying in all cases on post-WWII data, and in most cases on much more recent figures), they basically find that Hong Kong and Singapore grow the fastest and they think that implies the public sector should consume 20 percent of economic output.

But that implies, if you recall the data in Table 7 from above, that nations would have enjoyed more growth in 1870 if they doubled the burden of government spending. I think that’s nonsensical. What’s really happening is that researchers are simply measuring the downward-sloping portion of the Rahn Curve.

But just because Hong Kong and Singapore are the first two jurisdictions that can be plotted, that doesn’t mean the Rahn Curve peaks at that point.

But I realize I’m nit-picking, so let’s go back to the book.

In the following chapter, Professor Patrick Miniford shares some additional research on the link between government spending and economic performance. I especially like how he shares a very useful table looking at some scholarly findings on the relationship between the overall fiscal burden and national prosperity.

He also shares the conclusions from additional research.

"Later studies show similar associations. For example, Afonso and Furceri (2008) examine a number of EU and other OECD countries over the period 1970–2004. As well as several components of government expenditure and taxation, they include variables such as initial output, population growth, investment ratio, human capital and openness.

"Their finding is that a 1 percentage point rise in the government spending to GDP ratio cuts growth in the OECD by 0.12 per cent and in the EU by 0.13 per cent. …overall, the tax (or government spending) and growth studies, indicate a strong association between the two variables. As a rule of thumb, it would appear that a 10 percentage point fall in the share of national income taken in tax would lead to slightly more than a 1 percentage point increase in the growth rate – results of this order of magnitude occur over and over again."

And he discusses some new statistical findings, along with the potential implications for the United Kingdom.

"…the relationship between the growth rate of GDP per capita, the tax rate, a dummy variable specific to each time period, and a dummy variable specific to each country is modelled. Panel data were used that were averaged over consecutive decades from 1970 to 2000 for 100 countries. …overall, the modelling found an overwhelmingly strong negative relationship between tax and growth

"…there is an elasticity of growth to tax of approximately –1.4 at the mean of the growth rate (1.6 per cent). …a fall in the tax rate by 25 per cent of its existing value (from about 40 per cent to about 30 per cent of national income in the UK) would lead to a rise in the growth rate to 2.7 per cent if the initial growth rate were 2 per cent. This is roughly in line with the growth regression results discussed above."

I’m sure the data and conclusions also apply to the United States.

Which brings me back to where I started. I fretted yesterday that Trump’s election will be a challenge to advocates of economic liberty. Indeed, he explicitly called for more infrastructure spending and implicitly called for more VA spending in his acceptance speech. Combined with his apparent rejection of entitlement reform, this doesn’t instill much confidence.

But that’s all the more reason to disseminate this new research on the bad consequences of letting America become more like France.

Daniel J. Mitchell, a long standing contributor to The Commentator, is a Senior Fellow at the Cato Institute, the free-market, Washington D.C. think tank. His articles are cross-posted on his blog by agreement

http://www.thecommentator.com/article/6432/trump_may_et_al_must_cut_government_to_get_growth