Bank of Finland: Gov spending causing stagnation in EU

These findings should be read by every glum libertarian and every sad conservative

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Spot the stagnation
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Daniel J. Mitchell
On 13 December 2012 17:48

Earlier this year, I reported on some remarkable research from the World Bank, which found that “big governments are a drag on growth.”

Other international bureaucracies also have begun to admit that the welfare state isn’t conducive to prosperity.

- The European Central Bank published a study showing “…a significant negative effect of the size of government on growth.”

- The Organization for Economic Cooperation and Development noted in recent research that welfare programmes are economically destructive because they lure people into dependency because “net disposable income would increase despite putting in fewer hours.”

- A study from the International Monetary Fund concluded that “Cuts to pension and health entitlements had the most beneficial effect on economic growth.”

The negative relationship between economic performance and a bloated public sector also has been confirmed by research from other places not often associated with libertarian thought, including Harvard and Sweden.

And now we have some very interesting findings in this new research from the Bank of Finland.

Europe suffers from a growth slowdown. The GDP growth in Europe has lagged behind the GDP growth in the US and has been far worse than the GDP growth in the NIC countries, particularly China… However, what is the reason for slow or rapid economic growth?

…In many respects, the labour market plays the key role in the economy because it determines both the use of the labour input and the level of overall competitiveness of a nation. Obviously, the functioning of the labour market is not independent of the public sector. A large government is almost inevitably associated with a large tax wedge, and the functioning of the labour market appears to be critically dependent on the size of the tax wedge.

It may be fair to say that the harmful consequences of a high tax wedge are exceptionally well and unambiguously documented in the literature. …On the basis of the estimates derived in this study, the following guide for growth policies appears to be warranted: …Do not over-expand the welfare state. Larger governments are associated with slower growth rates.

Gee, that sounds quite familiar. Where have we come across this notion that big government has a negative impact on growth? Sounds a lot like the Rahn Curve.

Indeed, the paper makes another point that is very consistent with the Rahn Curve. As this simple chart illustrates, the Rahn Curve is sort of the spending equivalent of the Laffer Curve. Except government spending is on the horizontal axis and economic performance is on the vertical axis.

The ideal outcome is for government to be kept small so that economic output is at its maximum point. The academic literature suggests that prosperity is at its peak level when the burden of government spending is about 20 percent of GDP.

I actually disagree with those numbers, and I think they are the result of data constraints. Researchers looking at the post-World War II data generally find that Hong Kong and Singapore have the maximum growth rates, and the public sector in those jurisdictions consumes about 20 percent of economic output. Nations with medium-sized governments, such as Australia and the United States, tend to grow a bit slower. And the bloated welfare states of Europe suffer from stagnation.

So it’s understandable that academics would conclude that growth is at its maximum point when government grabs 20 percent of GDP. But what would the research tell us if there were governments in the data set that consumed 15 percent of economic output? Or 10 percent? Or even 5 percent?

Such nations don’t exist today, but it’s worth noting that the western world became rich when the burden of government spending averaged about 10 percent of GDP.

But I’m digressing. Let’s get back to the research from the Bank of Finland. The author makes a very sensible point that even modest reductions in the burden of government can yield positive results – sort of like going from Point A to Point B on the Rahn Curve.

Various nations have done this, achieving better economic performance after shrinking government spending relative to the productive sector of the economy.

Here’s the relevant excerpt from the study.

…A revolution is not required to generate one per cent of additional growth each year: the “welfare state” does not need to be eliminated, wages do not need to be lowered to subsistence income levels, and working hours do not need to be increased to medieval levels. In fact, in most instances, significant improvements in economic growth could be produced by simply reverting to the conditions of approximately one decade ago. …by reducing the growth of the public sector and decreasing tax rates, one may increase both the labour supply and the competitiveness of the private sector.

The future development of the public sector is indeed the key aspect of determining the future development of the economy. If the public sector can be maintained in a reasonable fashion, one may manage to achieve low tax rates and low tax wedges in labour markets, and one can also avoid fiscal crises and keep the risk premia (of interest rates) low.

These findings should be read by every glum libertarian and every sad conservative. Yes, there are plenty of reasons to be pessimistic about America’s future, particularly since both the Bank for International Settlements and the Organization for Economic Cooperation and Development estimate that America’s long-run fiscal status is even worse than most of Europe’s welfare states.

But it doesn’t actually take much to move policy back in the right direction. A modest bit of fiscal restraint can solve the short-run challenge and some well-crafted entitlement reform can avert the long-run crisis.

All we really need to do is give the private sector some breathing room, which is the point I make in this interview with Larry Kudlow. I was talking about the regulatory burden, but my argument is equally applicable to fiscal policy.

This doesn’t exactly get us to our libertarian Nirvana, of course, so I realize that “breathing room” isn’t the most inspirational motto.

But it should help us understand that the fight isn’t over. I certainly haven’t given up.*

* I reserve the right to defect to the Cayman Islands if the crooks in Washington ever succeed in saddling America with a value-added tax.

Daniel J. Mitchell 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

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