European countries are the largest welfare states in the OECD and among the highest in the World. At the same time, Europe’s economic dynamism has faded out and European leaders are getting increasingly worried about it. According to Christine Lagarde, the ECB President, Europe’s generous social model is at risk unless the region fixes a persistent decline in growth. In a recent report, Mario Draghi strongly calls for reforms and investments to reinforce productivity growth, while keeping untouched the continent’s oversized welfare state. For Austrian school economists, this sounds like having your cake and eating it too, because the issues of economic growth and income redistribution are intrinsically linked.
Europe’s problem with anaemic growth
Lagarde acknowledges that Europe trails behind the US in terms of productivity growth. Faced with rapid advance in innovation, the EU remained stuck in the “middle technology trap”, while the US and China are spearheading the digital revolution. Europe is falling behind in emerging technologies such as microchips, AI, and electric vehicles and only four of the world’s top 50 tech companies are European.
Draghi’s report on “The future of European competitiveness” reveals that economic growth has been lower in the EU than in the US over the past two decades. The EU – US unfavourable gap in terms of GDP at constant prices has doubled from about 15% in 2002 to 30% in 2023. Around 70% of the gap has been driven by lower productivity in the EU (Graph 1). Moreover, Europe’s growth prospects are not good. The continent enjoys relatively high trade openness, but is now facing strong competition from Chinese exporters and potential high tariffs from the US. On top, EU companies are burdened by high energy costs and European countries will probably need to spend significantly more for defence, adding to already high public spending.
Graph 1: EU vs US labour productivity
Source: The future of European competitiveness: Report by Mario Draghi
The solutions proposed by Draghi to boost productivity growth and innovation have little to do with increasing economic freedom. They are primarily aiming at centralizing and reinforcing government intervention and keep in place the massive welfare state.
Draghi calls for a new industrial strategy for Europe which should be coordinated at EU level. It may help overcome the current division of policies and financing sources among countries. But it cannot solve the more fundamental issue of inefficient allocation of resources and bad incentives that industrial policies bring about. In a similar way, decarbonisation and new clean technologies cannot reduce the current high energy costs without an economic cost. Current production facilities based on fossil fuels are cheaper and their replacement would increase the cost of doing business.
The report also argues that EU’s investment-to-GDP ratio should rise by around EUR 800 billion or 5 percentage points of GDP per year, which would require substantial public subsidies. Draghi advocates the creation of a common safe asset, funded by joint European debt. However, although cheaper, mutualized debt would still add to an already high debt burden.
A Large and Inefficient Welfare State
At the height of the eurozone crisis in 2012, German Chancellor Angela Merkel tried to make the case that Europe’s welfare states were too large, as Europe accounted for 7 percent of the global population, for a quarter of global GDP and for 50 percent of global social spending. The situation has not improved in the meantime and public social spending in many European countries exceeded by five to ten percentage points the OECD average of 21% of GDP in 2022. According to the OECD, public social spending in France, Finland, Denmark, Belgium and Italy is close to 30 percent of GDP, being driven by pensions, health spending and other social transfers such as unemployment benefits, disability pay and child allowances (Graph 2).
Graph 2: Public social spending (% of GDP)
Source: OECD Data [ OECD]
Despite its size, the European social model is fairly inefficient. The large spending on social protection in EU economies does not necessarily result in poverty reduction. According to the Brookings Institution, this is particularly the case in economies from Southern Europe, such as Spain, Greece, Italy and Portugal, where social spending is quite high, but the social assistance coverage of the poorest 20 percent of the population is relatively low. In contrast, small welfare states in Central and Eastern Europe, spend about half, i.e. less than 15% of GDP on social protection, but achieve a better coverage of the poorest strata of the population.
The Manhattan Institute goes one step further and argues that generous welfare states in Europe are not helping the working poor. Universal “social insurance” schemes that allow all the members of the society to live middle-class lifestyles during periods of unemployment, sickness or retirement are funded by most European countries through fairly high payroll and consumption taxes on workers with low earnings. In the largest EU welfare states, the poorest full-time workers are net taxpayers, subsidizing nonworkers, which is different from the US. In countries such as Germany, Denmark and the Netherlands, the poorest half of the population pay a much higher share of their income in taxes than the richest tenth. This distorts work incentives and renders everyone poorer.
Draghi’s welfarist error
It is wishful thinking to believe that EU’s growth problem could be solved without first downsizing the wasteful system of income redistribution from workers to nonworkers and reducing the tax burden. Overall government spending in Europe is also among the largest in the World at around 50% of GDP. The higher the level of government spending as a share of GDP, the bigger the overall tax burden, more of which will be spread from the rich to the middle-class and those of modest means.
In his magnum opus “Human Action”, Ludwig von Mises has already debunked the mainstream fallacy that production and distribution are two separate and independent economic processes. According to mainstream economists, when the production of goods and services has come to an end, the government can intervene to ensure a more “fair” distribution of the national income among members of the society. Allegedly, this would not weigh on economic output which is perceived as independent from the subsequent public redistribution of incomes. That is why Lagarde and Draghi believe that Europe can boost its growth performance irrespective of the social model. But, this is wrong.
In a market economy, goods and services come into existence as someone’s property and if the government wants to redistribute them, it must first confiscate them. Governments can easily encroach upon private property rights, but this cannot represent a solid basis for sustainable economic growth. According to Mises, investment and capital accumulation are founded upon the expectation that their fruits would not be expropriated. Without this assurance, people would prefer to consume their capital instead of safeguarding it for the expropriators. People would reduce savings and investments and entrepreneurs would take less risk. Workers would work less hours and enjoy more leisure if they earn less on a net basis. This would depress economic growth and living standards for both the rich and the poor.
Gwartney, Holcombe and Lawson have shown this empirically. As the size of general government spending has almost double on average in OECD countries from 1960 to 1996, their real GDP growth rates have dropped by almost two thirds on average. Moreover, the worst performers were some Sothern European countries that increased the size of the government the most (Graph 3).
Graph 3: Government spending and economic growth among OECD countries
Source: James Gwartney; Randall Holcombe and Robert Lawson, (1998), The Scope of Government and the Wealth of Nations, Cato Journal, 18, (2), 163-190
Europe’s slow economic growth, weak productivity and poor innovation are just symptoms of the excessive public spending and welfare state. In a short reaction to Draghi’s report, Blanchard and Ubide note that countries do not necessarily need to be leaders in innovation in order to prosper. They can use the innovations of others and still be able produce competitive products. But, according to Mises, this can only happen if governments allow markets to function freely and do not stifle individual entrepreneurship. This is the fundamental problem that Europe should fix first.
