TCS Daily

A Pivotal Year for the European Left

By Constantin Gurdgiev - December 29, 2004 12:00 AM

One day, years from now, a PhD student of economic history digging through columns of data will come to a realisation that 2004 was a pivotal moment for the European left. Looking at the returns from EU and US elections she will realise that the Great Unravelling between the world powers over the issues of Iraq, war on terror and other foreign affairs concealed nothing more than a manifestation of the age-old wisdom that all politics is local.

'Like we didn't know this', I hear you say. I beg to differ. A majority of European commentators failed to see that (a) the EU parliamentary elections were driven by the Left's failure to raise the issues of domestic policies; (b) the US presidential elections were centred on the issues of economy at least as much as on the war against terrorism. This is precisely why the majority of European press and academics in both elections endorsed the losing candidates.

In the European elections, centre-left parties argued about the EU role in, well, the EU affairs -- common defence and foreign policy, group-thinking about the environment and group-therapy approach to a perceived threat of American imperialism. Anything, but the rapidly putrefying European economy and fossilizing legitimacy of the EU. The economic views of the Left never once stretched beyond the traditional wishful thinking about rising inequalities and the need to secure generous welfare safety net via greater taxation of the 'rich'. Absent any ideas on actual jobs creation and incentivising higher labour force participation rates, the electoral platforms of the left increasingly looked like a Victoria Beckham shopping list presented as a bill to an average taxpayer. For the super-state mired in the doldrums of stagnant economy with 9.5% unemployment rate and nearly 40% of population out of the labour force, this was the luxury that any sane voter would reject. And reject it they did.

The dismay and disbelief that followed the left-centre defeat in the EU elections did not produce a single public admission that they were wrong. Instead, the pattern of denial continued, culminating in the US Presidential elections. Hours before Kerry's concession speech, European elites were claiming that 'reason' will prevail in the US and the voters will reject George Bush's policies. We all know the result. What we are yet to discover is that, just as in the case of their own electoral platforms, the left failed to see the law of politics -- it is local, not globally-local.

Despite the claims of Michael Moore and Noam Chomsky, contrary to the psycho-analysts of war mentality from the CBS/CNN/BBC and the likes, President Bush won elections because his domestic economic policies were better than anything seen since the golden age of the Reagan Administration. Take for example the tax cuts that represented one of the largest and best-timed applications of fiscal policy in history. From 2001 to 2003 the standard measure of fiscal activism, the change in the cyclically adjusted budget deficits went from a surplus of 1.1% of GDP to a deficit of 3.1% of GDP. The resulting stimulus, combined with the Federal Reserve's active monetary intervention pulled the country out of recession, saving millions of jobs and thousands of small businesses. In global terms, US Administration policies reduced repercussions of American economic slowdown on its trading partners, including the EU states, such as Ireland.

In contrast with the US, European policy makers failed to respond to the economic slowdown. As the result, EU interest rates remained high, while EU budget deficits went to finance increased social spending instead of the tax cuts. In many European countries taxes went up. Both, the government share in economy and the tax wedge in the EU have continued to rise since 1980. Currently an average employee in the EU spends at least 50% of their working time paying taxes, while in the US this figure stands closer to 30%. Seeing no evil in their own policies, European leadership followed the US Democrats in predicting a fiscally induced economic collapse for the US, dusting out the 1980s scenarios of rising national debt. European press and academics lined up behind Senator Kerry's proposals to increase taxes on 'the wealthy' in order to finance social spending.

Yet, the American voters and markets paid little attention to this nonsense for two reasons. First they remembered the 1980s, when a historically modest increase in the US debt (see Figure 1 below) financed a major investment expansion coupled with a large-scale reduction in tax burden. The Regan Administration put an end to the Cold War and ushered two decades of unprecedented prosperity in the US. Second, the Americans know that the usual measures of deficit and debt are misleading. Nearly 55% of the US National Debt (currently at $7.5 trillion) is held by the Government against itself. Of the remaining $3.4 trillion, 50% is held by foreigners, leaving the American public with a debt of $1.7 trillion.

Figure 1. Publicly Held US Debt as percent of GDP.

Source: CBO, 2004.

This begs a question -- how much of a problem is the US debt? Even at $7.5 trillion, the US debt is less than 66% of GDP (the EU Stability & Growth Pact (SGP) limit is 60%, while current EU15 average is 63.2%) and well below the historical average for the post-WW2 period. According to the Congressional Budget Office (CBO), the President's budget will be associated with $2.7 trillion in cumulative debt increase by 2014. The publicly held debt will peak at around 40% of GDP in 2006-2007 and will stabilise through 2012. Under conservative CBO assumptions, the Bush Administration should leave office with a primary surplus of 0.4% of GDP. These figures do not include the benefits of the permanent tax cuts proposed by the President. Given that both the EU's big economies and Japan have higher debt burdens and higher taxes, exacerbated by lower productivity, the US debt level is hardly a reason for grave concern. Figure 2 below shows that the real measure of the public debt burden, i.e. the ratio of publicly held government debt to potential GDP is lower in the US than in Canada, France, Italy and Japan.

Figure 2. Public Debt, per cent of potential GDP.

Source: OECD Economic Outlook 74 Database.

What about the federal deficit, i.e. the difference between the government spending and tax receipts? On the spending side, the US Government share of economic activity remains far smaller than that of the EU states. Given that each dollar of federal revenue costs roughly $1.30 in foregone private activity, this is a healthy alternative to European heavy tax-and-spend fiscal policy. In actual figures, the President's budget for 2005 implies projected deficit of $350 billion (2.8% of GDP -- well within the EU SGP limit of 3%). At least $75 billion of this is nominal deficit due to inflation, interest payments and maturity structure of the public debt, nearly $70 billion is new federal investment, net of depreciation, while $135 billion is emergency outlay for the war on terror. This leaves cyclically adjusted deficit of approximately $70 billion -- a few tenths of one percent of GDP. Comparing these figures with deficits in France (3.7%), Germany (3.9%) and other EU states, combined with lower economic efficiency of Government spending in the EU, explains the November election results -- as in the 1980s the American voters confirmed that the US is better off with smaller government consumption, higher federal investment and lower taxes than with European-style spending sprees at the expense of the taxpayer.

The latter highlights a fundamental difference between the US and the EU approaches to fiscal activism. As Figure 3 shows, when budget deficits are adjusted for the effects of inflation and debt service repayment, i.e. the inflation tax, since 1986, the US budget balances are smaller than those of the EU's Big Three -- France, Germany and Italy. The OECD analysis shows that in general private investment rises by 14% more in the long run in response to the tax cuts than to comparable increases in the general government spending. In the short run, however, this gap is much wider. As the result, even in terms of fiscal balance, tax cuts are more efficient than direct government expenditure increases.

Figure 3. Net Government Lending as percentage of potential GDP.

Source: OECD Economic Outlook 74 Database.

The latter proposition is supported by the evidence on the differences in correlations between the public deficits and the private savings rates. In the EU's Big Three (France, Germany and Italy) a 1% increase in public deficit is associated with 0.45% increase in private savings, well below the OECD average of 0.52. In the US this figure is close to 0.675. The difference in correlation between the deficit and the private savings rate between the US and the European economies arises from greater capacity of the American economy to absorb added spending into productive economic activity, contrasted by the general inability of the welfare-focused European public spending to generate private sector growth effects.

And here lie the lessons that EU's elites must learn. In the debate about debt and deficits, the ultimate determinant of the public acceptance of higher spending is not the amount spent, but the growth opportunities created. This means that the actual measure of debt significance is relative to the potential GDP, as shown in Figure 2. Thus the fiscal policy objective should not be maximising the redistributive powers of the state, but optimising real economic growth. In the US, this requires lower taxes and regulatory burden, consumption spending controls, pensions and welfare reforms, trade and services liberalisation, independent and well-targeted monetary policy.

In addition, in the world of local politics fiscal optimism must be transparent. In fact, the bulk of the Bush Administration spending is. The US Federal investment programs, debt repayment costs and emergency outlays, accounting for 80% of this year's deficit are immediately visible to the taxpayer. This is a far cry from the EU's penchant for hidden spending -- in the last ten years, even professional auditors hired by Brussels failed to certify the EU's accounts with respect to 94% of the Union's expenditure. In terms of the EU's relative standing in the world of public and corporate finance this implies that with the exception of the EU Commission, European public finances are in worse shape than those of either Enron or Parmalat.

The same agenda of pro-growth fiscal activism and transparency that works in the US should apply in the EU. Yet, judging by the recent reluctance of Brussels to liberalise trade in services (Bolkestein Directive), continued protectionism in state procurement and the ECB's unwillingness to incorporate the rising Euro exchange rate into monetary policy, the US experience is far from being recognised in Brussels. Similarly, the state governments remain unwilling to adopt an aggressive stance in promoting growth and curbing spending. Contrary to all logic, the EU continues the policy crawl in the direction of introducing tax harmonisation measures, while refusing to review the counterproductive minimum level floor on VAT rates. All of this means that in the years to come, the ongoing mud-slinging of the US twin deficits problem will continue to deflect European public opinion away from the deeper structural policy bottlenecks on the Continent.

Before it becomes a real road-kill of economic history, its time for the EU to wake up to the electorates' choice of agenda.

Constantin T. Gurdgiev is Lecturer in Economics (Trinity College Dublin), Research Associate at the Policy Institute (Trinity College, Dublin), and a Director of the Open Republic Institute, Dublin.


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