Can Europe Grow Out of its Debt?

A “ghost debate” spreads through Europe: a debate on higher economic growth in order to virtually grow out of public debt and to put an end to the crisis of individual Euro countries. The debate can be labeled “ghost-like” because:

• it is erroneously reduced to the growth of GDP
• it is putting the cart before the horse since economic growth stands at the end of a long process of destroying old economic sectors and building up new ones (in that sequence) as a result of millions of decentralized decisions on consumption, investment and savings, or, put it differently, as a consequence of millions of decentralized innovations cutting the costs of existing production lines (called process innovations), introducing new products (product innovations) or changing the location of innovations (locational innovations)
• it is reflexively focusing on public “innovation programs” following the belief that such programs could channel these millions of decisions and innovations into a desired direction.

The debate can be mirrored against the background of the concrete situation of mature and ageing high-income countries expecting in the long term equilibrium an expansion of their full employment productive capacity of no more than about 1–2 percent annually (a bit more in the poorer European periphery country and a bit less in the richer core countries). Effective barriers against a larger expansion are set by the demographic development, the availability of knowledge, natural capital, the environment and financial capital and last but not least by the inertia of the institutional framework. It would be a great achievement to upside shift this long run “steady state” rate of growth by a half or one percentage point. And, very importantly, it differs from the short run extent of exhausting the productive capacity which is displayed by the GDP growth rate.

How can this achievement be reached by the end of a long process in Europe?

Four factors are relevant:

• societies must be prepared to accept new technologies arriving at a market either exogenously “out of the blue” or endogenously (as a result of policy-induced incentives);
• societies must be keep their markets open and must refrain from seeing globalization as a risk and threat, since only markets open to foreign competition put a “price tag” to the investment, disclose whether investment is successful or not and allow for locational investment (outward or inward foreign investment) respectively;
• societies must be embracing sectoral structural change which dismisses obsolete sectors, industries and companies from the market in order to open scope and resources for new sectors, industries and companies;
• societies must improve communication and signaling between the four major actors: the public sector (being in charge of efficiently providing public goods), the private sector which together with the trade unions is responsible for the efficient production of private goods and for the level of employment, a monetary authority being responsible for monetary stability and finally the private households acting as the major source of finance for the private sector as well as the public sector. Once communication on objectives and means between the four actors is characterized by distrust and lacking credibility instead of reputation and trust, transaction costs in economic relations between the four actors rise, triggering “wait and see” attitudes on investment and suppress innovations.

How can the current state of these four factors in Europe be described?

First, the acceptance of new technologies is limited. Instead, in Europe it is the precautionary principle which prevails. If not everything is known about the long run consequences of new technologies on health and safety of consumers, European societies will in dubio be inclined to reject them. So they will against experiments limited in time and spatial scope. Introducing new products faces high costs in terms of money and time. Service markets like education and health remain highly regulated and dominated by state supply. This foregoes gains from better education and higher well-being. There is a vast number of examples of the dominance of the precautionary principle in European countries, for instance the very critically led discussion on genetically modified products (GMO) or on the CCS technology (carbon capture and storage) pumping carbon dioxide into an underground geologic formation. This resistance is perhaps stimulated by an ageing society which is satisfied with the status quo and values uncertainty higher than a younger population.

It also goes further. From protest against large infrastructure projects such as Stuttgart 21 or against the construction of “electricity highways”, carrying electricity from the renewable energy sources to the consumer sites. The NIMBY view point (not in my backyard) is a powerful weapon against innovations. This is extremely unfortunate since new technologies are an important breeding ground for product innovations. Unfortunately, financial markets after the crisis have become overly riskavers and thus act more as a stumbling block than as a stepping stone to bringing new technologies and products to the markets. After the excessively riskprone behavior of banks before the crisis, this is an “overshooting” in the opposite direction.

Second, as concerns the attitude towards open markets, many European governments are captured by mercantilist thinking: exports are welcome, imports are seen as a burden. This is why there is no concession to open domestic markets without equivalent reciprocity (irrespective how difficult and questionable it is to measure equivalent counter-concessions and this is why there is nothing more to expect from the EU than a defensive role in the Doha Round of multilateral trade liberalization (leaving the driver’s seat to the stalemated US). Yet, how can innovations be valued at “world market prices” if the markets are not opened and if in the case of a “surge” of imports governments retreat rapidly to antidumping complaints and escape clauses?

Third, the element of inertia in protecting obsolete old sectors, industries and companies is large, thanks also to effective vested interests of lobby groups. Structural change, however, is not a free lunch event without costs and pain. In the context of the crisis of some Euro countries it is primarily the permissive role against the financial sector which is deplorable. The fact that banks have lost funds in investments into unsafe havens gains more attention than the fact that banks have gained funds in investment in safe havens which only exist because there are unsafe havens. The claim that losses and gains should be weighed against each other and balanced as they belong together is rejected by the banks and governments. Yet, there is no reason to protect banks from going bust, not only highly subsidized producers of solar panels. Without market exit, there is no room for new suppliers under binding budget constraints. The latter can perhaps use part of the capital stock of the suppliers exiting from the markets. If not, a new capital stock must be financed. In any case, failed investment is a necessary prerequisite for the success of new market entrants. The German energy turnaround could offer a wide opportunity for structural change. Regrettably, it also offers a showcase for the resistance which highly subsidized suppliers of renewable energy exert against the cut back of their privileged treatment.

Fourth, communication and signaling between the four major actors in European countries warrant major improvement. The times are gone when a central bank needed few words to convey to the actors what it expected them to do and what tools it had once these expectations were not fulfilled. So are the times when a government could clearly explain to its electorate for which end specific measures were necessary and taken and what citizen could expect to win at the end. Also gone are the times when contracting parties in wage negotiations rapidly achieved a balance of their interests and a solution. Economists call problems of communication and signaling “time inconsistency”: based on a past record of policy failures, announcements and measures are discredited as non-credible and trigger a conduct that in a self-fulling prophecy leads to their failure. Rising costs of communication, implementation and enforcement are an eminently important barrier against innovations and against growth.

All these problems in Europe lead to escape reactions. Many suppliers outsource their production to poorer countries outside Europe in which the potential for longer run growth is higher than in the mature ageing home countries. The returns from these investments led the gross national product to rise faster than the GDP since the former includes the income produced from domestic capital and labor earned abroad. Japan is an excellent example for this gap between GNP and GDP. In a globalized world, therefore, one should look more to the GNP than to the GDP. But neither the GNP nor the GDP are relevant benchmarks for economic growth.

To conclude, everybody who wants to rise to a higher growth track of the productive capacity in Europe, must work on these four construction sites. Such work must focus on incentives, experiments, openness and credibility, but not on financial redistribution, fiscal policy stimulants, risk aversion and “stop and go” type of confusing policies. By the end of the day, at first glance, there might be a numerically small plus in the growth rate of the productive capacity of perhaps not more than half or one percentage point only. Yet, there is no reason to belittle it: It would be a leapfrog for the European economy and worth all pain.

(Slightly revised version of an article published on November, 11, 2012, in the Social Europe Journal under the title “Higher Economic Growth in Europe: Barking up the Right Tree”).