European states have the largest welfare systems among OECD members and among the most expensive in the world, symbolizing the post-war social democratic social contract. But all of this has begun to be overturned with the pandemic and later the Ukrainian crisis as a starting point.
At the same time, Europe’s economic dynamism has faded and European leaders seem unable to reverse the economic decline of the Old Continent.
According to the President of the European Central Bank, Christine Lagarde, Europe’s generous social model is at risk of imminent collapse unless the region reverses its downward growth trajectory. More specifically, the President of the European Central Bank, Christine Lagarde, reports that Europe’s generous social model is at risk unless the region reverses its downward growth trajectory.
In Mario Draghi’s well-known proposals, he strongly calls for reforms and investment to boost productivity growth while leaving the continent’s oversized welfare state intact. This is a huge mistake in his approach, because the issues of economic growth and income redistribution are inherently linked.
Anemic growth and digital lag
Lagarde acknowledges that Europe is lagging behind the US in terms of productivity growth. Faced with rapid progress in innovation, the EU has remained in the “middle-tech trap”, while the US and China are leading the digital revolution.
Europe is lagging behind in emerging technologies such as microprocessors, artificial intelligence and electric vehicles, and only four of the world’s top 50 technology 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 gap in real GDP has doubled from around 15% in 2002 to 30% in 2023.
About 70% of the gap is due to lower productivity in the EU (Figure). Moreover, Europe’s growth prospects are not positive. The continent has benefited from international trade – such as its once-powerful car industry – but now faces strong competition from Chinese exporters and potential high tariffs from the US.
In addition, EU companies are burdened by high energy costs due to Brussels’ senseless involvement in Ukraine, and European countries will likely have to spend much more on defense, adding to already high public spending.
Draghi’s Wrong Solution
The solutions Draghi proposes to boost productivity growth and innovation have little to do with increasing the economic freedom needed. They are aimed primarily at concentrating and strengthening government intervention and maintaining the huge welfare state.
Draghi calls for a new industrial strategy for Europe, which should be coordinated at EU level. It can help overcome the current distribution of policies and funding sources between countries. But it cannot solve the more fundamental issue of the inefficient allocation of resources and the disincentives created by industrial policies.
Similarly, getting rid of greenhouse gas emissions and new clean technologies cannot reduce the current high energy costs without economic losses. Current fossil-fuel-based production facilities are cheaper, and replacing them would increase production costs.
The report also argues that the EU’s investment-to-GDP ratio would need to increase by around €800 billion, or 5 percentage points of GDP per year, which would require significant public subsidies for productive restructuring.
Draghi advocates the creation of a common safe asset, which would finance the issuance of common European debt. However, although cheaper, the mutual debt would add to the already high level of sovereign debt (mainly in France and Italy, which are facing market pressure).
Large and Ineffective Welfare State
At the height of the eurozone crisis in 2012, German Chancellor Angela Merkel tried to argue that Europe’s welfare states were too large, as Europe accounted for 7% of the world’s population, a quarter of global GDP and 50% of global social spending.
The situation has not improved in the meantime, and public social spending in many European countries exceeded the OECD average of 21% of GDP by 5 to 10 percentage points in 2022. According to the OECD, social spending in France, Finland, Denmark, Belgium and Italy is approaching 30% of GDP, due to pensions, health care costs and other social transfers, such as unemployment benefits, disability payments and child benefits (Graph).
Despite its size, the European social model is quite inefficient. Large spending on social protection in EU economies does not necessarily lead to a reduction in poverty. According to the Brookings Institution, this is particularly true in economies from Southern Europe, such as Spain, Greece, Italy and Portugal, where social spending is quite high, but social welfare coverage of the poorest 20% of the population is relatively low.
In contrast, the limited welfare systems in Central and Eastern Europe spend about half that, or less than 15%, of GDP on social protection, but achieve better coverage of the poorest segments of the population.
The Manhattan Institute goes a step further and argues that generous welfare states in Europe are not helping those who should be helping them – the working poor.
Universal “social security” systems that allow all members of society to enjoy a middle-class lifestyle in times of unemployment, illness, or when the pension system is financed by most European countries through fairly high taxes on wages and on consumption for low-paid workers.
In the EU’s largest welfare systems, the poorest full-time workers are net taxpayers, subsidizing those who do not work, while the US follows a different practice.
In countries such as Germany, Denmark, and the Netherlands, the poorest half of the population pays a much larger share of their income in taxes than the richest 10%. This distorts incentives to work and makes everyone poorer.
Draghi’s mistake
It is wishful thinking to believe that the EU’s growth problem could be solved without first shrinking the wasteful system of redistribution of income from workers to non-workers and reducing the tax burden on wages and consumption.
Total social transfers in Europe are also among the highest in the world at around 50% of GDP. The higher the level of government spending as a share of GDP, the greater the total tax burden, most of which will benefit only the rich and the middle class and through moderately efficient means.
In his seminal work “Human Action”, Ludwig von Mises has already debunked the dominant fallacy that production and distribution are two separate and independent economic processes.
According to mainstream economists, when the production of goods and services completes its upward cycle, the government can intervene to ensure a more “fair” distribution of national income among the members of society. This would supposedly not burden economic production, which is considered independent of the subsequent public redistribution of income.
This is why Lagarde and Draghi believe that Europe can boost its growth performance regardless of the social model adopted. But this is a major mistake.
In a market economy, goods and services are created as someone’s property, and if the government wants to redistribute them, it must first confiscate them! Governments can easily encroach on private property rights, but this cannot be a solid basis for sustainable economic growth.
Investment and capital accumulation in the market system are based on the expectation that their fruits will not be expropriated. Without this assurance, people would prefer to consume their capital rather than hold it for expropriators to reap. People would reduce savings and investment, and entrepreneurs would take less risk.
Workers would work fewer hours and enjoy more leisure time if they earned less in net terms. This would reduce 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 doubled on average across OECD countries between 1960 and 1996, real GDP growth rates have fallen by almost two-thirds on average. Moreover, the worst performers have been some southern European countries that have increased the size of their redistributive systems the most (Figure 3). Europe’s slow economic growth, weak productivity and backwardness in innovation are simply symptoms of excessive public spending and an overstretched welfare state. In a brief reaction to Draghi’s report, we will say that countries do not necessarily need to be leaders in innovation to prosper. They can use the innovations of others and be able to produce competitive products. But this can only happen if governments allow markets to function freely and do not stifle entrepreneurship and freedom of economic activity. This is the fundamental problem that Europe must first fix – implement the principles of economic freedom, all else will prove to be disastrous choices.