A Note on European Growth

In my series on tax cuts vs. spending cuts, I explained that it is not possible for economies with big welfare states to reach adequate GDP growth rates while keeping their welfare states intact. However, with reference to the statistical aggregates presented in that article series, a couple of readers pointed out that European countries seem to be able to enjoy decent growth rates despite their large governments.

There are isolated examples of European countries that have seen very high growth rates, on occasion even in excess of ten percent. There are also examples of countries that have sustained four percent or more per year for an extended period of time. However, these examples do not contradict the conclusions I reported earlier, namely that a big welfare state depresses growth.

A closer look at the European economy – or economies – reveals where the perceived high growth comes from. To start from the top, so to speak: the European Union itself (in its current 27-state configuration) only saw 1.5 percent GDP growth in 2019. With the exception of a rare 2.8-percent rate in 2018, it has not seen growth anywhere close to three percent since 2007. The 19-country Euro zone is a tad worse, suggesting that the EU member states that kept their own currencies are doing better than those that adopted the common currency.

It is difficult to find clear-cut statistical evidence to establish this difference, but anecdotally there is some truth to this. There are only eight EU member states that have not joined the euro zone, but in 2019 seven of them were in the top-half of EU states in terms of economic growth. Only Sweden, with its paltry 1.26 percent, was at the bottom.

There are two reasons why a country would perform better outside of the euro zone, and one of them actually has to do with the welfare state. We will leave that discussion for a coming article on European fiscal policy; for now, let us note that it has everything to do with the kind of austerity that a country is forced into once its welfare state becomes chronically unaffordable. Euro-zone countries are forced by the EU constitution to adopt austerity measures when their budget deficits reach a certain ratio to GDP. Non-euro zone countries are theoretically bound by the same restriction; this is the so-called Stability and Growth Pact (SGP). However, since they do not belong to the euro zone the EU and its central bank have limited leverage to enforce the SGP.

In addition to having a bit more fiscal freedom, non-euro zone countries can use their national currency as an instrument to attract foreign investments and become big exporters. An examination of national accounts data from Europe points clearly in this direction.

We should also note, however, that there are countries within the euro zone that have made exports their main growth driver. Ireland is the most striking example. Their GDP growth rate has topped five percent in four of the past five years; in 2015 it reached incredible 25.2 percent – adjusted for inflation. That same year, exports increased by more than 39 percent; in 2017, 2018 and 2019 when the Irish GDP grew at more than five percent per year, exports increased by 9-10 percent.

Consequently, exports have become the largest source of absorption in the Irish economy. In 2019, their exports amounted to 133.7 percent of their GDP, a share that was only surpassed by Luxembourg and Malta. These numbers, of course, are possible because much of the exports consists of assembling imported inputs, but they do illustrate how dependent these countries are on exports for their economic growth.

Outside the euro zone, Hungary is the most conspicuous example of how strong GDP growth is generated by rising exports. In 2009, Hungarian exports were equal to 69.2 percent of GDP; in 2019 it was equal to 91.6 percent. The Polish economy experienced a similar trend, with exports growing from 38.2 percent of GDP to 55.5 percent during the same period of time.

Strong exports correlate with high levels of capital formation. To again take Hungary as an example, business investments accounted for less than 20 percent of GDP a decade ago; in 2019 it was 26.4 percent. This is far behind the Irish economy, where investments equaled 46.6 percent of GDP. However, while the Irish economy experiences high volatility in capital formation, with the rate swinging wildly from year to year, Hungary sees a steady stream of investments in productive capital.

While policies promoting exports can be beneficial to an economy, the harvest that exports sow is never guaranteed. In the Irish case, their exports have essentially become part of a revolving door: as a net between exports and imports, their foreign trade is almost inconsequential. Furthermore, it does not spill over in terms of increased standard of living: consumer spending has gradually lost relevance, falling from 44 percent of GDP to 29 percent in the past ten years.

Hungary is a counter-example, with consumer spending remaining around 50 percent of GDP. This means, plainly, that while Irish households do not benefit very much from the country’s strong growth and big exports, Hungarian families do in fact benefit from export-promoting policies.

To fully understand the role of exports and investments in driving economic growth, we need to get a deeper understanding of what role government plays in the economy. More on that in a coming article. Click the Follow button and get updates as soon as they post!