For Growth, Europe Needs To Curb Government Spending

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Includes: ADRU, DBEU, DBEZ, EEA, EPV, EURL, EZU, FEEU, FEP, FEU, FEUZ, FEZ, FIEU, HEDJ, HEGE, HEZU, HFEZ, HFXE, HGEU, IEUR, IEV, RFEU, SBEU, UPV, VGK
by: Disruptive Investor

On March 22, 2016, Eurostat released data on government expenditure in the European Union, and there are several reasons for concern for Europe. The Telegraph article on the same rightly puts things into perspective - "Europe accounts for just 7pc of the world's population, and 25pc of its GDP, and yet it also accounts for a massive 50pc of its welfare spending."

This article discusses the level of government spending in different countries in Europe and the reasons to believe that high level of government spending will continue to have a negative impact on the economy.

The chart below shows the general government expenditure (as a percentage of GDP) for the EU, the euro area and few specific countries in the region. The chart also singles out the social protection expense as a percentage of GDP, as it is the single-largest sub-component of the government expenditure.

Click to enlarge

It is clear that government expenditure in Europe is significant, and in my opinion, this factor will ensure that Europe's GDP growth remains sluggish for a prolonged period. There are several reasons for this conclusion.

First, as the Telegraph article puts it aptly, welfare spending is pure consumption, and it does not have an incremental impact on GDP growth or represent a kind of investment that repays over a period of time. Therefore, as welfare spending increases, a significant portion of tax money or debt is allocated towards non-productive spending (from a growth perspective).

Second, if welfare spending continues to swell, the total government debt will increase and there will be potential increase in taxation, and this is likely to result in a "crowding out" of investments from the private sector.

My point is further backed by research from the NBER, which states the following:

"Fiscal expansions sometimes have contractionary effects on the economy, and fiscal contractions may result in economic expansion. To understand why, we need to investigate the effect of fiscal policy on business investment. According to NBER Research Associate Alberto Alesina, Silvia Ardagana, Roberto Perotti, and Fabio Schiantarelli, increases in public spending can hit company profits and thus lead to a reduction in private investment and economic growth. Cuts in public spending, on the other hand, can lead to more private investment, and faster growth."

And the following...

"The magnitude of these effects, the researchers find, is substantial. A reduction by 1 percentage point in the ratio of primary spending to GDP in the sample OECD countries leads to an immediate increase in the investment/GDP ratio by 0.16 percentage points. It leads to a cumulative increase by 0.5 percentage points after two years and by 0.8 percentage points after five years...Increases in taxes also reduce profits and investment, but the magnitude of these tax effects is smaller than those on the expenditure side."

Another point that I want to mention here is that the government gross debt was 86.8% of GDP for the EU as of 2014. According to Carmen M. Reinhart and Kenneth S. Rogoff, the government debt and real GDP growth is weak for debt/GDP ratios below a threshold of 90% of GDP. Above 90%, median growth rates fall by one percent and average growth falls considerably more. With high percentage of social spending across the EU, I expect general government debt to continue to swell in the coming years, and this will continue to negatively impact real GDP growth.

With these points in consideration, it is of paramount importance that the EU reduces government spending if real economic activity has to witness some recovery. Else, the economy will oscillate between sluggish growth to period of no growth and recession. With the current government spending level, I don't expect Europe to see robust GDP growth even if the time consideration is for the next 5-10 years.