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To thrive, euro countries must cut welfare state

By Fredrik Erixon

Most criticism of government profligacy in Europe lately has focused on the obvious sinners, such as Greece, which already had massive public debts and deficits when the global financial crisis struck almost four years ago.

When it comes to overspending on social welfare, though, Europe has no angels.

Even the “good” Scandinavians, and governments that appeared to be in sound fiscal shape in 2008, but were then undone by unsustainable private-sector debts, were spending too much and will have to restructure. The only question is whether this will be done gradually, or via shock therapy.

Take the four countries at the epicenter of the euro-area crisis: Greece, Ireland, Portugal and Spain. They are in many ways different, but they have three important characteristics in common.

First, total debt in these countries expanded rapidly throughout the past decade -- either because of increased government borrowing (Greece and Portugal) or through a rapid buildup of private debt (Ireland and Spain). Second, they all ran substantial current-account deficits in the years before the crisis. Third, government spending in those nations grew at remarkably high rates. In Greece and Spain, nominal spending by the state increased 50 percent to 55 percent in the five years before the crisis started, according to my calculations based on government data. In Portugal, public expenditure rose 35 percent; in Ireland, almost 75 percent. No other country in Western Europe came close to these rates.

Bubble trouble

Clearly, the welfare-state expansion in Greece and Portugal was part of the reason these two countries ended up as clients of Europe’s bailout mechanisms. But Ireland and Spain had problems with the rapid expansion of the state, too. A big part of rising affluence during the boom years was generated by escalating real-estate bubbles, which caused private debt to soar. They boosted the construction sectors and, more generally, pushed domestic consumption to the point where Spain had to borrow as much as 8 percent of gross domestic product every year to finance its current account deficit. Like other bubbles, they spearheaded economic growth, which allowed governments to expand the state rapidly.

That growth vanished and gold turned to sand. Simply put, the bubble-fueled prosperity wasn’t sustainable. A record of solid fiscal surpluses was quickly turned into high structural deficits. Spain, for instance, entered 2008 with a budget surplus of slightly more than 2 percent, and ended 2009 with a structural deficit of 9 percent.

This has been a familiar story during the crisis. Yet surprisingly few people in Europe have bothered to understand the role that the welfare state played in creating it. The European debate zoomed in on two extreme positions, both bordering on caricatures as “Keynesian” versus “German.” The Keynesian school has a penchant for cradle-to-grave welfare states and sees Europe’s main problem to be a grossly insufficient fiscal expansion once disaster struck.

The German school blames the entire euro-area crisis on bloated budget deficits and a lack of fiscal discipline. One side thinks thrift is a vice, the other sees deficits as immoral. Each has its own fix at the ready: Keynesians call for a government-spending spree, Germans for purification by austerity.

Yet both fail to understand how a rapid expansion of state spending is part of the story in most economic crises, and that the composition of expenditure growth causes particular problems for post-bubble economies. Again, look at Spain. Its social- security systems expanded -- in terms of overall size and benefit levels -- at the same speed as general economic growth. That pushed up government expenditure, even as rising revenue kept deficits narrow.

Rising pension bill

Take as an illustration the average Spanish pensioner. Until recently, he or she received a state pension that was more than 80 percent of the average salary of current earners. So when the economy was growing strongly, salaries and therefore pensions did, too. That might not be a problem if wages (and pensions) were to fall again when the economy shrank -- but that doesn’t usually happen. Instead, the pension bill tends to remain at the same elevated levels even as economic growth and government revenue fall, creating an unaffordable ratchet effect.

Europe’s crisis economies will now have to radically reduce their welfare states. State spending in Spain will have to shrink by at least a quarter; Greece should count itself lucky if the cut is less than a half of the pre-crisis expenditure level.

The worse news is that this is likely to be only the first round of welfare-state corrections. The next decade will usher Europe into the age of aging, when inevitably the cost of pensions will rise and providing health care for the elderly will be an even bigger cost driver. This demographic shift will be felt everywhere, including in the Nordic group of countries that has been saved from the worst effects of the sovereign-debt crisis.

Germany, for example, still has an underfunded pension system. One study has projected that on current population- and spending-growth trends, health-care expenditure would account for 15 percent of Germany’s GDP by 2025 and almost 26 percent by 2050 (that last figure would be 33 percent for the U.S.).

Many Danes had to pinch themselves a month ago when their new prime minister, Helle Thorning-Schmidt, who heads a coalition of leftist parties, launched a strategy document called Denmark 2032. This addressed frankly the need for Denmark to define some tough spending priorities. Its underlying presumption was that the universal welfare state with its generous entitlements would not be able to survive in its current form.

Europe’s social systems will look very different 20 years from now. They will still be around, but benefit programs will be far less generous, and a greater part of social security will be organised privately. Welfare services, like health care, will be exposed to competition and, to a much greater degree, paid for out of pocket or by private insurance.

The big divide in Europe won’t be between North and South or left and right. It will be between countries that diligently manage the transition away from the universal welfare state that has come to define the European social model, and countries that will be forced by events to change the hard way.

*Fredrik Erixon is director of the European Centre for International Political Economy, a research group in Brussels.

[Bloomberg]

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