European voters, looking at Donald Trump’s chaotic presidency in the United States and the hard road ahead for a post-Brexit Britain, may be turning away from right-wing populists such as Marine Le Pen in France and Geert Wilders in the Netherlands. But if European governments are to keep their own populists at bay, they will need to implement the substantial structural reforms that are necessary to deliver higher long-term economic growth.
In their 1991 book, The Macroeconomics of Populism in Latin America, the late Rudiger Dornbusch of MIT and Sebastián Edwards of UCLA furnished the standard definition of economic populism. They describe it as “an approach to economics that emphasizes growth and income redistribution and deemphasizes the risks of inflation and deficit finance, external constraints, and the reaction of economic agents to aggressive nonmarket policies.”
According to Dornbusch and Edwards, economic populism can emerge when policymakers and citizens “are deeply dissatisfied with the economy’s performance.” In response, “[p]olicymakers explicitly reject the conservative paradigm and ignore the existence of any type of constraints on macroeconomic policy,” such that, “[i]dle capacity is seen as providing the leeway for expansion.” This then sets the stage for a populist program based on “reactivation, redistribution of income, and restructuring of the economy.”
The populist economic policies that Dornbusch and Edwards describe are eerily similar to eurozone economic policies since the 2008 financial crisis. According to Eurostat, from 2007 to 2015, the average public debt-to-GDP ratio across all 19 eurozone member states increased from 65% to an almost-unsustainable 90%; and average annual GDP growth stagnated. Across the European Union, average annual GDP growth did not return to its 2008 level until 2015.
European governments’ economic policies during this period have crowded out structural reforms. At a November 2008 G20 summit in Washington, the world’s largest economies committed to doing whatever it would take to restore growth and stimulate domestic demand through macroeconomic stimulus. But while monetary and fiscal expansion was justified at the time to stop a panic, these policies have not been curtailed since.
The crisis countries in Southern Europe have been the main proponents of this approach, while Germany – along with other Northern and Eastern European countries – has resisted it. Since 2008, eight EU countries have been locked out of financial markets at one point or another, requiring emergency assistance from the International Monetary Fund. And yet many economists still call for more macroeconomic stimulus, seemingly unaware of the damage such policies have caused.
The Nobel laureate economists Paul Krugman and Joseph E. Stiglitz argue that Europe’s problems stem from insufficient fiscal and monetary stimulus, and from structural flaws in the eurozone. But they ignore the need for reforms to increase European countries’ growth potential. Their prescribed cure has been amply applied in Greece and Italy, and it has failed miserably: Greece’s economy has now contracted for seven years, and Italy’s for five. And even after substantial debt reduction, their public debt at the end of 2015 still amounted to 177% and 132% of GDP, respectively.
The European countries that are growing soundly are those that have avoided taking on large public debts: Poland, Sweden, Estonia, Latvia, Lithuania, and Slovakia. Among the eurozone crisis countries, Ireland made the largest cuts to its public expenditures and debt, and it has since staged the strongest recovery.
This suggests that Europe’s economic problems stem not from inadequate demand, but from poorly functioning markets, excessive fiscal burdens, overregulation, and poor education. European countries should thus be focusing on resolving these real problems, rather than laying new debt traps.
In fact, EU countries should be reining in spending. Average public expenditure amounts to 47% of GDP in the EU, compared to an average of 37-38% of GDP in other developed economies. This reflects EU countries’ spending on enterprise subsidies, social transfers, and state administration – all of which should be reduced.
If EU countries rein in their public expenditure, they can cut taxes on labor, which are currently far too high. Unlike capital, which is more lightly taxed, workers cannot simply escape abroad. The rest of the EU should follow the example of several Eastern European countries and reduce taxes on labor to match the rate of taxes on corporate profits.
Countries such as the United Kingdom and Germany have achieved low unemployment (now around 5%), by deregulating labor markets, expanding vocational training, and reaching sensible wage settlements. By contrast, the overregulated labor markets in Southern European countries such as Greece, Italy, and Spain are hindering employment and discriminating against younger workers.
Southern European countries also lag far behind northern countries in apprenticeship programs and secondary education, which suggests that their unemployment has more to do with the labor supply than with demand. Indeed, Italy and Portugal grew slowly even during the 2000-2007 period leading up to the crash.
Finally, the EU needs to optimize its services market and open up its digital market, so that they function as well as its single market for goods. Its governments should concern themselves less with regulation and more with allowing competition and entrepreneurship to flourish – particularly with respect to pioneering companies like Uber and Airbnb – and boosting innovation. Continental Europe has too few elite universities, insufficient venture capital, and too many regulations, with only a half-dozen countries spending enough on research and development.
Rather than implementing structural policies to promote economic growth, European policymakers are pursuing economic populism, by promising high returns at little cost and consistently delivering the bare minimum. It is hardly surprising that many Europeans have been tempted by political outsiders.
Still, we need not despair. The half-dozen European countries that are doing well can serve as models for their neighbors. By learning from one another, Europeans can save themselves from economic populism – and thus from the political populists, who would make matters far worse