Evan Soltas
Jan 4, 2012

Long-Run Incentives Matter

The fall of European manufacturing edition

Attention remains fixed on Europe and its debt crisis. Some of the worries relate to short-term emergencies of solvency and liquidity, the ability of several nations -- Greece, Ireland, Portugal, Spain, and Italy in particular -- to avoid defaulting on loan obligations. Other worries are, in the economist's sense of the phrase, long-term, such as meeting further obligations several years down the road, or enacting the structural reforms required at both the national and E.U. levels.

Yet could there be longer-term historical forces at work? Robert Samuelson contends that European nations' unfavorable growth and demographic trends make their welfare states unsustainable, and that the current chaos is "ultimately a crisis of the welfare state." Paul Krugman disagrees, observing the lack of correlation between interest rates on 10-year debt and the level of government spending as a percentage of GDP.

I don't think I agree with either. Samuelson's claim is specious, as Krugman argues, because the data do not support a conclusion that investors regard European welfare states as inherently unsustainable. Yet I do not think that today's crisis can be entirely disentangled from the question of the economics of the welfare state, as Krugman seems to believe.
Adam Davidson of NPR's "Planet Money" wrote an article yesterday in The New York Times which agrees precisely:
Europe is undergoing not one but two simultaneous economic crises. The first is a rapid, obvious one — all about sovereign debt, a collapsing currency and austerity measures — that we hear about all the time. The second is insidious but more important. After decades of trying, Europe as a whole still can’t quite figure out how to be flexible enough to compete in the global economy.
There are trade-offs, in other words, to the welfare state, with which the very-long-run consequences of which Europe now grapples.

Robert Lucas' recent Milliman lecture, for one, suggests a balance between the long-run path of output growth and the size of government, a finding very much in line with an endogenous growth theory's model of the economy, which contends that very-long-run growth is best supported by uninhibited forces of "creative destruction," free competition, support for innovation and public distribution of knowledge, and open entry into markets. What Lucas concludes is that economies in welfare states have a lower growth level and flatter growth path than economies with less government involvement.

Our graph above is another example of the trade-off. The welfare state's social supports, depending on how you choose to see it, provide the average manufacturing worker with significantly more leisure time -- or seriously undermine the will to or possibility of harder work. We can see this in the consistent hours of the American worker, versus the hugely significant drop for the sample of European nations during the 60s and 70s, as the post-war welfare state crystallized.