Knowledge Base
The state

For decades, there was a consensus that reducing the role of the state and cutting public debt would generate wealth. This contributed to a chronic underinvestment in education and public infrastructure. New research focuses on establishing when and how governments need to intervene to better contribute to long-term prosperity and to stabilize rather than aggravate economic fluctuations.

The Challenge

Decaying infrastructure and a lack of investment in education and innovation expose the weaknesses of an overly market-driven paradigm

Two thirds of German companies in 2019 complain about inadequate public infrastructure as the constraint on their inability to increase production. One reason is that for many years the state has invested too little in roads, railways, schools and universities, digital services and the healthcare system. The authorities have also placed too little emphasis on the measures needed to create of a climate-friendly infrastructure, such as a network of charging points to accelerate the shift to electro-mobility.

The Kreditanstalt für Wiederaufbau estimates that the shortfall of investment in the maintenance of bridges, the sewage systems and other local infrastructure now comes to almost €160 billion in the  municipalities alone (Krone and Scheller, 2018).

German public investment has stagnated for many years at or just over two percent of gross domestic product (GDP). In the 1970s, it had reached around 4 percent.

Meanwhile, public bodies that have been planning for some time to increase investment now lack the necessary capacity within their construction and planning departments or enough appropriately qualified personnel/staff to initiate and manage investment.

What is true of Germany applies to the majority of the rich countries in the West. The US as well as in the UK, Italy and France are suffering from dramatic deficits in their infrastructure. Even more alarming is the situation in those eurozone countries that were especially affected by the euro crisis. In Spain and Ireland, the share of GDP accounted for by public investment dropped by 2.3 and 2.8 percentage points respectively between 2007 and 2015 (OECD, 2017). At 1.7% of GDP Ireland had the EU’s lowest rate of public investment in 2015.

What went wrong

Reducing the role of the state in the economy was seen as the best way to ensure high levels of growth.

One of the fundamental and central tenets of market-liberalism since the late 1970s has been that economic dynamism requires government activity to be reduced to a minimum. The great monetarist and Nobel laureate, Milton Friedman, once said that “Nobody spends somebody else’s money as wisely as he spends his own” and further “So if you want efficiency and effectiveness, if you want knowledge to be properly utilized, you have to do it through the means of private property.”

At the time, a whole era began where numerous academics tried to underpin the uselessness of nearly any state intervention through ever more creative theories. For example,  the supply-side economist Arthur Laffer argued that cutting taxes (in particular for the rich) would create enough additional economic activity to more than offset the initial loss of tax revenues; that is, tax cuts would pay for themselves. For its part, the theory of rational or adaptive expectations  maintained that people will not spend more of their own money in response to higher government spending, because they will reason that sooner or later taxes will have to rise. (Barro, 1979). Another theory – that of “expansionary fiscal austerity” –  claimed to show  that while harsh austerity will initially weaken the domestic demand, it will ultimately lead to stronger economic growth by lowering interest rates (due to the reduction of public debt). (Alesina and Ardagna, 1998, 2010).

This new guiding principle was applied in practice notably since the election of Margaret Thatcher in the UK in 1979 and Ronald Reagan in the US in 1981. Thatcher’s quote from 1987 became famous. She said that ‘…there’s no such thing as society. There are individual men and women and there are families. And no government can do anything except through people, and people must look after themselves first’   Reagan stated in 1981 that ‘Government is not the solution to our problem, government IS the problem’.

In both countries quite a few previously government-provided services were then privatized. Moreover, social benefits and public investment were cut. Germany and other European countries soon followed, adopting as a guiding principle that government spending as well and taxes should be reduced whenever possible. This in turn created more pressure to reduce government spending.

At the same time, since the early 1980s,  the idea that governments should, at least during an economic crisis, counteract the weakness of private sector demand by raising spending or cutting taxes fell into disrepute. The dictum of reducing the role of government also became part of the famed Washington Consensus, which soon came to determine not only the policy of the US administration but also the recommendations the International Monetary Fund issued to crisis-stricken countries. Moreover, the spirit of Milton Friedman and other followers of the free-market orthodoxy also left  their imprint on the Maastricht Treaty, which set the policy framework for monetary union in Europe and whose first priority was to limit and reduce state deficits and public debt, regardless of economic circumstances.

Sure, the drive to reduce the government’s role was not implemented as strictly as orthodox market-liberals had envisioned. For example, the Reagan Administration increased military spending by so much that the US was soon running government deficits. However, it is certainly the case that public services were cut and others privatized and investment curtailed  And for a long period of time there was widely-held scepticism that government should intervene to smooth economic cycles or promote innovation in the economy.

In the EU, as elsewhere, the fixation on reducing budget deficits led to governments cutting spending when their economies were already weak, in the process deepening downturns. These cuts often fell most heavily on investment, because it was politically easier to cut spending on say infrastructure than other more structural expenses.  On the other hand, governments made too little use of good economic times to reduce deficits. In an economic language, fiscal policy was systematically ‘pro-cyclical’, aggravating rather than minimizing fluctuations in economic activity.  Greece, in particular, suffered from this approach, with unprecedented austerity contributing to a decline in economic output of more than a third, and no improvement in the underlying dynamism of the Greek economy.

Indeed, recent empirical evidence strongly suggests that austerity is only  “expansionary”  in very specific circumstances; namely where a decline in domestic demand brought about by austerity can be more than offset by strong growth in exports. Estonia arguably managed to pull this off, albeit at the cost of an exodus of mostly young workers. However, such a strategy is only possible if the country’s major trade partners are performing well, which was not the case during the euro crisis.

According to recent estimates, the IMF and the European Commission systematically under-estimated the impact of austerity on economic performance.

In Greece, for example, the aggravating so-called ‘multiplier effect’ of spending cuts was significantly higher than they had assumed.

All in all, the combination of the drive to reduce the state’s role in the economy, privatization and pro-cyclical fiscal policy helps explain the dramatic deterioration of public infrastructure in countries such as Germany, the US or the UK.

First lessons drawn from the disaster

The drive to reduce the state’s role in the economy may have benefitted particular industries, but there is an increasing international consensus that it has had fatal side effects. The IMF has acknowledged that it made serious estimation errors during the financial crisis. For its part, there is growing recognition within the eurozone of the damage caused by excessively rigid deficit rules, and a greater attempt to align fiscal targets with the economic situation of the country in question. The focus is now more on reducing ‘structural deficits’ – the part of the deficit unrelated to economic fluctuations – and more willingness to acknowledge the impact of weak growth on fiscal positions rather than demanding spending cuts that  weaken economic activity and hence public finances, thereby requiring further spending cuts.

Faced with a mounting backlog of investment projects, more people have started to question the merits of such tight controls on public spending.

According to Forsa’s recent poll commissioned by the Forum New Economy, around 80 percent of Germans now think that the government should spend more money on schools, roads, railways and digital infrastructure.

Also, around 80 percent of the respondents believe that the privatization of public services in Germany has gone too far. Joint estimates by the German Institut der deutschen Wirtschaft and the Institut für Makroökonomie und Konjunkturforschung with ties to the trade unions suggest that Germany needs to invest a three-digit billion sum in the years to come. Meanwhile the situation in other countries seems to have taken a similar turn.

The Italo-American economist Mariana Mazzucato has determined that the years of spending cutbacks and reductions in public-sector employment together with the practice of criticizing the competence of public bodies has had pernicious effects. The less attractive public service is, the harder government institutions find it to attract the qualified workers needed to persuade others to take jobs in public institutions, In Germany, the decline in the number of public-sector jobs is a major reason why the state now often lacks the capacity needed to boost public investment.

New Economy in Progress

The challenges of our time require us to rethink the role of the state and the need for a more active fiscal policy.

In recent studies on fiscal policy researchers have primarily focused on finding more differentiated and empirically founded reasons to determine in which cases government activities make sense and in which cases they do not make sense from an economic point of view.

Part of this research is focusing on the multipliers of fiscal policy – with the result that, on the one hand, amplification mechanisms have proven to be more powerful than had been believed for a long time. On the other hand, the efficiency of economic policy measures obviously is heavily dependent on time factors and circumstances.

Other researchers have attempted to categorize the efficiency of government investment by estimating the expected economic and fiscal returns of these investments in the future. Ultimately, the objective is to determine how much additional revenue the finance minister can expect in the future by investing in a better infrastructure and thus in a better competitiveness or improved innovative capacity of the economy. If these returns are higher than the initial costs, this will then be a strong economic and financial argument in favor of the relevant investment – and vice versa (Krebs and Scheffel, 2016).

A third strand of research focuses on the question which role the state institutions play in the innovation process of the private sector. Oft-quoted preliminary work in this field has been carried out by Mariana Mazzucato. According to her analyses, public authorities, such as military agencies, have already played a major role in the development of digital technologies (the Iphone for example). According to Mazzucato (2015), such a diagnosis leads to a model in which in the future government and private actors should cooperate much closer to engage in joint long-term missions.  Such a mission was the 1960s project of taking man to the moon for the first time. Today the battle against climate change should be tackled in a similarly strategical approach.

Likewise, government agencies could play a significant role in providing support to a major sector like the auto industry in their move forward towards the forthcoming shift in the transport technology.

Another question that begs to be answered addresses the interplay of governments and central banks in times of persistently low inflation and deflationary tendencies that give reason for concern. Since the onset of the financial crisis the major central banks have responded to these problems at varying paces and to varying degrees by initiating an unconventional policy and by responding in the markets, for example, with the purchase of (government) bonds. These attempts, however, are only partially effective, because the money that was made available does not necessarily lead to more real spending. Instead it has, as standard estimates suggest, led to an increase in purchases of assets such as shares.

Thus, an alternative that has long been highly controversial is now being discussed as a viable option. The idea is that money should be made available directly to the citizens who in turn will actually consume a much larger share of it (“helicopter money”). One of the advocates of this concept is the British economist Adair Turner (2015).


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