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 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.

Read Part 3: Redefining the role of the state: New Economy in Progress


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  • Reagan, R. (1981). Inaugural Address. Available at https://www.reaganfoundation.org/ronald-reagan/reagan-quotes-speeches/inaugural-address-2/
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