Since the end of the 19th century, the share of government in the gross domestic product has grown from below ten percent to around fifty percent in the industrialized countries. Fascism and Socialism were only the more extreme expressions of this tendency. The United States, too, has experienced a transformation by a steady encroachment through government and its bureaucracy (Figure 1).
The driving force behind the public expenditure have been war, and social security The data show that calling the modern state a “warfare-welfare state” is backed up by the facts.
Government spending did rise in the first half of the 20th century mainly because of the two world wars. A second wave took place in the 1960s and 1970s with the implementation of the comprehensive social welfare state.
Besides the military conflicts and the expansion of social policy, third factor is expansionary fiscal policy. The most extreme example is Japan. Its fiscal policy since the 1990s has led to a long phase of mammoth expansion of public spending. From a low of 50.6 percent in 1980, the ratio of public debt to gross domestic product rose to 253 in 2017 (Figure 3).
What happened in Japan since the 1990s, is taking place in the United States since the 1980s and particularly since the financial market crisis of 2008. From a low of 31.70 percent in 1981, the ratio of public debt to gross domestic product rose to around 60 percent in the 1990s and from there to over one hundred percent in the past ten years (see Figure 4)
The problem of public debt has economic structures, but its causal framework is politics. Democracy in its present form rests on the competition of political parties to buy votes through public spending. Many voters live by the illusion that what they get from the government is gratis. The political system ferments this false belief as governments prefer more debt over taxation.
Consequently, there is no industrialized country left where public debt has not reached a critical level.
Debt can only serve as a temporary remedy. Over time, it makes matters worse and when the debt limit is reached, it is all over. During the past decades, central banking and economic policy have been an exercise in the art of the postponement of the reckoning. Along the way, these policies have created a system of financial socialism. The string of bailout has destroyed the capacity of the financial market to calibrate risks. Subsequently, the allocative process of the economy has become deeply distorted. One factor is the effect of government expansion in crowding-out competitive markets. The other factor is the low-interest rate policy, which sustains many companies that otherwise would fail if the interest rate were free from manipulation.
The Next Downturn
Governments love to praise the ‘job creation’ in recent years. Yet many of these workplaces could not last if interest rates were at their market level and when government would not mis-allocate investments. Employment is kept high but productivity remains low because of a myriad of zombie companies.
It takes not much fantasy to imagine what will happen when the next economic downturn strikes. The present high levels of public expenditures and government debt have come about at a time when interest rates were at historical lows.
A new recession would not only mean lower or even negative economic growth rates, it would also induce governments to increase public spending. Then, the public debt quotient (debt over gross domestic product) would rise because of a lower denominator and a higher numerator. With the interest rate at historical lows, and the debt ratios already at the point of fiscal unsustainability, there is no space for a new stimulus.
If the next downturn will be inflationary, the central banks may be forced to raise interest rates, which would add further to public expenditures. Even more so than in the 1970s, a stagflation in the years to come would mean a financial hurricane for the public finances and it would hardly pass by without political turmoil. Not much brighter is the political outlook for a deflationary depression.
The European debt crisis of 2010 concerned mainly the smaller countries such as Portugal and Greece. The next debt crisis could hit also the large industrialized countries. In the financial market crisis of 2008, “too big to fail” was the claim to justify the bailout. Next time the dictum may read “too big to save” because there is no institution that could bailout the large countries if these should falter.