Among the more hotly debated issues in the investment banking world is the issue of government spending, and in particular government spending in Europe. The fundamental question is: Should European nations continue to reduce the costs of government services (i.e. reduce government spending to the point of a balanced budget)?
Germany answers this question with an honest yes. France and other struggling EU members say no, it’s politically unfeasible. So far, the Germans are proving to be correct, at least according to the simple correlation evidence.
Advocates for Greater Government Spending
On the one side of the debate are left-leaning investment bankers (there are more than you think), and government and academic economists, who simply think government spending is the easiest way to improve economic growth. Individuals with this somewhat naive view generally justify their thinking by employing the use of the “government spending multiplier.” The government spending multiplier represents the idea that an increase in government spending induces firms and individuals to expand spending, and thus improve the economic outlook.
Advocates for greater reliance on government spending point to, for example, governments paying private firms to construct buildings or build railways as “proof” of the effect of government spending.
The Government Spending Realists
On the other side of the debate are most of the investment banking world, non-academic and non-government economists, and most business leaders. Individuals with this view could accurately be classified as government spending “realists.” Government spending realists see the usefulness of government spending at certain points in the economic cycle, but also acknowledge that government spending is in no way the way to improve prolonged economic growth. Instead, government spending is almost always correlated with reduced economic growth when looking over many years.
Overall, government spending realists generally see government spending as something to be minimized when possible, even when politically unpopular.
Debate Aside. Here’s a Look at Government Spending.
Acknowledging the long-standing debate, we can now inspect the evidence.
First, here’s the government spending side. The following table inspects shows what government spending has done by certain European governments since 2009.
Interestingly, of the nations shown, the biggest spender since January 2009 to October 2014 is the Italian government, up 73%. Other governments with larger spending increasing include Finland (72%), Belgium (32%), Luxembourg (29%), and Spain (22%). On the other side, the “prudent” governments include Greece (down 39%), Switzerland (down 3%), Netherlands (up 1%), Ireland (up 4%), Germany (up 8%), Denmark (up 8%), the U.K. (up 10%), and Sweden (up 13%).
Next is a look at government spending across 16 so-called advanced economies.
Debate Aside. Here’s a Look at GDP Growth.
Switching to GDP, GDP is the broadest measure of economic growth. When academics talk about government spending and try to connect its effect, they usually do so by trying to connect government spending with GDP growth.
The following graphic is what GDP growth has done over the past few years. The best performing economy of the economies shown is Australia, up 20% since 2007. On the other end, the worst performing country is Greece, down 25%.
Connecting Government Spending and GDP Growth
With the two components addressed, the question can now be answered. Are the Germans or the French right? Is reducing government spending causing havoc on European economies? The accurate answer to the latter question is no, implying that the Germans are right.
Consider, for instance, Italy, which has seen the largest expansion in government spending while performing the second worst. On the flip side, Greece has reduced government spending the most and has also experienced the worst economic performance.
The contradictions continue. Switzerland, which over the period covered has reduced government expenditures second most (down 3%) has experienced the third best economic performance. Finland, with the second largest increase in government spending, has experienced the the fifth worst economic performance of the economies listed.
If this were an academic paper, the next step would be to present scatterplots, panel regressions, and other econometric evidence. What it would show is exactly what was just said – government spending is not the cause of poor European economic performance.
Overall, the Germans and most of the investment banking world are right – reducing government spending is not the cause of poor European economic conditions.