And when I discuss my work on the economic impact of government spending, I often get the same reaction.

This is why it’s important that a growing number of establishment outfits are slowly but surely coming around to the same point of view.

• The European Central Bank published a study showing “…a significant negative effect of the size of government on growth.”
• A study by two Harvard economists found that “large adjustments in fiscal policy, if based on well-targeted spending cuts, have often led to expansions.”
• The Organization for Economic Cooperation and Development noted in recent research that welfare programs are economically destructive because they lure people into dependency because “net disposable income would increase despite putting in fewer hours.”
• A study from the International Monetary Fund concluded that “Cuts to pension and health entitlements had the most beneficial effect on economic growth.”

This is remarkable. It’s beginning to look like the entire world has figured out that there’s an inverse relationship between big government and economic performance.

That’s an exaggeration, of course. There are still holdouts pushing for more statism in Pyongyang, Paris, Havana, and parts of Washington, DC.

But maybe they’ll be convinced by new research from the World Bank, which just produced a major report on the outlook for Europe. In chapter 7, the authors explain some of the ways that big government can undermine prosperity.

There are good reasons to suspect that big government is bad for growth. Taxation is perhaps the most obvious (Bergh and Henrekson 2010). Governments have to tax the private sector in order to spend, but taxes distort the allocation of resources in the economy. Producers and consumers change their behavior to reduce their tax payments. Hence certain activities that would have taken place without taxes, do not. Workers may work fewer hours, moderate their career plans, or show less interest in acquiring new skills. Enterprises may scale down production, reduce investments, or turn down opportunities to innovate. …Over time, big governments can also create sclerotic bureaucracies that crowd out private sector employment and lead to a dependency on public transfers and public wages. The larger the group of people reliant on public wages or benefits, the stronger the political demand for public programs and the higher the excess burden of taxes. Slowing the economy, such a trend could increase the share of the population relying on government transfers, leading to a vicious cycle (Alesina and Wacziarg 1998). Large public administrations can also give rise to organized interest groups keener on exploiting their powers for their own benefit rather than facilitating a prosperous private sector (Olson 1982).

In other words, government spending undermines growth, and the damage is magnified by poorly designed tax policies.

The authors then put forth a theoretical hypothesis.

…economic models argue that the excess burden of tax increases disproportionately with the tax rate—in fact, roughly proportional to its tax rate squared (Auerbach 1985). Likewise, the scope for self-interested bureaucracies becomes larger as the government channels more resources. At the same time, the core functions of government, such as enforcing property rights, rule of law and economic openness, can be accomplished by small governments. All this suggests that as government gets bigger, it becomes more likely that the negative impact of government might dominate its positive impact. Ultimately, this issue has to be settled empirically. So what do the data say?

These are important insights, showing that class-warfare tax increases are especially destructive and that government spending undermines growth unless the public sector is limited to core functions.

Then the authors report their results.

Figure 7.9 groups annual observations in four categories according to the share of government spending in GDP during that year. Both samples show a negative relationship between government size and growth, though the reduction in growth as government becomes bigger is far more pronounced in Europe, particularly when government size exceeds 40 percent of GDP. …we provide new econometric evidence on the impact of government size on growth using a panel of advanced and emerging economies since 1995. As estimates can be biased due to problems of omitted variables, endogeneity, or measurement errors, it is necessary to rely on a broad range of estimators. …They suggest that a 10 percentage point increase in initial government spending as a share of GDP in Europe is associated with a reduction in annual real per capita GDP growth of around 0.6–0.9 percentage points a year (table A7.2). The estimates are roughly in line with those from panel regressions on advanced economies in the EU15 and OECD countries for periods from 1960 or 1970 to 1995 or 2005 (Bergh and Henrekson 2010 and 2011).

These results aren’t good news for Europe, but they also are a warning sign for the United States. The burden of government spending has jumped by about eight percentage points of GDP since Bill Clinton left office, so this could be the explanation for why growth in America is so sluggish.

Last but not least, they report that social welfare spending does the most damage.

Governments are big in Europe mainly due to high social transfers, and big governments are a drag on growth. The question is whether this is because of high social transfers? The answer seems to be that it is. The regression results for Europe, using the same approach as outlined earlier, show a consistently negative effect of social transfers on growth, even though the coefficients vary in size and significance (table A7.4). The result is confirmed through BACE regressions. High social transfers might well be the negative link from government size to growth in Europe.

The last point in this passage needs to be emphasized. It is redistribution spending that does the greatest damage. In other words, it’s almost as if Obama (and his counterparts in places such as France and Greece) are trying to do the greatest possible damage to the economy.

In reality, of course, these politicians are simply trying to buy votes. But they need to understand that this shallow behavior imposes very high costs in terms of foregone growth.

To elaborate, this video discusses the Rahn Curve, which augments the data in the World Bank study.

As I argue in the video, even though most of the research shows that economic growth is maximized when government spending is about 20 percent of GDP, I think the real answer is that prosperity is maximized when the public sector consumes less than 10 percent of GDP.

But since government in the United States is now consuming more than 40 percent of GDP (about as much as Spain!), the first priority is to figure out some way of moving back in the right direction by restraining government so it grows slower than the private sector.

Some of the obvious ideas include:

• Lowering tax rates to boost incentives for productive behavior.
• Reducing the burden of government spending to allow more efficient allocation of labor and capital.
• Cutting back regulation and red tape to boost market efficiency.

But those are only obvious ideas if you want a growth plan that actually leads to…(drum roll, please)…more growth.

Merkel and Sarkozy must have some other objective in mind, because they’ve proposed a plan comprised of new taxes, higher taxes, and tax harmonization.

This is beyond satire. Even if I was trying to make fun of the French and Germans (perish the thought), I wouldn’t be able to make up something this absurd.

Here’s some of what the EU Observer reported.

A six-point plan drafted by France and Germany has suggested corporate tax “co-ordination,” an EU financial transactions tax and the re-deployment of EU funds in troubled countries as ways to spur growth and jobs. …Paris and Berlin have teamed up once more and drafted a six-page paper called “Ways out of the crisis – strengthen growth now!” …The financial transactions tax – a pet project of French President Nicolas Sarkozy ahead of his re-election bid in April – features among the six proposals under “efforts to reinforce the framework of financial market.” …plans for “tax co-ordination” and another Franco-German proposal to be put forward by end of February on the “convergence of their corporate tax.” “European institutions and member states should accelerate the process of tax coordination in order to foster growth” …Apart from the Tobin tax, both leaders want to speed up EU legislation on an energy tax and a “common consolidated corporate tax base.”

Even Obama is not this blind to reality. He’s a big fan of higher taxes, of course, but at least the President realizes you don’t pass the laugh test if you tell people that higher taxes will “spur jobs and growth.”

Returning to Merkel and Sarkozy, the dynamic duo of statism also have some bizarre ideas on the spending side of the fiscal ledger. Here are a couple of additional passages from the story.

…proposal would have 25 percent of unspent EU regional funds in countries under a bail-out program or under serious economic difficulties redirected to a special “fund for growth and competitiveness.”  …As for employment-boosting measures, one of Sarkozy’s make-or-break campaign themes, the document asks governments to instruct employment agencies to make an offer to every unemployed person – be it for a job, an apprenticeship or further training.

The notion that bureaucrats and politicians can boost prosperity with some sort of “fund for growth and competitiveness” is hardly worth a rebuttal. I’ll just wish them luck as they create European versions of Solyndra.

The other idea, though, is worth a bit more analysis. If the article is correct, the Merkozy twins are going to wave a magic wand and direct employment agencies to make an offer to everybody.

Gee, isn’t that wonderful. While they’re at it, why don’t they turbo-charge the wand and insist that all the offers be for jobs making twice the national wage. With this kind of magical thinking, it’s just a matter of time before 90 percent of the population is part of the top-10 percent.

You may be thinking the previous sentence doesn’t make sense, but that’s probably because you’re one of those crazy libertarians who doesn’t understand how higher taxes boost economic performance.

In previous posts, I’ve expressed some pessimism about the future of Europe. After considerable reflection, I want to retract those statements and instead say that the outlook is hopeless. If you’re reading this from Europe, get out while you still can.

=========================================================================

P.S. I’ve been reminded that Merkel and Sarkozy are not alone in their crazy theory that higher taxes are good for growth. The geniuses at the Congressional Budget Office have written that higher taxes are good for long-run growth, even to the point of implying that 100 percent tax rates would maximize economic performance.

P.P.S. I’m further reminded that the Congressional Research Service also seems to think that higher taxes increase economic growth. Perhaps German and French spies have taken over Washington?

I’m mystified, though, why some Republicans are willing to walk into such a trap. If you were playing chess against someone, and that person kept pleading with you to make a certain move, wouldn’t you be a tad bit suspicious that they weren’t trying to help you win?

When I talk to the Republicans who are open to tax hikes, they sometimes admit that their party will suffer at the polls, but they say it’s the right thing to do because of red ink.

I suppose that’s a noble sentiment, though I find that most GOPers who are open to tax hikes also tend to be big spenders, so I question their sincerity (with Senator Coburn being an obvious exception).

But even if we assume that all of them are genuinely motivated by a desire to control deficits and debt, shouldn’t they be asked to provide some evidence that higher taxes are an effective way of fixing the fiscal policy mess?

I’m not trying to score debating points. This is a serious question.

European nations, for instance, have been raising taxes for decades, almost always saying that higher taxes were necessary to balance budgets and control red ink. Yet that obviously hasn’t worked. Europe’s now in the middle of a fiscal crisis.

So why do some people think we should mimic the French and the Greeks?

But we don’t need to look overseas for examples. Look at what’s happened in Illinois, where politicians recently imposed a giant tax hike.

The Wall Street Journal opined this morning on the results. Here are the key passages.

Run up spending and debt, raise taxes in the naming of balancing the budget, but then watch as deficits rise and your credit-rating falls anyway. That’s been the sad pattern in Europe, and now it’s hitting that mecca of tax-and-spend government known as Illinois. …Moody’s downgraded Illinois state debt to A2 from A1, the lowest among the 50 states. That’s worse even than California. …This wasn’t supposed to happen. Only a year ago, Governor Pat Quinn and his fellow Democrats raised individual income taxes by 67% and the corporate tax rate by 46%. They did it to raise $7 billion in revenue, as the Governor put it, to “get Illinois back on fiscal sound footing” and improve the state’s credit rating. So much for that. …And—no surprise—in part because the tax increases have caused companies to leave Illinois, the state budget office confesses that as of this month the state still has $6.8 billion in unpaid bills and unaddressed obligations.

In other words, higher taxes led to fiscal deterioration in Illinois, just as tax increases in Europe have been followed by bad outcomes.

Whenever any politician argues in favor of a higher tax burden, just keep these two points in mind.

1. Higher taxes encourage more government spending.

2. Higher taxes don’t raise as much money as politicians claim.

The combination of these two factors explains why higher taxes make things worse rather than better. And they explain why Europe is in trouble and why Illinois is in trouble.

The relevant issue is whether the crowd in Washington should copy those failed examples. As this video explains, higher taxes are not the solution.

Heck, I’ve already explained that more than 100 percent of America’s long-fun fiscal challenge is government spending. So why reward politicians for overspending by letting them confiscate more of our income?

On today’s edition of Coffee and Markets, Brad Jackson and Ben Domenech are joined by Francis Cianfrocca to discuss the the top stories in politics, the marketplace and sports for 2011.

We’re brought to you as always by BigGovernment and Stephen Clouse and Associates. If you’d like to email us, you can do so at coffee[at]newledger.com. We hope you enjoy the show.

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So it’s especially noteworthy that economists at the European Central Bank have just produced a study showing that government spending is unambiguously harmful to economic performance. Here is a brief description of the key findings.

…we analyse a wide set of 108 countries composed of both developed and emerging and developing countries, using a long time span running from 1970-2008, and employing different proxies for government size… Our results show a significant negative effect of the size of government on growth. …Interestingly, government consumption is consistently detrimental to output growth irrespective of the country sample considered (OECD, emerging and developing countries).

There are two very interesting takeaways from this new research. First, the evidence shows that the problem is government spending, and that problem exists regardless of whether the budget is financed by taxes or borrowing. Unfortunately, too many supposedly conservative policy makers fail to grasp this key distinction and mistakenly focus on the symptom (deficits) rather than the underlying disease (big government).

The second key takeaway is that Europe’s corrupt political elite is engaging in a classic case of Mitchell’s Law, which is when one bad government policy is used to justify another bad government policy. In this case, they undermined prosperity by recklessly increasing the burden of government spending, and they’re now using the resulting fiscal crisis as an excuse to promote inflationary monetary policy by the European Central Bank.

The ECB study, by contrast, shows that the only good answer is to reduce the burden of the public sector. Moreover, the research also has a discussion of the growth-maximizing size of government.

… economic progress is limited when government is zero percent of the economy (absence of rule of law, property rights, etc.), but also when it is closer to 100 percent (the law of diminishing returns operates in addition to, e.g., increased taxation required to finance the government’s growing burden – which has adverse effects on human economic behaviour, namely on consumption decisions).

This may sound familiar, because it’s a description of the Rahn Curve, which is sort of the spending version of the Laffer Curve. This video explains.

The key lesson in the video is that government is far too big in the United States and other industrialized nations, which is precisely what the scholars found in the European Central Bank study.

Another interesting finding in the study is that the quality and structure of government matters.

Growth in government size has negative effects on economic growth, but the negative effects are three times as great in non-democratic systems as in democratic systems. …the negative effect of government size on GDP per capita is stronger at lower levels of institutional quality, and ii) the positive effect of institutional quality on GDP per capita is stronger at smaller levels of government size.

The simple way of thinking about these results is that government spending doesn’t do as much damage in a nation such as Sweden as it does in a failed state such as Mexico.

Last but not least, the ECB study analyzes various budget process reforms. There’s a bit of jargon in this excerpt, but it basically shows that spending limits (presumably policies similar to Senator Corker’s CAP Act or Congressman Brady’s MAP Act) are far better than balanced budget rules.

…we use three indices constructed by the European Commission (overall rule index, expenditure rule index, and budget balance and debt rule index). …The former incorporates each index individually whereas the latter includes interacted terms between fiscal rules and government size proxies. Particularly under the total government expenditure and government spending specifications…we find statistically significant positive coefficients on the overall rule index and the expenditure rule index, meaning that having these fiscal numerical rules improves GDP growth for these set of EU countries.

This research is important because it shows that rules focusing on deficits and debt (such as requirements to balance the budget) are not as effective because politicians can use them as an excuse to raise taxes.

At the risk of citing myself again, the number one message from this new ECB research is that lawmakers – at the very least – need to follow Mitchell’s Golden Rule and make sure government spending grows slower than the private sector. Fortunately, that can happen, as shown in this video.

But my Golden Rule is just a minimum requirement. If politicians really want to do the right thing, they should copy the Baltic nations and implement genuine spending cuts rather than just reductions in the rate of growth in the burden of government.

The U.S. unemployment rate fell last month to its lowest level in more than two and a half years, as employers stepped up hiring in response to the slowly improving economy.

The Labor Department said Friday that the unemployment rate dropped sharply to 8.6 percent last month, down from 9 percent in October. The rate hasn’t been that low since March 2009, during the depths of the recession.

Still, 13.3 million Americans remain unemployed. And a key reason the unemployment rate fell so much was because roughly 315,000 people had given up looking for work and were no longer counted as unemployed.

Employers added 120,000 jobs last month. And the previous two months were revised up to show that 72,000 more jobs added—the fourth straight month the government revised prior months higher.

Private employers added a net gain of 140,000 jobs last month. Governments, meanwhile, shed another 20,000 jobs, mostly at the local and state level. Governments at all levels have shed almost a half-million jobs in the past year.

More than half the jobs added were by retailers, restaurants and bars, a sign that holiday hiring has kicked in. Retailers added 50,000 jobs, the sector’s biggest gain since April. Restaurants and bars hired 33,000 new workers. The health care industry added 17,000.

The presidential election is less than a year away, which means President Barack Obama will almost certainly face voters with the highest unemployment rate of any president since World War II.

And Europe’s financial crisis threatens to slow U.S. growth next year. A recession in Europe could reduce U.S. exports, hurt global financial markets and dampen business confidence.

Read more here. Its a bit odd that if someone out of work gives up looking for a job they are no longer considered ‘unemployed.’ There are some legitimate reasons for this, but it is still a bit of a quirk which suggests some caution in evaluating the unemployment rate.

This is the worst-case scenario from Europe, and it just might come true: Italy defaults on its debts. Every major Italian bank collapses. Recession grips the eurozone. Sovereign defaults and bank failures ripple across the Continent. Saddled with bad loans to nations and lenders in Europe, American banks hemorrhage cash. Credit freezes in the United States. Multinational companies, unable to raise money, curb U.S. investment and hiring. Wall Street demands, but fails to get, new bailouts. The entire developed world plummets into recession and, quite possibly, depression.

This, in contrast, is the placid warning that President Obama gave Americans about the threat: “If Europe is contracting,” he said on Monday, “then it’s much more difficult for us to create good jobs here at home.” There’s still a chance that Europeans, through some combination of fiscal and monetary action, can stop the crisis before it shatters the feeble U.S. recovery. But the worst case is so much worse than Obama’s description, and Washington has failed to prepare voters for the possibility. “The [potential] shock we’re talking about is of very large magnitude,” says Viral Acharya, a New York University professor who studies financial risk extensively. “If you’re just having an Armageddon coming your way, [America’s] buffers may not be adequate.”

The eurozone’s struggles are already hurting the U.S. recovery. Stocks have fallen, and exports to the European Union—the world’s largest economy—are dropping as the Continent slides into recession. In the best case, the pain inflicted on the United States basically stops there. Europeans marshal the political will to bail out Italy and Spain, and they wall off Greece from the financial system at large. Lending slows but doesn’t stop. The European recession proves comparatively mild, and America avoids one.

But the situation could worsen quickly for the United States. The biggest risk is a massive credit freeze. Loans from European banks account for one-fifth to one-quarter of the American lending market, Acharya says, and loans from those banks would disappear fast if they begin tumbling under bad sovereign debts. American banks would likely pull back on lending, too. Consumers and businesses would curb spending. “The precipitating event for the global financial crisis and the Great Recession was the bankruptcy of a single, relatively small broker-dealer, Lehman Brothers. The bankruptcy of a nation as large as Italy would be many times more severe,” says Karl Smith, an economist at the University of North Carolina who cowrites the popular economics blog Modeled Behavior. “In theory, there is no limit to how bad it could get.”

Early warnings of economic doom will show up in indicators of credit stress—signs that lending has tightened here—such as the LIBOR rate (the amount of interest that banks charge to lend money to one another) and the TED spreads (the difference between those interbank rates and the return on U.S. government debt). Those indicators are already rising methodically. When they spike toward 2008 levels, watch out.

Read more here.