The Myth of the Exploding Welfare State

10/29/2012 04:39 pm ET | Updated Dec 29, 2012

By Martin Eiermann

Public debt has become the main argument against the welfare state. But the two are barely related.

Five years have passed since the advent of the current crisis, and while the beast has since morphed from a financial crisis into a confidence and debt crisis, some mantras have become so deeply engrained into our collective psyche after loud proclamations and endless repetitions that they feature is almost any discussion about the future of the economy or, for that matter, the future role of the state. They have assumed the status of self-evident truths and have reduced public discourse to the squabble over fitting solutions. The mantra itself is taken for granted.

The myth of the link between the welfare state and the debt crisis is one such mantra. It posits, roughly, that the excessive welfare state has been responsible for out-of-control public spending and must be cut back down to size in the name of fiscal sustainability. This discussion is especially nascent in Europe, where austerity has become the name of the political game. Already in February 2010, the German foreign minister Guido Westerwelle proclaimed (to a domestic audience), "Those who promise effortless prosperity to the people are inviting late-Roman decadence. This is the kind of thinking which will lead to Germany's decline." Philipp Rösler, another German politician and the head of the liberal Free Democrats, likewise proclaimed that crisis must not result in increasing burdens for the well-to-do. Similar sentiments are echoed by leaders across Europe: We must look no further than across the English Channel, where British Prime Minister David Cameron recently argued in a speech on the welfare state that "for far too long in this country, people who can work, people who are able to work, and people who choose not to work: you cannot go on claiming welfare like you are now."

An important component of international conditions imposed on countries like Greece (and, to a lesser and less formal extent, on Spain or Portugal) is to ensure precisely that: People won't be able to go on claiming welfare like they are now. In Greece, the government has stated that it will more thoroughly examine the wealth of welfare claimants, which sounds legitimate and reasonable but is usually a euphemism for hidden welfare cuts: For the reduction of the size and duration of unemployment benefits, for the Greek 22 percent cut to the minimum wage, for the restriction of collective bargaining powers in the US on the state level, for the privatization of health care in Britain or for health care cuts in Ireland.

The argument is always the same: In light of heavy public debt, such welfare expenditures have allegedly become unsustainable. For too long, the people have apparently lived above their pay grade and have relied on the state to provide for them (cue in Romney's "47 percent" comment here) without considering whether the benefits are financially sustainable. The welfare state entrenched promises and entitlements that it cannot guarantee any longer. The cuts, we hear, are no vicious payback campaign against the working class but simply a reminder of harsh realities. In London, Labour leader Ed Miliband accomplished the rhetorical feat of condemning the government's welfare cuts and warning against "tough choices" almost in the same sentence.

Thankfully, welfare expenditures have been recorded for decades by national governments, by the Organization for Economic Cooperation and Development (OECD), by the International Monetary Fund (IMF) or by the EuroStat statisticians. We can rely on data to check whether generalizing claims about the unsustainability and inevitable death of the welfare state hold up. We can even submit the alleged link between crisis and welfare expenditures to empirical scrutiny.

1. The welfare state isn't out of control. In examining the sustainability of welfare expenditures, the critical number isn't the total amount of expenditures but their relation to GDP. Simply put, the relation between welfare costs and GDP tells us whether a country can afford its welfare state. As long as the economy grows (economists use GDP growth as a proxy for economic growth), welfare expenditures can grow as well. When more money is available, more can be spent -- for example, to finance social programs or public health initiatives. Whether that money is indeed spent wisely is a political question, not an economic one.

According to the OECD, welfare expenditures in its 34 member countries rose steadily between 1980 and 2007, but the increase in costs was almost completely offset by GDP growth. More money was spent on welfare because more money circulated in the economy and because government revenues increased. In 1980, the OECD averaged welfare expenditures equal to 16 percent of GDP. In 2007, just before the financial crisis kicked into full gear, they had risen to 19 percent -- a manageable increase.

Let's look at one country in particular: In Germany, the National Office of Statistics reports that welfare costs rose from 423.6 billion euros in 1991 to 754 billion euros in 2009. During the same time, however, welfare expenditures as a share of GDP barely increased, from 27.6 percent to 31.9 percent. This trend is even more obvious if we discount the first two years of the crisis (which saw an increase in welfare spending as unemployment rose and social problems became more pronounced) and focus on the years between 1975 and 2006. Again, German welfare expenditures increased, but their share of GDP actually declined from 30.7 percent to 30.3 percent. Measured in relation to the overall wealth of the country, welfare costs decreased.

As long as the rise in welfare costs doesn't drastically exceed economic growth, the much-maligned current system remains financially viable. (Another factor to consider is the increased reliance of governments on private welfare savings -- a decision that has itself come under scrutiny from several economists -- that has already reduced the role of governments for providing pensions or healthcare and has shifted welfare costs from the treasury onto the citizen).

2. The welfare state isn't responsible for the debt crisis. Public debt has risen quite significantly since 2008, especially in the eurozone. The average debt increased from 80 percent of GDP to 87 percent, and countries like Greece and Ireland saw much larger increases. According to data by the OECD, industrialized countries tend to carry the largest debts -- the G7 now average gross public debt of over 125 percent of GDP. It's tempting to conclude that those countries all have extensive social safety nets and high public welfare expenditures, and that the former must somehow be causally linked to the latter. But a country's debt doesn't correlate with the size of its welfare state. The three European countries with the biggest welfare state -- Denmark, France, and Sweden -- aren't exactly fiscal troublemakers.

The American economist Paul Krugman recently published a graph that plots state spending against interest rates. If it were true that higher state expenditures increased the fiscal precariousness of a country, an extensive welfare state would presumably correlate with higher interest rates for government bonds. Investors would demand higher returns for riskier investments, and the government would have to pay higher interest rates on its debt. To make a long story short: Again, no correlation exists. Almost all eurozone countries fall in the interest rate range between two percent and four percent, regardless of whether state spending amounts to 41 percent of GDP (Slovakia) or to 58 percent (Denmark). At the same time, countries with similar levels of public spending (around 50 percent) face drastically different interest rates, from Sweden (2 percent) to Greece (18 percent).

We cannot explain the fiscal problems of countries like Greece with the size of their welfare state. Instead, it is more likely that the housing bubble (in the U.S.), the real estate bubble (in Spain), misguided budget planning and political nepotism (in Greece), deregulated derivative trading, risky speculations, and -- since 2009 -- taxpayer-funded bailouts of banks, industries or other countries have contributed to the ballooning of public debt. Gert Wagner, head of the German Institute for Economic Research, concludes: "Upon closer inspection, the rise in expenditures can hardly be blamed on a bloated welfare state and state bureaucracy." Almost three-quarters of German debt since 1990 can instead be traced back to the costs of reunification or to the rescue packages for the Eurozone. In the U.S., the Congressional Budget Office estimates that U.S. budget deficits are almost entirely due to the Bush-era tax cuts, the wars in Iraq and Afghanistan, and the costs of the economic bailout.

3. The welfare state isn't about to collapse. While the welfare state cannot be held responsible for the current crisis, another important argument remains: Demographic change will make it unsustainable in the future even if it remains viable at present. Between 1965 and 2007, life expectancy rose by several years in most industrialized countries while the average retirement age continued to decline -- by as much as nine years in France. Fewer young people finance the retirement of more old people, who are also reliant on their pensions for longer. (A reader pointed out that the precise extent of demographic shifts is disputed, but the principal point remains valid.)

But this is no full-scale argument against the welfare state: It is first and foremost an argument for pension reform. Current forecasts expect costs of unemployment insurance, subsidies for families and anti-poverty programs to remain steady until the end of the century. Heath care costs will rise: The Congressional Budget Office expects an increase of around 10 percent of GDP but also concludes that the increase could be offset by changes to the tax code. If we subtract the additional costs of demographic change, the share of health care costs in America would even decline slightly, thanks to "Obamacare".

The sluggish pace of economic recovery and demographic change do pose a challenge. But it's not a challenge to the welfare state generally, and it's not insurmountable. It is misleading to demand cuts to unemployment benefits as unavoidable, or to argue that the job market must become more "flexible" and more reliant on temporary and part-time employment schemes. Yet this is precisely what is happening: The crisis has provided the context in which the dismantling of the welfare state has become politically feasible. We can currently observe the social fallout of welfare austerity in the streets of Athens or Madrid.

Warnings against unchecked welfare spending have a long tradition. They are regularly invoked by liberal and conservative politicians - and amplified by the media -- during budget discussions or whenever the discussion focuses on "free riders" and the incentivization of work. Even the social-democratic Left has become enmeshed in this tradition and bound to its myths: The promise of politicians like Ed Miliband (in the U.K.) or Peer Steinbrück (in Germany) appears to be that they'll do a better and fairer job of administering welfare cuts -- not that they'll rethink the narrative.

As long ago as 1993, then-chancellor Helmut Kohl argued in Germany that "we cannot secure our future by organizing this country like an amusement park." That was almost 20 years ago. The arguments were similar -- and the eurozone crisis wasn't on anyone's radar yet.

This piece originally appeared in The European Magazine.