Tuesday, November 14, 2006

The Microeconomics of Europe

Regular readers of this blog will know that fertility, and particularly its tattered state in Europe, is a favorite theme of mine. The Economist magazine has a great summary of what economic theory has to say both about why fertility is declining and the implications. Much of the declining-fertility story in Europe boils down to some relatively simple economic ideas:

Free Riding: The decision to have a child, given the existence of state pensions, has benefits for other citizens, but allows each citizen to draw on the contributions of others having children as well. This is a classic recipe for free riding – contributing to a good only insofar as there are private benefits, even though the benefits to others are substantial. Each child pays taxes that provide public-pension benefits for everybody, but the costs of that child are borne only by the parents. The parents, seemingly secure in the knowledge that most of their retirement needs can be met by the children of others, are likely to have few themselves. But this is how everyone behaves, meaning that the national cradle is nearly empty. (If you are comfortable with formal economic research, this working paper provides evidence that more generous state pensions are associated with lower birth rates.)

Economic Growth: In many Western European countries, per capita GDP is roughly 70% that of the US. According to conventional growth theory, since the production technology is the same everywhere, these countries should converge toward the US standard of living. But they stopped doing this roundabout 1980. This is because the taxes needed to support the welfare state deter wealth creation and because laws designed to protect existing workers make it irrational to hire more (which keeps present companies from growing and destroys the incentives to found new ones). Globally, Europe is still rich, but if present trends continue the gap between France and Germany on the one hand and the US on the other will in a single generation’s time be like the gap between Romania and the US now.

Innovation: Technological advance is a risky enterprise. The aforementioned factors deter not just growth in the existing sorts of things, but the creation of new ideas that help humanity. Critics of what they see as the “obsession” with economic growth by many economists argue that we have enough stuff, and don’t need more. But economic activity is fundamentally an exercise in problem solving – figuring out ways in which humans have unmet desires, and then rearranging scarce resources in a (risky) attempt to meet them. The less (for the above reasons) people attempt risky entrepreneurial innovations, the less we progress technologically. This is not just about having fewer Big Macs or a plasma TV that is a little bigger. It is the difference between having more medical innovation and not, between solving environmental problems and not, between pulling hundreds of millions of people out of desperate poverty and not, and so on. It is the difference between solving the many human problems that remain unsolved and not. When Europe drops out of modern global competition, they cease to contribute to technological progress. Since I have very recently posted> that demand in the US increasingly drives medical innovation regardless of the extent to which US medical problems are synonymous with global medical problems, I was glad to see this point make it into an outlet as widely read as The Economist. (I have also notedthat India and China will increasingly make up, perhaps more than make up, for Europe’s growing absence, but Europe’s absence is still costly.)

The one omission from the Economist piece was the idea that Europe’s population decline may be exacerbated by emigration by its most creative, least risk-averse individuals. It is these people who most move the entrepreneurial frontier forward, but in many European countries they are punished by high levels of taxation and the near-impossibility of laying off workers during bad times. Some of these creators of progress will decide not to take their risks and deprive humanity of what they have to offer, but many of them will end up in the US or Britain or even India or the UAE. (See a report about this phenomenon in Germany here.) That is good for the world in that it lessens the total global cost of the European social model, but it means that Europe will continue to shrivel up until it, essentially, blows away like a tumbleweed down the streets of a once-flowering Great Plains ghost town.

All the economics one learns in the principles classes actually explains quite a bit, including the long sweep of human history. If present trends continue, the US will continue to be a nation with a relatively modest welfare state and thus a much higher rate of economic growth, innovation, and dust contribution to human progress. On the other hand, if we were to go down the European path, the impact not just on Americans but on the rest of the planet would be catastrophic.


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