Debt, Democracy and the Welfare State: Are Modern Democracies Living on Borrowed Time and Money?

In this chapter, the development ofgovernment debt in the traditional OECD member states since the Second World War is traced. Some countries were saddled with a large debt as a legacy of the war, but their debt as percent of GDP gradually fell until the mid-1970s. After the energy crisis of 1973 the debt began to rise in most countries. In many countries the debt has continued to rise ever since, almost without interruption, and in some countries it has reached world war proportions. Some countries have managed to reverse the debt accumulation, all of them relatively small.

Government debt rises because expenditures exceed revenues. Expenditures are the result of government consumption and transfers. In this chapter the development of public expenditure and consumption in the traditional OECD countries in the postwar period is traced. Also shown is the annual growth rate of GDP. In most countries the growth rate was higher before the mid-1970s than later, which facilitated growth in public expenditures. In most countries public consumption has grown more slowly since the mid-1970s. Countries with the highest government debt are typically not those with the highest GDP per capita, nor the ones with the largest government expenditures or consumption.

The cost-disease model explains why the public sector expands in an economy with rising productivity. Because of the nature of most public services, the scope for increased productivity is limited. Therefore, if both public and private consumption are to expand at similar rates, labor will have to be transferred from the private sector to the public sector and taxes will have to increase. Raising public pensions on par with incomes in the private sector will have a similar effect, and a rising share of retirees will further strengthen this effect.

The beginnings of the welfare state are usually traced to the social legislation initiated by Chancellor Bismarck of Imperial Germany in the late 1800s. Social reformist politicians in the United Kingdom around 1900, such as Winston Churchill and Lloyd George, were in part inspired by Bismarck. The growth of the welfare state is traced to the widening of the franchise, the growing power of the labor movement, shortage of labor after the two world wars and the increased administrative capabilities of the state following the war effort. The welfare state is not just social insurance, but involves redistribution of income, bound to be popular with voters. Gross social expenditures vary greatly among countries, while the difference is much less when measuring net social expenditures.

Modern democracies are very different from the city-state democracy in ancient Greece, being ruled by competing elites, assisted by professional, permanent bureaucracies. To secure reelection, ruling elites have to pander to often ill-informed and disinterested voters. This is a formidable barrier to necessary reforms that in the short run are likely to be unpopular. Governing elites are tolerated and rewarded in good times and punished in bad times, even if they have limited control over events. Is democracy a way of governing in good times? Recent history shows examples of democratic elites pushed aside in times of economic difficulties by usurpers in waiting. Democracy is good at distributing the fruits of economic growth more evenly, possibly to the point of hampering or even reversing economic growth. Contrary to conventional wisdom, the roots of the industrial revolution lie in societies where only a fraction of the relevant age group had the right to vote. Recent economic miracles of East Asia all happened under enlightened authoritarianism, which in some countries has morphed into democratic government.

The European Union is a term way ahead of its time. Instead of a union, we have a half-way house between an international organization and a confederation. The EU is sometimes presented as a peace project, but a more sober analysis would look at its beginnings as a cooperation among previous enemies necessitated by new superpowers that had totally sidelined them as world powers. The current problems of the EU are often ascribed to a “democratic deficit,” but they are more likely due to the absence of a common European identity and little delegation of power that matters from its still sovereign member states. The debt accumulation problem of the euro countries, although no greater than that of the United States and Japan, is often ascribed to the absence of national currencies in the member countries of the Eurozone. The euro was, however, adopted in large measure to get away from the classical problems of devaluations used to bridge the gap between wages and productivity.

Sweden is one of the most successful countries in the world and one of the pioneers in building the welfare state. The welfare state was built on 100 years of virtually uninterrupted economic progress, which came to a halt in the 1970s. Sweden tried to cope with its rising unemployment and financing of an ever more ambitious welfare state by borrowing. Gross public expenditure and government debt both reached 70 percent of GDP in the early 1990s. Both welfare expenditures and government pensions were cut in the 1990s, and the accumulation of debt was reversed. Sweden is now one of the EU countries with the lowest debt ratio and has been able to avoid its rising again after the financial crisis of 2008. There appears to have been a wide consensus about what needed to be done among Swedish governing elites; economic reforms legislated by one elite were often prepared by expert groups commissioned by the other.

The welfare state is a nice thing to have, but we must be prepared to pay for it. The welfare state is built on the private sector producing the necessary material goods and the taxes used to pay for it. A too ambitious welfare state with its concomitant taxes may in fact hinder the growth of the private sector on which the welfare state is built. The accumulation of public debt in almost all rich countries is due to a rising gap between welfare ambitions of governments and their willingness or ability to let their citizens pay for them. Unfortunately,funds for a further increase in debt often dry up suddenly, with governments facing sudden problems in financing their ongoing deficits and renewal of existing debt. Sudden and deep cuts in expenditures or increases in revenue may then be necessary. The understanding among the electorate may lag far behind events, governing elites may suddenly lose their electoral support and usurpers or incompetent populists in waiting could be voted into office as untainted and worth a try. This is how the Nazis came to power in Germany about 80 years ago. The accumulation of public debt in rich countries will have to end, but whether it can be reversed in a timely fashion or will result in a political crisis and hyperinflation as in the interwar years is anybody’s guess.