Big Government Is Turbo-Charging the U.S. Economy. Can It Transform Europe?

When it comes to “more government,” Americans are supposed to be the skeptical ones. Yet the U.S. is now leaning on the state to transform the economy by giving trillions of dollars to consumers and even taking a more direct hand in industrial planning.

In government-loving Europe, political limitations may prevent a comparable economic boost.

Next week, the European Union will start approving member nations’ spending plans as part of the bloc’s €673 billion pandemic recovery package. Analysts expect Europe to bounce back strongly from Covid-19 but, unlike in the U.S., they forecast permanent economic damage.

More money will go to countries most in need: Spain and Italy will receive grants making up 6% and 4% of their gross domestic products, respectively. Although spread over many years, this isn’t insignificant. Spanish officials believe it could boost economic growth by 2 percentage points a year.

But can it also help fix the deep productive imbalances that have turned European stocks into chronic underperformers? A broad analysis of the Italian and Spanish proposals suggests that only 11% and 22% of the funds, respectively, will be spent nurturing specific industries where underperforming nations might gain an edge.

Indeed, most of the money seems earmarked for projects such as refurbishing buildings, modernizing infrastructure and helping small businesses go digital—all worthy goals that boost demand and help the climate, but probably less transformational.

Economists have found a tight link between prosperity and exports of complex products and services, as expressed by both American technology leadership and German manufacturing might.

As Europe has become more economically integrated, the periphery has fallen further behind the more industrialized North in terms of GDP per hour worked—except for some Eastern European nations that have benefited from offshoring. While the South retains some prowess in making cars, it has suffered disproportionately from post-1990s deindustrialization in less-advanced sectors dominated by suppliers that depend on other firms for innovation.

Italy’s Treasury found in a 2018 analysis that 59% of its exports are exposed to significant competition from China, compared with around 40% for its peers, due to the country’s focus on textiles and labor-intensive parts of the manufacturing supply chain. Losing its ability to depreciate the currency after the euro’s creation in 1999 was particularly damaging. Spain remains overly reliant on tourism, and has diversified into less complex goods.

The question is how to change this entrenched division of labor.

Since the 1980s, economists and policy makers have rejected “vertical” industrial strategies, which hark back to Alexander Hamilton’s 1791 “Report on Manufactures,” on the basis that picking winners and losers creates inefficient companies. EU law further blocks members from providing their industries with unfair advantages.

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Instead, most Western officials have focused on “horizontal” spending that promotes basic science and modernization across all sectors. The argument goes: If governments in Italy and Spain wrote better regulations and invested more in technology and education, they wouldn’t be stuck with small firms focused on low-tech products and kept alive by low interest rates.

But in the last few decades, horizontal policies on their own have done little for the laggards. The Pentagon’s research money may have fostered the internet, but EU “cohesion” funds spent in the South failed to boost productivity. Meanwhile, both Covid-19 vaccine development and breakneck growth in East Asia are examples of the power of government pre-purchase agreements and vertical planning to foster innovation and chart a path out of underdevelopment.

Now that the West fears losing its economic lead, it is slowly shifting gears. On Tuesday, the U.S. Senate passed a $250 billion bill designed to help American companies face off against China, which includes building up domestic semiconductor capacity. The EU is granting antitrust exemptions to climate-focused industrial policy.

Yet Northern Europe seems more predisposed to identify favored sectors. Italian and Spanish officials remain reluctant, even though the Harvard Kennedy School of Government’s Atlas of Economic Complexity ranks Spain first—ahead of India and Turkey—in opportunities to shift from lower-skill exports to more complex products in fields like machinery and pharmaceuticals.

Spain plans to invest €10 billion in the auto sector and build an electric-vehicle battery factory near Barcelona, plus spend a further €1.6 billion to promote clean hydrogen production. Pictured here is a hydrogen bus that will circulate in Madrid.

Photo: Alberto Sibaja/Zuma Press

To be sure, the EU’s green agenda has provided a welcome backdoor for some vertical bets. Spain plans to invest €10 billion in the auto sector and build an electric-vehicle battery factory near Barcelona, plus spend a further €1.6 billion to promote clean hydrogen production. But these are crowded areas: In 2019, the EU already cleared €3.2 billion for developing batteries, three-quarters of which went to “core” countries. So far, the European race to build battery factories is led by Sweden’s Northvolt.

Investors should welcome Europe’s turn away from austerity policies, but remain skeptical of fixes for its lopsided economy. Redistributing wealth is difficult to reconcile with investing it productively, since the bloc’s delicate political balance makes it hard for the South to build up firms that challenge Northern industrial supremacy.

Europe may want more government, but not always where it is most needed.

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