Schumpeter in Malta

Europe urgently needs economic policies which support investment and fair pay rather than more austerity. 

The European Commission’s Spring 2024 Economic Forecast published recently predicts economic growth will be slow because “investment growth appears to be softening” and is “expected to pick up only gradually”. In particular, it highlights investment in housing and manufacturing as particular concerns. 

The situation could be made worse in the coming years as the EU’s Recovery and Resilience Facility (RRF) ends in 2025 and new fiscal rules risk placing strict limits on public investment by member states when they take effect in 2027. 

By contrast, the good news in the forecast is a result of public investment and some wage growth. The Forecast says that investment in non-residential construction has been boosted by public investment and that the little growth that has been achieved has been “largely driven by a steady expansion of private consumption, as continued real wage and employment growth sustain an increase in real disposable incomes.”  

The economic forecast is yet more proof that Europe urgently needs economic policies which support investment and fair pay rather than more austerity.  Yet we still have the European Central Bank disincentivising private investment with high interest rates. Meanwhile, new fiscal rules will risk putting a straitjacket on public investment and some conservatives claim falsely that wages are to blame for our economic problems ̶  when real wages will still not have returned to 2021 levels in all member states by next year. 

Looking at the investment picture, it is quite bleak. During the period 2015-2019, investment growth in the eurozone was not that great while the next three years were heavily impacted by the Covid period. In comparison, Malta’s performance between 2015 and 2019 was great and even better in the subsequent three years, though the latter figure was almost entirely due to a high growth in 2022.

Looking at the next three years, the eurozone forecast for investment as a percentage of GDP is uninspiring at an average growth of 0.97%. Although public investment will be around 3.4% of GDP, the average growth in investment in equipment will be 2.3% while construction investment will decline. The outlook for Malta is quite negative, with investment as a percentage of GDP expected to decline by 4.4% due to a steep drop in 2023 and despite a growth of 3.6% in public investment. The average growth in investment in construction will be negative, while investment in equipment will see a whopping fall of 46% in 2023 ̶ the latter figure however needs to be considered with caution as the Commission forecast does not have a figure for 2024-2025.

In the UK, the shadow chancellor Rachel Reeves has promised to lead the most “pro-growth” Treasury in UK history if Labour wins the general election and has promised that Labour will not oversee a return to austerity. What happens in the UK will still affect the EU, even if the majority of people there now believe that Brexit was a disaster and the UK should rejoin the bloc.

The EU’s major economy

In the EU itself, its major economy ̶ Germany’s ̶ economic weakness threatens to become chronic. According to the Commission, its economy will grow by just 0.1% this year.  While unemployment in Germany remains low, many companies complain about a shortage of skilled labour. Keynesian demand management is not the policy prescription.

A 1970s-style supply-side policy is being urged by Christian Lindner, federal minister of finance and leader of the market-liberal Free Democratic Party (FDP). However, Robert Habeck, the minister for economic affairs and climate action, from the Greens, favours by contrast a modern version, labelled ‘transformative supply policy’.

Traditional supply-side policy is characterised by the idea that the state is ultimately the cause of all problems, and the solution must therefore be to reduce its influence on the economy. The FDP’s programme is characterised by the demand for strict adherence to the Schuldenbremse (debt brake) enshrined in the Basic Law, the German constitution.

In principle, this fiscal rule requires a balanced national budget, the exception being a permissible deficit for the federal government of 0.35% of gross domestic product. At the same time, the FDP is in favour of extensive tax cuts and depreciation relief for companies, as well as tax relief for households with higher incomes. These would be complemented by cuts in social expenditures: the social-insurance-based statutory pension and the Bürgergeld (citizen’s income) for the long-term unemployed and individuals unable to work.

On the other hand, the ‘transformative supply policy’ preferred by Habeck has little in common with Hindner’s. Habeck is sceptical about the Schuldenbremse and has made no secret of the fact that he thinks the German debt brake is ‘very static’ and fails to distinguish between current expenditure and investment. Unlike Lindner, Habeck opposes a blanket reduction in corporate taxes. Instead, transformative investments should be supported in a targeted manner.

Why is this discussion in Germany so hugely important for the rest of the EU? Well, for a start, Germany accounts for 24% of the EU’s €14.7 trillion GDP. So, as they say, if Germany sneezes, we all get a cold. Also, though Germany no longer dictates EU economic policy, it still contributes by far the biggest chunk of the budget ̶ a whopping €19.7 billion compared to France’s €10 billion and Italy’s €3.9 billion.

The controversy between Lindner and Habeck is paralysing German policy. It boils down to the ever-present clash between the Neoclassical view ̶ where the perfect market always provides the best solution and the State is just a troublemaker ̶ and Joseph Schumpeter’s growth theory ̶ which focuses instead on the ‘reutilisation’ of available resources for completely new goods, innovation, and high credit creation.

Schumpeter’s theory

Who would suit Schumpeter’s description? Surely, somebody like Elon Musk, the American entrepreneurial innovator and risk-taker. And where did Tesla get the funding to bring its electrical vehicles successfully to market? In 2014-15, Musk received more than $2 billion in state subsidies and loans, primarily from Nevada and New York. So, rather than the banks, it is states that provide financial support for particularly innovative, and therefore also very risky, projects.

Schumpeter’s growth theory is important because it is based on three hypotheses, namely that credit growth has a positive impact on GDP growth; credit growth is independent of saving growth; and saving growth has no impact on GDP growth. The first two hypotheses are generally acceptable but the third one is quite controversial and disputed by other economists. 

Many important tests of the hypotheses have been carried out. One which bears mentioning is that carried out by Fabian Mayer et al of the University of Wuerzburg. Drawing on credit data from the Bank for International Settlements (BIS) database, the authors used dynamic indicators to analyse the impact of finance on growth for a panel of 43 countries.

The authors found a strong positive relationship between credit growth and GDP growth in both developed and developing countries, though for developed countries, the growth effect was only significant in the period before 2000. They could not find positive effects of savings on either GDP growth or credit growth.  

What can the EU do?

The evidence for the hypotheses that credit growth stimulates economic growth is very strong; yet the EU apparently does not look kindly on it. The European Investment Bank itself says, in one of its publications, that the capacity of many banks to lend to relatively high-risk sectors such as SMEs, and particularly to young, innovative firms, is seriously impaired by capital constraints.

The EIB considers the prospect of a continued stagnation of bank lending as a cause for great concern. It quite rightly notes that, if the dependence of European firms on bank lending continues, and if banks are unable to fully recover their capacity to provide the finance that European firms need, the result will be a further constraint to a respectable economic growth rate in Europe.

What can the EU do? For sure, there need to be more diversified sources of finance accessible for Europe’s SMEs. Better developed capital markets across Europe would help improve the resilience and efficiency of Europe’s financing structures in the longer term, not least because of the size and economic importance of the SME sector.
Another prerequisite is a more efficient allocation of risk, helping banks to share part of the risks of lending to SMEs with a wider range of investors. Facilitating a greater development of prudent securitisation in Europe – including SME loan-backed securitisation – is one way of doing this, allowing capital market investors to invest in SMEs, through banks, or even through more direct approaches.

Another approach, which it is important not to overlook, is the greater development of credit guarantee schemes. Both public and private solutions can be considered. Banks’ risk-taking capacity and their room for new lending needs to be spurred, by increasing their ability to resolve or dispose of non-performing loans as well as addressing deficiencies in national regulations and institution.

Risk of missing out

It is, therefore. not that difficult to see that Germany’s problems are also those of the EU, which is now at risk of missing out on the Deep Tech Revolution, falling behind the US and China when it comes to innovation in various technologies.  Consider that over half of recently established deep tech companies are found in the US, and in 2022, $51 billion (€46.6 billion) was invested into US deep tech – more than double the European investment of around $20 billion (€18.3 billion).

This gap is seen in particular in AI. Investment in AI for 2024 in the US is estimated to be around $100 billion (€91.4 billion) – 50 times that of Europe if you consider the generous estimate of $2 billion (€1.8 billion). China is also rapidly catching up with Europe, investing significantly more in technologies such as autonomous mobility and generative AI.

The chart shows that, within the EU itself, there are wide divergences in innovation. Unsurprisingly, the Scandinavian countries top the rankings. Most of the lower places are occupied by East European countries. One might say that Malta’s 17th place is not bad, but it’s below the average and nine places below Cyprus.

The innovation lag in Europe comes from complacency, believing scientific achievements would inevitably result in innovation and foster economic growth. However, deep tech innovation cannot be guaranteed through science alone. Interestingly, a report from November 2023 finds 95% of Europe’s patents remain inactive, never finding their way into companies or products.

Innovation is regularly associated with inventions that have successful reached the market domain, whether in products and services. But that is too narrow a definition and it actually includes other types of innovation, such as management innovation and organisational innovation.

It is also important to note that inventions entering the market are not only dependent on efforts by individual firms but sometimes they are to be viewed as part of industry or market sectors (industrial ecology) or part of trajectories with multiple actors (networks for innovation).

Europe spends too much time talking about regulation and not enough about how to stimulate innovation. The American computer scientist and writer Paul Graham put it succinctly in a post four years ago. His remarks are still valid. We get our communications and business platforms almost exclusively from the US. Meanwhile, we source the hardware from China. If this hardware needs to be operated, we tend to outsource this to the lowest bidder, again almost exclusively delivered from outside of Europe.

US vs Europe

How is the situation different in the US than in Europe? For a start, in the US the expectation value of launching/joining an innovative (startup) organisation is relatively speaking far better than taking a normal job. In Europe a less exciting job offers a pretty good expectation value, whereas a startup might ruin you, and gets you into mortgage and tax problems.

Then, talented people have a choice of careers. In Europe we steadfastly underpay technologists. Though many people get into engineering and programming, a larger number gets swayed by better paying jobs in financial engineering and other non-productive shenanigans. The response here to far higher US salaries for technical people is always that money is not the only factor.

In Europe we outsource technology, as we don’t really consider it a core activity. Not only do we not appreciate technologists; we also penalise founders. Banks, tax agencies, and even family members distrust startups and will make life difficult for you.

Another factor is that Europe is not an attractive destination for ambitious immigrants: we do not have major companies with immigrant CEOs (compare Microsoft and Google).

A bigger dose of Schumpeterian economics would certainly help the EU and Malta deepen tech innovation and significantly drive long-term economic growth. 

Main photo: Shutterstock

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