Government Subsidies

 

A Step Back for the Free Market or Necessary Tool?

Government subsidies - widely discussed and controversial - something you can often hear about in the news, accompanied by pictures of protesting Greek farmers, who are blocking the Bulgarian border using brand-new new agricultural machinery. Sometimes it might be French or Spanish farmers, also blocking something, no matter what, causing millions of losses.

But let us start with the definition of "Government subsidy": A benefit given by the government to groups or individuals usually in the form of a cash payment or tax reduction. The subsidy is usually given to remove some type of burden and is often considered to be in the interest of the public.

Now that we know what subsidies are, lets check on some numbers. The European Union spends around €59 billion a year on farm subsidies. The Common Agricultural Policy (CAP) is the most expensive scheme in the EU - accounting for more than 40% of its annual budget.

According to the new EU budget, farm subsidies will consume some 38 percent of it for 2014-2020, equivalent to 363 billion euros ($485.7 billion) of the 960 billion total. In the last program period (2006-2014) it was 417 billion euros. The general conclusion is that we spend billions and billions of euros on this - but is it effective? We'll get back on this later.

Just after the budget negotiations, French President Francois Hollande quickly claimed victory, saying that France had managed to maintain its farm subsidies while other nations saw theirs cut - The relative share of agricultural spending in the European budget will decrease, but I made sure to preserve the funding destined for our farmers, he told at news conference after the end of the 24-hour talks. This leaves me wondering, if the EU members are part of the union, because they are willing to walk together for better future, or they just race in some contest for taking biggest piece of the cake. It's also bringing up some questions about the lobbies, that influence the policy of the union.

Overall, farmers in the 15 older EU member states benefit much more from the CAP than the newer members. Nationally France benefits most, with about 17%, followed by Spain (13%), Germany (12%), Italy (10.6%) and the UK (7%).

For example, France, Spain and Germany benefit more, compared to Romania and Poland, although, in these two countries there is more people employed in the agriculture sector in absolute terms. Even Greece gets more subsidies. Here's how it looks like:

Correct me if I'm wrong, but to me this pretty much looks like "double standard". It appears that EU government decided that French, Spanish,  and German farmers deserve more subsidies per capita of employees, compared to their colleagues from Eastern Europe. How is this going to help fix the "Two-speed Europe" issue? Let me know, if you have any idea.

I would like to kindly remind you, that it was not long ago (on a very sad occasion), when president Hollande stressed, that France will defend European moral values with all available tools. He even managed to spare a tear or two (although I'm not sure if it was for the victims or the European moral values). There was a lot of talking about patriotism, fighting and for people who want to defend their nation and their way of living. My intention is not to downplay the terrible tragedy in Paris, but to make a point, that France (and others as well) is more eager to pay attention to European values at it's convenience, but NOT when it comes to defend the principle for equality with the European citizens, living from the other side of what was once called "The Iron Curtain". I can't see a better example of this, than the allocation of the farming subsidies, and let's not forget, that we are talking about billions of euros.

While I was putting together all the information above, a famous quotation from Alexander Fraser Tytler (1747-1813) was crossing my mind all the time: A democracy is always temporary in nature; it simply cannot exist as a permanent form of government. A democracy will continue to exist up until the time that voters discover that they can vote themselves generous gifts from the public treasury. From that moment on, the majority always votes for the candidates who promise the most benefits from the public treasury, with the result that every democracy will finally collapse due to loose fiscal policy, which is always followed by a dictatorship.
Although these words were spoken more that 250 years ago, everyone can see the parallels with "modern" Europe. Picture again the protesting farmers, all the riots, strikes etc., but can you blame people for wanting better future and life? Usually, this is how it all starts, and finally you end with the march of Marine Le Pen in France, Nigel Farage in UK, Podemos in Spain, Law & Justice in Poland, Viktor Orban in Hungary, Tsipras' Syriza in Greece... Far-left and far-right parties are popping like mushrooms and all promise a better life, even if it means to leave EU. They promise more money and more prosperity, and most important - spending of more public funds - and people are buying it. And all this is multiplied by the ongoing migrant crisis. Alexander Tytler's words are so true indeed...
If you think that this problem is specific to EU - I will have to disappoint you. For decades US is subsidizing the corn production, which led to modification of the entire food industry, consuming habits and farming methods. Now 70% of all food products in US contain corn in some form. Corn products are the main ingredient of all junk food, and they are also what made it so cheap (with the kind help of government subsidies of course).

I'm focusing on this specific issue, because it is affecting directly the entire global economy - unfortunately in a negative way. In spite of the common understanding, government subsidies are hurting the economy, and are completely inconsistent, if you are committed to capitalism, which is our case. In addition to this, subsidies are also causing the people consuming habits to change - by making given food the cheapest, you also make it the most affordable for people. In the next part of this publication I'll try to picture the general negative trends, that are result of this particular type of government policy.


Economic Consequences

Deflationary pressures

Government subsidies helped reduce Europe's reliance on imported food but led before long to over-production, and the creation of "mountains" and "lakes" of surplus food and drink. As we all well know, when supply exceeds the demand - the prices go down (just like the current conditions in the oil market), thus we can make the conclusion that government subsidies led to deflation in terms of food prices. In addition to this, subsidies are perfect ground for price dumping. Each food producer, as participant in the free market, naturally wants to be more competitive among others. Supported by the government subsidies, producers can dump prices, and as result lower them even more. At some point producers start to sell their products at prices, which are below the production costs (which wouldn't be possible without subsidies). So we have farmers dumping the prices and hurting each other inside EU, and on the other hand, acting against our international trading partners by exporting our deflation outside EU as well, thus hurting their domestic producers. It is well known that someone's trade surplus is equal to someone else's deficit. This is extremely unsustainable environment, that can easily collapse in conditions of financial instability. Remember the Greek farmers...

The majority of economists agree that inflation of 2%, or just below, is what's healthy for a given economy (whether this is true or not is a matter of another discussion). This is also the target set by the European Central Bank and it's president Mario Draghi. He said many times in the last 2 years that the institution will use all available tools in order to reach this target. Let's see how the ECB is dealing with this task so far:

As we can see, in the last 2,5 years ECB is not having much of success in reaching it's target. So far, all available tools include artificial lowering of interest rates (negative at this point) and Quantitative Easing (a fancy phrase for "printing money") for 1,6 trillion euros. This program will probably expanded in 2016, may be as soon as March. Very low interest rates are also part of the problem, as they create debt bubbles, including among food producers - combining this with the under-production-cost prices makes the entire sector extremely vulnerable to more dramatic economic events.
Many will argue that food and energy prices are not important since they are not part of the core inflation measurement. But "core inflation" is term, which is invented to offset the effects of temporary shocks in food and energy prices. However, what we are talking about here is not a temporary shock, but a long-term trend, which is result of EU policies. In addition to this, the crisis in oil prices, which is also not temporary, is causing even more pressure.
So we have ECB, printing and pumping money in the system and boosting debt with low rates, in effort to spur inflation and create growth. And on the other hand, we have the EU government providing subsidies, which indirectly result in deflation. The fact that two of the main European institutions have policies in severe conflict is very disturbing.


Resource reallocating shocks

It's very important to realize, that each money unit spent by government, is coming from taxes. This literally means, that the government takes money from the private sector and reallocates them to a certain place. This is hurting the free market directly, since it is causing disturbances in the investing policies of the private sector. Investors have to spend more money for taxes, which usually results in curbing capital investments and wages. Then government takes this money and injects it in the agriculture sector, for example. This is totally devastating for the free market and private sector.
The problem is that state administration doesn't have the same incentive, as the private sector, to invest efficiently and innovate. Led by profits and competitiveness, private sector always will be more efficient and will keep develop. On the other hand, when a state bureaucrat reallocates resources will only comply with certain predefined parameters, without being concerned if this is effective, or not. As result, the government is boosting given industry on the back of the entire private sector, thus hurting all European citizens, for example. It's very interesting how this policy of "taking from all and giving to one" goes under the name of "social policy" and "growth policy".  Best example for the results are the communist countries of 20th century. We now know, that when the state takes the entire economy under control it takes about 50 years for the system to collapse. And it was supposed to be social system...


Corruption

With each additional subsidy for farming, fishing, tourism or something else, the government needs to expand it's administration to manage the processes. This is the perfect environment for growing corruption - more licenses, more permits, more papers and more control mechanisms -  and on the other hand, another reason for more public spending. Investors and producers needs to pay more money "under the table" in order to get things done, otherwise it would be so slow, that losses will occur. Even the iron grip of the Communist Party in China can't stop corruption - simply because it's unstoppable, and can only be limited by reducing bureaucratic burdens. All this is another hit against the free market and the private sector.

The Keynesian theories for more government deficits and more public spending were supposed to come into effect only in times of recession and crisis. Now we see that they've become everyday normal.
These negative trends have long-term effects, and recovering, even if it starts today, will be very painful. Each step for more government deficits, more public spending and expanding administration is a STEP BACK for the free market. I believe that we should ask ourselves two questions: First, "Are we really committed in building true capitalism, and let free market and private sector find their balance?" and second, "Do we really want to take all European countries, and sew them together into one social-capitalistic Frankenstein, consuming tax money like a black hole?"

Remember the Greek farmers...




Sources: European Commission, BBC, Reuters, Bloomberg, Investopedia, Wikipedia, and my personal experience