Prosperity problem: Index reveals the winners and losers since 2008 crash

Sponsored insight: The Great Recession of 2008 left economies in tatters around the world. The recovery has been slow and some nations have fared better than others. But the Legatum Institute's Prosperity Index shows that the most successful governments had two things in common: they invested in small businesses, and kept their citizens' trust.

The best-selling item at Virginia Ferrasin's pasta shop in Alessandria, a town in Italy's industrial north-west, was rabaton. The local Piedmontese specialty – small pouches of herbs, flour and ricotta cheese – are favoured by frugal housewives looking for a cheap way to satisfy hungry bambini. During the 20 years she owned her shop, the fortysomething divorcee also made fresh tortellini, agnolotti and tagliatelle; sauces ranging from vegetarian pesto to meaty ragu; and crostate – traditional jam tarts. "Towards the end I added pizza, too," she rolls her eyes in horror at the admission: the Piedmontese look down their nose at the Neapolitan staple. "I was ready to try anything to keep the shop going. But it was no use."

Two years ago Ferrasin closed her shop. Her experience exemplifies Italy's decline. Gone are the days (the late 1980s) when Italy's network of small firms and industrial giants powered the country's economy to overtake Britain's, in what commentators dubbed the "sorpasso". Today, Italy has become the sick man of Europe. The financial crisis hit this weak economy hard: GDP growth hit a record low of -5.5% in 2009; and in the last quarter of last year, it contracted by 0.4%. In the 2014 Legatum Prosperity Index, which ranks countries not only on GDP but on other indicators of wellbeing such as health, safety, trust in government, Italy ranks 37th – behind Uruguay, Slovakia and Chile.

While stagnating GDP squeezes customers' incomes, Italy's dysfunctional state squeezes its entrepreneurs like Ferrasin. She complains of high costs – not for her raw materials, like eggs, flour and meat, but for the high taxes levied by the government and high bills imposed by Italy's old-fashioned and inefficient utilities. Italy's corporate taxes are among the highest in the EU at 31.4% (the UK's, by comparison, are 20%). The average wholesale electricity price is the second-highest (Ireland is the first) in Europe, at 62/MWh.

In a friendlier business environment, Ferrasin would have responded to the downturn by raising productivity and offering services with more value added. She considered home delivery, but high labour costs and stifling labour laws discouraged her.

Italy's rate of job creation has been poor as a result: unemployment has been running at 13% – compared with 4.7% in Germany, 5.5% in the US, and 5.4% in the UK. Youth unemployment too soared to 40% – compared with 7.4% in Germany, 11.9% in the US and 16.3% in the UK .

Help, in the form of tax breaks or subsidies, was not forthcoming. Beyond the burdensome inspections and bureaucratic hassles, Ferrasin felt her business was not competing on a level playing field: "I knew there were others who were breaking the laws, but because they were ready to bribe the officials to look the other way, they were getting away with it."

The low growth rate is only one indicator: Ferrasin is now employed at the checkout in a local supermarket. But her entrepreneurial spirit has been broken.

The Mediterranean's social breakdown

Italy's near-bankruptcy is not only economic. Its once bounteous social capital has grown miserly. The country that American political sociologist Robert Putnam hailed in 1993 as a thriving society with solid institutions rooted in personal connections, where everyone took part in church choirs, sports clubs, literary circles and rituals rich in folklore, is no more. Today, only 17% of Italians volunteer, a third of Italians give to charity and just half have helped a stranger recently. The comparison with other countries should leave Italians red-faced: 32% of Germans volunteer, 49% give to charity and 61% have helped a stranger recently. In the US, 44% volunteered, 63% give to charity and 76% helped a stranger. In the UK, those figures are 32%, 75% and 63%.

Although the family continues to be of importance, marriage rates in Italy have halved since 1965, while religious attendance, once integral to daily life, has slumped to 48%. This picture of a people bereft of emotional, social and financial support extends beyond Italy to other countries in the Mediterranean – Spain, Portugal and, above all, Greece – who all scored poorly in the Prosperity Index. Yet, while these countries face a bleak scenario as they struggle on their road to recovery, Canada, New Zealand, America and Britain emerge from the Prosperity Index as success stories.

The Index shows clearly the winners and losers since the 2008 financial crash. By considering education, health, safety and security, personal freedom and social capital in each country, as well as economic sub-indices, the Index measures a country's real performance.

A pattern emerges: countries whose governments invested in creating opportunities for businesses, and whose citizens enjoyed trusting and plentiful relationships, scored highest in the Index. They survived the financial crisis and are now well on the road to recovery. Entrepreneurs thrive when the government supports business by keeping start-up costs low, taxes fair, and offering the kind of tax breaks that incentivise innovation. In a country like this, Ferrasin would have been able to trust institutions, from the local council to the guild of pasta makers, for support and confidence.

In between the two poles – the Club Med countries and their opposites – are the majority of OECD countries, which mostly show sluggish growth since 2008. These offer a mixed record. But their scores confirm how prosperity requires both strong social bonds and a business-friendly environment: strong scores in one area cannot make up for low ones in the other. Estonia, for instance, despite being the darling of businesses for its transparent high-tech government and entrepreneurial spirit, ranks below Poland in the Prosperity Index, because the Poles – who also score well on entrepreneurship – enjoy strong bonds of family, religion and charity.

How to beat a recession

Too many policy-makers and politicians focus exclusively on increasing productivity and employment figures and shrinking private and public debts, pointing to these trends as indices of success. In doing so, however, they risk overlooking the factors that create trust and an environment where people can thrive.

Any strategy to support the recovery of those nations worst hit by the crisis must address their social capital and innovation. It is not enough for the EU, the IMF, the European Central Bank to take on the tax evasion, inefficient public spending and ownership and closed professions that blight Mediterranean countries. They must address the lack of trust and optimism that constrains these nations.

In this special report, we show how Greeks, in a country that has become one of the least prosperous in the rich world, struggle to start even a small business, their efforts frustrated by government corruption and institutional incompetence. When taxes are among the highest in the OECD countries, take 198 hours to file each year and deliver badly run services in return, entrepreneurs and ordinary citizens feel dissatisfied.

The report also illustrates the success stories since 2008 – New Zealand, for instance, which has risen to No 3 in the Prosperity Index. Even as the country slid into recession, New Zealand was investing in R&D far beyond its economic weight and the government was lowering start-up costs and improving the regulatory environment. Today the country ranks second on the World Bank's measure for ease of doing business. Yet its economic success is rooted in social resources that were already high as the crisis started but grew after 2008.

Some countries have taken up the challenge of building social capital and innovation for improved prosperity. Britain's then coalition government, and, in particular, its Secretary of State for Work and Pensions, Iain Duncan Smith, successfully implemented policies to promote work, stronger families, volunteering and charitable giving. In Ireland, meanwhile, the government climbed out of the recession by implementing pro-business legislation and taxation. Its headline corporate tax rate at first 20%, now only 12.5% and double tax agreements have led digital giants like Google and Facebook to set up their EMEA headquarters in Dublin.

This report argues that standard economic analysis, which decrees that countries stuck in low-growth and high debt have little room for manoeuvre, ignores an important opportunity. To stage their own recovery, countries like Italy and Greece should be open to the audacious scheme proposed by Dag Detter, a Swedish public policy analyst: catalogue all government-owned public assets and hand them over to a more efficient management – thereby saving $75trn globally. That could mean lower taxes for business, better infrastructure and public services – all of which improve the business environment and citizens' trust in their institutions.

The road into the mess

Global affluence reached unprecedented levels between mid-2007 and mid-2008: American house prices reached an all-time high in March 2007; the UK's followed in November; inflation in Europe was at a steady 2%, and unemployment reached an all-time low in early 2008. But the good times came to an abrupt end on 15 September 2008, when Lehman Brothers filed for bankruptcy and plunged the global economy into the "Great Recession", registering negative growth for the first time since the Second World War. The 30 OECD economies shrank 4.2% between the first quarter of 2008 and the first quarter of 2009. The banking crisis severely curtailed normal bank lending, resulting in a fall in investment and consumer spending. The fall in house prices risked dragging many owners into negative equity, which also affected spending. The global nature of the crisis affected trade, too, lowering demand as exports fell worldwide.

The worst affected countries were those in the Mediterranean: Italy, Spain, Portugal, Greece. These four countries slid into the recession from an already weak position. Productivity growth faltered in the run-up to 2008. According to the OECD, Portugal saw productivity growth of 0.2% between 1995 and 2011, while Spain saw no growth at all and productivity declined in Italy and Greece. Business creation dipped. The Greek economy creates around one new business per 1,000 people per year, while the Italian economy creates about two and the Spanish and Portuguese economies around 3.5 businesses (Britain produces an average 9.5 new businesses per 1,000 people per year and New Zealand about 20.)

More than a quarter of Greece's working age population is unemployed; in Spain unemployment stands at 24%. 75,000 public sector jobs were cut in Greece, with a further 75,000 expected to go. Labour markets that protected those in work to the detriment of those outside, coupled with economies that failed to produce jobs, gave rise to high youth unemployment – rates increased by over 30% in Spain and Greece and by nearly 20% in Italy and Portugal.

But such dire economic stats were only part of the story. Unemployment and productivity were aggravated by a lack of resilience among citizens. Like the Italians, only a few Greeks in 2008 reported that they regularly volunteered (7%) or that they helped those in need (34%). The figures were 15% and 46% for Spain, and similarly low for Portugal.

When the downturn came, this weak social capital meant that few people exhibited the altruism that fuels giving to charity or caring for the elderly and infirm. With no support from civil society to mitigate their burden, the poorest suffered worst from the crash. The financial crisis in these countries eroded more than its citizens' good intentions. It undermined their trust in national institutions.

Since 2008 or 2009, confidence in the government has nosedived across the Mediterranean. Most dramatically, 58% of Spaniards had confidence in the government in 2008, while this figure now stands at 21%. Half of all Greeks had confidence in the government in 2006, now only one in five does.

Few citizens of the Club Med countries believed their homeland offered the opportunity to work themselves out of their situation. Instead of feeling they lived in a land of opportunity, would-be entrepreneurs in Mediterranean countries faced an obstacle course: in Italy it costs 14.1% of gross national income or $5,056 to start a business. In the UK it only costs $125 and in New Zealand it costs $107. It takes 1,580 days in Greece to enforce a contract, such as a payment dispute with a supplier, and 38 separate procedures must be completed.

The problem of tax

The perception that corruption is endemic in society has grown in the Mediterranean countries. Citizens now judge the government to be just as corrupt as business. People aren't paying their taxes because they see little benefit in doing so and avoiding them is easy because of tax systems which have grown increasingly complex as a result of corruption. The total tax rate (% of commercial profits) for these countries is high: for Greece, it was 49.9% in 2014; in Italy, it was 65.4%, in Portugal, 42.4%, in Spain, 58.2%. This is almost as high as some Scandinavian countries where the state delivers taxpayers far better and more efficient services, from schools and hospitals to child care and roads.

According to the World Bank, filing and paying taxes in Greece requires 193 hours per year. In Cyprus it takes 147, in Denmark 130. The Bank's Ease of Doing Business Index, which ranks countries from one (top) to 189 (bottom) in terms of how business-friendly they are, placed Greece at 61, Italy at 56, Spain at 33 and Portugal at 25.

As a percentage of GDP, New Zealand's government collects almost the same amount of tax as Spain, Portugal and Greece, but the Mediterranean countries do this with far higher tax rates. Income tax rates are significantly higher in Greece, Portugal and Spain (almost 20% higher in Spain's case), while corporation tax rates are about the same.

No one may be paying tax, but that doesn't mean that they are not working. Greece, Portugal, Spain and Italy all have large "shadow economies". The shadow economy refers to economic activity that is not inherently illegal but is unreported or undeclared. It ranges from sole traders not declaring earnings to large firms that under-report profits. A World Bank paper estimated that Greece's shadow economy is worth around 26.5% of GDP, Italy's is worth 26.8%, Portugal's is worth 23% and Spain's is worth 22.2%. Contrast this with the United States, which has a shadow economy of around 8.4% of GDP, or the UK and New Zealand, with shadow economies of around 12% of their GDP. The result of a large shadow economy is reduced economic output. As well as taxes going uncollected, businesses stay small and workers are paid less. Trust in institutions is also further undermined: as the shadow economy grows, workers balk at paying taxes and the problem compounds.

No wonder that only 36% of Italians when surveyed last year thought that where they lived was a good place to start a business.

Cruel Britannia warms its heart

The stereotype of the Mediterraneans as warm-hearted and generous has taken a beating during the recession; so has the one of the British as stiff upper-lipped, crusty and individualist. The data in the 2014 Prosperity Index showed instead a nation so charitable – 74% had donated to a charity in the last month – that it ranked third in the world. One in three volunteered, and more than half had helped a stranger recently.

Moreover, when asked if they could rely on the kindness of family or friends, most British people answered a resounding yes. The image of Cruel Britannia was replaced with a caring sharing nation rich in terms of social capital.

Though partly the legacy of a long tradition of civic engagement, Britain's thriving social capital since 2010 has been bolstered by government policy. Prime Minister David Cameron launched a campaign, the Big Society, to stoke support for good causes. Cameron appealed to "small platoons" of volunteers to breathe new life into local community organisations. But his attempt to orchestrate for charitable impulses failed to stir the public imagination – and the idea soon floundered.

Iain Duncan Smith, the Secretary of State for Work and Pensions, sought to tackle the benefits system, whose counter-productive incentives eroded family ties as well as initiative. Claimants had found that staying out of work and living off the government earned them more than a job; and that living apart from the father/mother of their children would earn them benefits that were denied a married couple.

In 2013, Duncan Smith introduced Universal Credit, which removed these incentives and simplified the multi-layered and confusing benefits system. He rolled out a programme to help the long-term unemployed find, train for and stay in work. The Credit contributed to a "jobs miracle" that turned Britain's economy around: more than 1.9 million jobs have been created over the past five years, which was more than in the rest of Europe put together. The percentage of households in which no one had worked dropped by 14%.

Duncan Smith sought to develop policies that promoted relationships beyond the workplace. The Work and Pensions Department rolled out a raft of policies: free relationship counselling, both before marriage and cohabitation, and during couples' difficulties; nurses' visits for first time young mothers, and help for troubled families.

Their impact has been encouraging: more than 48,000 couples have participated in relationship counselling; nearly 160,000 people have accessed preventative relationship support; over 12,000 practitioners trained to help support families experiencing relationship difficulties; and 250,000 more children are living with both their birth parents.

The department also invested in civil institutions, giving grants to the charity and voluntary sectors. The £36m Social Action Fund supported 215 models to engage volunteers in a wide range of activities, from mentoring young children to organising community sports days. Funding also went to a programme that connected wealthy people with charities that needed their support. Duncan Smith feels his approach has been vindicated: "Building social capital through social investment offers a way forward," he says, "It ensures that each and every pound we spend has a demonstrable purpose."

Challenges remain. Affordable housing is critical to improve social cohesion, but prices for homes across the UK have soared: fewer than one in 10 properties are affordable to single house-buyers, while in London house prices rose £50,000 a month over the 2012-13 period. Renting proved equally prohibitive – working out as £1,000 more expensive per year.

For Nick Boys Smith of the Create Streets campaign, "too many large buildings are a short-term, unsustainable, energy-inefficient, socially divisive, wrong form
of capitalism – the architectural equivalent of the banking crisis which prioritised interests of short-term investors and intermediaries above the long-term interests of society and the rest of us".

The Irish model

While Britain decided to invest in civil society as a means to regain prosperity; and Ukraine to invest in civil society as an alternative to the government, Ireland chose to boost innovation. Ireland has opted for a series of state interventions to create a climate so business-friendly that some of the world's biggest companies – including Google and Amazon – have set up headquarters in Dublin.

Ireland's four million inhabitants came into the recession with strong social capital – enjoying strong family bonds, engaging in community and religious life, and giving to charity (73% of the Irish did so). But alongside the financial crash and collapse in the property market, falling productivity, low levels of female participation in the labour force and a comprehensive property tax were acting as a brake on the Celtic Tiger's continued growth. By 2010 unemployment in Ireland hit 17.5%, and one person was leaving the country to look for employment abroad every six minutes.

Ireland's Taoiseach (prime minister) Enda Kenny was determined to reverse
the trend. Last year he published a policy statement on entrepreneurship, ensuring public support for start-ups: "Government cannot create entrepreneurs and start-ups, but what we can do is remove barriers and support an environment where more businesses can start."

Start-ups that qualify may pay no corporation tax in their first three years. To encourage investment activity, the government launched an Employment and Investment Incentive (EII) to provide relief for Irish taxpayers when they invest in startups which meet certain criteria. Ireland has a largely favourable tax regime, with a headline corporate tax rate at just 12.5%, combined with double tax agreements. Technology giants like Google, Facebook, Twitter and Amazon (and many more) have put their EMEA headquarters in Dublin, contributing to
an ecosystem of digital innovation that is helpful for those just starting out. Ireland has more technology accelerator programmes per capita than any other European country, and more venture funding available per capita.

Enterprise Ireland, a government agency working to accelerate the development of Irish enterprises, offers equity investment to innovative High Potential Startup clients, investing in partnership with other investors in a founding round. One High Potential Startup is Soundwave, a mobile music-discovery company based in Dublin. Founded in 2012 by Brendan O'Driscoll (CEO) and Aidan Sliney (CTO), its free app allows users to see what the people they follow are listening to on their smartphones, in real time. Brendan advised that anyone looking to set up a business in Ireland should "take advantage of all the great resources that are available right now like accelerators, incubators, pitch days, meetups, grants and co-working space". The country has more technology accelerator programmes per capita than anywhere else is Europe; in an attempt to be a world leader, Ireland offers two relatively new visas through the Start-Up Entrepreneur Programme and the Immigrant Investor Programme.

The way out

In 2008, the average New Zealander was poorer than the average Greek, and a great deal poorer than the average Spaniard and Italian. Its "sorpasso" of those nations bears out the Prosperity Index findings, that a government determined to promote prosperity needs to invest in social capital and innovation.

But governments can do more. With the state being the single largest owner of assets in nearly every country, central governments manage vastly more commercial assets than private equity firms, pension funds, or the super-rich together. The value of public commercial assets is on the same order of magnitude as annual global GDP – and comfortably higher than global public debt. If central governments managed their assets better, they should easily generate additional annual returns of $3trn. In their forthcoming book The Public Wealth of Nations, Dag Detter and Stefan Fölster show how these assets can provide a boost to public prosperity.

Public discussion around prosperity tends to focus on who gets what and how much we have, rather than on whom we become as individuals and as a society. Yet, as the Great Recession has shown, countries that pursue only an agenda of economic recovery will fail to flourish. Countries, instead, that invest in new ideas and individual well-being – above all, by promoting trust – are more likely to recover.

Government and policy-makers are able to do much to turn their country around. They can ensure that the state incentivises enterprise, charitable giving and volunteering, rather than reinforcing the structures that stifle it. They can focus on getting investment into start-ups that deliver in the future rather than over-invest themselves in short term projects. In this way, government can stoke people's confidence and earn their trust, creating a climate where everyone can prosper.