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The importance of the supply-side

    There’s something deeply annoying about the debate surrounding spending cuts, both here and in much of mainland Europe. Governments have allowed opposition parties and public sector workers to frame the current response in terms of austerity vs. growth – accepting as axiomatic that increased Government spending is a prerequisite (a guarantor even), of prosperity. This, despite all the academic evidence which suggests otherwise.

    Over the past week I’ve realised why this polarised debate has developed. It stems from two very different views of recessions that mirror the debates between Keynes and Hayek during the Great Depression. Essentially, the two sides are looking at the current circumstances from very different perspectives.

    Those in favour of austerity are largely explaining the continued poor growth in terms of the unsustainability of the preceding boom. They believe they have identified the causes: too much debt, a property bubble, and excessive government spending – which all came crashing down during the financial crisis. They believe the economy will only meaningfully recover when the economy adjusts, that the growth of recent years has been illusory due to the expansion of debt, and that this illusory growth was masking the deficiencies of increasingly uncompetitive western economies.

    Like Keynes in the 1930s, advocates of more ‘stimulus’ are less interested in the genesis of the slump and more concerned with the puzzle of dealing with the persistence of high unemployment. They view their proposed interventions as a means of ‘getting us back to growth’ and regard the crisis as a temporary phenomenon which the Government can solve by supporting demand backed by increased borrowing. They blame Government spending restraint, or at least the announcement of Government spending cuts, as having caused the double-diprecession. By reversing these planned cuts, they believe the party can continue.

    Perhaps unsurprisingly, I’m more inclined to the first view. Tim Morgan’s superb analysis by sector shows that following the credit boom over the past decade, the UK’s economy has developed so that 60% of GNI in 2009 was in industries dependent on either borrowing, mortgage issuance or increasing public expenditure. Removal of this pool of easy credit inevitably impacted on the economy. The process of deleveraging and rebalancing will take time. In other words, the past growth was unsustainable.

    Sustainable economic growth only comes through increasing productivity. As Raghu Rajan writes in his Foreign Affairs essay, this is not automatic - it requires maintaining – and increasing - competitiveness. It requires a more skilled workforce, yes – but also a more efficient economy that incentivises wealth creation and encourages saving and investment.

    It’s for this reason that the Government here, and those in the eurozone, need to be doing much, much more to improve the supply-side of their economies. Tough reforms cannot be put off – a large artificial inflation of the economy via fiscal stimulus is off the cards for many of the southern European countries and undesirable for countries like the UK. For those inside the eurozone, the ‘inflate and devalue’ option associated with an expansive monetary policy is not available.

    Many who favour the Keynesian solutions dismiss the role supply-side policies can play in improving growth. In particular, they dismiss deregulation and labour market liberalisation.

    Strangely, these people also tend to say ‘we should be more like Germany.’ They admire Germany’s more robust employment performance since 2008. But what they seem to conveniently forget is that Germany undertook significant supply-side reforms through the 2000s to both make themselves more competitive and their economy more flexible.

    It had to. When Germany first entered into the euro alongside the PIIGS, her low inflation resulted in the country having the highest real interest rates in Europe. This stifled growth, increased social expenditures and reduced tax revenues. Without the ability to engage in monetary policy, and with fiscal policy constrained by the Stability Pact, Germany recognised the need to internally devalue. That is, it had to undertake tough supply-side reforms to drive up its international competitiveness.

    Germany’s large industrial unions in the export sectors decided to protect existing jobs through wage restraint – a supply-side strategy that allowed employers to capture most of the productivity gains in the hope of stabilizing employment by improving the profitability of domestic production and the competitiveness of German industries in international markets. Between 2000 and 2005, the Government managed to reduce taxes on company profits and capital incomes, to lower the level of employment protection, primarily by deregulating temporary and part-time employment, and to drastically cut benefits to the long-term unemployed in order to reduce the reservation wage of job seekers.

    In fact, the downturn after 2001 paved the way for a paradigm shift in labour market and social policies as well as new deregulatory reforms. The Hartz reform packages together with the controversial ‘Agenda 2010’ meant a transition from human capital oriented labour market policies to a stronger emphasis on, for example, reinforcing jobseekers willingness to take up even low paid jobs. This meant stricter job search monitoring, harsher provisions in unemployment benefits and a shift from long-term training and direct job creation measures to shorter programs aiming at an accelerated reintegration into the labour market.

    Unemployment insurance benefit duration for older workers was shortened from 32 to 18 months, which effectively removed a de facto early retirement tool. Even more important was the merger of earnings-related, but means-tested unemployment assistance and social assistance into ‘Arbeitslosengeld II’, a general minimum income support scheme with strong activation requirements as part of the ‘Hartz IV’ reforms.

    Other types of atypical work were also liberalised. Newly established firms were allowed to use fixed-term contracts for up to four years without requiring special justification. Agencies could now repeatedly hire a worker only for the length of his assignment in a user company. In 2003, the prohibition on agency work in the construction sector was abolished. As agency work was seen as a promising tool to integrate unemployed into the labour market, staffing agencies were introduced into active labour market policies. These new work types were supplemented by modest reforms of the core labour market. For example, in 2004 the firm size threshold for dismissal protection was lifted again to ten employees and employees were allowed to opt for severance pay instead of taking legal action.

    The benefits of these changes can be seen in Germany’s recovery and strong export performance from 2005 onwards – it went into the crisis in comparatively good shape nationally and employment has recovered more quickly since the crisis than most other EU countries (though an undervalued currency also helps!). The same, to a certain extent, can be seen in America. America’s lower tax burden and deregulated labour markets have meant it almost always recovers much more quickly than the countries of Western Europe. According to the World Economic Forum, it has the most competitive fire and hiring practices, the third most competitive retention rate of skilled workers and the least rigid employment of any country worldwide. Those who attribute its stronger recovery to Obama’s stimulus are mistaken. This stimulus was largely extending unemployment benefits and protecting State budgets – the equivalent of the UK’s automatic stabilisers. Instead, it’s the US’s flexibility and faster deleveraging which have seen it recover sooner.

    Likewise, to blame austerity alone on the current woes of the southern European countries would ignore just how uncompetitive they were at EMU and how their competitiveness has further declined – but was previously cushioned by lax monetary policy and easy credit. By denying this is to assume that the prior spending was sustainable. This is the context in which the current cuts to expenditure must be seen.

    Let’s take Greece and Spain. Of 142 countries in the World Economic Forum’s Global Competitiveness Report, they have the 128th and 110th ‘most’ competitive ‘extent and effects of taxation.’ In other words, Greece and Spain were less competitive than Venezuela. Greece is 135th on ‘ease of starting a business’ and is in 100th place for ‘ease of doing business’ (behind Yemen). Both rank near the bottom of the list for “a strong link between pay and productivity”, “flexibility of wage determination” and “hiring and firing practices”. Both have high taxes – and are increasing them - as part of their fiscal consolidation. Both score poorly on the effects of government regulation and experience significant ‘brain drain’.

    Are the advocates of more spending really saying that these things do not matter for the prosperity of these countries? Are they really saying that these things aren’t important when a business is deciding where to invest in a country?

    Now, there is a strong argument (as made by Howard Flight) to suggest that in countries like Greece, the country is so far behind that it is impossible for internal devaluations to improve competitiveness. But if the Greeks want to remain in the euro (as opinion polls suggest), then they either a) have to make these huge structural reforms, b) have to receive large transfer payments from the stronger economies like Germany, or c) to have the Eurozone experience significantly higher inflation. The drastic cost of a), especially given the measures are being imposed by outside bodies, means that this option looks untenable. As Germany is not going to foot the bill directly or indirectly, b) and c) are ruled out. So, for Greece, an eventual euro exit and devaluation is likely. But those of us who think this is now the least bad option should not be under any illusions that this too will be extremely painful. And there is no guarantee that eurozone exit alone will have a significant boosting effect on the economy. Greeks have already lost 10-12% in nominal wage terms, but the economy is still tanking. Without many of these necessary supply-side reforms in future, Greece is unlikely to have a prosperous and productive economy.

    Thankfully, the UK is not in anywhere near such a grim position. But the same principles apply. There are many factors which prevent or depress productive activity outside of government tax and spending totals. It’s obvious when you think about it: as an investor, would you be more or less likely to put your money into a country which is contemplating new wealth taxes, has high business taxes or introduces new regulations which require you to spend time complying with?

    Would you be more or less likely to start a business if employing people meant the threat of expensive employment tribunals, if it was difficult to fire poor performing staff or your employees working hours were strictly regulated?

    Would you be more or less likely to move into the labour market if you faced marginal tax rates of 96% due to the removal of benefits and the new taxes you would pay?

    Supply-side reforms or structural reforms, unlike stimulus programmes, are sustainable and bring long-term improvements in productivity. They are the tax cut that doesn’t cost any money. The welfare and education reforms started by this Government will have hugely beneficial impacts on the productiveness of the workforce, but alone they are not enough. Fundamentally opening up more public services to competitive pressures, reforming employment legislation and a large-scale rethink of the tax system to lower marginal rates could have hugely beneficial effects – not just to growth, but to the robustness of our economy to any future crisis.

    We’ve tried fiscal stimulus. We’re doing monetary stimulus. Our problems are much deeper than simply reflating back to some trend growth path. The supply-siders have been side-lined for too long. It’s time to embrace the supply-side agenda.


    Ryan joined the Centre for Policy Studies in January 2011, having previously worked for a year at the economic consultancy firm Frontier Economics.

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    Adam Dixon - About 3421 days ago

    Last time i checked, it was de regulation that caused the financial crisis.

    Bretton woods ere Keynsian economics seems attractive now, compared to the nation breaking Neoliberalism this 1% supporting think tank touts.

    Remember the Manufacturing we used to have, that somehow Germany managed to keep. It tolls for thee Cameron, the British public are tired of taking the Brunt of the recession when there globalist millionaires are still growing and sapping money out of the economy to tax havens.

    Scandinavia and Germany have much more sustainable economies than ours and you know it.

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