Supply matters – but so does demand

Co-authored with Marcus Miller

At long last, the defenders of George Osborne’s deficit-reduction strategy have come up with a reasoned case.

The thoughtful argument in support of the UK chancellor is made by Ryan Bourne and Tim Knox, economists at the centre-right Centre for Policy Studies think-tank. They say that Britain suffered a huge supply shock following the recession of 2008. This left it not only with reduced output, but also – by undermining the banking system and by causing a big increase in state spending and the national debt – with less capacity to produce output.

Since the problem is one of reduced capacity, Bourne and Knox contend, expansionary monetary and fiscal policy will not solve it. Policy should, instead, aim at raising the “medium term growth rate”. How to achieve this? By a “relentless focus on reducing the burden of government spending”, combined with measures that include cutting welfare benefits and taxes, rehabilitating the banks, scrapping planning laws and opening up public services to competition.

The logic is the familiar one that high public spending, whether financed by borrowing or taxation, crowds out more efficient private spending. So even if their recommended transfer of resources to the private sector involves a large drop in current output, these transitional costs will be worth it. Policies to avoid or mitigate this cost are wrong-headed. We would be, as Bourne and Knox say, mortgaging our future. So it is more austerity we need, not less.

Restive rightwing backbenchers from Mr Osborne’s Conservative party, such as Dominic Raab and Liam Fox, who urge him to go further and faster down this road, dismiss the chancellor’s insufficiently austere policy – including the fact that he has twice revised his deficit-reduction schedule – as weakness of will. Indeed, they take the increase in public spending to be the explanation (together with the collapse of the banking system) for the UK’s miserable growth rate since Mr Osborne took office. Like those who blame the crutches for the patient’s inability to walk normally, they would kick away the crutches.

Bourne and Knox nevertheless advise further years of belt-tightening as a price worth paying to transfer resources from public to private sector.

Apart from the dire implications for income inequality, there is a flaw in their position: it ignores the subtle connection between demand and supply. Prolonged unemployment, or underemployment, destroys not just current but also potential output. A physics graduate may be able to find employment as a cab driver or waiter. But how much physics “potential” will they retain after years of doing such jobs? Economists call this “rusting away” of human capacity through disuse “hysteresis”. If an output gap is allowed to persist, the effect of hysteresis on skills and infrastructure is to reduce the growth potential of the economy itself.

Supply-siders and their Keynesian critics both agree that the government should help to protect and promote the output potential of the economy. The difference is that the supply-siders ignore demand and focus entirely on direct measures to improve economic efficiency, as listed above. By contrast, modern followers of John Maynard Keynes, both in this country and in the US, believe that an essential element of a growth strategy is to avoid a prolonged recession by acting directly to maintain demand.

We touch here on the oldest debate in macroeconomics. Early in the 19th century, the French economist Jean-Baptiste Say proclaimed: “Supply creates its own demand.” There could never be a shortage of demand, he said, because people necessarily spend what they earn, either on consumption or investment. But, in the conditions of the 1930s Great Depression, Keynes pointed out the fault in this logic. Money earned is not necessarily spent: part of it is saved, and savings may be held in cash. Indeed, the lower people’s confidence in the future, the more of their savings they will want to hold in cash. So demand can fall below supply.

With skills (or “human capital”) recognised as a factor of production, we can transcend this age-old division between supply-siders and demand-siders. Because of hysteresis, pure supply-side policies are not sufficient. Buoyant demand, though necessary for sustained medium-term growth, is not sufficient either: supply-friendly policies are also called for. As the recent London School of Economics Growth Commission report points out, the promotion of skills, the development of infrastructure and support for innovation are “the essential drivers of the productivity growth on which the UK’s future prosperity depends”.

In present conditions of depressed demand, the provision of more skills and better infrastructure in Britain is not a call for more mindless austerity. It is a call for productive investment by both government and private sector to create jobs today and to promote growth in the future. Surely we can all agree on that?

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