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The Decline and Other Myths of the Supply-Side Pessimists

The Decline and Other Myths of the Supply-Side Pessimists

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The temptation of pessimism is greatest when optimism would require people to alter their worldview. I attribute the rise of supply-side pessimism, as notably proselytised by the likes of Andrew Lilico and CityAM’s Allister Heath, to this.

Yet the basis of supply-side pessimism is largely speculative. They cry “structural damage” because the austerity policies that they endorsed have failed to provide the growth that they forecast. That the economy did not rebound much faster than it has was not, the argument goes, because expansionary fiscal contraction was an unwise response to a severe economic shock but because the productive capacity of the economy has been significantly (and perhaps permanently) impaired.

To build policy around such speculation, however, would be folly. Why raise interest rates, and condemn struggling households and businesses to painful cuts or default, before there are clear signs of domestic inflation pressures? Why assert that 7% is the “new normal” non-accelerating inflation rate of unemployment (NAIRU) while almost one million young people remain out of work?

In Duncan Weldon’s latest blog post he suggests that much of this creeping theme of declinism reflects political rather than economic concerns. Declinists claim that the pre-crisis growth rate was inflated by excess leverage, and that the underlying trend was labour’s declining share of output caused by oversupply. That is, there were simply too many people chasing too little work for competition for workers to keep wages rising – and more importantly, there is nothing that policy can do about it. 

I am sympathetic to the argument that globalisation and the fracturing of the labour union movement has weakened labour’s bargaining position. But I think there are a number of good reasons to resist the conclusion that this suggests an inevitable fall in living standards and structurally higher levels of unemployment.

Firstly, as Mark Carney stated earlier this month at his first Inflation Report press briefing, although there are tentative signs of improvement in the UK economy “underlying domestic inflationary pressures remain subdued”. Those claiming that the UK is sitting on an inflationary powder-keg need to explain why CPI has been pushed over target by a combination of “past increases in import prices and an unusually large contribution from administered and regulated prices”. Though he was too polite to say so explicitly, this suggests government policy has been a key factor in propping up inflation over 2% in recent years.

Secondly, papers examining the empirical case for the NAIRU in recent years have challenged the assumed relationship between unemployment and inflation. Roger Farmer’s recent paper, for example, found that rather than a sharp pick up in inflation when unemployment is low, as suggested by the traditional Phillips curve, the data suggests that there is no consistent correlation between the two. As such he concludes that there is no “natural rate” that unemployment trends towards - so we need not fear the kind of wage/inflation spiral that haunted policymakers in the 1970s.

Moreover, the lingering attachment to out-of-date assumptions about the NAIRU could in itself be a cause of economic damage.  Servaas Storm and C.W.M. Naastepad at the Delft University of Technology found that “overly restrictive macro policies, in the OECD countries, have actually and unnecessarily thrown millions of workers into unemployment by a policy-induced decline in productivity and output growth”. Though their work is far from conclusive, it is certainly of note that fear of a wage spiral could have contributed to the European Central Bank’s strongly criticized decision to raise interest rates in 2011 against a worsening economic backdrop.

Their findings appear to support Weldon’s conclusion that the answer to Britain’s current economic malaise is a combination of:

“Corporate governance reform, policies supportive of collective bargaining and an increasing wage share, looking at how the minimum wage can be strengthened and the living wage extended, how the tax system can encourage business models that are better for the national economy and the wider role of industrial policy in rebalancing the economy towards higher waged, higher skilled, higher productivity jobs.”

I find little to disagree with there except in one aspect. The reason why we now have little to fear from wage inflation is at least in part a consequence of the labour reforms of the 1970s. By reducing the ability of workers to demand inflation-proof salary hikes the likelihood of a self-feeding stagflationary outcome has been much reduced. Going back to the days of Wage Councils, or mandating a wage share, may only repeat the problems of the past even as we seek to address those of the present.

Furthermore, if Chris Dillow and Janan Ganesh are correct in their oversupply of labour thesis then increased collective bargaining may not offer workers much protection – there will always be plenty of “scabs” willing to cross the picket line somewhere in the world.

The flexibility of the workforce could be a great strength of the UK economy, providing that it does not force living standards down to unacceptable levels. Winding it back would not, therefore, be optimal economic policy. Instead the government should be looking at more creative solutions – including  schemes that directly hire the unemployed (particularly the young) or following a Basic Income-type model that would effectively set a price floor for labour.

The bottom line is that the weakening case for the NAIRU means policymakers have a lot more room to experiment with ways of reducing unemployment and raising living standards. There is no alternative is not an acceptable response.    


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Tomas Hirst

Anton,

I don't really understand your objection. The piece above does not advocate "slightly out-of-date economic theories" but rather is a discussion of the growing evidence against a "natural rate of unemployment" as suggested by Phillips/Friedman/Phelps etc.

Of course the solutions to the current malaise in developed countries must address the realities of globalisation, as I say. It would be folly to attempt to unwind global supply chains that have increased the quality of life for so many on both sides and that is why I think tying policy to arbitrary unemployment rates is unwise. In my opinion governments and monetary policymakers need to start coordinating their actions to prevent high unemployment from becoming entrenched and the hysteresis effects causing the very structural damage that the supply-side pessimists fear.

That is my hope, though not yet my expectation.

I think we need to look more globally rather than the slightly out-of-date academic economic theories quoted above. 50 year old economic papers....
Loss of manufacturing employment in UK is more about emerging markets increased share of the home market than it is about historical political theories pertaining to Europe in the 20th Century. Its more like a global steam roller...

Most EMs have a very poor and large workforce. They now have modern high-tech production solutions and can export mountains of high quality goods at laughably low prices. (lets talk about deflation in another post...)

Back to Europe for a minute - Greece. A common example of a struggling economy in Euroland.
Is the Greek workforce comparable to other workforces? The GNI per capita in Greece is about $23000 per annum. In UK its is $38000. The UK still seems to perform better than Greece, but for other reasons than pure cost of labour. OK, currency devaluation compared to Germany - blah blah blah.

The Chinese GNI per capita is about $6000 per annum and the Indian figure is $1600. So India's workforce is 14 times cheaper and there's up to a billion people. That's just India.

India supplies retailers like Primark and Clarkes Shoes. Further, the standard of Indian clothing and shoe making is now far surpassing anything that UK could design. They have the intelligence and the technology. So even the former UK advantage on quality and standards is no longer true.

I hope readers can draw their own conclusions without me, rather patronisingly, spelling them out.

But, the solutions are economic and workable, it *should* mean more goods and services for everyone if we can only get the economics correct. There is enough supply and there is enough demand at present, but its more a global issue.

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