There is a new religion in economic policy. It’s a more modern view of supply-side economics, with converts on both the right and left. But what that means and how it can be achieved divides policymakers. The different paths taken by the UK and Europe might provide some insight.
Prices and levels of economic activity are determined by supply and demand. The supply is what the economy produces and the demand side is its appetite for goods and services. Politicians can tinker with both.
The supply economy used to have a bad reputation. In the 1980s, it was believed that by cutting enough taxes, you would stimulate enough growth that the tax cuts would pay off. That may be true when marginal taxes are very high — as at more than 95% — but at more normal levels it was wishful thinking. Tax cuts are not free lunches. While the move can increase growth, that growth is usually not enough to make up for lost tax revenue.
So the supply economy became a punch line. Supply issues such as what the economy can earn from workers’ skills and restrictions on starting or building a business received less attention or were downright derided. The approach fell completely off the radar during the Great Recession, which decimated household balance sheets and caused people to spend less. Instead, policymakers thought they could grow the economy by stimulating demand: giving people money to spend, or by government spending more.
Consumption is a big part of the economy, so the idea was that if the people or the government demanded more stuff, that would create more growth. Some economists have argued that demand across the economy is insufficient even during booms, requiring much government spending regardless. Increasing demand became a political goal until the emergence of Covid, when the pandemic curtailed supply. Attempts to stimulate demand in 2020 and 2021 ran into inflation, so attention has been drawn back to work on the supply side.
And that brings with it a return of free-lunch thinking: that more stuff and productivity and cheaper housing and all that excess will bring inflation down. Surely it’s long overdue to worry about supply. Take housing: there are many building restrictions that limit supply, which is one of the reasons why prices are so high (prices are also high because the government is subsidizing demand, but that’s so popular politically that nobody wants to touch it).
But there are already disagreements over how best to boost supply. Liberals are more inclined towards industrial policy, meaning the government selects desirable industries and gives them tax credits and subsidies to increase production. Traditional conservatives are avoiding a way out: they want less regulation and lower taxes. The difference is whether you think growth comes better from individual initiative and business creation, allowing markets to direct their own investments, or you think it’s better for the government to decide where the resources go.
The government approach makes sense when you think markets are sending capital to the wrong places, or when the economy needs projects that require so much fixed investment that the government needs to make the first move.
The Biden administration has primarily followed this more state-run approach, which outlines many of the provisions in the Build Back Better bill (although much of the original plan failed Congress). Chances are we’ll see more of this. Conservatives in America have also become fans of industrial policy.
And now we have what it takes for a real-world experiment overseas. Britain’s new Prime Minister wants to try tax cuts and claw back regulations. The hope is that this would reduce disincentives to work, innovate and start new businesses. So far, the markets have not been very receptive, to say the least. In part because the timing suggests the government will not prioritize inflation as it intends to finance proposed tax cuts with higher deficits. There is also good reason to believe that any growth would be thwarted by further rate hikes by the Bank of England in its fight against inflation.
The execution and communication around Liz Truss’ proposed cuts was also atrocious, as Clive Crook points out. But some of the criticism and market reaction was overdone. The tax cuts weren’t actually that big, about £45bn ($52bn) of their £160bn overall plan – and only about £2bn of that has been reversed. A lot of money goes into energy subsidies. And the basic idea is sound, allowing growth from the ground up by removing economic barriers and perverse incentives.
Meanwhile, Europe is getting far less attention for trying out the government-led approach and spending a similar amount of money relative to its GDP. The EU, which has never introduced regulation it didn’t like, has allocated €806 billion ($804 billion) for various forms of industrial policy, including digital infrastructure and battery production, plus another €1.2 trillion for Europe’s Green New Deal (the war in Ukraine could change these plans), with individual countries making additional expenditures to achieve these goals. France, for example, has a higher debt ratio than the UK, but plans to spend €100 billion (40% funded by the EU, the rest with debt) on the initiative. European governments also spend heavily on energy subsidies.
So which approach works best? It depends. The key to future supply-side growth is the innovation that generates it. This is the only free lunch because if you innovate you can make more things with fewer goods and improve the standard of living. But innovation is inherently a messy, risky and unpredictable process. Industrial policy doesn’t have a great track record of picking winners — it’s difficult when there’s so much uncertainty about which innovations will be the big game-changers. When there is a clear need for a project and it is well executed, like Operation Warp Speed for Covid vaccines or the Manhattan Project to create nuclear weapons, government investment can be effective. Infrastructure spending can also accelerate growth if you choose the right projects, though there’s been some real clunk and waste there too.
Tax cuts also depend largely on implementation. Tax cuts funded by deficits are less effective, and the best tax reform eliminates loopholes and other distortions and tax cuts. Deregulation also has a good track record when done well.
I’m a market oriented person, so I prefer the get out of the way approach. I have more faith in individuals and a market that rations risk than in government bureaucrats. But which approach works better really depends on how well it’s executed and what problem it’s trying to solve.
Both spending and tax cuts can be inflationary, at least in the short to medium term, as supply can take years to expand while the impact of spending or tax cuts on demand is felt immediately. Nonetheless, there is a strong political bias towards the spending approach. Deficit-funded government spending is often seen as a smart, albeit leveraged, investment in the future, while deficit-funded tax cuts are seen as lavish gifts to the rich. But actually they are two sides of the same coin.
The supply side might not get too much traction in the near future. With interest rates and inflation rising and energy scarce, most countries do not have the fiscal space to implement deficit-funded tax cuts or spending. Liz Truss has already quashed interest rate cuts for the benefit of the highest earners. Deregulation is free and can even save money, but requires special interest takeover. After the pandemic, there is a tendency towards more intervention. But with lower productivity and aging populations, all developed countries need a supply-side revolution.
More from other authors at Bloomberg Opinion:
If Kim Kardashian and Liz Truss get caught: John Authers
The camouflage tax buried in Kwasi Kwarteng’s budget: Stuart Trow
UK Shoddy makes it hard to be an anglophile: Pankaj Mishra
This column does not necessarily represent the opinion of the editors or of Bloomberg LP and its owners.
Allison Schrager is a columnist for the Bloomberg Opinion on economics. She is a Senior Fellow at the Manhattan Institute and the author of An Economist Walks Into a Brothel: And Other Unexpected Places to Understand Risk.
For more stories like this, visit bloomberg.com/opinion
Comments are closed.