Sunday, April 14, 2013
Supply-side reform: the winning formula of the 1980s
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

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My regular column is available to subscribers on www.thesundaytimes.co.uk This is an excerpt.

Lady Thatcher's death has produced an avalanche of remininscence and interpretation of the 1980s' decade. I was around in the 1980s, and have the suits and Filofax to prove it, The first chancellor I interviewed was her first, Sir Geoffrey Howe. But fear not, this is not going to be another stroll down memory lane.

Rather, I wanted to draw out a more fundamental lesson. At the recent Royal Economic Society conference, LSE professors Tim Besley and John Van Reenen presented the findings and recommendations of its Growth Commission. One of the most striking was in what they called “the economic story of the UK”.

From 1870 to 1980, Britain suffered more than a century of relative economic decline. The British economy grew but France, Germany, America and other competitor economies grew faster.

Since 1980 that has not been true. On a range of measures, Britain’s relative performance improved. There was a turnaround. From 1980 to 2011 - including the 2008-9 recession and some of the subdued recovery - gross domestic product per capita outgrew America, Germany and France. So did GDP per working-age adult. The productivity gap narrowed and in some cases was reversed. Things got better. North Sea oil helped in the first haf of the 1980s but made little difference over the period as a whole.

Some people are determined not credit Thatcher for any of this, or say that it was more than outweighed by the huge negative of the crisis. I’ll return to that.

I regard the LSE’s Van Reenen as a fair witness. He was no fan of Thatcher when younger. Had he been at the LSE in 1981 he would no doubt have joined the 364 economists who signed a letter protesting at her policies. The rise in inequality and failure to invest enough in infrastructure were significant downsides of the Thatcher era, he says. But he also gives credit where it is due for the supply-side changes that led to the improvement in Britain’s performance.

Those changes: union and other labour market reforms, removing industrial subsidies, privatising and regulating state industries, strengthening competition policy, membership of the EU single market, opening the door to inward investment and expanding the higher education system all contributed to the improvement. As he puts it: “Most, but not all of these were initiated by Mrs Thatcher.”

Her supply-side changes mainly survived, Helped by changes in the structure of the economy, there was no return to destructive union power or, despite some huffing and puffing from Labour, no renationalisation of privatised industries.

Under Tony Blair and Gordon Brown from 1997 there was some re-regulation of the labour market but this was partly balanced by an improved competition regime, with the Office for Fair Trading and Competition Commission. Tax got much more complicated, though until the very end of new Labour the consensus held that low rates of direct taxation were best.

In the long run, it is the supply-side that matters and Thatcher enacted a series of supply-side reforms. Those changes laid the foundation for Britain’s improved perforamce over three decades.

We should remember that. Though we devote acres to whether George Osborne should relax austerity or whether the Bank of England should announce £25bn of quantitative easing, supply-side policies matter much more.

So cutting corporation tax to 20% and other changes to try to make Britain a magnet for inward investment; tax and welfare changes to improve work incentives;, education reforms and the cut in the top rate back to 45% matter a lot more than the fiscal picture set out in the next budget or autumn statement, or the next meeting of the monetary policy committee.

You can see that in the macroeconomic record of the Thatcher government. Though fiscal policy was prudent - average cyclically-adjusted net borrowing of less than 0.5% of GDP over the period 1981-9 was close to a balanced budget - it was too tight at the start and too loose at the end.

Monetary policy was a dog’s breakfast. Sir Alan Walters, her economic adviser, pointed out in the early 1980s that 17% Bank rate and a sky-high exchange rate inflicted unnecessary damage on industry.

When, after many twists and turns, her period in office ended with Britain in the European exchange rate mechanism, Walters told me it would undo 30% of the economic gains made. As it was, despite an average Bank rate of 12%, she left with inflation back in double figures.

The consensus is that inflation-targeting in 1992, followed by Bank independence in 1997, improved considerably on the turbulence of the 1980s. It certainly led to much greater stability, with low inflation and interest rates. But that, in turn, fostered excessive risk-taking. Once fear of sharp upward lurches in rates went, many of the normal constraints were removed.

The search for the Goldilocks macroeconomic policy middle-ground - which neither scares the hell out of people nor encourages them to throw caution to the wind - will go on. But through short-term macro trials and tribulations, we should remember the supply-side. Anything that can be done to improve it, even or perhaps especially in difficult times, will pay dividends in the long run.

What about the crisis? Wasn’t there a direct route from Big Bang in 1986 to the banking collapse in 2008? Wasn’t that the legacy? No. People forget Big Bang was all about ending the stock exchange’s restrictive practices. It was not just unions forced to change their ways: the City’s cosy cartel ripped off its customers.

Big Bang helped London regain its position as the world’s leading financial centre but did not give a green light for irresponsibility to investment banks, which occurred long after she left office. If you want to pin the crisis on anything, pin it on the rise of America’s shadow banking system and the relaxation and eventual abolition of the Glass-Steagall restrictions on its banks.

She would have taken a dim view of the irresponsibility. Given her unhappiness with the Bank in the early 1980s, I suspect she would have taken a dim view of independence too. That would have left the Bank in charge of banking supervision. Whether it would have done better than the Financial Services Authority we will never know.