More blindness to production

This is my latest column for Fund Strategy

It is striking how little public discussion of Britain’s economic plight focuses on what is generally referred to as the ’supply side’. Mainstream politicians and commentators focus heavily on demand instead: the assumption is that once it picks up the economy will recover. But what if they are wrong?

In recent articles I have argued that the debate on the British economy is shamefully narrow. The Conservatives put a little more emphasis on monetary policy (see last week’s column) and Labour attaches slightly more importance to fiscal policy (see June 11 cover story).

But this is at root a discussion of which channel is better to bolster demand. It is about whether more importance should be attached to monetary expansion or to a fiscal stimulus. Both sides see the crisis as essentially the stalling of what should be a cyclical recovery.

To be sure, both Conservatives and Labour would say a little about the supply side. Both would accept the need for a better regulatory framework to make production more efficient. They just differ about exactly what reforms would be best. But for neither party is this area a prime concern.

Most of the time the most high-profile public commentators also concentrate on demand. Their focus is on finding the best mechanisms to ensure the sluggish economy will pick up.

However, it is not possible to avoid supply entirely. Experts need to have at least some basis for dismissing the supply side as secondary. Indeed there is a nerdy debate on the subject among specialists although it rarely makes a public impact.

Bill Martin, a senior research associate at the Centre for Business Research at Cambridge University, is one of the most influential figures in this area. Although he is far from a household name his work has been cited by prominent commentators, including Paul Krugman in his New York Times blog (June 1, 2012) and Martin Wolf in the Financial Times (May 31, 2012), as showing Britain’s crisis is not on the supply side. Martin’s career included a spell in the City as the chief UK economist at UBS and a stint as a special economic adviser to the Cabinet Office.

In his most recent piece on the subject*, co-written with Robert Rowthorn, he developed his argument against what he calls “supply side pessimists”. Although the details are intricate it is possible to outline the main points briefly.

The starting point is to identify a gap between actual and potential output. If this is large it would suggest there is considerable slack in the economy that could be taken up in the event of recovery.

To make a rough estimate it is possible to calculate the difference between actual output and the level it would have reached if output had continued growing at its trend before the recession. This gives a figure of 14.2% if calculated for the first quarter of 2012.

The paper then concedes that for various technical reasons, such as statistical deficiencies, the real level could be put conservatively at 9.5%. That would still leave a considerable amount of slack that could be taken up in the event of an upturn in demand.

Of course there could be other ways to read this figure. It could, for example, be that the output has been lost forever or that the economy was operating above capacity before the crisis.

The main riposte is based on an examination of the statistics for labour productivity. They point out that a shortfall in productivity – that is output per worker – is apparent across a range of economic sectors.

Several conclusions flow from this observation. For a start the crisis cannot be seen as simply the result of the collapse of the financial sector or of North Sea Oil. It is evident across wide swathes of the economy.

Martin and Rowthorn argue that the productivity statistics are indicative of labour hoarding. Employers are keeping hold of workers, while often reducing their real wages, in the hope of an economic upturn.

However, there are several reasons to question the thrust of their argument. First, as the two authors acknowledge, the notion of an output gap is inherently problematic. It is a simple mathematical exercise to extrapolate the growth before the recession to estimate where it would have reached if it had continued at the same rate.

But that is a hypothesis about an alternative world of smooth growth that does not exist (except perhaps in a parallel universe). In this world there was a recession and it did hit economic output.

Tyler Cowen, a professor of economics at George Mason University, has also outlined problems with Martin’s approach on his Marginal Revolution blog (June 5, 2012). Much of Cowen’s argument focuses on the labour productivity question.

For instance, he points out that the paper assumes that weak labour productivity is a symptom of falling demand. They do not see that weak productivity growth could be a cause of Britain’s economic weaknesses.

Ultimately it is hard to resist the conclusion that the whole conceptual framework of contemporary economics is flawed. Rather than divide the economy into demand and supply sides it would be better to go back to the categories of consumption and production. It would then be necessary to examine the links between the two in each specific circumstance.

There also needs to be room for what could broadly be called cultural factors. For instance, the contemporary tendency to shy away from any initiatives that involve a significant degree of uncertainty.

Fundamentally different conclusions would flow from such an approach. These would include the need for a broad cultural shift and for bold measures to revitalise the real economy.

* Bill Martin and Robert Rowthorn. “Is the British economy constrained II? A renewed critique of productivity pessimism”. May 2012.