Published on 17 October 2022
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Supply-side economics will be needed to drive growth

Truss’s approach of supply-side economics should focus on factors such as skills policy enabling workers to capitalise on technological development, says Thomas Aubrey.

Liz Truss’s economic policy announcements have met with profound scepticism. Financial market investors have firmly rejected the idea that her plans will generate faster growth in the UK.

Her approach is grounded in the idea of supply-side economics, which as a political agenda originated with Ronald Reagan’s years in office. The basic idea of increasing the economy’s capacity to supply products and services is perfectly sensible –  particularly at a time of rising inflation and low unemployment which would make demand-led policies more inflationary.

Truss’s definition of supply-side economics is, though somewhat simplistic, focused on tax cuts. Sometimes tax cuts to stimulate demand and drive growth are a good idea. Indeed, there is some evidence that when economies operate below their potential, productivity growth is sluggish too. However, the idea that running the economy hot will in itself result in increased productivity growth – an idea favoured by some commentators – is not well supported by the evidence.

What matters more in improving the supply-side and raising the rate of productivity growth now is a focus on factors including: skills policy enabling workers to capitalise on technological development; reducing regulatory divergence across markets enabling firms to export more and scale up; and encouraging innovation through supporting R&D.

Although Reaganomics is often associated with tax cuts, the Reagan administration also developed an industrial policy to enhance innovation through the Small Business Innovation Research (SBIR) programme. The SBIR enabled firms to develop new products and services based on gaining access to customers – in this case, the government. Between 1995–2018, the SBIR programme alongside the Small Business Technology Transfer (SBTT) programme generated an additional $184bn of value added for the US economy.

While the US domestic market is large enough to support firms attempting to scale up, the UK economy is not. This is why Margaret Thatcher pushed through the European single market in order to reduce the regulatory burden for UK firms wishing to grow their sales. In contrast, Liz Truss continues to advocate for regulatory divergence placing UK firms at a competitive disadvantage, as now companies have to conform to multiple regulatory frameworks if they wish to grow and export.

Perhaps the Truss Government, after the economic and political chaos the initial policy has caused,  will begin to look more realistically at the supply-side measures needed. But for these to be successful in increasing the rate of productivity growth, the variance in the performance of different sectors needs to be taken into account, as each sector tends to have its own dynamics and challenges.

The most recent UK labour productivity data indicates that its growth (excluding real estate activities which largely consist of imputed rent for housing) is 3.3% since 2019. This rate of growth is to be welcome given that it was just 1.5% between 2010-2019 over the entire period.

The public sector has contributed about a third to this growth, indicating that private sector growth was just 2.1% over 3 years. But labour productivity growth across the private sector is highly variable as shown in Table 1.

Table 1: Sectoral disaggregation of labour productivity Q2 2019 – Q2 2022[1]

One positive piece of news in the data is that the negative productivity effects resulting from the Covid pandemic are no longer impacting the economy, with only financial services contributing negatively to growth between Q2 2019 – Q2 2022 (in red). The Financial Services sector is about 11% of the private sector economy excluding real estate.

The worrying issue for any government wishing to raise the rate of growth is that 47% of the private sector economy, excluding real estate, has stagnated since 2019 (in blue). While some subsectors such as computer programming have experienced robust productivity growth, telecommunications continues to underperform as shown in Table 2. Both of these subsectors form part of Information & Communication.

On a more positive note, Professional & Scientific continues to forge ahead driven by legal and accounting activities. Accounting activities grew by 42% in gross value added (GVA) between Q2 2019 and Q2 2022, while the GVA of legal services grew by 19% over the period.

And while manufacturing has started to grow, once again the picture is highly variable with the automotive and aerospace sectors (transport equipment) continuing to demonstrate a significant decline as highlighted in Table 2. Conversely, the manufacture of basic metals has performed well due to pent-up demand after the pandemic, although it is hard to see how this sector can continue to outperform given the jump in energy costs and falling demand across the economy.

Table 2: Best and worst performing subsectors Q2 2019 – Q2 2022 for labour productivity growth

So if the government really is committed to improving the capacity of the supply side, where should it focus its attention, particularly given the current lack of fiscal headroom? Two areas that could be prioritised are skills policy and regulatory reform.

One of the persistent challenges for UK firms has been the shortage of technical skills where over 300,000 core technical job vacancies were difficult to fill because of technical skills shortages[2]. If the government wants to upskill UK workers, these programmes must be devolved into functional economic areas such as the combined mayoral authorities. Denmark, Switzerland and Austria are small countries in terms of size and population and yet their skills policies are both devolved and successful. The digital sector has been highlighting issues surrounding skills shortages for many years now, but little has been done about this.

Devolved skills policies enable local institutions to adapt to market conditions as they have an understanding of the needs of firms and the capabilities of workers, and hence can tailor appropriate courses and training. Conversely, countries with centralised skills systems struggle to adapt to changing market conditions due to the lack of local knowledge. By ensuring there are enough workers with technical training who subsequently receive company-specific training, productivity growth in the computer programming sector would have been much higher.

The other area that would also boost private sector productivity is to rethink the country’s regulatory strategy. The post-Brexit environment is a barrier to firms because of the extra costs and frictions due to the need to jump through multiple regulatory hoops. If the government really wishes to see productivity growth it must become more pragmatic. There is no benefit for UK firms in sectors such as manufacturing and agriculture to comply with both UK and EU standards. This UK government intervention to increase regulatory complexity is a classic example of what Reagan opposed, not what he stood for. If the UK is serious about driving up productivity growth it will need to become a rule-taker in many sectors. This, however, should not be the case for more dominant sectors such as financial services, which is why joining the European Economic Area – or the Norway option – is not a potential solution.

Calling for growth is easy. But achieving growth requires making some policy decisions that do not fit neatly into simplistic political agendas. The evidence so far is that the Truss government is not really committed to driving up growth.


[1] The disaggregation uses Tang & Wang 2004; the ‘within’ effect is value added per hour in the sector and the ‘between’ effect measures labour reallocation.

[2] See Aubrey – Why adaptive technical skills systems are needed to capitalise on the technological revolution (2018)

Authors

Thomas Aubrey

Thomas Aubrey is the founder of Credit Capital Advisory. He has written widely on financial and economic issues including Profiting from Monetary Policy (2012) and co-authored Prediction Markets: The end...

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