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SUPPLY SIDE POLICIES
TREND GROWTH AND THE OUTPUT GAP
Trend (or potential) growth is the rate at which real Gross Domestic Product can grow, on a
sustained basis, without putting upward or downward pressure on inflation. An increase in the
trend rate of growth is particularly important for the British economy since it is then able to grow
at a faster annual rate without generating inflationary pressures, which would require the Bank of
England to increase interest rates.
The largest single underlying influence upon trend growth is the growth of labour productivity.
Other influences are changes in the size of the population of working age, in the participation
rate, and in the average number of hours worked. Except for short periods, UK productivity
growth has been historically low compared with that of our major competitors, largely on account
of the scrapping of capacity in recessions, an inadequate manufacturing base, skills shortages, and
insufficient investment in physical and human capital.
The economy’s actual growth rate is particularly significant since it has a large bearing on
employment and unemployment levels, on living standards, on export levels and on the
government's fiscal position (and thus its tax revenues and spending options).
The output gap is a measure of the amount of spare capacity in the economy – Keynesian
economists calculate its size by subtracting actual GDP from potential GDP. The size of the
gap is open to dispute, not least because there are wide variations in estimates of productive
capacity, and hence potential GDP. There may also be inflationary pressures even if there is
significant spare capacity in the economy, and especially if firms are reporting skill shortages. As
a result, the more modern approach is to compare actual output growth with an estimate of the
economy’s SUSTAINABLE (non-inflationary) output growth – and it is the latter that is
normally described as the TREND growth rate.
AGGREGATE SUPPLY AND THE SUPPLY SIDE APPROACH
An increase in the trend rate of growth can be represented by a rightward shift of the aggregate
supply schedule. The position (and elasticity) of the AS schedule is influenced by:
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the pace of technical progress (product and process innovation)
the trend growth of factor productivity
the expansion of productive capacity through investment
the size and quality of the workforce
the flexibility and competitive structure of product, labour and financial markets.
Demand management policies have historically been used to reduce cyclical output fluctuations
around the trend growth line, thus reducing the size of a positive output gap in a period of above
trend growth, or of a negative output gap in a period of below trend growth. By contrast, supply
side policies are designed to increase the economy’s productive potential and thus its TREND
RATE OF GROWTH through shifting the economy’s aggregate supply schedule to the right,
and making it more elastic. Successful policy implementation means that any increase in
aggregate demand results in a greater increase in output and a smaller increase in the inflation rate
than would otherwise be the case – and so the economy is able to grow at a faster rate. Supply
side policies are designed to improve the operation of labour, product and capital markets, and so
they focus on improving the stock and quality of factor resources, and the efficiency with which
they are used.
There is some dispute over whether ‘trend growth’ and ‘sustainable growth’ are the same thing.
The Chancellor certainly uses the terms interchangeably, while the Monetary Policy Committee
also takes the view that a services-based, ‘high tech’ economy can achieve higher (and therefore
sustainable) levels of growth with lower levels of inflation than a predominantly goods-based
economy.
CONSERVATIVE AND LABOUR GOVERNMENT POLICIES
Conservative Governments between 1979 and 1997 were particularly concerned to reduce the
role of the State in the economy, in the belief that the replacement of a ‘dependency culture’ with
an ‘enterprise culture’ would result in an increase in the productive capacity, efficiency and
flexibility of the economy. Hence the emphasis was on:
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the deregulation of markets (through privatisation of nationalised industries and the
introduction of competition into previously protected monopoly industries)
the promotion of small businesses
the reduction of trade union power
cuts in personal and corporate tax rates
greater labour market flexibility
a decrease in the real value of social security benefits
the sale of council houses to tenants at discounted prices
attraction of direct overseas investment to the UK.
Labour Governments since 1997 have continued with much of this approach, though there has
been more emphasis on competition policy, on introducing market disciplines into the public
sector (often through private-public sector partnership) and on education and training. There is
greater recognition of the importance of human capital as a vehicle for increasing productivity
and trend growth. This is seen in the introduction of (and regular increases in) the national
minimum wage, the adoption of the employment protection provisions of the Social Chapter, and
the use of an elaborate system of tax credits to make work a more attractive option for the low
paid.
Gordon Brown, on appointment as Chancellor, declared that there would be no return to the
familiar ‘boom-bust’ cycle, and put in place a greatly improved macro-economic framework. An
inflation target was retained, while the primacy of monetary policy was confirmed in the decision
to grant independence to the Bank of England and in the adoption of explicit fiscal policy rules.
In recent years there have been no ‘wild’ policy swings, while the economy has remained
resilient, surviving fears of slowdown in 1998 (after the Russian debt default) and after 9/11.
HAVE SUPPLY SIDE POLICIES BEEN SUCCESSFUL?
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There is widespread agreement that supply side policies have been successful, though not
over whether it is Conservative or Labour Governments that should take the lion’s share of
the credit for the improved economic performance. Since the early 1990s the combination of
rising living standards, near full employment, and stability has not been matched by any other
G7 nation – the USA has grown faster than the UK, but has suffered much more from
financial instability and widening inequality. Some 75% of the potential UK labour force is
now in work; two million more are now employed than in 1997; employment is at a record
level, as are the number of self-employed. Unemployment levels (well below 1 million on the
Claimant Count) are lower than at any time since 1975. Productivity growth has risen since
1997 at a greater rate than in France, Germany, Japan and the USA, though absolute
productivity levels are still significantly lower. Inflation has remained low for more than a
decade, averaging only 2.5% over the past 11 years, the longest period for half a century;
indeed, the rate of inflation fell below 1% in November 2001 for the first time in 38 years.
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Periods of recession reduce the trend rate of growth, and there have been five major UK
recessions since 1920 (1920-21, 1929-32, 1973-75, 1979-82, 1989-93); in each case output at
the trough of the recession was at least 8% below its trend level. Between the end of the most
recent recession and the end of 2004 there have been 50 successive quarters of positive
growth.
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It is generally accepted that the Bank’s proactive monetary policy regime would have been
nothing like as effective without the micro-economic flexibility created by 18 years of
Conservative government deregulation. The combination of the two prompted the Treasury
(in 2002) to suggest that the trend growth rate has now risen from 2.25-2.5% to 2.5-2.75%.
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Growth has, however, been very unbalanced, regularly leading to claims that there is a ‘two
speed’ economy in the UK. While employment is running at a record level, continuing
manufacturing job losses mean that now barely 3.5 million are employed in this sector. Since
1995, while output of the services sector has increased by 35%, manufacturing production has
barely risen at all. UK productivity performance remains relatively poor (the average annual
increase since 1997 has been only 2.3%), which has serious implications for the trend growth
rate. Actual growth has been driven largely by consumer spending, which has risen at an
average of over 4% a year since 1995. Since consumer spending accounts for over 70% of
aggregate demand, and has been increasing at some 1.5% more each year than potential GDP
growth, the inevitable outcome has been a marked deterioration in the overseas trade balance.
The move from fiscal surplus to deficit over the last five years also suggests that present
growth rates may be unsustainable in the years ahead. There are also fears for future growth
rates if oil prices remain historically high, world growth slows down and interest rates are
increased in 2005, and the widely expected tax increases are introduced after the next
election.