Time to commence supply-side reforms

This article is part of
Investing for 2015 - January 2015

Most people’s introduction to economics begins with learning the concept of supply and demand.

It is impossible in the financial media to escape commentary on demand parcelled up as economic growth, industrial output or embedded in the inflation numbers. Supply, however, is less considered, and that is a shame.

Say’s Law states that supply creates its own demand. In short, an economy can improve its competitiveness via enhanced training and education, lower taxes, reduced regulation or any other manner of supply-side factors, and hence be more successful globally. Supply-side reforms are often overlooked by economic commentators, but they offer the best source of a sustainable economic improvement in continental Europe and will create a sustainable rise in wealth far in excess of any application of quantitative easing.

Article continues after advert

Europe’s economic problems are well documented. Growth has been slower than in the UK or the US in recent years. Much attention has been placed on internal competitiveness divisions centred on different productivity levels between, say, Germany and some of the peripheral European nations, such as Greece or Spain.

Inexorably within a fixed rate monetary union it generally makes sense to use German workers, unless the cost of employing a Greek or Spanish worker is considerably lower – and hence the recessionary conditions over much of the past six years in such countries. Lower wages, lower demand and lower economic growth are components of an inevitable austerity cycle.

Boosting general demand conditions via European Central Bank (ECB) actions like quantitative easing will help all European countries but it is unlikely to create sustainably stronger economic conditions. The Spanish and Greek economies may have, via a recession, reached some kind of equilibrium with Germany but it has been at a huge cost.

As ECB president Mario Draghi noted in a speech at the end of last year, most European countries have been so busy firefighting in their domestic economies that they have slipped against global peers. He cited the World Bank’s Doing Business rankings, which showed that all eurozone nations lagged well behind the US and the UK.

Quantitative easing in more flexible economies such as the US and the UK was a helpful prop at times of banking system stress and low business and consumer confidence, which allowed these economies to move on. By contrast, the use of quantitative easing in Japan has failed to boost its economy sustainably. The missing ingredient for what until recently was Asia’s largest economy has been an economic flexibility and entrepreneurial spirit willing to make the necessary changes to take the economy into the 21st century.

The growth of part-time working, greater engagement of women and older people in the workforce, reduced trade union influence and a shift away from corporation tax to indirect sales taxes are central to the structure of the UK and US economies, but not in Japan and not in continental Europe.