A case for supply-side reform

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When the recession ended, the UK economy rebounded into a brief period of vigorous growth. But since the snow-induced contraction at the end of 2010, the economy has just about stuttered along. The UK is now unlikely to return to pre-recession levels of output until early 2013. Commentators on either side of the political spectrum have been eager to suggest cures for this malaise. But an appropriate treatment requires knowledge not just of the symptoms, but also the cause, of economic weakness.

Typically pundits are divided between predominately supply- or demand-side explanations. While those on the left have blamed the Chancellor's cuts for choking off demand, opponents of this view would highlight that the still-constrained financial environment and a lack of spare capacity are limiting the economy's ability to grow. In reality there are problems on both sides, but at a time when the government's ability to act is constrained by tight fiscal mandates, the question as to which is a bigger drag is particularly important.

The factors bearing down on demand are significant. Government spending cuts will necessarily reduce domestic demand and household consumption looks likely to remain subdued for some time to come. The malignant combination of falling real incomes and a weakening labour market has hit consumer confidence and spending power hard. Weak consumer demand is bad news for growth prospects as consumption accounts for approximately two thirds of GDP.

But if we want better balanced growth in the UK, it should not be so reliant on consumption. A consumption-based recovery is unlikely to be the path to sustainable growth in the longer-term. Perhaps, as long as consumption does not actively drag on growth, it is no bad thing if spending remains fairly static. What rebalancing requires is an improvement in net exports and investment. The question, then, is what is holding these back?

Net trade has so far failed to live up to expectations. Despite impressive export growth*, import growth has proved tenaciously strong. Partly this is because UK businesses have global supply chains, and in order to increase exports they need to import the parts that they cannot make themselves. In the longer-term this may mean we see an improvement in exports as a result of imports now, but in the shorter-term this capacity constraint is clearly a supply-side problem.

Investment has also been hit by supply-side problems. Despite businesses having continually expressed intentions to increase capital expenditure, this has yet to translate into economy-wide investment growth. This is, in part, a result of caution from businesses who not-too-long-ago suffered the trauma of recession, but it is not the whole story. Critically, access to finance remains constrained, particularly for small firms, making it difficult for them to invest.

The economy is suffering from demand- and supply-side weaknesses. In many ways, given that pre-recession growth was built on consumption, demand-side weaknesses will loom large. But it is the supply-side weaknesses that stand in the way of a better balanced economy, and for that reason, it is these we should focus on.

*excluding recent figures which show the damage global turmoil can do to external demand


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