Returning to Growth: Policy Lessons from History - Wiley Online Library

FISCAL STUDIES, vol. 34, no. 2, pp. 255–282 (2013) 0143-5671

Returning to Growth: Policy Lessons from History* NICHOLAS CRAFTS† †University of Warwick ([email protected])

Abstract This paper considers ‘unconventional’ monetary stimulus and supply-side reform as ways to speed up UK recovery in the context of fiscal consolidation, drawing on the experience of the 1930s and 1980s. To imitate the 1930s, the inflation-targeting regime may need to be reformed to cut real interest rates, with land-use planning liberalised to ‘crowd in’ residential investment. To emulate the 1980s, supply-side reforms to improve productivity and to raise permanent income are required and possibilities in the areas of infrastructure, education and taxation are outlined. A problem common to all these options is that they are ‘politically challenging’.

Policy points • • •

Fiscal consolidation need not prevent an early return to growth if other policies provide stimulus. Monetary stimulus was effective even with very low interest rates in the 1930s, but repeating that now requires major changes to inflation targeting by the Monetary Policy Committee. Supply-side policies could be used to ‘crowd in’ private spending as financial liberalisation did in the 1980s.

*Submitted December 2012. This paper is based on the 2012 Royal Economic Society Policy Lecture. The author is grateful to Stuart Adam, Jagjit Chadha, Tim Leunig, Roger Middleton and John Muellbauer for advice and help with data. The usual disclaimer applies. Keywords: fiscal consolidation, monetary stimulus, productivity, supply-side reform. JEL classification numbers: E65, H12, N14. © 2013 The Author Fiscal Studies © 2013 Institute for Fiscal Studies. Published by John Wiley & Sons Ltd, 9600 Garsington Road, Oxford, OX4 2DQ, UK, and 350 Main Street, Malden, MA 02148, USA.

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The best candidate for a quick-acting policy to promote growth and increase medium-term efficiency is reform of land-use planning.

I. Introduction The UK economy is struggling to recover from the worst recession since the Second World War. At a comparable stage in the aftermath of the severe recessions of the early 1930s and the early 1980s, notwithstanding fiscal consolidation in each case, strong growth had returned, whereas for the last two years the economy has flatlined (see Figure 1). This raises the related issues as to what part policy played in those earlier episodes and whether there are lessons that could be valuable today; an attempt to answer these questions is provided in what follows. There are basically three possible ways in which policy can promote recovery from recession – namely, through fiscal stimulus, monetary stimulus, and supply-side policy that ‘crowds in’ private sector spending. In episodes of fiscal consolidation, we can assume that only the last two types of policy are available, but even then the composition of the fiscal measures can be chosen to be more or less medium-term growth friendly. When, as at present, nominal interest rates cannot be cut further, it seems clear that supply-side policy has an important part to play. The rationale for supplyside policy reform is to improve economic efficiency and either the level or the rate of growth of real GDP. Much of the impact of these reforms takes time to materialise. Of course, if forward-looking agents are convinced that FIGURE 1 Real GDP (quarterly)

Source: Mitchell, Solomou and Weale, 2012; Office for National Statistics. © 2013 The Author Fiscal Studies © 2013 Institute for Fiscal Studies

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reforms will succeed in raising future incomes, this can stimulate spending in anticipation of this outcome. An ideal package would also, however, include elements that directly encourage the private sector to invest or consume more in the short term. Given that supply-side policy is important for improved growth performance in both the short and longer terms, what reforms should the UK government undertake? In order to address this question, this paper draws on empirical findings from applied growth economics and the economic history of recent decades to suggest an evidence-based approach.

II. Background points The legacy of the financial crisis is that the UK has a substantial structural fiscal deficit. The centrepiece of the coalition agreement on which the government’s strategy is based is to give priority to restoring fiscal sustainability through deficit reduction. This is controversial and some economists believe that this approach is misconceived.1 This issue is not explored here; rather, it is taken as read that fiscal stimulus is ruled out and that the alternative routes to promoting recovery are to be explored. Indeed, fiscal consolidation normally has a negative effect on aggregate demand in the short term (the multiplier is greater than 0); the extent to which this impedes recovery depends on how far it is offset by monetary stimulus2 or by supply-side reforms.3 If fiscal consolidation is the order of the day, there are many permutations available with different supply-side implications. For example, generally speaking, expenditure cuts that reduce benefits will not have adverse effects on productive potential, but those that reduce infrastructure or education spending will have.4 If taxes are increased, it is better to raise taxes on consumption and property rather than those on corporate or personal income.5 If there were no political constraints or issues of ‘fairness’, it would be easy to make fiscal consolidation supply-side friendly. Government policy affects productivity performance through many channels, not only these obvious fiscal ones. It is important to recognise that a wide range of government actions impact on incentives to invest, innovate and adopt new technology. These include horizontal industrial policies such as the regulatory and competition frameworks.6 Similarly, the effectiveness 1

Bagaria, Holland and Van Reenen, 2012; Holland and Portes, 2012. Guajardo, Leigh and Pescatori, 2011. 3 Alesina and Ardagna, 2012. 4 Kneller, Bleaney and Gemmell, 1999. 5 Arnold et al., 2011. 6 More generally, ‘horizontal’ industrial policies are not aimed at selected industries or firms but at addressing market failures – for example, in the provision of education, infrastructure, and research and development (R&D) – and at providing framework conditions conducive to investment and innovation. 2

© 2013 The Author Fiscal Studies © 2013 Institute for Fiscal Studies

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of government expenditure depends on incentives for efficient delivery of services. This implies that the contribution that government makes to productivity outcomes can sometimes be improved by reforms that do not entail significant increases in expenditure. It is important to recognise that the scope for delivering monetary stimulus is constrained by the existence of the lower bound on nominal interest rates, which cannot be negative. This implies that ‘unconventional’ monetary policy is required. Since 2009, the Monetary Policy Committee has employed quantitative easing with a view to affecting economic activity by changing asset prices and stimulating investment.7 A more radical approach would entail a major revision to the current inflation-targeting regime with a view to pushing ex-ante real interest rates well into negative territory. This strategy may be hard to implement, however. There is a problem of ‘time inconsistency’ in that the private sector may anticipate that the central bank will change its policy as soon as the economy starts to recover. For the real interest rate policy instrument to be effective, it is vital that the central bank is seen as credibly committed to future inflation and the rate of inflation that is needed may well exceed the previous target rate, currently 2 per cent.

III. The 1930s An aspect of the 1930s that is especially relevant for today is that it represents the only experience that the UK has had of attempting fiscal consolidation when nominal interest rates were close to the lower bound and reductions in interest rates could not be used to offset the impact of tighter fiscal policy on aggregate demand. Over the fiscal years 1929–30 through 1933–34, the structural budget deficit was reduced by a total of nearly 4 per cent of GDP as public expenditure was cut and taxes increased; the public debt to GDP ratio stopped going up after 1933, while from mid-1932 shortterm interest rates stabilised at about 0.6 per cent (Tables 1 and 2). Despite the severe recession, the budget was balanced in 1933–34. The standard analysis has concluded that this fiscal consolidation depressed demand.8 Yet, from 1933 to 1937, there was strong growth such that real GDP increased by nearly 20 per cent over that period.9 Recovery in the 1930s did not take place under the auspices of inflation targeting. It began while fiscal policy was deflationary but when control of monetary policy moved from the Bank of England to the Treasury. Subsequently, monetary policy can be thought of as targeting an increase in the price level and acting to stimulate the economy through reducing real 7

Joyce et al., 2012. Broadberry, 1986. 9 Mitchell, Solomou and Weale, 2012. 8



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interest rates. The episode suggests that this was a viable way to provide a monetary offset to fiscal consolidation. Although the first phase of recovery was based on monetary policy and the end of deflationary expectations, from 1935 onwards there was a significant fiscal stimulus through rearmament. The news of this change in defence policy was an exogenous shock TABLE 1 Fiscal indicators for 1930s’ Britain

1929 1930 1931 1932 1933 1934 1935 1936 1937 1938

Government debt

Budget surplus

Debt interest

158.4 159.2 169.8 173.6 179.2 173.1 165.0 158.7 147.2 143.8

–0.7 –1.4 –2.2 –0.5 0.4 0.5 –0.3 –0.7 –1.5 –3.7

7.7 7.6 7.7 7.8 7.0 6.2 6.0 5.7 5.4 5.2

Per cent of GDP Constant employment budget surplusa 0.4 1.1 2.5 3.0 4.2 3.2 2.0 0.8 –0.1 –1.5

a Figures are for the fiscal year, i.e. the first entry is 1929–30, etc.; a bigger positive indicates that fiscal policy has been tightened. Source: Database for Middleton (2010), generously made available by the author.

TABLE 2 Interest rates in 1930s’ Britain Bank rate 1929 1930 1931 1932 1933 1934 1935 1936 1937 1938

5.50 3.42 3.93 3.00 2.00 2.00 2.00 2.00 2.00 2.00

Treasury bill rate 5.26 2.48 3.59 1.49 0.59 0.73 0.55 0.58 0.56 0.61

Yield on consols 4.60 4.48 4.40 3.75 3.39 3.10 2.89 2.93 3.28 3.38

Real short rate 5.26 8.63 9.73 5.11 0.66 0.80 0.59 –2.86 –2.09 –2.56

Per cent Real long rate 5.14 8.01 9.20 7.24 5.65 4.26 3.59 1.22 0.93 0.99

Note: Real rates of interest are calculated on an ex-post basis. Real long rates are based on the yield of consols minus a three-year backward-looking weighted average of actual inflation rates; for further details, see Chadha and Dimsdale (1999). I am grateful to Jagjit Chadha for providing me with the data. Source: Bank rate, Treasury bill rate and yield on consols – Dimsdale (1981). Real interest rates – Chadha and Dimsdale (1999). © 2013 The Author Fiscal Studies © 2013 Institute for Fiscal Studies

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administered while nominal interest rates remained very low. So, a further interesting aspect of the 1930s’ experience is the use of expansionary fiscal policy in these unusual conditions, which are sometimes thought to be conducive to a high fiscal multiplier. Until the UK left the gold standard, the Bank of England set interest rates with a view to maintaining the $4.86 parity. In practice, this meant that policy had to ensure that rates were not out of line with foreign, especially American, interest rates. After leaving gold, it took some time for policy to be reset. By the end of March 1932, the Treasury had decided that it wished to lock in a devaluation of about 30 per cent and moved to a policy of implementing exchange rate targets defined in terms first of pegging the pound against the dollar at $3.40 and then, after the American devaluation of March 1933, against the French franc at Ffr. 88 and later at 77.10 The policy was underpinned through market intervention using the Exchange Equalisation Account set up in the summer of 1932 and by a ‘cheap money’ policy symbolised by the reduction of the bank rate to 2 per cent on 30 June 1932. The Chancellor announced the objective of raising prices back to the 1929 level at the British Empire Economic Conference in Ottawa in July 1932 and subsequently reiterated it frequently. The fall in the exchange rate from $3.80 in March 1932 to $3.28 in December 1932 is consistent with escaping the liquidity trap in the ‘foolproof way’, as are the sustained fall in the value of the pound and the large increase in foreign exchange reserves over the next four years which reflected intervention by the authorities to keep the pound down.11 So market reactions suggest that the cheap-money policy quickly became credible. Based on archival research, economic historians have provided an overview of the strategy for economic recovery after the UK left the gold standard and control over monetary and exchange rate policy passed from the Bank to HM Treasury. Partly building on Howson (1975), Booth (1987) argued that from 1932 there was coherence in the Treasury’s thinking, which deserved the label of a ‘managed-economy’ approach. The hallmark was a central objective of a steady increase in the price level – which, on the assumption that money wages would not react, also amounted to reducing real wages and restoring profits – subject to not letting inflation spiral out of control. The rise in the price level would be promoted through cheap money, a weak pound, tariffs, and encouraging firms to exploit their (enhanced) market power, similar to the proposal in Eggertsson (2012), but fears of an 10

Howson, 1980. Howson, 1980. Svensson (2003) suggested that a ‘foolproof’ way to escape the liquidity trap is to combine a price-level target path with an initial currency devaluation and a crawling exchange-rate peg which will require a higher price level in equilibrium and can be underpinned by creating domestic currency to purchase foreign exchange. 11



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inflationary surge would be allayed through balancing the budget and intervening if necessary to prevent a currency crisis. This particular managed-economy strategy is clearly quite similar to a price-level target. It was sustained over several years from the middle of 1932, although prices rose by a bit less than Treasury officials expected and had still not returned to the 1929 level in 1937. As Table 2 reports, it brought about a big reduction in real interest rates compared with the start of the decade. On this measure, monetary stimulus was still being provided after nominal interest rates bottomed out. Obviously, this strategy does not represent an irrevocable commitment, but it was a credible policy given that the Treasury and the Chancellor of the Exchequer were in charge.12 Cheap money and a rise in the price level were clearly in the Treasury’s interests from 1932 as a route to recovery and better fiscal arithmetic and to provide an alternative to the Pandora’s box of jettisoning balanced-budget orthodoxy and adopting Keynesianism.13 The direct effects of cheap money were felt from mid-1932 onwards with reductions in nominal and real interest rates, as reported in Table 2. Business investment responded to lower interest rates,14 improved profit expectations reflected in higher share prices and increased sales,15 while bank lending was largely maintained in a climate of business as usual in the absence of a banking crisis.16 Housebuilding was the sector most positively affected by the cheap-money policy but was well positioned for a number of other reasons, including enhanced availability and affordability of mortgage finance, permissive land-use planning rules, and a shortfall of investment in the 1920s.17 Private housebuilding investment increased by £55 million, or about 23 per cent of the increase in GDP, between 1932 and 1934. The number of private unsubsidised houses built rose sharply from 63,000 in the half-year ending September 1932; in the peak year to March 1935, 293,000 houses were constructed.18 Broadberry (1987) estimates that about half the additional housing investment was due to lower interest rates. An increasing ratio of rents to construction costs was also favourable but, as Howson (1975) stresses, the leap in housebuilding only occurred once it was believed that construction costs had bottomed out. Here may be the most concrete illustration of the importance of monetary policy in changing inflationary expectations. 12

This would not have been the case had the Bank of England run monetary policy. Governor Norman plainly disliked cheap money and regarded it as a temporary expedient (Howson, 1975, p. 95). 13 Howson, 1975. 14 Broadberry, 1986. 15 Lund and Holden, 1968. 16 Billings and Capie, 2011. 17 Humphries, 1987; Richardson and Aldcroft, 1968. 18 Stolper, 1941. © 2013 The Author Fiscal Studies © 2013 Institute for Fiscal Studies

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The cheap-money policy was sustained through 1938, by which time inflation had clearly replaced the deflation of the early 1930s (see Table 2). The Treasury bill rate remained at about 0.6 per cent and real short rates were negative from 1936, while real long rates were around 1 per cent. The distinguishing feature of the post-1935 phase was a switch to expansionary fiscal policy associated with rearmament; in these circumstances, it might be thought that there was scope for fiscal policy to have a sizeable multiplier effect. The budget, which had been balanced in 1934, showed a deficit of 3.7 per cent of GDP in 1938 (Table 1), although the ratio of public debt to GDP continued to decline slowly. As the discussion below suggests, it is plausible that rearmament boosted the recovery after 1935, but it is important to understand how this stimulus worked. The formal announcement that the British government intended to rearm came in the Defence White Paper of March 1935 (Cmd 4827), and by the end of the year defence spending had risen 28 per cent compared with a year earlier. The ante was upped considerably in February 1937 when the Defence White Paper (Cmd 5374) warned of expenditure of £1,500 million over the next five years, which would be partly deficit-financed, and the Defence Loans Bill, which authorised borrowing of £400 million over five years, was approved. It is generally believed that this promoted a substantial increase in GDP and employment.19 The analysis in Crafts and Mills (2012), based on time-series analysis using the concept of ‘defence news’,20 produces an estimate that the government expenditure multiplier was 0.76 in the interwar period and finds no evidence that it was higher than this in the cheap-money years after 1932.21 The authors do find an impact of about 5 per cent of GDP in 1938, but if rearmament had such a big impact it was because the future spending plans were massive rather than because there was a large fiscal multiplier. The observation of a large increase in output at a time of increased defence expenditure should probably not be interpreted as a large Keynesian multiplier but as partly reflecting firms gearing up for anticipated future increases in government spending.22 The reason for a multiplier well below 1 in the 1930s may be the overhang of a high ratio of public debt to GDP, which is well known to lead to low multipliers even in severe recessions.23 It is reported in Table 1 that, despite rearmament, the public debt-to-GDP ratio (D/Y) was falling in the years after 1934 when fiscal consolidation was abandoned. Does this suggest that austerity was ‘self-defeating’ in terms of its medium-term effects on D/Y? This was clearly not the case. A check on 19

Thomas, 1983. Ramey, 2011. 21 These estimates are, however, consistent with the hypothesis that fiscal consolidation was contractionary in its short-term impact on GDP. 22 A very similar account is given by Robertson (1983). 23 Auerbach and Gorodnichenko, 2011. 20



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the fiscal arithmetic shows that about two-thirds of the fall in D/Y came from continuing (albeit smaller) primary budget surpluses, with about onethird from the real interest rate falling below the real growth rate in an economy with capital controls.24 This experience does, however, underline the point that ‘financial repression’ reduced considerably the severity of the required fiscal squeeze to improve this fiscal indicator.25 The interwar economy saw a major shift in supply-side policy. Prompted initially by high unemployment and the travails of the old staple industries and given considerable impetus by the world economic crisis, governments became more willing to intervene. This period saw the beginnings of industrial policy in the 1920s, the general tariff on manufacturing in 1932, the encouragement of cartels and the imposition of controls on foreign investment in the 1930s. Britain in the 1930s has been described as a ‘managed economy’,26 but, looked at another way, this was a major retreat from competition which turned out to be quite long-lasting given the political difficulties of reversing it. Only in the later 1960s did tariffs fall below levels in the mid-1930s and only in the 1970s did price–cost margins in manufacturing return to pre-First-World-War levels. Crafts (2012a) provides a detailed account of the implications for productivity. As might be expected from the literature on competition and productivity performance for the recent past,27 the implications of weak competition were seriously adverse. Three big lessons can be drawn from the experience of the 1930s. First, when attempting fiscal consolidation at the zero lower bound (ZLB), monetary stimulus is important to underpin growth. This implies that conventional 2 per cent inflation targeting delegated to an independent central bank is likely to be inappropriate and that reducing real interest rates through committing to create higher inflation may be helpful. Second, if monetary stimulus is to work, the transmission mechanism into the real economy that ‘crowds in’ private spending is important; in the 1930s, this worked to a large extent through the housing market because mortgage finance was permissive and planning controls were absent. Third, it is wrong to assume that the fiscal multiplier is necessarily large in a depressed economy; when public debt-to-GDP ratios are high, this may not be the case.

24 These proportions are derived using the standard formula; see, for example, Ali Abbas et al. (2011). It is, however, true that the first-year effect of a fiscal consolidation would have raised D/Y in the 1930s because, although the multiplier may have been low, the debt ratio was very high. 25 ‘Financial repression’ occurs when governments intervene to gain access to funds at below market interest rates, typically through regulations imposed on the capital market including imposing obstacles to international capital mobility. This played a major part in the post-Second-World-War reduction in D/Y in Britain and other European countries. 26 Booth, 1987. 27 Bloom and Van Reenen, 2007; Nickell, Nicolitsas and Dryden, 1997.


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IV. The 1980s The 1980s are interesting for today because fiscal consolidation was accompanied by tight monetary policy and yet the economy achieved a strong recovery from 1983. In so far as policy contributed to this return to growth, supply-side reform played a leading role rather than monetary or fiscal stimulus. For the longer term, the supply-side policies of the 1980s, which were largely upheld or extended by later governments, had a favourable effect on productivity performance through until the crisis. Table 3 shows that the structural budget deficit was reduced by about 4 per cent of GDP during the first Thatcher government. The fiscal stance was defined by the controversial 1981 Budget, which intensified fiscal consolidation during a severe recession and was greeted with much disapproval by many economists, including the 364 signatories to a letter to The Times deploring the policy. The impact of this tight fiscal policy was not offset by reductions in real interest rates or devaluation. On the contrary, as Table 4 reports, real interest rates rose in the early 1980s and remained high on average throughout the decade. Indeed, the disinflation of the first half of the 1980s was based on maintaining persistently high real interest rates.28 This marked the end of the long period of capital controls and financial repression and was a hallmark of the Conservative years through 1997.29 The exchange rate rose by over 25 per cent in the first two years of the Thatcher government, driven largely by monetary policy tightening.30 However, relaxation of fiscal policy and exchange rate depreciation associated in part with oil price falls did provide a modest stimulus to growth as recovery gathered pace in the mid-1980s. TABLE 3 Fiscal indicators for 1980s’ Britain

1979–80 1980–81 1981–82 1982–83 1983–84 1984–85 1985–86 1986–87 1987–88

Government debt 44.0 46.1 46.1 44.8 45.1 45.1 43.2 40.9 36.6

Source: http://www.ifs.org.uk/fiscalFacts. 28

Nelson, 2001. Chadha and Dimsdale, 1999. 30 Britton, 1991. 29


Budget deficit 4.1 4.8 2.3 3.0 3.7 3.6 2.4 2.0 1.0

Per cent of GDP Structural budget deficit 4.0 3.4 –1.5 –1.4 0.0 0.6 0.6 1.9 2.2


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TABLE 4 Interest rates in 1980s’ Britain

1979 1980 1981 1982 1983 1984 1985 1986 1987

Short rate 13.65 16.07 13.15 11.51 9.09 7.62 10.78 10.68 9.66

Long rate 11.34 11.93 13.01 11.74 10.24 10.16 10.11 9.47 9.31

Real short rate 2.10 –0.47 1.91 3.26 4.59 2.74 4.86 7.34 5.58

Per cent Real long rate 0.11 –2.75 0.83 1.93 2.21 4.12 4.03 5.13 5.29

Note: Real rates of interest are calculated on an ex-post basis. Real long rates are based on the yield of consols minus a three-year backward-looking weighted average of actual inflation rates; for further details, see Chadha and Dimsdale (1999). I am grateful to Jagjit Chadha for providing me with the data. Source: Data set for Chadha and Dimsdale (1999).

The conduct of monetary policy, which was based ostensibly on targets for the growth of the money supply, was complicated by financial innovation which contributed to the eventual abandonment of these targets as unworkable. The background to this was financial liberalisation and deregulation of credit markets, which was a key component of supply-side reform aimed at improving the efficiency of the capital market; the implication was very rapid growth of consumer credit and bank lending to the company sector, which grew at 17 and 13 per cent per year, respectively, during 1983–87.31 Financial liberalisation was a desirable policy trajectory for long-term economic performance.32 But this was also a supply-side reform that had a major short-term impact on the growth of aggregate demand, working in particular through the household savings ratio, which fell by about 7 percentage points between 1980 and 1987.33 Econometric analysis by Aron et al. (2012) that takes into account the direct and indirect (through house prices and household debt) implications of the change in credit conditions facing consumers suggests that financial liberalisation raised consumer spending by an amount equivalent to at least 3.5 per cent of GDP in 1987.34 31

Cobham, 2002. It was central to the UK’s ability to develop and exploit its comparative advantage in financial services. That said, it is clear that the subsequent spectacular rise in banks’ leverage went too far and that regulation that required banks to have higher ratios of loss-absorbing equity capital to assets would have been appropriate (Miles, Yang and Marcheggiano, 2013). 33 Office for National Statistics, 2006. 34 This is implied but not explicitly stated by Aron et al. (2012). I am very grateful to John Muellbauer for extracting this estimate for me. The econometrics also finds a small effect from expectations of improved future income growth as the Thatcher reforms were implemented. 32


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TABLE 5 Real GDP per head 1870 1913 1937 1950 1964 1979 1989 2007

West Germany 57.6a 74.1a 75.4a 61.7 101.3 115.9 109.8 98.6

France 58.8 70.8 72.2 74.7 92.2 111.1 105.4 94.3

UK 100 100 100 100 100 100 100 100

a Estimate refers to Germany. Source: Angus Maddison historical database and the Conference Board (2012). West Germany in 2007 calculated from Statistisches Bundesamt Deutschland 2010.

The macroeconomic problems of the early Thatcher years were partly caused by and partly used as a justification for radical supply-side reforms that departed from the ‘post-war consensus’ and that were aimed at ending a long period of relative economic decline during which British economic growth had failed to match that of other European economies. Among the signature policies were reforms to industrial relations, tax and benefits, privatisation, deregulation and the abandoning of selective industrial policy and reliance instead on horizontal industrial policies. Over time, this change in policy stance had favourable effects on productivity performance and the NAIRU.35 As Table 5 suggests, by the end of the 1980s the tendency to fall behind France and West Germany had started to be reversed and, over the long term, by 2007, it had been eliminated. The fiscal consolidation phase of the first two Thatcher governments had some supply-side-friendly components, the effects of which built up over the medium term. Reforms of fiscal policy were made, including the restructuring of taxation in 1980 by increasing the standard VAT rate from 8 to 15 per cent while reducing the top rate of income tax from 83 to 60 per cent (then to 40 per cent in 1988), and, by indexing transfer payments to prices rather than wages, reducing the OECD measure of the replacement rate from 24.2 per cent in 1981 to 18.6 per cent in 1987 while saving about 3 per cent of GDP by the mid-1990s.36 Industrial subsidies were cut (at 1980 prices) from £5.6 billion in 1978–79 to £0.9 billion in 1986–87.37 Privatisation proceeds averaged 0.7 per cent of GDP in the years 1984 to 1987, while the process of making nationalised industries saleable improved

35

The non-accelerating inflation rate of unemployment (NAIRU) is the unemployment rate where the labour market is in equilibrium and the economy has a zero output gap. 36 Tyrie, 1996. 37 Wren, 1996. © 2013 The Author Fiscal Studies © 2013 Institute for Fiscal Studies


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productivity by cutting labour costs.38 Nevertheless, cuts to public capital spending, failure to expand the VAT base, a surprising timidity in reducing corporate tax rates and flawed design of privatisations were serious blemishes. In terms of international comparisons, British total factor productivity (TFP) growth was relatively strong in the period 1980 to 1995 (Table 6), which was quite a contrast with the earlier post-war period. A central reason for this was a shift of emphasis from industrial to competition policy. Selective industrial policies had proved a massive disappointment in the 1970s with regard both to sponsoring hi-tech national champions and to dealing with the problems of ailing industries, while the weakness of competition in product markets was a defining characteristic of Britain from the 1930s through the 1970s.39 An intensification of competition in product markets especially in the internationally-tradable sector, which started before and continued after Thatcher, proved an effective way to address problems of weak management and debilitating industrial relations which had undermined productivity performance hitherto. Protectionism was discarded with liberalisation through GATT (General Agreement on Tariffs and Trade) negotiations, entry into the European Community in 1973, the retreat from industrial subsidies and foreign exchange controls in the Thatcher years, and the implementation of the European Single Market legislation in the 1990s. Trade liberalisation in its various guises reduced price–cost margins.40 The TABLE 6 TFP growth in the market sector

Austria Belgium Denmark Finland France Germany Italy Netherlands Spain Sweden United Kingdom

Per cent per year 1995–2007 1.5 0.1 –0.1 2.8 0.9 0.7 –0.4 1.1 –0.6 1.6a 1.0

1980–95 1.3 0.7 1.1 1.4 1.3 0.8 0.8 0.4 0.6 1.7 1.6

a Figure for 1995–2005. Source: Timmer et al. (2010) and van Ark (2011) using data from EU KLEMS.

38

Green and Haskel, 2004. Crafts, 2012a and 2012b. 40 Hitiris, 1978; Griffith, 2001. 39


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average effective rate of protection fell from 9.3 per cent in 1968 to 4.7 per cent in 1979 and 1.2 per cent in 1986.41 Increased competition and openness in the later twentieth century was associated with better productivity performance. Proudman and Redding (1998) find that across British industry during 1970–90, openness raised the rate of productivity convergence with the technological leader and, in a study looking at catch-up across European industries, Nicoletti and Scarpetta (2003) find that TFP growth was inversely related to PMR.42 The implication of a lower PMR score as compared with France and Germany was a TFP growth advantage for the UK of about 0.5 percentage points per year in the 1990s. At the sectoral level, when concentration ratios fell in the UK in the 1980s, there was a strong positive impact on labour productivity growth.43 Entry and exit accounted for an increasing proportion of manufacturing productivity growth, rising from 25 per cent in 1980–85 to 40 per cent in 1995–2000.44 The impact was felt at least partly through greater pressure on management to perform and through firm–worker bargains that raised effort and improved working practices. Increases in competition resulting from the European Single Market raised both the level and growth rate of TFP in plants that were part of multi-plant firms and thus most prone to agency problems.45 Liberalisation of capital market rules allowed more effective challenges to incumbent management and a notable feature of the period after 1980 was divestment and restructuring in large firms and, in particular, management buyouts (often financed by private equity), which typically generated large increases in TFP levels in the period 1988–98.46 The 1980s and 1990s saw major changes in the conduct and structure of British industrial relations. Trade union membership and bargaining power were seriously eroded. This was prompted partly by high unemployment and anti-union legislation in the 1980s but also owed a good deal to increased competition.47 The 1980s saw a surge in productivity growth in unionised firms as organisational change took place under pressure of competition48 and de-recognition of unions in the context of increases in foreign competition had a strong effect on productivity growth in the late 1980s.49 The negative impact of multi-unionism on TFP growth, apparent from the 41

Ennew, Greenaway and Reed, 1990. PMR is an abbreviation for ‘product market regulation’ and denotes an OECD index of the extent to which competition is inhibited by regulation. 43 Haskel, 1991. 44 Criscuolo, Haskel and Martin, 2004. 45 Griffith, 2001. 46 Harris, Siegel and Wright, 2005. 47 Brown, Bryson and Forth, 2008. 48 Machin and Wadhwani, 1989. 49 Gregg, Machin and Metcalf, 1993. 42



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1950s through the 1970s, evaporated after 1979.50 The NAIRU, which was 9.5 per cent in the early 1980s, eventually fell to 5.7 per cent by the late 1990s driven by falls in the replacement rate, cuts in taxes on labour and rapid declines in the coverage of collective bargaining.51 Overall, the productivity pay-off was boosted by the interaction of labour market reforms and product market competition. Three more big lessons can be taken from the experience of the 1980s. First, supply-side reforms can, to some extent, offset the deflationary impact of fiscal consolidation even in the short run. The key characteristic of such policies is that they increase efficiency and productivity while also crowding in private sector spending. Second, the composition of fiscal consolidation matters; it can be designed to promote better supply-side performance and, to some extent, this was achieved in the 1980s. Third, a serious programme of supply-side reform based on improved horizontal industrial policies – not all of which require government expenditure – can significantly improve long-term growth performance. In this respect, the main message from the 1980s is the key contribution made by increased competition in product markets.

V. Applying the lessons from history today The key to promoting economic growth in the early 1930s was to combine fiscal consolidation with other policies that expanded demand, in particular ‘cheap money’. Cheap money was a policy package that entailed keeping short-term interest rates close to zero while raising inflationary expectations through announcing policies intended to raise the price level. This reduced both short and long real interest rates and then pushed the former into negative territory. The policy worked once it was clearly communicated and the government was credibly committed to it. Given that interest rates are at the lower bound, a modern equivalent to the cheap-money policy may be appropriate if growth continues to be weak. This would, at the very least, entail significant modification of the inflationtargeting regime currently delegated to the Monetary Policy Committee (MPC) but it could deliver more stimulus than further quantitative easing. At the ZLB, economic theory tells us that an option is to reduce real interest rates by a policy that convinces people that inflation will be higher in future. Although the UK has had above-target CPI (consumer price index) inflation for some time now, unlike the 1930s ex-ante real interest rates have not been reduced to the extent required to offset the aftermath of a severe banking crisis. Inflation measured by the GDP deflator, which is a better measure for 50 51

Bean and Crafts, 1996. Nickell and Quintini, 2002. © 2013 The Author Fiscal Studies © 2013 Institute for Fiscal Studies

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producers, has averaged about 2.4 per cent in the last three years;52 moreover, the public’s medium-term inflationary expectations have changed very little during the crisis53 and the Bank has repeatedly emphasised that its central expectation is that inflation will return to the target rate before long as transitory inflationary shocks evaporate. In sum, this suggests both that there has not been a regime change and that the MPC remains keen to emphasise that. The experience of the 1930s tells us that, to be effective, a change in monetary policy would have to be clear and credible. To implement an equivalent to the cheap-money policy, it would be important formally to abandon the 2 per cent CPI target and replace it with a new mandate for the Bank of England. This could take the form either of raising the target rate of inflation or of adopting either a price-level target or a nominal GDP target that entails a significant average rate of inflation over a period of years. In any event, the key would be to persuade the public that there will be inflation, that nominal interest rates will not be raised to counter this and that the target is credible.54 Abandoning the current framework for monetary policy and its well-anchored low inflationary expectations is not a step to be taken lightly, although it has started to be explicitly discussed as economic growth remains stubbornly weak.55 If monetary stimulus is not forthcoming, then this places a premium on supply-side measures. The starting point here is that it is important to make the composition of fiscal consolidation as growth friendly as possible. Even in the 1980s, this was by no means fully achieved even though, at a time when Labour splintered and the Falklands were invaded, the Conservative government survived the adverse electoral implications of its policies as unemployment rose steeply and income inequality surged, the latter to no small extent as a result of fiscal changes.56 In terms of its likely impact on the supply side, the trajectory of fiscal consolidation post-2010 does not compare favourably with that of the 1980s, perhaps reflecting tighter political constraints and/or the difference that coalition makes. Table 7 reports that while net investment by government is projected to fall by 54 per cent from 2009–10 to 2017–18, current expenditure is

52

Office for National Statistics, 2012. Macallan and Taylor, 2011. 54 Fully to implement a 1930s-style monetary stimulus, control of monetary policy would have to be taken away from an independent Bank of England and given back to HM Treasury. This would be ‘regime-change big time’. 55 However, the more radical step of ending Bank of England independence and its possible rationale in terms of making higher inflation more credible does not appear to be under discussion. 56 Clark and Leicester (2004) suggest that about half of the 9 percentage point medium-term increase in the Gini coefficient resulted from changes in tax and benefit policies compared with the counterfactual of continuing as under the previous government. 53



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TABLE 7 Public spending totals

Current spending Social security benefits Debt interest Net investment Total

2009–10 (out-turn) 600.9 197.1 30.9 49.5 669.7

£ million, current 2017–18 (projected) 716.2 230.7 67.1 22.9 765.5

Note: Tax credits are included in social security benefits. Source: Office for Budget Responsibility, 2011 and 2012.

expected to rise by 19 per cent and an increase in spending on social security of £33.6 billion is likely to be largely paid for by a cut of £26.6 billion in net investment. In 2017–18, interest payments on the national debt are expected to be about three times net public investment. Since 2009–10, replacement rates for unemployed workers have risen appreciably57 as benefits have been indexed to the RPI (retail price index), which has risen faster than earnings, and this threatens an increase in the NAIRU. On the tax side, the standard rate of VAT was increased to 20 per cent at the start of 2011 and the headline corporate tax rate is coming down from 28 per cent in 2009–10 to 21 per cent in 2014–15. But an analysis of the composition of tax revenue shows that the increase in the share from VAT is much more modest than in the 1980s (only about 2.6 percentage points), while the projected increase through 2016–17 in the sum of receipts from income tax, corporation tax and National Insurance contributions exceeds that of consumption and property taxes by £15 billion.58 The number of higher-rate income tax payers is projected to be 5.2 million in 2015–16 (about three times the 1990–91 figure), compared with 3.2 million in 2009– 10,59 while the VAT revenue base remains narrow by OECD standards. Moving beyond the design of fiscal consolidation per se, a wide range of supply-side reforms could be made which would raise either the potential level of GDP or, more ambitiously, its rate of growth. The experience of the 1980s suggests this is a strategy worth considering. Such reforms can be seen as a substitute for more conventional macroeconomic stimuli or they may even be regarded as an essential complement if it is believed that the financial crisis has undermined productive potential to the point where a demand stimulus would very quickly run into supply constraints.60 Policies 57

Adam, 2012. Institute for Fiscal Studies, 2012. 59 Adam, 2012. 60 The size of the output gap at present is quite unclear amidst much discussion of the so-called ‘productivity puzzle’. The Office for Budget Responsibility (2012, chart 3.4) displays estimates for 2012 58


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that improve productivity performance will generally also make investment more attractive and will raise permanent income and thus consumer expenditure. Moreover, in the context of worries about fiscal sustainability, faster productivity growth makes the fiscal arithmetic less challenging. The appropriate strategy is to pursue evidence-based improvements to horizontal industrial policies while retaining the advantages of strong competition in product markets and an open economy. Some possibilities focusing on infrastructure, education, taxation and regulation are sketched below. In each case, the aim is to highlight examples where there is highquality applied economics research to support the argument that there is a significant impact on the level and/or growth of productivity. This survey is intended to be indicative rather than comprehensive. From a growth perspective, the UK has been investing too little in infrastructure. Making good this shortfall soon is a good idea. Investment in public capital has positive effects on real GDP where an output elasticity of about 0.2 is a reasonable assumption and also ‘crowds in’ private capital in the medium term.61 To maximise the impact of infrastructure on growth, it is best financed by indirect taxation.62 The UK net stock of public capital relative to GDP, and to the stock of private capital, fell sharply between 1980 and 2000 (from 63.9 to 40.3 per cent and from 61.5 to 37.0 per cent, respectively) and recent levels of public investment imply these ratios will continue to fall over the long run to levels that are clearly suboptimal. To maintain the level of public capital to GDP at a growth-maximising level, investment of about 2.7 per cent of GDP per year would be needed,63 but over 1997–2008 the UK invested only 1.5 per cent of GDP and over the period 2012–13 through 2017–18 this will fall to an average of 1.1 per cent.64,65 Transport infrastructure, especially roads, is a key aspect of public capital where there is a strong case for more investment. Eddington (2006, pp. 204–6) estimated that, in the absence of road pricing, there was a case for from reputable independent forecasters ranging from 0.8 to 5.2 per cent of GDP, but Martin and Rowthorn (2012) make the case that it could even be close to 10 per cent. 61 Kamps, 2005a. 62 Kneller, Bleaney and Gemmell, 1999. 63 Kamps, 2005b. 64 Office for Budget Responsibility, 2012. 65 The growth-maximising ratio of public to private capital is where the marginal product of public capital equals the after-tax marginal product of private capital and the interest rate on government debt. For a Cobb–Douglas production function using the two types of capital, this ratio Ω = γ/(1–γ)2 where γ is the output elasticity of public capital and the growth-maximising ratio of public capital to output Φ = Ω1–γ. For γ = 0.21, this is 42.3 per cent and, given the 95 per cent confidence interval around γ, the 95 per cent confidence interval on Φ is 32.4–52.1 per cent (Kamps, 2005b). The growth-maximising rate of public investment can then be shown to be (δ+g)Φ where δ is the depreciation rate of public capital and g is the trend growth rate, assumed to be 4 per cent and 2.3 per cent, respectively, for the UK. In the long run, public capital / GDP = (Ipub/Y)/(δ+g), so investing 1.5 per cent of GDP in public capital implies that this ratio would be only 23.8 per cent. © 2013 The Author Fiscal Studies © 2013 Institute for Fiscal Studies


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investment of £30 billion on strategic roads between 2015 and 2025 to deliver annual welfare benefits of about £3.4 billion per year and a GDP impact of £2.3 billion per year in 2025. However, if road pricing were to be implemented, then the much smaller road-investment programme (£5–£8 billion) that would be justified would generate welfare benefits of about £30 billion (about 1.6 per cent of GDP) and a GDP gain of about half that figure. Government gross revenue from charges would be about 1.3 per cent of GDP or about 1 per cent allowing for reduced flows of indirect taxes.66 Most of this investment has not been made and, of course, road pricing has not been introduced for the strategic road network as vote-seeking behaviour dominates economic efficiency. Reviews of unfunded transport schemes regularly show a large number of schemes with high benefit–cost ratios.67,68 The public is firmly opposed to road pricing, which is not surprising given that many individuals rationally fear that they will be losers and that the history of the one major British scheme, the London Congestion Charge, shows that it has been manipulated for revenue-raising purposes.69 A potential solution to this systemic government failure is to change the governance structure and make the road network a regulated utility with statutory obligations, as has been quite widely recognised of late.70 Such an entity would need a revenue stream, which could initially be derived from regarding some current government taxes as ‘user charges’ and then substituting these user charges by road pricing in a transparent way. There is evidence that the quality of education as measured by cognitive skills has strong positive effects on growth. On this measure, UK schooling quality has increased slowly over time since 1975 but is still well below that of the best performers. Hanushek and Woessmann (2012) estimate that increasing the average of PISA (Programme for International Student Assessment) scores in maths and science from 503 in 2009 by 25 points – roughly half the difference between the UK and Finland or Singapore – would raise the long-run growth rate by about 0.3–0.4 percentage points. What does this imply for policy? The obvious point might seem to be that education spending should be protected during fiscal consolidation. Careful studies do point to modest improvements in test results for English schools when educational spending rises, especially if this is focused on disadvantaged pupils, and well-targeted spending appears to have respectable benefit–cost ratios.71 That said, it may be more important 66

Department for Transport, 2006. Dodgson, 2009; Smith, Alexander and Phillips, 2011. 68 The typical unfunded scheme has a benefit–cost ratio of 3.6 – about three times the latest estimate for HS2. 69 Crafts, 2009. 70 CBI, 2012; Glaister and Smith, 2009; Newbery, 2005. 71 Machin and McNally, 2012; Holmlund, McNally and Viarengo, 2010. 67


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effectively to address principal–agent problems in the delivery of education. Woessmann et al. (2007) find that, across countries, about 80 per cent of the variance in cognitive skills is explained by the organisation of the education system. The most important implications of this study for English schools seem to be to strengthen the examinations system and to provide effective competition in the provision of schooling. The key point is that designing better incentive structures could improve the quality of schooling even at a time when expenditure is under pressure. The Mirrlees Review provides a powerful case for tax reforms which would have significant positive effects on the level of GDP and its growth rate. The key is to reduce personal and, especially, corporate income tax, paid for by raising consumption and property taxes. The proposals made include implementing a land value tax, ending exemptions from VAT and making a normal rate of return non-taxable.72 For example, the revenue of around £25 billion from ending VAT exemptions could finance a reduction of about 20 percentage points in the corporate tax rate and, according to OECD estimates, this might raise long-run real GDP by as much as 6 per cent.73 If revenues were used to address the distributional effects of VAT reform, the opportunity to cut corporate taxes would be greatly reduced but not completely eliminated. While some of these changes could be made quickly, the Mirrlees Review agenda is, as its authors themselves say, really a long-term programme for reform and is ‘politically challenging’. An aspect of corporate tax that has had considerable attention of late is the treatment of innovative effort. The main reform of the previous government was the introduction and subsequent extension of the R&D tax credit. This is reasonably well targeted and has probably stimulated R&D expenditure by an amount similar to what modelling had predicted ex ante,74 in which case it is reasonable to think that benefits in terms of productivity increases would be a multiple of the revenue costs.75 However, these remarks clearly do not apply to the costly new ‘patent box’ proposal.76 More generally, there is a danger that government exaggerates the importance of domestic R&D for productivity growth. As Table 8 reports, its contribution is relatively small compared with that of other forms of intangible capital or TFP growth, which in considerable part reflects the diffusion of new technologies from abroad. In this regard, it is striking that the sector that contributed most to labour productivity growth in the recent past was distribution – which did virtually no R&D but was a very effective

72

Mirrlees et al., 2011. Arnold et al., 2011. 74 Bond and Guceri, 2012. 75 Griffith, Redding and Van Reenen, 2001. 76 Griffith and Miller, 2011. 73



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TABLE 8 Sources of growth in real GDP per hour worked in the UK market sector

Tangible capital Labour quality R&D Other intangibles TFP Total

1990–95 0.95 0.17 0.05 0.58 1.19 2.94

1995–2000 0.74 0.25 0.04 0.63 1.87 3.53

Per cent per year 2000–08 0.67 0.16 0.05 0.47 0.90 2.25

Note: Derived using the formula Δ(Y / HW ) Δ(TK / HW ) Δ( HK / HW ) Δ( RD / HW ) Δ( IK / HW ) ΔA =α +β +γ +δ + Y / HW TK / HW HK / HW RD / HW IK / HW A where TK is tangible capital, HK is human capital, IK is intangible capital, RD is the stock of R&D, all weighted by their factor shares, A is TFP, Y is real GDP and HW is hours worked. Intangible capital includes capital services from mineral exploration and copyright, from design, from advertising and market research, from firm-level training and from organisational capital. Source: Dal Borgo et al., 2013.

user of new technologies, especially ICT. In turn, an important reason for relatively rapid adoption of ICT in the UK was light product market regulation.77 It should be noted, however, that not all UK regulation is productivity friendly. Land-use planning is an aspect that creates massive allocative inefficiency and reduces labour productivity both by making land unduly expensive and by restricting city size, which means that agglomeration economies are forgone and spatial adjustment is impeded – successful British cities are too small from the point of view of efficiency.78 Cheshire and Sheppard (2005, p. 660) conclude that ‘controlling land supply by fiat has created price distortions on a par with those observed in Soviet-bloc countries’. One of the implications is an implicit regulatory tax rate of around 300 per cent on office space, which makes cities such as Leeds and Manchester more expensive than even New York and San Francisco.79 These findings, together with suboptimal investment in transport, are worrying given the role of agglomerations in underpinning productivity. Graham (2007) analyses productivity on a disaggregated spatial basis and finds it is very strongly related to measures of market potential, in particular proximity to GDP defined in terms of time rather than distance, with elasticities being much larger for services than manufacturing and particularly big for financial and business services. The policy implication is that reform of land-use planning should be a high priority. This point can be given more force by considering the housing 77

Conway and Nicoletti, 2007. Leunig and Overman, 2008. 79 Cheshire and Hilber, 2008. 78


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market, where the distortions caused by planning restrictions lead to a large welfare loss – in 2007, the value of land used for building was 300 to 400 times its value if restricted to agricultural use80 and the price of a new house greatly exceeded its construction cost. The number of housing starts in England has not exceeded 200,000 in any year since 1988,81 but household formation is projected to be at least 220,000 per year over the next 20 years.82 Hilber and Vermeulen (2012) offer a baseline estimate that, if there were no planning restrictions, the real price of houses would be 35 per cent lower, which would imply a housing stock for England around 17 per cent or 3.8 million bigger. On grounds of economic efficiency, it is clear that a policy of liberalising planning restrictions is highly desirable in any case and this could be an important complement to a policy to reduce real interest rates. Whereas, in the modern era, the transmission mechanism for a cut in real interest rates works in the housing sector primarily through its impact on house prices, in a situation where the supply of housing land was elastic it could work, as in the 1930s, through increases in the number of houses built and in the equilibrium housing stock. This would be much more useful in generating economic growth. Building an extra 100,000 houses per year would have a direct impact on real GDP of about 1 per cent,83 and a liberalisation of the housing market might sustain an increase of at least this magnitude for quite some time. This is the aspect of supply-side reform which has the potential to raise aggregate demand rapidly in a similar way to the liberalisation of credit in the 1980s if, as in the 1930s, it provided a price signal that delaying construction was an option worth giving up. Given that planning decisions continue to be implemented by local authorities, it is clearly important that local communities are given significant financial incentives to make them wish to encourage development. Since there are very large gains to be shared from the change in land use, this is, in principle, perfectly possible and could be achieved in a number of ways. One attractive solution is the idea of community land auctions proposed by Leunig (2011), which could deliver perhaps £45,000 per house to local councils in the south-east.84 Once again, a key component of returning to growth would be to redesign incentive structures and, once again, given the powerful lobby groups opposed to such initiatives, this reform would be ‘politically challenging’. 80

Nickell, 2009. Department for Communities and Local Government, 2012. 82 Nickell, 2009. 83 Centre for Economics and Business Research, 2011. 84 The basic idea is for the local authority to invite offers of land. It then grants planning permission and re-auctions the land, keeping the difference in value. The council can, in effect, exploit its monopsony power to obtain a much larger share of the planning gain than has been possible hitherto. 81



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VI. Conclusions Faced with a weak recovery, it is important to have policies to offset the deflationary impact of fiscal consolidation. In both the 1930s and 1980s, this was achieved; the mechanism was monetary stimulus at the ZLB in the first case and supply-side reform in the second. There is scope to adopt similar strategies today and there could be important complementarities between macro and micro economic policies. Successful supply-side reform need not involve massive government outlays – so it can be compatible with fiscal consolidation – but it definitely involves paying serious attention to incentive structures and dealing with government failure. In the 1930s, monetary stimulus was delivered through a strategy for reducing real interest rates when the scope to cut nominal rates was exhausted – namely, through the adoption of a credible policy to raise the price level and change inflationary expectations. This is quite different from current Bank of England policy, which emphasises that inflation will soon return to its target level. To follow the example of the 1930s would entail abandoning the current framework of delegating to an independent central bank the task of hitting a 2 per cent target for CPI inflation. This may well be politically ‘too difficult’. In the 1980s, supply-side reform had positive effects on productive potential. Interestingly, an important component was financial liberalisation, which had an appreciable short-term impact on consumer spending as credit conditions were relaxed. The most likely candidate now to deliver a similar crowding-in effect is liberalisation of land-use planning, which could stimulate a significant increase in housebuilding and would be an important complement to monetary stimulus by strengthening the transmission mechanism to the real economy. Reforms to horizontal industrial policies to improve productivity performance are desirable in any event but gain added importance as a way of improving the fiscal arithmetic in the context of seeking to eliminate an uncomfortable structural deficit. There are plenty of candidates that can be identified from research in empirical economics but all of them are ‘politically challenging’. Among these are policies to repair a shortfall in infrastructure investment, to improve the quality of education, to facilitate the expansion of successful agglomerations, and to make the tax system more conducive to growth without undermining the achievement of distributional objectives. Any redesign of supply-side policy should be mindful of the importance of minimising adverse effects on competition in product markets, which suggests that returning to selective industrial policies like those of the 1970s or to protectionism would not be appropriate. The coalition government’s approach to fiscal consolidation since 2010 is clearly not designed to give a high priority to growth-friendly policies and © 2013 The Author Fiscal Studies © 2013 Institute for Fiscal Studies

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this suggests that significant supply-side reform is unlikely. Overall, the worrying implication of this review of policy options for today is that if conventional monetary and fiscal policies are not available, unlike the 1930s and the 1980s, politics may make it impossible to turn to the alternatives. Then the Chancellor is left just like Mr Micawber – hoping that something will turn up.

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