February 28, 2015 by Paul Goldsmith
In a wonderful article in Prospect Magazine, the Labour peer Stewart Wood, a key advisor to Ed Miliband, has explained his case for how social democracy can be achieved without money, particularly from the City. Essentially, he puts the case for Labour becoming the “champions of a supply-side revolution from the left”. Unlike many of their current policies, it isn’t populist and it makes long-term economic sense. If only the current Labour leadership were able to present his thoughts in a way that would appeal and be understood by the electorate, it could make a massive difference to their economic credibility. Because I believe in what he is proposing, I’m going to try and do it.
First of all, a bit of economics explanation is needed. In 1945, the Labour Party manifesto “Let us Face the Future” introduced their rightly lauded programme to implement changes such as a proper safety-net welfare system and the NHS to help combat William Beveridge’s five “giant evils” of squalor, ignorance, want, idleness, and disease. Whilst the NHS and the nationalisation of 20% of the means of production are remembered most, behind it was the teachings of John Maynard Keynes, the economist. These teachings dominated economic and thus political policy for the next thirty four years (until 1979), apart from a short and significant period of Labour Government in the 1960s which I will come back to later.
Keynes argued that much of unemployment during recessions was “demand-deficient”, meaning that the economy had the productive capacity to produce a lot more than it was, but resources weren’t being allocated efficiently, so we had unemployment. Keynes felt that the solution to this was to stimulate aggregate demand (which is the demand for what the country produces and consists of consumption, investment, government spending, and net exports). If that happened, firms would need to employ people to meet that demand, and the money they paid those people who then increase demand further as those new employees would now be able to be consumers, and so on in a virtuous circle (economics students know this as the “multiplier effect” where one injection of money into the circular flow of income creates a more than proportional increase in aggregate demand). This would help reduce unemployment, which he felt was the most importance of the five “giant evils” (idleness) and should be able to help solve the
Keynes also pointed out the existence of the “paradox of thrift”, which meant that as a recession approaches, just when you would want the population to spend to lift aggregate demand and stave off the recession, people save more and consume less as they feel insecure. This “withdrawal” from the circular flow of income I talked about above leads to further falls in aggregate demand as firms may have less need for workers so hire fewer, meaning less income comes to households who spend less and so on. Keynes said that the answer to this would be for the government to spend money itself to fill in the gap in aggregate demand left by people saving. The government spending would lift aggregate demand, then firms either don’t lay off workers or hire more, those workers still have money to spend, and recession can be staved off.
This is what is commonly known as the ‘Keynesian stimulus’. It was invoked by Ed Balls and Labour during the last recession as a way to make sure that recession didn’t end up as a depression. It was recommended by Nicola Sturgeon, the SNP leader, last week as a way of shoring up the recovery and stimulating growth. It is also the basis of the new Greek governing party Syriza that there is an alternative to austerity in creating growth in order to pay off their debts. But the reason it was so keenly accepted by both mainstream parties from 1945 in this country was because we were genuinely rebuilding the country and had the opportunity to do so in a way that didn’t leave people unemployed. An example of how deeply Keynesianism pervaded into the political mainstream is that in 1961, after 10 years of CONSERVATIVE rule following the Labour government, we had unemployment of only about 100,000. Quite an achievement.
Yet, as we now know, the economy stored up problems like a balloon. The labour force, and in particular the unions, recognised that they possessed real power, due to owning what was now the scarcest factor of production. So they started pushing for large wage rises and resisting attempts to change their working methods in attempts to make them more productive. But more importantly, a policy that relied on redistribution of income and stimulating aggregate demand without any corresponding increase in the country’s productive capacity, which meant that inflationary pressure began building up, to the point where prices began to increase more than wages, leading to higher wage demands, which caused prices to rise more, and we ended up in a classic wage-price spiral. All this was happening without money to spend on investment to increase our productive capacity, which increased inflation further.
The other problem with the Keynesian stimulus was that it relied on the workers spending the money in their pockets on goods and services from UK firms. But UK firms, particularly the nationalised ones, free from any competitive pressures, were not producing goods and services at the price and quality that UK consumers wanted to buy. People bought imports instead, and so we found ourselves with two problems – firstly the rise in government spending wasn’t resulting in British jobs being created, and secondly we had a massive ‘Balance of Payments’ problem, which means the value of our exports was way beneath the value of our imports, and we were running out of foreign currency to buy those imports. This, in the end, led to us having to go cap in hand to the IMF in 1976 for a £2.3 billion loan, caused by a triple problem of unemployment, inflation and balance of payments deficits.
This paved the way for the governments of Margaret Thatcher. Convinced that the answer to our economic problems lay in markets being set free – so if you didn’t provide goods and services people wanted at a good price, your firm went bust, and if you didn’t provide skills that firms wanted at a good wage, you lost your job. The incentives that this would provide for firms to produce goods and services people wanted and for workers to learn skills that were valued would make our economy more competitive. That meant that, in the long run, inflation would come down, unemployment would come down, and foreigners would buy our exports. The Thatcher governments would help this along with what were known as “supply-side” policies – the idea being to grow aggregate supply (not demand) – which is the productive capacity of the economy. Or, in other words, the quality and quantity of our factors of production (land, labour, capital (man-made aids to production) and enterprise).
These supply side policies included withdrawing subsidies for loss-making industries to stop them relying on those subsidies and become more efficient (or close down), privatizing many of the utilities and other firms that had been state run to introduce competition to them, in addition to reducing benefits and lowering tax to incentivise people to seek a job. Central to all this were the teachings of so-called ‘Monetarist’ economists such as Milton Friedman – who argued that there was no such thing as ‘demand-deficient’ unemployment. Friedman said that there was always ‘full employment’, but some people just weren’t prepared to work at the wage that would get them a job. This, being so, any attempts to artificially inflate aggregate demand would result in inflation without actually solving any long-term problems – and all policies should therefore be aimed at increasing aggregate supply instead. Put another way, you don’t just throw extra wages at people, and hope they will be more productive, you offer them extra wages IF they are more productive.
You may, with the aid of hindsight, have spotted the problem already. The ‘supply-side’ reforms that took place over the course of the Thatcher government may have increased the UK’s productive capacity in the long-term, but there were some major short-term side effects and also some long-term ones too. Short-term, as we know, three million people were unemployed, entire towns and villages abandoned as their sole source of income was removed, the homeless re-appeared on our streets, and the country became unequal and divided. Long-term, the deregulation of the financial sector caused people to become dependent on debt, the population started to define themselves as consumers not producers, and, most importantly – ‘competition’ in the labour market became accepting jobs at low wages, paving the way for those who run firms to keep more of their profits, with many of those owners being foreign firms with no vested interest in the living standards of the British people.
THIS is where Stewart Wood and the concept of a “supply-side revolution from the left”. Wood points out that the 2008 financial crisis destroyed the view that markets left to their own devices would be engines of efficiency, stability and prosperity. But it also deprived the left of the tax revenues on which it its commitment to social investment and redistribution depended. They were relying too much on a narrow tax base (the City of London), and so cash transfers and public spending had to take a fall.
Wood then goes on to say that the real motivation for rethinking how the Labour Party could govern in a socially democratic way is not fiscal, but more about building a “better kind of economy” rather than simply compensating for the “side-effects of the economy that we have”. Wood mentions that the only time this has happened was for a short attempt by Harold Wilson in the mid-sixties to modernise British industry in the “white heat of technology era” (that foundered on barriers put up by both business and labour). But generally – “Labour’s economic policy has preferred the levers of tax-and-spend to those of economic restructuring”.
But this must change if Labour is going to have a credible answer to Britain’s long-term economic issues – which include not just declining real wages and rising inequality, but also a fall in productivity and international competitiveness. The changes that will achieve this HAVE to be presented honestly. There is no quick fix. What will be required will take a long time (more than one parliamentary term) and will probably need to be implemented incrementally. Labour can not achieve a left-wing supply-side revolution without working in partnership with business, instead of what continues to look like defiance. Given time – Wood feel we CAN move “Britain towards a higher-wage, higher-skill economy, sustaining higher standards of living and a more competitive private-sector economy.”
So, what steps would be needed? Wood sets them out:
- Incentives and constraints are needed on employers to radically improve their record in vocational training – to help make sure every job in the economy has a chance of providing a higher wage as it is more productive.
- Boosting competition in banking and energy markets – because the cost of energy is a constraint on supply of goods and the inability to get loans is a constraint on investment.
- Reforms to our labour market, including increasing the minimum wage and eliminating exploitative zero-hour contracts, which make work more rewarding and secure, and also create an incentive for more employers to invest in the productivity of their workforce – and for employees to be more motivated in their jobs to take advantage of ways to increase productivity.
- Modern industrial policy should be less a matter of who gets which subsidies, and more a matter of how to encourage employer organisations to exercise greater self-governance over companies in their sector – by using government’s procurement policy to promote best practice in areas such as skills training; and putting the export needs of British companies at the centre of government activity abroad.
- It also means having the courage to shift power away from Whitehall to help build thriving local and regional economies. Rather than putting up with a growing division between a productive (in money terms) minority in the south east and everyone else – build the clusters of institutions—at city and regional level—that can raise productivity and reduce inequality across our country.
The reason I support this approach is because, as Wood says, it is both fiscally credible but also potentially transformative. The modern Labour Party needs to be challenged to care as much about raising productivity and competitiveness as it cares about redistribution and public investment. But most importantly, this approach to supply-side reform could help achieve a long-term solution to the challenges of social injustice.
Stewart Wood has the ear of Ed Miliband, but that is only part of the battle. Miliband, who I believe agrees, needs to be brave enough and lucid enough to put this case forward in a way that the electorate will listen too. If not, maybe his replacement will do.