The key to real economic growth is in the supply-side

Politics – and there must be a clichéd quotation to accompany this – moves very quickly. Rewind ten months, to a time not mired by double dip recession, and we see an impressive David Cameron at the helm: clear and firm in deficit reduction, internationally outstanding in Libya and managing a cohesive Lib-Con coalition against all odds. He even managed to steal some of the limelight at the Olympic Games just the other day.

Today, however, Cameron and his Government are under intense pressure to change their economic strategy. As economic output fell by 0.5 per cent in the second quarter (a revised figure) and public borrowing rose by 5 per cent, the very basis of their deficit reduction plan and its supposed effects are being undermined.

The most recent and resounding of these calls to Osborne have been made by two heavyweight economists on the Left, Joseph Stiglitz and Paul Krugman. Stiglitz, in a deliberately comical letter to the Chancellor, asks him to “call off the mad austerity”; Krugman bluntly declares, “This is a time for the UK government to be borrowing and spending. Boost the economy and give the private sector time to de-leverage.”

At the heart of this very argument we see the phrase “Growth versus Austerity” being tossed around. This is an inaccurate description of the dilemma. Proponents of austerity cannot simply disregard economic growth, one of the most significant macroeconomic measurements of performance. Likewise, a Labour government would certainly be making similar cuts in public spending. The argument boils down to the issue of whether a Keynesian, demand stimulus should be employed or not; whether the Government needs to spend its way both out of recession and debt.

It is not difficult to see why a change in course would be a political disaster. If Osborne were to announce softer cuts and more spending now, after months of pressure from the economic Left – quite frankly the thought of the smile on Ed Balls’ face is somewhat nauseating. Cameron’s government would be annihilated and it would be the perfect ammunition for Labour’s resurgence in 2015.

But most importantly, a change would be economically foolhardy. There is very little evidence to suggest that short term, demand-induced economic growth can either properly rescue us from recession or reduce the deficit. In fact, the sort of growth that more spending would bring would only lead to further inflationary problems.

Perhaps the most flagrant reason to avoid any more spending is the simple fact that this is no ordinary cyclical downturn: we have the highest levels of debt since war – this is a downturn with debt very much at the heart of the problem. How can more spending solve the problem of too much spending in the past?

The Government therefore must achieve real growth through different means. With very little room for manoeuvre on the demand side, the key is the supply-side. A panacea of the dismal science, a radical supply-side agenda is the only way to achieve long term real economic growth through an increase in the productive capacity of the economy.

Such policies involve a lot of buzzwords that we are used to hearing: incentives, education, technology and deregulation, to name but a few. The fundamental idea is that by liberating labour and product markets, by pruning red tape, we can stop suffocating small businesses and the employment prospects of the young. In reality, many improvements in the supply-side of the economy arise from the private sector – private firms increasing training budgets to boost labour productivity, for example. The point here is that strong and lasting economic growth, through rises in productivity, can be brought about without necessarily exacerbating the deficit.

It is true that a rise in demand is needed to harness this spare capacity. But supply-side improvements are the very means by which the State can create the conditions for greater demand and spark private investment– and perhaps the only means at the moment.

Think of the Swedish recovery: reforms such as for-profit schools, vouchers in health and education and the privatisation of pensions. Think contracting out and deregulation to create hyper-competition. And think capital market measures, promoting enterprise culture and improving incentives to work. The ideas and schemes are there – what is needed is some political initiative.

The case for the supply-side has been shrouded in ideology and stigmatised ever since the days of Thatcher. But this is no ideological movement – this is a measure of pragmatism to try to rescue the British economy. And as Jonathan Portes, Director of NIESR, has declared: “almost all economists would agree that over the medium to long term, what really determines growth, jobs and prosperity is indeed the health of the supply-side of the economy”. He would even support opening up our borders further to let the market allocate labour more efficiently.

This Government has flirted with the supply-side improvements – we have seen the creation of new enterprise zones and falls in corporation tax. But a more rigorous approach and thus active leadership is needed. Vince Cable, the Business Secretary, has surprisingly stood by the Coalition’s spending cuts, but has been the main obstacle to deregulation that so badly needed. He has labelled the deregulatory push needed as “ridiculous and bizarre”. It would not be ridiculous or bizarre to replace him in the looming reshuffle.

This is a defining moment for Cameron and Osborne. For the latter, it is a difficult time to stand by his guns, and add a few more weapons. He may have reached new levels of unpopularity, but any future improvement in economic performance would be hugely rewarding for him. And they say fortune favours the brave.