Supply and demand

‘We need a drastic and urgent shift in our economic values’

What comes first – production, or consumption? That is one of the oldest puzzles in economics, the chicken or egg of the dismal science, and the one that always comes to mind whenever the latest retail figures drop, as they did yesterday. Does supply create its own demand, as Jeanbaptiste Say is meant to have put it, or does consumption drive production? If the latter, is it the government’s job to bolster demand to make sure that factories don’t run at half capacity? If the former, should we even bother celebrating yesterday’s strong numbers – sales volumes rising 0.6pc month on month in June?

Modern free-marketeers, of which I’m one, are in part followers of Say. We believe in radical supply-side reform: ultimately, the long-run prosperity of the economy is all about entrepreneurship, the right kind of investment and productivity growth. It’s about people making goods and services ever more efficiently, and inventing new ones and new ways of doing things; for that, they need to enjoy the best possible incentives to work, invest, save and acquire the right skills. Tax rates need to be low and flat, and regulations not too burdensome. Labour markets must be flexible.

But what of the short term? Demand can fluctuate, on occasion wildly, and that can lead to a hit to the supply-side, even if prices and wages are pretty flexible. A collapse in demand can lead to a collapse in supply, as we saw during the financial crisis. But there is a way to avoid that: to make sure that monetary policy absorbs shocks and that the financial system remains robust at all times. The answer isn’t for the government to spend and borrow a lot: that is an inefficient and ultimately counter-productive way of smoothing out the economic cycles, contra Keynes. Ideally, the entire banking system would be reformed along much more free-market lines, but absent that governments and central banks should aim for sound money and make sure that nominal GDP never collapses. We haven’t been very good at this: monetary policy tends to be either too loose or too tight, but that’s no reason not to try to do better.

It is great news, of course, that the retail sales figures bounced back in the second quarter, but not because they are somehow sustainably driving the economy. The purpose of economic activity is consumption, both now and in the future. Nobody works for no reward. Month to month, and even year to year, consumers who decide to run down their savings can, of course, trigger greater demand and greater GDP growth. But that isn’t sustainable. Over long periods of time, consumption isn’t the real driver of growth: it is the product of an expanding economy, not its cause.

So why is it that the financial markets, which don’t think like I do on this matter, were so intrigued by the latest retail numbers? Sales volumes jumped 1.5pc quarter on quarter in the three months to June. Car sales are down, which means that overall consumer spending may also have fallen, but this is largely as a result of the substantial increase in Vehicle Excise Duty in April 2017. The bottom line: the economy, while sluggish, isn’t falling off a cliff and is growing slowly.

But the problem is that we have spent the past 25 years, at least, excessively focused psychologically on consumption and the latest retail snapshot, and not enough on production. A 1pc increase in capital expenditure, or an improvement in our skills base, will do far more for our economy than a 5pc increase in retail spending.

Long-termism and deferred gratification trump short-termism. Ideally, the Government would already be working on a supply-side revolution intended to reposition the post-brexit UK, with massive changes to our tax code, regulatory system, planning rules, infrastructure financing and education system. The reality, of course, is that the May administration is debilitated: it cannot even handle the negotiations, let alone think about anything else. But there is no choice: to make Brexit a success, and confound the doomsayers, we need a drastic and urgent shift in our economic values.

‘Tax rates need to be low and flat, and regulations not too burdensome’