Come over to the supply side and transform your world

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This was published 14 years ago

Come over to the supply side and transform your world

By Ross Gittins

SOME people think economists' enthusiasm for ''free markets'' is the root cause of the world's present woes.

It's true that many economists were naive in their attitudes to regulation of the financial markets. But it's also true that their rediscovery of the power of market forces over the past 50 years has led to rapid growth in the world economy and much higher incomes in the developing countries.

Australia has participated in - and benefited from - this changed attitude under the heading of ''micro-economic reform''. But Professor Anne Krueger, of Johns Hopkins University, calls it ''supply-side economics'' and puts it in a global context in a paper she delivered to the Reserve Bank's 50th anniversary symposium last week.

Economists think of the economy as having two sides. The supply side covers the way land, labour and capital are combined to produce goods and services. The demand side covers the way people who have earned income from participating in production spend that income on the goods and services produced.

So Krueger says supply-side analysis focuses on the factors that increase the quantity of labour and capital available for the production process, as well as their productivity.

Fifty years ago, most economists were preoccupied with managing the strength of demand from year to year. Their great fear was that the economy would slump back into depression, so they kept stimulating our spending to make sure the economy never fell far short of full employment.

They took little interest in the production side of the economy, believing it would look after itself and that, in any case, there wasn't much governments could do about it.

''A major consequence of this focus was the neglect, or even the disbelief, in the role of incentives, and to some degree even of prices, in affecting the workings of the economy,'' Krueger says.

Marginal tax rates greater than 80 per cent were not uncommon, unemployment benefits were often almost as high as the wages workers had been getting, and some industries were taken over by the government.

Many people believed the Great Depression had shown that markets didn't work. They were preoccupied with the problem of ''market failure'' and the need for governments to intervene. The idea that governments could make things worse never occurred to them.

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So for a long time no one noticed the production side of the economy becoming less competitive, more inflexible (unable to quickly recover from the shocks that hit the economy) and inflation-prone. Its ability to keep growing was being affected. By the 1980s, however, economists started to wake up. Disillusionment with the performance of public sector enterprises led to privatisation, financial markets were considerably deregulated and tax structures reformed so that marginal tax rates didn't greatly damage incentives. There was also considerable deregulation of domestic industries and the labour market.

But Krueger is interested in the far more dramatic effects of supply-side reform in many developing countries, particularly in Asia.

Influenced by the attitudes of development economists in the postwar years, many newly independent countries set up quite socialist economies, with much government ownership of industries and extensive regulation of private industry.

They saw the establishment of a large manufacturing sector as the path to higher living standards, which they tried to bring about by adopting a strategy of import-replacement. That is, they protected their fledgling manufacturers against competition from imports, doing so at the expense of their agricultural export industries.

They were convinced that pretty much the only way to increase production was to acquire more capital equipment. Despite their fixed exchange rates, they adopted expansionary fiscal and monetary policies in the hope of spurring investment.

So they mainly generated inflation and ended up with overvalued exchange rates. This damaged their exporting farmers, who were also hit by high prices for their inputs and price controls on their output.

Eventually, however, the developing countries noticed the failure of agriculture to grow as expected. The peasants had been given poor incentives and had reacted accordingly. The more the economic managers tried to suppress market forces, the more trouble they had with black markets, smuggling, tax evasion and bribery of officials. Their infant industries never grew up to be able to survive and export without protection. But countries had trouble paying for the imports they still needed.

In the mid-1950s, Taiwan became the first developing country to abandon the import-replacement model and switch to export-oriented growth. South Korea followed in 1960. It cut protection, moved to a more realistic exchange rate, abandoned price controls, reformed tax structures, reduced budget deficits and raised interest rates.

The results were spectacular. In Korea, real wages and income per person increased sevenfold between 1960 and 1995, while the unemployment rate fell from 25 to 5 per cent. Little wonder China had started down the same track by 1980 and India by the early 1990s.

The rediscovery of the supply side is transforming the world economy. Over the 50 years to 2000, real income per person rose much more than fivefold in Asia, compared with less than threefold for the world as a whole. And with increased income came a rise in life expectancy of more than 20 years for the developing countries, as well as a doubling in the rate of literacy.

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