Time for supply-side policy: Thatcher versus Schumpeter

Peter Bofinger explains what lies behind the conflict within Germany’s Ampelkoalition on economic policy.

Germany’s economic weakness threatens to become chronic. According to the European Commission’s latest forecast, its economy will grow by just 0.1 per cent this year.  The spring forecast of the German Council of Economic Experts comes to a similarly unfavourable prognosis of 0.2 per cent.

As unemployment in Germany remains low, however, while many companies complain about a shortage of skilled labour, Keynesian demand management is not the policy prescription. ‘Time for supply-side policy’ was therefore the title of a recent commentary by Gerald Braunberger, one of the editors of the Frankfurter Allgemeine Zeitung.  

Talk of ‘supply-side policy’ immediately conjures up Margaret Thatcher, the British prime minister primarily concerned with breaking the power of the trade unions, and Ronald Reagan, the tax-cutting United States president who was her ideological soulmate. In Germany, the supply-side policy propagated by the Council of Economic Experts in the 1970s primarily stood for the idea that the then high unemployment called for wage restraint by the unions.

Market-liberal

In Germany today, a 1970s-style supply-side policy is being urged by Christian Lindner, federal minister of finance and leader of the market-liberal Free Democratic Party (FDP). Robert Habeck, the minister for economic affairs and climate action from the Greens, favours by contrast a modern version, labelled ‘transformative supply policy’.

Traditional supply-side policy is characterised by the idea that the state is ultimately the cause of all problems and the solution must therefore be to reduce its influence on the economy. The programme of the FDP is paradigmatic in this regard. It was recently advanced in two papers, ‘12 points to accelerate the economic turnaround’ and ‘Five-point plan for an intergenerationally fair budgetary policy’, published last month and this.

Both are characterised by the demand for strict adherence to the Schuldenbremse (debt brake) enshrined in the Basic Law, the German constitution. In principle, this fiscal rule requires a balanced national budget, with the exception of a permissible deficit for the federal government of 0.35 per cent of gross domestic product. At the same time, the FDP is in favour of extensive tax cuts and depreciation relief for companies, as well as tax relief for households with higher incomes.

This would be made compatible with the Schuldenbremse via cuts in social expenditures: the social-insurance-based statutory pension and the Bürgergeld (citizen’s income) for the long-term unemployed and individuals unable to work. There would also be reductions in ‘bureaucracy’—although it is unclear which specific regulations would be abolished or restricted—and subsidisation of renewable energies would be ended ‘as quickly as possible’.

Little in common

The ‘transformative supply policy’ propagated by Habeck has little in common with this. Habeck is sceptical about the Schuldenbremse which is such a totem for Lindner. ‘Personally, I make no secret of the fact that I think the way the German debt brake is constructed is not intelligent enough,’ he said in an interview last November. It was ‘very static’ in failing to  distinguish between current expenditure and investment which brought returns in later years.

Habeck’s alternative is focused on climate neutrality. So the goal is not merely to expand existing production structures but to accelerate their reorganisation to achieve more sustainable and resilient prosperity.

Unlike Lindner, Habeck is thus against a blanket reduction in corporate taxes. Instead, transformative investments should be supported in a targeted manner.

This is described in more detail in a paper from the ministry, ‘Industrial policy in the new era’. It reads: ‘Economic security is therefore a new priority of our industrial and economic policy … This means … keeping strategically important industries in Europe, bringing back those that have been lost and attracting new key industries.’

Neoclassical view

With these diametrically opposed ideas of supply-side policy, it is hardly surprising that Habeck and Lindner cannot find a common answer to the serious economic problems facing the country. But, standing by the Schuldenbremse,Lindner has the upper hand—even though this prevents the active industrial policy urgently needed to address the ‘middle technology trap’ of the German economy.

Conceptually, Lindner reflects a simple neoclassical view in which fully informed companies always find the best solutions in the face of perfect competition. In this model world, the state ultimately only plays the role of troublemaker.

Habeck’s ‘transformative supply policy’, on the other hand, is not quite so easy to categorise. It differs from traditional, Keynesian-style, demand-focused policy, in that it does not derive its justification from a lack of demand linked to un- and under-employment.  

The patron of such a concept is not John Maynard Keynes (1883-1946) but his contemporary Joseph Schumpeter (1883-1950). Schumpeter was (and still is) overshadowed by Keynes, because his theory of innovation-driven growth, developed as early as 1911, hardly resonated during the decades of hyperinflation and then mass unemployment bracketed by two world wars.

Subsidies and loans

Neoclassical growth theory assumes the accumulation of a given unit good, which inevitably leads to diminishing marginal returns. Schumpeter, by contrast, focused on the ‘reutilisation’ of available resources for completely new goods. But Schumpeter’s growth theory does not stop there. He was aware that good ideas alone are not enough to bring successful new products on to the market. The innovator needs ‘purchasing power’ to procure the necessary resources: employees, machines, building land.

Here too, Schumpeter sees the world differently from the neoclassical economists, for whom savings must precede investments. Schumpeter recognised, more than almost anyone else, that banks are able to create loans without first having collected savings from households. For him, the banker is therefore a central figure in economic activity.

Fast forward and Elon Musk is the kind of innovator Schumpeter had in mind. Where did Tesla get the funding to bring its electrical vehicles successfully to market? In 2014-15, Musk received more than $2 billion in state subsidies and loans, primarily from Nevada and New York. So it is no longer the banks but states that provide financial support for particularly innovative, and therefore also very risky, projects. The Italian economist Mariana Mazzucato refers to this as the ‘entrepreneurial state’.

The Chinese growth model of the past four decades is a perfect example of Schumpeter’s supply-side theory. It is based on extremely high credit creation by the banks, by international standards, and a state that has generally been successful in identifying promising business models, such as battery and solar technology, at an early stage. As the current property crisis makes clear, this does not though rule out undesirable developments.

Government-sponsored innovation

Ultimately, the Inflation Reduction Act and the CHIPS and Science Act initiated by the current US president, Joe Biden, are an expression of a supply-side policy which aims to drive economic growth through government-sponsored innovation. Germany is however at a crossroads between the supply-side policy of the 1970s and a modern iteration.

A basic prerequisite for a supply-side policy in the style of Schumpeter would be to abandon the Schuldenbremse, which today prevents the state from financing future expenditure through loans. As this would entail an amendment to the Basic Law, which requires a two-thirds majority in the Bundestag, the conservative CDU/CSU party would also have to be prepared to support such a reform.

This is anything but likely. Therefore, one cannot expect that the ‘sick man of Europe’ will make a speedy recovery.

This is a joint publication by Social Europe and IPS-Journal