After many years of steady growth, Western economies are in trouble. The US economy grew at an annual rate of just 0.6 percent in the last quarter of 2007 and industrial output was static. Given substantial population growth, this suggests incomes may actually have been falling in recent months.
Whether the US slowdown will lead to recession in Europe is a moot point. Some countries, like Germany, are major exporters to America and will suffer accordingly. Others, like the UK, are characterised by high levels of personal debt related to house price inflation, and may be particularly vulnerable to turbulence in the banking sector.
In the UK the number of mortgage approvals in January 2008 was one third lower than in January 2007. This may reflect banks and building societies tightening their lending criteria in response to the recent liquidity crisis (when financial institutions found it more difficult to borrow money from other financial institutions) as well as reduced confidence among buyers. Large reductions in lending do not augur well for UK house prices. In many respects a fall in house prices will be a good thing for the economy but it is a development that may not help business in the short term, as lower house prices might lead to lower levels of consumption.
And there are other worrying developments. Energy bills have risen dramatically over the last five years due to political instability in the Middle East and increased demand in Asia. High gas, electricity and petrol prices mean people have less to spend on other products and raise business costs. In turn, this may also put downward pressure on wages as businesses seek to keep costs under control.
Manufacturers therefore face a double whammy higher input costs due to spiralling energy prices and lower sales growth due to declining customer confidence and falling disposable incomes.
Of course some firms are in a better position than others. Those that export to cash-rich oil exporting countries or booming Asian economies may well be better placed to weather the storm than those whose business is focused on the US, at least in the short term. Notwithstanding such variations, it seems likely that demands for governments and central banks to respond to the economic slowdown will grow. So what should they do?
Central banks will be tempted to try and boost their economies by cutting interest rates, and governments may want to increase the budget deficit and bail out people who have lost money. This has been the policy in the US but it could lead to problems. For example, rescuing failed businesses with taxpayers money is likely to encourage more reckless behaviour in the future. Higher government borrowing is likely to drive interest rates higher in the medium term and to reduce investment in the private sector.
In both the Eurozone and the UK, inflation is currently above target, by a large margin in the former case. The ability of the central banks to make significant interest rate cuts is therefore severely limited.
Many European countries have high budget deficits which further reduces their room for manoeuvre. The UK is a good example. After several years of sustained economic growth, the government should be in surplus. In fact it is likely to borrow more than £40bn this year. There is little scope to raise taxes to cover the shortfall, while the government seems unwilling to cut spending levels, which have now risen to around 45 percent of national income higher than in Germany. Economic slowdown will cut tax receipts and raise borrowing even further. Its a bleak picture and private industry will end up carrying the burden.
Many other European countries face similar problems and given these kind of constraints it seems unlikely that the manufacturing sector can look forward to significant reductions in either interest rates or the tax burden. Fortunately there is another way governments can help industry by deregulation.
A programme of deregulation will help manufacturing reduce costs. Energy is a good example. In this sector government intervention has made a difficult situation far worse. An increasing share of bills is being used to subsidise uneconomic renewable energy, such as wind power. In the UK, the governments Renewables Obligation will add £1bn a year to electricity prices by 2010. Proposals by the European Commission to introduce legal targets for green energy are likely to lead to further bill increases of ten to fifteen per cent by 2020.
And there is more bad news. Governments are increasingly turning to nuclear power in order to address fears about climate change and energy security. Yet when capital costs are included nuclear generation is significantly more expensive than coal-fired generation. Construction overruns, as well as largely unknown decommissioning and waste disposal costs, are likely to further inflate bills.
These developments could be disastrous for industries using large amounts of energy and will hit other manufacturers as consumers spend a higher proportion of their income on energy bills.
There is also a danger that these environmentalist policies will be counter-productive. Energy-intensive production may shift to the developing world, to China in particular, where plant is less efficient. Accordingly, overall pollution levels could actually rise.
There is therefore a strong case for deregulation of the energy sector in order to prevent government policies driving prices even higher and putting industry under still greater pressure in the context of the economic slowdown.
If politicians want to tackle climate change then there are far more efficient ways to do so than increasing the regulation of energy markets. A first step would be for governments to stop subsidising sources of CO2 such as the European coal industry. Second, energy companies should be allowed to build new, more efficient fossil-fuel power stations which promise to cut emissions by 20 per cent compared with existing plant. Third, the EU must stop subsidising biofuels. Rainforest is being ripped out to plant biofuel crops and oil-based fertilisers used to increase yields, while at the same time industry must pay more to support the subsidies.
While competitive energy prices are vital for the future success of European manufacturing, and heavy industry in particular, the deregulation of labour markets is perhaps even more important.
The high cost of employing workers in Europe is a major cause of the regions rapid relative economic decline and high unemployment. These costs are not only wages, but also additional burdens created by complex employment and tax regulations. Simplifying taxes and cutting red tape would provide an immediate boost to industry by significantly lowering overheads. Such a deregulation agenda should be an urgent priority for both EU institutions and national governments.
Unfortunately both the European Commission and some governments have taken a series of steps that have made labour markets more rigid in recent years. This means that workers laid off during the slowdown will find it more difficult to find new jobs. Manufacturers will find it harder to adjust the size of their workforces according to changing economic conditions.
On a more positive note, the entry of former Eastern-bloc countries into the EU, and the resulting increase in labour mobility, has partly compensated for the stricter regulation of industry in other respects. The larger pool of labour has enabled businesses to keep wage costs down and overcome particular skills shortages.
The liberalisation of migration within Europe shows how deregulation can deliver enormous economic benefits to manufacturing industry. National governments and EU institutions must learn from this and start reducing the burden of red tape, not just in energy and employment, important as they are, but across the board. Deregulation will not only help businesses survive difficult times it is absolutely essential if European industry is to remain competitive and fully exploit the opportunities presented by greater economic globalisation.
Dr Richard Wellings
Deputy Editorial Director
Institute of Economic Affairs
Industrial Focus: The European Journal of Manufacturing
, May/June 2008.