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What Have Two Decades of British Economic Reform Delivered?
David Card and Richard B. Freeman
For much of the nineteenth and twentieth centuries, the British economy, which pioneered the Industrial Revolution, had a disappointing growth record, falling markedly from the top ranks in the league economic tables. In 1979, the United Kingdom was twelfth in per capita gross domestic product (GDP) among advanced Organization for Economic Cooperation and Development (OECD) member countries, well below Germany, France, and other European Union (EU) economies. In response to this weak economic performance, successive U.K. governments adopted policies designed to move the economy back to "premiere league" status. Beginning with Margaret Thatcher and continuing under John Major and Tony Blair, these reforms sought to increase the eﬃcacy of labor and product markets and limit government and institutional involvement in economic decision making.
The trend toward more markets and less government is not unique to the United Kingdom. Many other advanced economies also responded to the economic challenges of the 1980s and 1990s by granting markets more leeway in the allocation of resources and the setting of prices. All the major economies eliminated restrictions on the flow of capital by the early 1980s. Most privatized state-run industries in the 1980s and 1990s. All lowered marginal-tax rates for high-income earners. Most also made labor contracts more flexible and moved from national wage setting to more localized collective agreements in the 1990s. For its part, the EU Commission pushed competition policies and the reduction of subsidies to declining industries while seeking a uniform social charter to regulate labor market outcomes. Outside the EU, the other English-speaking economies--the United States, Canada, Australia, and New Zealand--moved toward less state and institutional intervention in the economy.
Have two decades of economic reform significantly shifted the market orientation of the U.K. economy relative to other advanced OECD economies, or has the United Kingdom only kept pace with its peers? What have the reforms done for aggregate economic output and the average income of citizens? Have the reforms improved the position of the United Kingdom in the economic league tables?
This paper examines these questions. Section 1.1 compares the market orientation of the United Kingdom relative to other advanced economies using a diverse set of market indicators. We find that the post-1980 reforms have made the United Kingdom more market friendly than its EU competitors and that, in the 1990s, the United Kingdom ranked higher on some measures of freedom of markets than the United States. Section 1.2 contrasts macroeconomic outcomes. We show that from the 1980s through the 1990s the United Kingdom arrested the relative declines in gross domestic product (GDP) per capita and labor productivity that characterized earlier decades, and partially closed the gap in per capita income with France and Germany through relative gains in employment and hours. While the United Kingdom did not experience an American-style "New Economy" boom, it combined high employment-population rates with rising real wages for workers--an achievement that the United States was unable to match until the late 1990s. Section 1.3 examines the link between the reforms and outcomes. Since there is no ready counterfactual against which to compare the observed U.K. performance, our analysis is more judgmental. Based on macro-level analyses and the micro-level evidence available from several companion studies, we conclude that economic reforms contributed to halting the nearly century-long trend in relative economic decline of the United Kingdom relative to its historic competitors, Germany and France.
1.1 The Market Friendliness of the United Kingdom and Other Advanced Economies
They used, when I first came in, to talk about us in terms of the British disease. Now they talk about us and say, "Look, Britain has got the cure. Come to Britain to see how Britain has done it." That is an enormous turn-around. (Margaret Thatcher, Financial Times, 15 February 1988)
Government should have a role that is enabling: supporting small businesses, encouraging technological advance; investing in science; above all, promoting competition and removing the barriers to business growth ... I call it a Third Way ... Supporting wealth creation. Tackling vested interests. Using market mechanisms. (Tony Blair, speech at World Economic Forum, Davos, Switzerland, 18 January 2000)For the past two decades, British economic reforms have been motivated by a desire to increase the reliance on market forces relative to the role of the state in the determination of prices and the allocation of resources. Thatcher's Conservative government privatized industries and council housing, enacted laws to weaken trade unions, created financial incentives for workers to choose private pensions, and reduced the benefits available to unemployed workers--all the while preserving national health insurance and other features of the welfare state. The subsequent Major government pursued a similar agenda, abolishing the Wages Councils and privatizing many of the remaining state-owned enterprises. In the late 1990s, Blair's New Labour government continued to introduce market-enhancing reforms. It created tax breaks for employee share-ownership programs, opposed EU directives that business interpreted as antibusiness, and enhanced the work incentives of the income support system. In the realm of monetary policy, the Labour Party went beyond the Tories by shifting in-terest-rate-setting authority from the Treasury to an independent Monetary Policy committee. While there are some exceptions--the Thatcher campaign to centralize public-sector decision making and limit the independence of local government, and the Blair eﬀorts to ease the formation of unions and introduce a national minimum wage--the main goal of the U.K. policy reforms has been to reduce the economic role of the state and enhance the role of markets in determining economic outcomes.
For purposes of analyzing the potential eﬀect of these reforms on the economic performance of the United Kingdom relative to other advanced countries, it is important to determine whether these reforms were larger or smaller than, or similar to, those in other advanced countries. This in turn requires measures of the institutional and policy stance of advanced countries. In the absence of a single GDP-style measure of the free-market stance of economies, we use a variety of indicators that rate countries by the way diﬀerent markets determine outcomes. Some of these indicators are based on objective data, while others are based on the assessments of expert analysts or surveys of managers. Some of the measures are produced by think tanks with conservative ideological bents, such as the Fraser Institute's and Heritage Foundation's "economic freedom" indexes. These indexes stress particular measures of economic freedom, including low taxes, that fit a more conservative agenda while excluding social-inclusion factors such as education spending. Another broad set of measures are the indexes of "competitiveness" produced by the World Economic Forum, most recently in conjunction with the Harvard Center for International Development. These indexes mix the stance of policy, institutions, and specific outcomes and give more favorable scores to social democratic regimes that perform well economically than do the economic freedom indexes. Finally, the OECD and some independent scholars have produced diverse indexes of regulations and procedures in particular markets, such as labor markets, product markets, and capital markets.
All of these measures of the market friendliness of institutions have shortcomings. Some are formed by weighting linear sums of subindexes, with the weights determined subjectively and with some potential measures excluded; some choose scalings for their measures that have little basis in theory or other empirical work; and some treat written regulations as if laws or administrative decrees were enforced, when in fact enforcement of regulations that limit markets may vary across countries. All of the measures ignore potential complementarities or substitutions among institutions. The economic freedom indexes, which are designed to measure the economic stance of entire economies, diﬀer in several ways among themselves. The Fraser Institute index includes military conscription, top-marginal-tax rates, transfers and subsidies, and the size of government expenditure. The Heritage Foundation and Wall Street Journal (Heritage/ WSJ) index includes corporate and value added taxes as well as government expenditure, but it ignores conscription and individual tax rates. Both the Fraser and Heritage measures include low inflation, which is an outcome of institutions and policies rather than a measure of freedom in markets.
Competitiveness indexes have other problems. The groups who provide these measures have changed their modes of calculating competitiveness over time, and so their indexes do not reflect the same underlying data over time. In 2001, for example, the Fraser Institute revised its historical indexes, producing generally modest adjustments as it accumulated additional data (see http://www.fraserinstitute.ca). The World Economic Forum and Harvard Center for International Development's 2000 Competitiveness Report reported two diﬀerent indexes, one for "current competitiveness" and one for "growth competitiveness," reflecting the diﬀerent weights placed on the same data for diﬀerent purposes. Finally, the measures for individual markets can be criticized for focusing on some features of markets and regulatory mechanisms but not on others. For instance, measures of labor market performance concentrate on the extent of centralization of bargaining and employment protection legislation but not on the potential for court suits over discrimination or insurance of pension moneys. Comparisons of the market friendliness of product markets ignore diﬀerences in bankruptcy laws, which can greatly aﬀect business formation and dissolution. While the subindexes necessarily cover only parts of economies, they provide checks on the more aggregate measures. If an aggregate index rates an economy as market friendly even though it has highly restrictive labor contracts or a highly regulated product market, then we will know that something is amiss. These measures also allow analysts to relate policies or institutions to the specific outcomes they are designed to aﬀect, rather than to measures like GDP per capita, which depend on a wider set of factors.
Diﬀerences and shortcomings among the indexes notwithstanding, the principal indicators of the market stance of economies show that the policy reforms of the 1980s and 1990s made the United Kingdom one of the most market-friendly economies in the world. The high ranking of the United Kingdom in market friendliness at the turn of the twenty-first century reflects that there were more rapid market-oriented reforms in the United Kingdom than in most other advanced economies, rather than any increased regulation in other countries.
1.1.1 Measures of Economic Freedom
The indexes of economic freedom produced by the Fraser Institute and the Heritage Foundation value key features of capitalist economies: private property rights, freedom to operate a business, and freedom of capital and labor markets. Both include measures of free trade, which reflect international policies, while neither includes measures of immigration policies. Each treats cursorily the labor market institutions on which much policy discourse concentrated in the wake of the divergence of unemployment- and employment-population rates between the United States and the EU in the 1980s and 1990s. The indexes diﬀer in their emphasis on particular dimensions of "freedom" (Hanke and Walters 1997). The Fraser Institute index rates countries with military conscription as having less economic freedom and gives countries with high top-marginal tax rates and government transfers and subsidies low scores. The Heritage/WSJ index includes low corporate taxes and low value added taxes. Reflecting the view that even a democratically chosen state sector is inimical to economic freedom, the Fraser and Heritage indexes rate the size of government as an important negative indicator of freedom. The Fraser and Heritage measures also count low inflation, which is an outcome of institutions and policies, as a measure of economic freedom.
There is a third aggregate index of economic freedom, the Freedom House indicator, which diﬀers somewhat from both the Fraser and Heritage measures. This indicator was produced only once, however, and we exclude it from our analysis. It diﬀers from the Fraser and Heritage/WSJ indexes by considering freedom of association in the labor market as a measure of economic freedom but ignoring tax rates. It is suﬃciently well correlated with the other two indicators in the period covered by all three measures that we do no harm to the analysis by leaving it out.
While the Fraser and Heritage measures lead to somewhat diﬀerent rankings of the market stance of particular countries, the high correlation between them shows that they are measuring essentially the same phenomenon. For all of the countries covered, including the less developed countries, Hanke and Walters (1997) report a rank-order correlation between the two indexes of 0.85 in 1995 to 1996. For advanced OECD countries, we obtain rank correlations of 0.83 between the Fraser and Heritage/WSJ measures. Most important, both indexes give a relatively high rank to the United Kingdom in the 1990s. In the Heritage/WSJ, the United Kingdom ranks third in 1996 among advanced OECD countries in market friendliness (after the United States and New Zealand, tied with the Netherlands) and fifth in 2001 (after Ireland, New Zealand, the United States, and Lux-emburg). According to the Fraser Institute index, in 1995 the United Kingdom was tied for second with the United States among the advanced OECD countries (after New Zealand), while in 1999 it ranked second after New Zealand and just ahead of the United States.
The Fraser Institute Index
Because the Fraser Institute index (FII) is available from 1970 to the present, while the Heritage index covers a shorter period, we use the FII to measure the change in the United Kingdom's position over time. The FII measures the degree of economic freedom on a scale from 1 to 100, with higher values reflecting more freedom in market transactions.
Table 1.1 reports the FII for the United Kingdom and other major OECD countries every five years from 1970 to 1995 and for 1999. The levels and trends in the FII for various countries accord well with informal observations on the level and change in policy stances toward markets. Most analysts place the United States and other English-speaking countries at the market-friendly end of the spectrum, and Nordic countries and other social-democratic EU countries at the other end. The FII orders the countries in the same manner. Still, the index has potential errors. It does not deal with the implementation or enforcement of regulations that limit markets, so countries like Italy with a sizable underground economy are arguably given too low a score. It also ignores the use of the judicial system to regulate market transactions, which may lead to an overstatement of the market freedoms in the United States. From 1970 to 1975, the index shows a decline in economic freedom in most countries (although not in the United States) when governments struggled to control inflationary pressures.