How Big Government Killed Britain’s Regions: State spending has driven jobs out of England’s former industrial heartland..

Commentary, Taxation, Frontier Centre

The question of how to revitalize Britain’s economically moribund regions has bedevilled successive governments for at least three decades. The fact is, all the taxpayer money that has been poured into Wales, Scotland, Northern Ireland and the north of England in the name of reviving the local economies there is doing active harm to the emergence of a private-sector, post-industrial economy.

Britain, the first nation in the world to industrialize, was hit hard by de-industrialization in the 1970s and 1980s. Its origins and causes were complex, but the extraordinary power of trade unions in the workplace was a key factor. This power made the labor market the Achilles’ heel of the British economy for most of the 20th century. An additional factor was the very high ratio of public expenditure to GDP, which was in turn driven up by state subsidies to failing industries and the large losses incurred by nationalized industries.

Thirty years later, the trade unions have been reformed, the private sector exhibits genuine flexibility in pay bargaining and the U.K.’s formerly nationalized industries have been privatized. And yet for all this, the surprising thing is that the U.K. economy has not performed better than it has. This is partly explained by the fact that the ratio of public expenditure never fell much below 40% of national income. For protracted periods the performance of the economy appeared to be flattered by what turned out to be unsustainable bubbles in property and financial asset markets accommodated by monetary conditions that were too loose.

In the areas of the country where de-industrialization hit hardest, there was little sustained recovery in terms of private-sector activity. Instead the public sector expanded as a result of increased health, local authority and regeneration expenditure and increased spending on social-security transfer payments to households of working age. This created the conditions for de-marketization, which followed de-industrialization and made sustainable economic regeneration all but impossible in the Midlands and the North. Businesses and startups that want to do business in Britain’s de-industrialized hinterland must compete on world markets to sell their products and services. But they are forced to compete for labor with a state sector that overpays relative to the wages that the private sector can bear.

While trade-union power and an identifiable trade-union wage mark-up have largely been eliminated in the private sector, it remains entrenched in the public sector. Public-sector pay is set through national pay bargaining arrangements and the pay premium in the public sector has risen over the past 10 years. Today, average public-sector pay in the U.K. is more than 12% higher than in the private sector, and the true premium is significantly higher when one takes account of generous public-sector pension arrangements.

This pay premium is sometimes explained by the fact that the public sector employs a higher proportion of higher-skilled employees such as teachers, scientists, nurses and doctors. But even when pay is disaggregated by earnings levels, the public-sector pay premium at the bottom end of the earning distribution is more than 20%. And outside the Southeast of England, the public-sector pay premium can be 30% or higher relative to local wages in the private sector.

This premium, combined with welfare benefits whose rates are set nationally, emasculates local labor markets. The replacement ratio of welfare payments to average earnings in the U.K. is about 56%, slightly down from the 60% level in the 1970s. But in many local labor markets, social security benefits represent a much higher ratio of realistic private-sector earnings.

Social security benefits set a floor on wages—few people will work for less than they can receive on the dole. But at the same time, high public-sector pay drives the reservation wage—the wage at which an individual would be willing to accept a job—even higher. The result is that many households become permanently detached from the labor market and a large proportion of people who do work in these regions enjoy pay from the public sector that has no relationship to a market-determined wage.

In this way, for all practical purposes, many communities and whole regions—such as the North East and North West of England and Wales—are "de-marketized." The private-sector cannot flourish because price signals cannot operate properly in the labor market, which is probably the most important market in any economy. Increased local public expenditure, far from having positive multiplier effects, is at best irrelevant or, worse, a further aggravating factor.

Regional policy initiatives, such as community regeneration and the creation of regional development agencies, have had little or no impact. In fact the prosperity gap between Britain’s best- and worst-performing regions has if anything widened slightly over the past 15 years.

This feature of de-marketized communities and regions is not unique to Britain. The way the transition process was implemented in East Germany has created similar conditions as a result of analogous policy choices, such as moves to national pay bargaining and social security benefits and high levels of public expenditure. The result is comparable historical monuments and public buildings that look as handsome as ever. But there is little self-sustaining private-sector activity.

The high proportion of the local economy supported by the state in some parts of Britain has led some journalists to describe these parts of the British economy as Soviet. That may be a vivid way of getting the point across, but it is not strictly accurate. Consumers and public purchasing bodies pay world prices for goods and they enjoy the benefits of the division of labor through international trade.

The root causes of de-marketization in Britain’s regions is a bloated public sector aggravated by a national public-sector pay premium and social-security benefits that take no account of local labor-market conditions. A large public sector imposes costs that do particular damage to the manufacturing industry, the sector that faces the greatest international competition. If advanced economies such as Britain are to compete internationally and rebalance their economies, the principal mechanism for engineering this rebalancing will be lower ratios of public spending to national income.

Mr. Lightfoot has been special adviser to both the secretary of state for employment and the chancellor of the Exchequer. He is the author of the recently published "Sorry, We Have No Money—Britain’s Economic Problem," (Searching Finance, 2010).