Industrial strategy must foster new sectors, not save existing ones

Industrial strategy must foster new sectors, not save existing ones

Phil Mullan

Many commentators have been critical of the UK Government’s recent Green Paper ‘Building our Industrial Strategy’ (January 2017) for its timidity and lack of substance. While these assessments are valid there is a more important prior issue to get right in developing a modern industrial strategy: clarity about the sources of Britain’s appalling levels of productivity. In fact until this understanding is attained, spending more on industrial policies could compound the existing problems by sustaining a zombie economy.

Too often in the past, in this country and in other advanced economies, ‘modern’ industrial strategies have been launched to little positive effect in the succeeding years. Instead, pre-existing economic trends have mostly continued as before. This ineffectiveness is usually because governments adopting industrial strategies have at the outset jumped the crucial stage of identifying the fundamental barriers to further economic development. Partly, this is because some experts believe that the advanced economies are already at the frontier of most existing technologies. The focus for industrial policies easily slips into building on what is already in place, and maybe rectifying any shortcomings relative to other advanced countries. This is far from enough to reinvigorate today’s tired mature economies.

To set the objective of ‘catching up’ with the best technologies available is a legitimate initial goal for today’s less developed countries. But for mature economies, the goals should be: ensuring the very best businesses are able to keep reinventing themselves, and creating the conditions for the new to develop. The objective should be facilitating transformation to a stronger future, not reinforcing the present.

Unfortunately the Green Paper risks going down that same path with its emphasis on ‘extending our strengths’ and ‘closing the gaps’. Instead the government should focus on bringing about what doesn’t yet exist, not on adjusting and extending what does exist. Any country’s economic prospects five, 10 or 20 years hence depend not on its current capabilities – or lack thereof – but on the assets and strengths which have yet to be realized, possibly even to be imagined. To give Britain a prosperous 21st century, we must acknowledge that it is sectors and businesses that are currently largely unknown and possibly even unimagined that will really drive productivity and employment growth.

Old sectors vs. new ones
It is reasonable to identify certain existing sectors that have more potential to develop and expand. The Green Paper, for instance, mentions automobiles and ultra-low emission vehicles, artificial intelligence and satellite technology, aerospace, life sciences, industrial digitalisation and nuclear energy. But it is even more important that an industrial strategy’s sector policy doesn’t limit horizons to what can already be identified. Britain’s future economy will not ensure prosperity for everyone if it remains limited to the sectors of today. An effective industrial strategy needs to guard against a mentality that targets initiatives on existing sectors, at the expense of setting the conditions for brand new, still-to-be-born ones.

Setting the conditions for new sectors of production has nothing to do with ‘picking winners’, or even picking the ‘next’ winners – approaches about which the Green Paper is rightly sceptical. Rather, setting the conditions for a real economic renaissance demands that policymakers assess, in depth, why new sectors of production and the new, high-value jobs that go with them have for years largely eluded us. Identifying and removing the barriers to new industry formation is the best thing governments can do to realize the benefits of industrial strategy.

Get serious about public spending on R&D
The Green Paper does include important proposals that could, in suitable circumstances, make a genuine difference to productivity, even if they often don’t go far enough. For instance, the Green Paper is right to indicate that inadequate research and development (R&D) limits making the discoveries, inventions and the follow-on innovations necessary for productivity growth over the longer term.

In the UK both business and public spending on R&D fall far below what is needed. Each has been on a declining trend since the 1980s: for the year 2014, the OECD puts UK business enterprise expenditure on R&D as equivalent to 1.1 per cent of GDP, while government-financed R&D is 0.5 per cent. This level of commitment represents little more than half the EU’s target of 3 per cent of GDP by 2020. Much more government commitment to R&D spending – including an increase to 2 percent of GDP in public spending, over three times the level supported by current plans – needs to be sustained for at least a decade. This would help to reverse the effects of years of declining spend by successive governments and most businesses.

Bring back creative destruction
The Green Paper highlights another crucial area for necessary change: the productivity benefits from higher rates of capital investment. But the existing proposals don’t get to grips with why capital investment has been so lacking.

The Green Paper does suggest some useful investment measures, not least when it wants more seed and early-stage venture capital funding to help genuine entrepreneurial startups – those employing people – to experiment, innovate and grow. However, until the structural constraints on business dynamism – the process of business birth, growth, decline and exit – are dealt with, even these pro-entrepreneurial proposals will be much less effective than they could be. State-backed venture capital funding could simply go to the safest, established startups, leaving younger, riskier firms starved of cash. That would stifle innovation, not foster it.

This point illustrates the most important shortcoming in the Green Paper. Many of its proposals risk perpetuating the productivity problem by supporting existing businesses, rather than by starting a durable, full-on revival of economic dynamism. A big part of today’s productivity problem is the failure of innovation and technological development to spread across the whole economy. This is due to the decay in business dynamism, a trend highlighted in my forthcoming book Creative destruction: How to start an economic renaissance.

‘Creative destruction’ is primarily the process by which older, less productive firms close down and are replaced by newer, more productive ones. Businesses that adopt new and improved procedures, products and services grow, displacing those that don’t. The term was popularised in the 1940s by the economist Joseph Schumpeter, in his book, Capitalism, Socialism and Democracy, who described it as ‘the essential fact about capitalism.’ Politically a conservative, Schumpeter drew upon themes developed by Marx in describing both capitalism’s limits and also its intrinsic tendencies to overcome those limits through the periodic destruction of capital values.

Free market economists gave a fresh airing to the term in the 1980s and 1990s, though mostly in a narrower sense to justify deregulation, business reorganisation and a diminished role for the state. Ironically, at exactly this time, mature capitalism was entering a period of more contained business cycles and a more muted process of creative destruction. This underlay the major problem accounting for the productivity slowdown, not an absolute disappearance of investment and innovation, but the wider economic atrophy that hinders their spread.

This has brought about what many now term a ‘zombie’ economy: too many resources are stuck in low productivity areas and in ‘zombie’ firms. The latter are businesses that are too weak to invest in transforming their basic operations. That slows down the diffusion of innovations. At the same time, zombie firms have enough income from somewhere to survive. In that way they hold back the creative destruction effect. Zombie firms spread congestion across the economy. In turn, that has a dampening effect on the investment plans of startups and existing viable businesses.

Aggregate national productivity is held down. First, more low-productivity businesses hang on. Second, fewer higher-productivity businesses set up or expand, because they’re constrained by a sclerotic economy. Overall, innovation slows and productivity growth suffers. Reviving creative destruction today, with its original association with renewal, can usher in a different culture and business climate from that of the past quarter-century, and help energise the economy.

Public policy keeps zombie firms on life support

Public policies have played a significant role here in keeping low-productivity businesses on life-support. The application of regulations, government spending and procurement policies, changes to insolvency rules, easier monetary policies: all these and more policies since the 1980s have primarily acted to support incumbent businesses and conserve the economy as it is.

This policy-induced aspect of productive weakness needs to be openly recognized, not least because this is something an active industrial policy can seek to change. Policies with unhelpful, if unintended, consequences can be amended or revoked to reverse their productivity-impairing effects. An effective industrial strategy is one that shakes the economy up, not preserves it. Economic renewal necessitates closing down low-productivity, low-profit or loss-making businesses to make way for new sectors and new businesses.

Such a return to higher levels of business dynamism will need to go hand in hand with comprehensive measures to assist people during the transition between jobs. These transitional measures are necessary because displaced workers and their families deserve generous public financial assistance as they transfer to good new jobs. The assistance given should include real help to find new jobs and, if required, to move house to be near them, and publicly funded training provided by the new employers.

A national public conversation
Recasting industrial strategy to enable creative destruction to operate again will not be a painless affair. A national public conversation is necessary to explore why a different course of policy is needed for economic renewal. Such a nationwide debate is a precondition for securing popular understanding and support, and a mandate for this direction of change. This is how Britain’s economic renaissance can begin.

Further reading:
Adalet McGowan, M., Andrews, D., Criscuolo, C. and Nicoletti, G. (2015) The Future of Productivity, OECD.
Adalet McGowan, M., Andrews, D. and Millot, V. (2017) ‘The Walking Dead? Zombie Firms and Productivity Performance in OECD Countries’, OECD Economics Department Working Papers, 1372, January.
Caballero, R., Hoshi, T. and Kashyap A. (2008) ‘Zombie lending and depressed restructuring in Japan’, American Economic Review, 98(5).

Phil Mullan is the author of Creative Destruction: How to start an economic renaissance (Policy Press, 2017). He combines business with research and writing on the economy. Previous publications include the book ‘The Imaginary Time Bomb: Why an Ageing Population is not a Social Problem’ (IB Tauris, 2000). Currently working independently, in 2014 Mullan completed eight years in senior management roles with Easynet Global Services, an international communications services company. Previously he had been chief executive of the internet services and training company Cybercafé Ltd.