Going-For-Growth Feb2011 1826.Pdf

Going for Growth

Edited by Will Straw

Contents

Acknowledgements v

Contributors vii

Introduction xi by Will Straw

PART 1

The international challenge facing Britain 1 by Philippe Legrain

Britain’s long-term challenge 11 by Duncan Weldon

German economic policy at a crossroad 19 by Gustav Horn An American perspective on innovation and growth 23 by Richard Seline

What is business for? 31 by Charles Leadbeater

Taming the goose that laid the golden egg 41 by Kitty Ussher

Time for an economic challenge strategy 53 by Adam Lent

PART 2

Essential investment requires state enterprise 63 by Gerald Holtham

An audit of skills, immigration and growth 73 by Andy Westwood

Encouraging growth through innovation 83 by Stian Westlake

Driving growth at the regional level 101 by Anna Turley

Rethinking macroeconomic policy in the UK 115 by Tony Dolphin Acknowledgements

This book began life as a series of three lively roundtable discussions on the drivers of growth in the autumn of 2010, jointly organised by the Friedrich-Ebert-Stiftung, Left Foot Forward and the Progressive Economics Panel. Most of the chapters in this book were initially presented by their authors at those discussions so we are grateful to everyone who came along and provided valuable input at that stage. Thanks also to Anjum Klair at the TUC, Claire French at Left Foot Forward, and Shanna Hagen and Jeannette Ladzik at the Friedrich-Ebert-Stiftung who helped with the logistics and arrangements for the seminars. In putting together this volume, we are grateful to Chris Clothier, Tony Dolphin, Adam Lent, and Nick Pearce who all provided invaluable drafting suggestions and challenges to the ideas in the book.

v Going for Growth

And finally, we are grateful to all the authors in this book for their outstanding contributions.

Will Straw Associate Director for Strategic Development, Institute for Public Policy Research

Karl-Heinz Spiegel Director, Friedrich-Ebert-Stiftung, London Office

vi Contributors

Tony Dolphin is Senior Economist at the Institute for Public Policy Research. Previously he was a civil servant at HM Treasury and the Department for Education and worked for a time in the City.

Gerald Holtham is the Managing Partner of Cadwyn Capital LLP and Visiting Professor at the Business School of Cardiff University. Among many other positions, he was Chief Investment Officer at Morley Fund Management, Director of the Institute for Public Policy Research, Chief Economist and Deputy Head of Research at Lehman Brothers Europe, Head of General Economics Division within the OECD, Paris. Gerald is also a Non-Executive Director at Merrill Lynch Greater Europe Investment Trust, Member of Economic Research Advisory Panel to the Welsh Assembly Government, and a Board Member at the Institute of Welsh Affairs.

vii Going for Growth

Gustav Horn is the Director of the Macroeconomic Policy Institute (IMK) at the Hans-Böckler Foundation. Since 2007 he has also been Professor of Economics at the University of Flensburg. From 2001-09 he was an adviser to the European Parliament. From 2000-04 he was Head of the Department of Macro Analysis and Forecasting at the Hans-Böckler Foundation. From 1986-98 he was a research associate at the German Institute for Economic Research (DIW Berlin).

Charles Leadbeater is a leading authority on innovation and creativity – his latest book We-think: the power of mass creativity charts the rise of mass, participative approaches to innovation from science and open source software, to computer games and political campaigning. Charles spent 12 years as a journalist working for the Financial Times and Independent and subsequently as an independent author and advisor to the Downing Street policy unit, European Commission, and government of Shanghai among others. He is a co-founder of the public service design agency Participle, a senior visiting fellow at the British National Endowment for Science Technology and the Arts, a senior research associate at Demos, and a visiting fellow at Oxford University’s Said Business School and the Young Foundation.

Philippe Legrain is principal adviser to the President of the European Commission, José Manuel Barroso, and Head of the Analysis Team at the Bureau of European Policy Advisers. He is a visiting fellow at the London School of Economics’ European Institute and a contributing editor to Prospect magazine. Previ- ously Philippe worked for The Economist and the World Trade Organisation. Philippe has published three books including Aftershock: Reshaping the World Economy after the Crisis. viii Contributors

Adam Lent has been Director of Programme at the RSA since March 2011. Prior to that he was Head of Economics and Social Affairs at the TUC.

Richard S. Seline has provided strategic counsel to over 100 innovation projects in the US and abroad, including an eighteen-month initiative for Manchester City Council and the Manchester Knowledge Capital efforts funded by NESTA. Based on his prior role as Deputy Assistant Secretary of the US Department of Commerce in charge of national and regional economic development, he has emerged as a prom- inent speaker, facilitator, and advisor on innovation-based economic strategies and implementation tactics for federal Cabinet Secretaries, Governors, Chancellors and Presidents of Academic Institutions, CEOs and Venture Capital leaders.

Will Straw is Associate Director for Strategic Development at the Institute for Public Policy Research. He is founder of LeftFootForward.org where he worked as editor until December 2010 and a visiting fellow at the Center for American Progress in Washington, DC where he worked from 2008-09 as Associate Director on Economic Growth. Previously, Will was a 2007-08 Fulbright Scholar at Columbia University and worked for four years at HM Treasury primarily on enterprise and growth policy.

Anna Turley is Deputy Director at New Local Government Network responsible for external relations and the strategic direction, and profile of the organisation. Anna was previously a special adviser to Hilary Armstrong MP in the Cabinet Office and to David Blunkett MP in the Department for Work

ix Going for Growth and Pensions, focusing on child poverty and equality. She started her career as a fast-stream civil servant in the Home Office where she worked on a range of issues including youth crime, policing, and immigration.

Kitty Ussher is Director of the think tank, Demos. She was a Member of Parliament from 2005-10 during which time she was a Government Minister in the Treasury (twice) and Department for Work and Pensions.

Duncan Weldon works for an international trade union confederation. He previously worked at the Bank of England, as a Partner in a fund management firm, and for the Labour Party.

Stian Westlake is Executive Director of Policy and Research at the National Endowment for Science, Technology and the Arts (NESTA). Before this, Stian worked in social venture capital at The Young Foundation and worked for five years at McKinsey & Company in Silicon Valley and London. Stian was a Kennedy Memorial Scholar at Harvard University and holds a BA from the University of Oxford and a Masters in Finance from London Business School.

Andy Westwood was special adviser at the Department for Innovation, Universities and Skills and a member of the Leitch Review of Skills. He is now Chief Executive of GuildHE and a visiting professor at London South Bank University and the University of Buckingham and a fellow at the Institute of Education.

x Introduction by Will Straw

In the second decade of the twenty-first century, Britain faces several simultaneous challenges. How best should the budget deficit be reduced? Where will new jobs come from to replace those lost by the recession and spending cuts? How can our education, health, and housing systems cope with changing demographic pressures? Increased economic activity, otherwise known as growth, is a critical part of the answer to all these questions. Growth increases the exchequer’s tax take, reduces the need for welfare as recipients find their way back into work, and increases the size of the economy against which the debt and deficit are measured. Growth is the result of the creation of new jobs that provide consumers and government with goods and services. Once the budget is in balance, growth provides the basis for the real term increases in public spending which will pay for improved public services and infrastructure. Without growth, the path back to prosperity and economic security will be far steeper.

xi Going for Growth

There are those who argue that growth is a dangerous market-based construct which denigrates the environment and communities in its quest for a more material world. Others argue that a relentless focus on growth does little but make a society’s citizenry unhappy as they join a rat race that can only end in disappointment with someone else always further up the greasy pole. Another claim is that the pursuit of growth is ultimately polarising since it reinforces class divisions and increases inequalities. All these arguments have their merits but miss the wood for the trees. Growth in economic activity – more jobs and more output – can be consistent with a society that values environmental sustainability, happiness, and greater equality. The problems that our society has faced in recent years – rising carbon emissions, increased dislocation and insecurity, rising inequality – have not been caused by growth per se. They have been caused by a world that has not yet fixed a price for carbon nor on the use of irreplaceable raw materials; has not found an adequate way to measure happiness; and has allowed the gap between top and bottom to spiral out of control. Another world is possible where growth takes place in a more sustainable manner and where its proceeds are distributed more equitably. The recommendations presented in this book all have at their heart a more sustainable and equitable British economy. Getting unemployed people back into work is the most important issue facing Britain over the next few years. But economic forecasters, including the Office for Budget Respon- sibility (OBR), do not expect output growth in the UK during 2011 to be strong enough to reduce unemployment. In fact, the OBR is forecasting a small increase in unemployment xii Introduction between the final quarter of 2010 and the final quarter of 2011.1 As the Confederation of British Industry has noted, the government’s approach to growth has so far been limited. The main focus has been placed on cutting the deficit and hoping that the private sector will fill the gap (so-called expansionary fiscal contraction). Additional policies to cut corporation tax rates and regulations provide no guarantee of increased investment or job creation and will only take place over a number of years. Meanwhile increased trade is contingent on improvements in the global economy.2 The focus of this book is the role of smart government in creating the conditions for growth, and therefore jobs. In the real world, rather than in the theoretician’s text book, the free market will create neither full employment, the perfect allocation of resources, nor the right amount of innovation. Instead, creating jobs and growth requires:

• a strategy to increase Britain’s chronically low investment levels by taking advantage of the relatively lower cost of capital in the public and private sector; • a relentless focus on skills to ensure that the best ideas are developed in the domestic economy and that Brit- ain’s labour market is able to compete with the “rise of the rest”; • support for the innovation ecosystem – critical for Brit- ain’s future prosperity – which goes beyond a narrow focus on tax incentives; • devolution of policy levers to the right administrative

1 Office for Budget Responsibility, Economic and fiscal outlook, 2010. 2 HM Treasury, The path to strong, sustainable and balanced growth, 2010.

xiii Going for Growth

level so that incentives for economic activity exist at the appropriate level for businesses; and • a rethinking of Britain’s monetary rules to recognise that macroeconomic stability requires more than just price stability.

Critical to all these outcomes is a role for government. This must not be a government that crowds out the private sector or seeks to take business’ role. Instead, it is a government that enables the private sector to flourish and thrive in Britain’s dynamic economy by plugging market failures in the supply of infrastructure, lifelong education and training, and the flow of capital to potentially marketable innovations. It is a government that ensures that the barriers for all businesses - and especially those with growth potential - are kept as low as possible. And it is a government that does everything within its powers to keep the economy balanced and redesigns its monetary and fiscal rules to ensure that the great recession can never happen again.

Structure of the book

The ideas in this book represent a starting point for public discussion on the role of government in promoting growth. They are not intended to cover every area of policy that impacts growth or to be fully worked-out policy proposals. Much of that work will be covered by the Institute for Public Policy Research’s “Growth and Shared Prosperity” project, which will be headed by Eric Beinhocker of the McKinsey Global Institute. Nonetheless, the ideas that follow set out an analysis of where we are and where we need to go. xiv Introduction

The structure of the book is as follows. Section 1 puts the needs of the British economy in context. Philippe Legrain examines the international challenges facing Britain’s position in an increasingly globalised world. Legrain argues that the emergence of China, Brazil, India, and a host of other countries requires Britain to become more, rather than less, open. He argues that Britain’s prosperity will benefit from exporting our goods and services to these new economies, attracting investment from their globalising companies, tapping into the skills provided by highly skilled mobile workers, and using international know-how to develop the new clean-tech industries of the future. Duncan Weldon examines the three main challenges facing the domestic economy in the coming years. First, demographic changes are likely to alter the ratio of retired to working age people and with it place pressure on public services. Second, squeezes on government spending, constrained consumption, risks to trade from a volatile global economy, and a historic lack of investment mean that the sources of growth are uncertain. Third, and related, because investment – where it has taken place – has been focused on commercial or residential property there has not been enough focus on future productivity capacity. Gustav Horn examines why the German economy grew more rapidly than the UK in 2010 and looks set to do so again in 2011. He outlines that it was high levels of flexibility with regard to working hours and the promotion of temporary work, alongside strong stimulus packages that contributed to Germany’s strong performance. However, Horn questions whether 2012 will be as rosy warning that without wage increases, consumer demand will not rebound. Meanwhile,

xv Going for Growth continued instability in the eurozone will dampen Germany’s export performance. Richard Seline offers an American perspective on innovation and growth. He pours scorn on popular desire for an “innovation-based economy” that does not go deeper and examines what that really means. Drawing on experience in the UK, Seline sets out some clear lessons for policy-makers when designing policies to encourage growth which go beyond a singular desire for regions to create nanotechnology clusters. Seline outlines that understanding local capacities, using local networks and knowledge, targeting investment, and unleashing the potential of everyone in a region provide the only approach through which innovation will really flourish. Charlie Leadbeater examines the different models of capitalism that are currently in existence around the world and then sets out the tools that government can use to ensure that Britain has the right model. Rejecting both the old notion that corporations should only be driven by shareholder value and the newer idea that companies can drive profit through lip service to corporate social responsibility, Leadbeater reviews new, more cooperative models of business operation where the main rationale for business is not to make a profit but to help society to learn. Chief among these models are the “mission driven capitalism” of Google and Facebook where revenue are a by-product rather than a goal; the “shared value capitalism” of the Apple app store where the system is as important as the product; and “way of life businesses” that dominate the French wine industry. Government can enable these new models through company law that encourages employee ownership and a renewed debate about the quality of work. xvi Introduction

Kitty Ussher examines the causes and lessons of the financial crisis. She argues that the crisis was due to a series of regulatory decisions in the US and catastrophic management failure in some (but not all) banks. This was exacerbated in the UK by Britain’s low savings ratio and the insufficient amount of capital held by the banks. Reforming the banks is critical – not least to improve their management, oversight, and investment decisions – but Britain’s future prospects require taming rather than killing the goose that laid the golden egg. Ussher argues that banking still has a huge role to play in Britain’s economy, that not all bankers are bad, and that government must understand that banks cannot simultaneously lend to the real economy and restore their balance sheets. Adam Lent outlines the role for state-led intervention in those key areas that drive innovation and productivity but which the market has been shown to be unable to deliver fully. Taking a longer view, Lent looks at what went wrong in the decades immediately following the Second World War and identifies successive governments’ failure to modernise British industry in the 1950s twinned with business leaders’ failure to innovate as they protected themselves from European and American competition by exporting solely to the Commonwealth where they held a dominant position. The lesson of the schism from this approach under Margaret Thatcher in the 1980s is counter intuitively that intervention has a critical role to play. Driving innovation and productivity will require state-led intervention in business investment, skills and training, and the creation of innovative, high productivity SMEs. Section 2 looks at the policy response. Gerald Holtham sets out the case for a state-led investment strategy. Picking

xvii Going for Growth up where Duncan Weldon left off, Holtham outlines Britain’s historic investment problem. The solution to this, at a time when the private sector is so reluctant to invest, is targeted state-led infrastructure projects for marketed services such as high speed rail, west coast tidal power, and toll roads. The business case is reinforced by the lower cost of borrowing available to the government at present while concerns about the fiscal deficit can be addressed by adopting international practice on the classification of public sector borrowing and excluding borrowing by state entities for commercial purposes. The policy would turn the ill-fated Private Finance Initiative on its head by allowing the public sector to raise cheap finance to procure assets that are then leased or sold back to the private sector for operation, thereby servicing its debt. Andy Westwood looks at the link between skills, immigration and growth. Despite the best efforts of the last government, Britain is still stuck in a “low skills equilibrium” with large numbers of technically illiterate or innumerate adults. To plug the gap, immigration was encouraged with little consideration for the political consequences. He argues that building the domestic stock of skills will require more than a supply-side approach to improving schools, expanding further and higher education, and encouraging lifelong learning. In addition, government must play an active role in the demand-side of the economy. Consideration must be given to how and where new skills can be deployed including the government’s own role in buying goods and services, and through regulation. Stian Westlake explains what constitutes innovation, who does it, and how it happens. His model sets out four roles for government in the innovation process. First, government has xviii Introduction a critical role in knowledge creation. This takes place through the traditional role of funding basic research, through the informal exchange of knowledge and people by universities, and through public procurement which encourages research in the private sector. Second, government can encourage businesses to turn new ideas into new products. Removing barriers to successful clusters and giving businesses access to pre-existing innovations – rather than tax incentives – is the most effective route here. Third, by encouraging competition and large markets, and through being responsible in its role as the UK’s largest customer, government can play a role in determining which innovations take off. Finally, the government has a role in ensuring that business finance, particularly venture capital, is available to firms. Anna Turley examines successive governments’ approach to enabling growth at the local level. She finds much to commend Labour’s £15 billion investment through Regional Development Agencies but questions whether these administrative boundaries allied effectively with the relevant economic geography. Turley praises the coalition’s Local Enterprise Partnerships (LEPs) for allowing local authorities to become the driving force behind growth but outlines that there is uncertainty over the government’s financial commitment and over whether the broader public service reform agenda will undermine these efforts. Further reforms are needed, she argues, to ensure that all powers are devolved to the necessary level with LEPs given full discretion around spending on regeneration, transport, and housing. Tony Dolphin takes a second look at Britain’s macroeconomic policy arguing that neither Britain’s monetary nor fiscal rules are fit for purpose. The narrow price stability goal

xix Going for Growth of monetary policy is no longer sufficient and the Bank’s remit should be extended to include discretion in supporting output and employment growth. Although this might have little impact on interest rates it would increase the transparency of current practices. In addition, Dolphin argues that asset price inflation should be brought into the policy framework – with the limiting of loan-to-value ratios as an effective way of achieving this. New fiscal rules should retain a counter-cyclical approach to ensure that economic activity can be supported in a downturn through temporary tax reductions targeted at low-income families and increases in capital spending.

xx PART 1

The international challenge facing Britain by Philippe Legrain

Economic and political debate at the moment focuses rather narrowly on how to cut the budget deficit. But this should not crowd out discussion of the longer-term challenges – and opportunities – that the British economy faces. If the coalition government lasts a full term, the next election will not be held until 2015, by which time the deficit will hopefully no longer be such a pressing issue. So there is a strong rationale, both economically and politically, for taking a broader perspective.

The rise of the rest

The most important factor that will shape the world economy in coming decades is the rise of China in particular and emerging economies more generally: Brazil, India, Mexico, South Korea, Turkey, Indonesia and a host of smaller economies.

1 Going for Growth

For the first time since the Industrial Revolution, over half of global economic activity now takes place outside the West, and the rest of the world is likely to account for the bulk of global growth in the years ahead. China has just overtaken Japan as the world’s second largest economy and it looks set to surpass America within the next 20 years. With its younger and rapidly growing population, India will also be a force to be reckoned with. While there will no doubt be setbacks and perhaps even the odd crisis along the way – development never proceeds in a straight line – the direction of change seems clear. Inexorably, the centre of gravity of the world economy is shifting east (and south). This will affect almost every aspect of the global economy and how it is run:

• trade, investment and people flows; • the development and dissemination of new ideas and technologies; • interest rates and exchange rates; • the price of commodities, not least oil and food; • global energy use and climate change; and • the agenda at the G20, voting rights at the Interna- tional Monetary Fund, the chances of success in the World Trade Organisation’s Doha Round, etc.

Britain is a medium-sized economy that is mostly open to the world; it is connected to distant places through a wider variety of business, financial and people ties; and has as an outsized say in international institutions. All this means Britain will be particularly affected by these dramatic changes.

2 The international challenge facing Britain

Whether the question is how we create the growth, jobs and businesses of the future, what skills we need to equip people of all ages with, or how we shift to a low-carbon economy, the answer will increasingly depend on developments in emerging economies and how we respond to them. The overarching issue is this: Will the West accept the rise of the rest, adjust to it and try to make the most of it, or will we try to resist it? Will we treat it as an opportunity or as a threat? That strategic choice will define global political economy in the coming decades. So far, the debate has focused mainly on the emerging economies’ role as low-cost competitors (from a production perspective) and a source of cheap imports (from a consumption angle): China in manufacturing, India in IT services, South Korea in electronics and cars, and Brazil in agriculture. That is understandable, since the change in the pattern of trade has been remarkable: China now exports more in six hours than it did in a whole year in 1978 and India, still a desperately poor country, has become the world’s biggest exporter of IT services. While in fact technological change – not least computers and the Internet – culls more jobs than international trade, emerging economies are widely seen as a threat to British jobs and businesses. Politically, it is easier to advocate trade protectionism than curbs on the Internet to preserve high- street travel agents displaced by cheaper online bookings. Certainly, competition from emerging economies is likely to increase, and it will affect people of all skill levels. Some emerging economies, like South Korea or Taiwan, are already highly advanced, while others have highly advanced pockets. Nowadays, development no longer happens in neat stages:

3 Going for Growth while some parts of the Indian economy are stuck in the eight- eenth century, others are at the cutting edge of the twenty-first. At the same time, what determines whether a job is at risk from international competition is not how skilled it is, but whether it is readily tradable and where Britain’s comparative advantage lies. Thus number-crunching jobs in accounting and finance are more susceptible to be sent offshore to India than jobs of all skill levels that need to be done on the spot: lawyers, psychotherapists, physiotherapists, plumbers, hotel staff, care workers, cleaners and so on. Being expensive does not matter provided you are the best, as Germany’s export success shows. Indeed, despite all the fears about Indian IT, Britain is the world’s third-biggest exporter of IT services, and indeed exports more IT services than it imports. So the challenge for Britain is to continue to move up the value chain and to upgrade people’s skills and its infrastructure, while taking full advantage of the benefits of low-cost imports and foreign production. And while Britain may specialise in export sectors such as IT, finance, media, telecoms, pharmaceuticals, aerospace, energy and others, it will continue to create lots of jobs, of all skill levels, in areas sheltered from international competition. While competition and imports from emerging economies are likely to increase, that is only part of the story. Increasingly, Britain’s prosperity will depend on exporting to emerging economies, attracting investment from their globalising companies, tapping into global networks of highly skilled mobile workers, researchers and businesspeople, many of whom will come from China and India, and developing the new clean-tech industries of the future, often thanks to technologies developed here or abroad with the help of Chinese and Indian brainpower.

4 The international challenge facing Britain

Exporting to emerging economies

Start with exports. Of course, Britain’s traditional markets in Europe and America will remain important. But most of the additional growth is likely to come from outside the West. Over the past decade, Britain’s exports to China have more than quadrupled, while those to America and Europe have scarcely increased. In the years ahead, emerging economies’ huge investment needs will combine with their vast pent-up consumption demand to help drive the global economy. They already account for 40 per cent of global imports, and soon they will account for more than half. For British businesses and their employees, it is the opportunity of the century. Over the past 15 years, China has become the world’s assembly plant. Over the next 15, it could become the world’s shopping mall. China is planning to build 400 million new homes over the next 20 years – just think what that could mean for Ikea or any other company selling household products. Chinese tourists may soon be as ubiquitous as the Japanese became in the 1980s. Three in eight people on the planet live in China and India, and if their living standards continue growing at 8 per cent a year, they will double every nine years and quadruple in eighteen. By 2025, the Chinese – many of whom were starving as recently as the 1970s – could be as prosperous as the Portu- guese are today. And by 2035, so could the Indians. The McKinsey Global Institute reckons that over the next 15 years Chinese consumers alone could generate nearly a fifth of the world’s consumption growth and as much asa quarter of it with helpful reforms. So a big part of rebalancing

5 Going for Growth the UK economy away from its unhealthy dependence on finance and housing will be investing in the businesses and skills needed to take advantage of these new opportunities.

Attracting foreign investment

At the same time, Britain will increasingly need to attract foreign investment that brings in capital, expertise and jobs, not just from American, European and Japanese companies, but also increasingly from emerging economies. Britain’s biggest manufacturer is now an Indian company, Tata, which owns Tetley Tea, Corus (the old British Steel), Jaguar and Land Rover. Whereas in 1990 multinationals from emerging economies accounted for a mere 5 per cent of global foreign direct investment flows, by 2008 that figure had risen to 16 per cent. Britain has traditionally been relaxed about foreign investment, whether it is investments in new factories by Japanese car companies or the sale of UK companies to foreign ones. But as the Chinese government seeks to diversify its $2.5 trillion of foreign currency reserves and its often state-owned companies seek to expand globally, the risk of investment protectionism is real. How would the British government feel, for instance, if a weakened BP attracted a prospective Chinese buyer?

The best and the brightest

The third dimension, migration, is already highly contro- versial. Considering Ed Miliband’s father and grandfather

6 The international challenge facing Britain were both illegal immigrants, Britain’s centre-left should need no persuading of the benefits of immigration. But more generally, the political desire to cut down on immigration increasingly clashes with the economy’s needs, as the coalition government is finding out as it tries to implement its immigration cap, starting with highly skilled foreign workers. Success in the global economy increasingly depends on tapping into global networks of mobile workers, researchers and businesspeople who generate trade, investment and enterprise. Companies will not locate in Britain or be successful unless they can hire the right people, in the right place at the right time. Increasingly, those talented people will come from emerging economies. China already generates more university graduates a year than all of Europe, and India is catching up fast. This year’s Nobel prize in physics was won by two Russian-born scientists, Andre Geim and Konstantin Novoselov, at the University of Manchester who might have been denied entry by the coalition government’s immigration cap. And as Geim and Novoselov pointed out in a letter to The Times, “International collaborations underlie 40 per cent of the UK’s scientific output, but would become far more difficult if we were to constrict our borders.” In a global economy where goods, services, and capital move about freely, it is increasingly important that labour can do the same. Not, primarily, as a movement of permanent settlement, but increasingly for the purposes of temporary work overseas. Only a quarter of those who arrived in Britain in 1998 were still here a decade later, and many migrants – be they Polish plumbers, Indian IT workers or American

7 Going for Growth accountants – move back and forth regularly, like international commuters. These newly mobile people are a bit like bees flying from flower to flower, cross-pollinating them. The simplistic black-and-white debate about “immigration” ignores this new kaleidoscope of mobility. The potential prize is huge. Consider that more than half of the start-ups in Silicon Valley over the past decade have a migrant as a chief executive or lead technologist, that Google, Yahoo!, eBay, and YouTube were all co-founded by people who arrived in the US as children, and that foreign-born inventors contributed a quarter of global patent applications from the US. If we want to create Silicon Valley-style entrepreneurial dynamism here in Britain, we need to remain open to the rest of the world.

A greener world

The final international challenge is climate change. From a global perspective, whatever Britain does or does not do will be dwarfed by what happens elsewhere. Most additional energy demands in the coming decades are likely to come from emerging economies, although we must not forget that it is advanced economies like Britain and especially the US that account for most emissions up until now and have much higher emissions per person. Despite the failure of the Copenhagen summit, the EU is still proceeding with its emissions trading scheme and a target to reduce emissions by at least 20 per cent from 1990 levels by 2020. While there are grounds for scepticism, not least given the record of carbon markets in reducing emis-

8 The international challenge facing Britain sions, we are still moving in the right direction. That could all be undone, though, if French President Nicolas Sarkozy gets his way and provokes a trade war with China and India by imposing carbon tariffs on their imports. There is also scope for the British government to set its own standards and regulations. As Germany’s experience as a pioneer in adopting tighter environmental regulations shows, there is a clear advantage in moving first, and encouraging the development of new clean-tech industries. Together with the policy response, higher oil prices driven by demand from emerging economies will make clean energy more attractive and encourage businesses to invest in developing and deploying new clean technologies. Here again emerging economies will be crucial: among the global leaders in electric cars are India’s REVA and China’s BYD; the world’s largest maker of solar panels is China’s Suntech Power; Brazil is a global leader in bioethanol; and Indian and Chinese brainpower are also at the centre of the clean-tech revolution in Silicon Valley. In short, there is huge potential for Britain to develop new clean tech industries.

Conclusion

Let me conclude with the overarching theme of my new book Aftershock. We should not surrender to the pessimistic logic of austerity Britain or the xenophobic logic of those who want to put the shutters up. I believe the new dividing line in politics is between those who believe in dynamic, open and progressive societies and those who want to shut the doors and turn the clock back.

9 Going for Growth

The world is still rich with opportunities for progress if we reach out and grab them. Achieving that requires all sorts of changes. But above all it requires optimism. The optimism to try to improve things, invest in the future, and embrace change. The optimism which believes that challenges – even crises – create new opportunities. Belief in progress is an essential part of building a fairer and more prosperous Britain.

10 Britain’s long-term challenge by Duncan Weldon

As outlined in the introduction, the issue that has dominated economic debate in the UK over the last year is the question of the government deficit and how to close it. Instead of rehashing now familiar arguments on the appropriate pace of deficit reduction or the balance between spending cuts and tax hikes, this chapter looks beyond the question of how to cut the deficit and onto the major domestic challenges facing the UK economy in the next decade and beyond. Of course how the deficit is closed matters. In 2015, and indeed in 2020, the future prospects of the UK economy will be influenced not just by its current state but by how it got there. Large scale cuts in capital spending, for example, would have effects felt for many years to come. Instead, this chapter deals in turn with three primary challenges: how demographic change will affect Britain in the long term, where sources of growth will come from over the medium term, and the vexed issue of Britain’s obsession with property.

11 Going for Growth

Demographic Change

The longer term issue facing the UK is the prospect of demographic change. The old age dependency ratio has been relatively consistent in the UK. From 1971 until now it has been around 3.3:1 (i.e. there have been over 3 people of working age for every retiree). By 2051 this is projected to hit 2.9:1 with an increase in the retirement age and 2:1 without an increase. An estimated 24 per cent of the population in 2051 will be over 65, up from 16 per cent currently. While 2051 sounds a long way off, the ratio will begin to rise rather sharply in the late 2010s, with the bulk of the increase taking place in the 2020s and 2030s. There are two major economic impacts from this shift. First, an ageing population will put pressure on government finances. One recent study has estimated that the £8.8 billion currently spent by local authorities on the long term care of the elderly will have to increase (in real terms) to over £20 billion by 2031. Care of the over 65’s currently takes up one third of all NHS spending, an ageing population will make for severe pressure on this budget. Any long term repair of the public finances will have to be prepared to deal with this challenge. More generally an ageing population will mean different consumption cycles. The traditional pattern of life time consumption is that people borrow when they are young (to purchase a house for example) and pay the debt down as they age. All things being equal, an older population will lead to a higher savings ratio. This puts further pressure on consumer spending as a potential source of growth. It is notable that one of the major factors explaining Japan’s

12 Britain’s long-term challenge failure to recover from the 1989-90 banking and financial crisis has been its aging population (Japanese per capita growth during the two lost decades has actually been comparable to US per capita growth) – a warning sign to British policy makers to take the issue seriously. Of course demographic change, managed the right way, could be almost as much of an economic opportunity as a challenge. It will lead to a thriving care sector in the economy creating new jobs and potentially acting as a major catalyst towards further research and development (and manufacturing) in the pharmaceuticals sector.

Sources of Growth

In the medium term the only sustainable way of reducing the UK’s debt to GDP ratio is through economic growth. Nominal GDP growth that is higher than the nominal interest rate on UK debt will lead to a falling ratio of government debt to GDP. In the absence of such growth the government would be forced to run a consistent budget surplus in order to pay down debt. The question of where this much needed growth will come from is a pressing one. The major drivers of growth in the decade before the recession both appear tapped out. Well over two thirds of GDP growth in the period from 1998 to 2008 came from either government spending or consumption. Given the medium term fiscal constraints on the UK, not to mention the public’s current distaste for budget deficits, it seems highly unlikely that government spending can be such a major driver of economic growth in the near future.

13 Going for Growth

While there is a strong case for more public investment, it seems likely that governments will be reluctant to run deficits in non-recessionary conditions in the next decade. Gerald Holtham’s chapter gives this in more detail. Consumption too looks set to be squeezed too. Slower wage growth, higher taxation (both direct and indirect) and, possibly, higher inflation than in the last decade are all set to slow the growth of disposable income. Even without these headwinds the household savings ratio looks set to rise, suggesting slower consumer spending in the future. It is now widely accepted that the consumer debt binge of the 1990s and 2000s, whether in the form of housing equity release loans or credit cards, was unwise and unsustainable. Even if consumers’ appetite for debt was to return, it is not clear that the banks would be in a position to satisfy demand. Counter intuitively to many economists raised on horror stories of 1970s’ wage-price spirals, stronger wage growth could be one sustainable source of increased consumption and hence growth. A reversal in the three decades long decline of the wage share of GDP could potentially offset a rising savings ratio allowing consumers to both save more and spend more. Exports and investment are the coalition’s preferred panacea. While the prospects for exports were dealt with more fully in Philippe Legrain’s chapter, it is important to note that “export-led growth” is a worthy aim, an aim so worthy that almost every country in the world is pursuing it. It has become almost a “cliché” – albeit an accurate one – to note that the UK economy became too dependent on finance and property during what came to be known as the “Great Moderation”. Concentrating on the issue of the UK’s overde-

14 Britain’s long-term challenge pendence on finance and property, however, risks obscuring the UK’s major, and historical, problem: a lack of investment. In the UK during the recession (Q1 2008 until Q3 2009) quarterly GDP fell by £20.1 billion, of this £9.9 billion was accounted for by a fall in gross fixed capital formation (GFCF, or investment). While consumption fell by only 4 per cent, investment collapsed by 16.7 per cent. Despite the media and political focus on consumption, the real driver of the recession was a fall in investment. Even the near 17 per cent fall in GFCF understates the crisis as it includes government investment. Private business investment fell by 23 per cent over the same period. The problem though is not a new one. According to IMF data, since 1980, the UK has consistently invested a smaller proportion of its GDP compared to other leading economies. The question of why UK industry fails to invest as much as its international rivals, with long term effects on UK growth, is a long running one. Answers have been sought in regulation, the perceived poor quality of British managers, chronic short-termism, the structure of UK shareholding, and a possible lack of investment opportunities. One long- running debate focuses on the UK financial sector and why it does not appear willing to finance the creation of new industries (from chemicals in the 1920s to renewable energy in the 2010s). This is an old debate. Before the First World War, British industry complained that the City preferred to send capital overseas rather than invest it domestically. During the interwar period, the Macmillan (established by a Labour government) examined the operation of the banking system. In the 1950s, the Radcliffe Committee (established by a Conservative

15 Going for Growth government) re-examined the same issues. Both Wilson’s indicative planning and Heath’s 1970-72 attempts to introduce the forces of competition into the British economy were aimed at raising the rate of investment. Politicians from Anthony Crosland in 1951 writing Britain’s Economic Problem to Gordon Brown’s Where There’s Greed: Margaret Thatcher and the Betrayal of Britain’s Future in 1989 have engaged with the issue. Over the past two decades, however, the issue has dropped out of the policy-making debate, despite the problem becoming worse. If the UK economy is to enjoy decent growth in the decades ahead, this issue cannot be ignored. There will always be a role for the City in providing insurance services, capital raisings, and financial intermediation, as well as the ancillary activities of law, accountancy, and custodian services – roles in which Britain is a world leader and which attract vital overseas earnings. That said, the domestic activities of the City need to be re-examined. It is a tragedy that the coalition government has seen fit to cut the loan to Sheffield Forge- masters, but it is perhaps a greater tragedy that the company could not find finance from the private sector.

Britain’s obsession with property

For decades in Britain the safest bet for a bank manager, and the easiest way to “fail conventionally” as Keynes might have put it, has been to lend against property, either commercial or residential. Between December 1997 and December 2007, the pre-recession decade, UK banks advanced £1.3 trillion to UK residents as loans. Of this lending, 46 per cent went to

16 Britain’s long-term challenge financial companies, another 12 per cent to commercial real estate companies, and 23 per cent to mortgages for households. Very little found its way into the productive economy. The abnormal returns on UK property, coupled with the British public’s belief in the attractiveness of “bricks and mortar” as an investment opportunity, have helped to create an environment in which the savings of the British public are channelled into inflating property prices rather than future productive capacity. Dealing with this issue might go some way towards cracking the UK’s historic investment problem. Potential solutions might lie in some form of land value tax, planning laws, capital gains tax on primary residences or in macro-prudential financial regulation which raises the capital that has to be held against property loans. Reducing the amount of bank lending which flows into property from one third to even one quarter would have freed up over £100 billion in the decade before 2007.

Conclusion

Even if the deficit is eliminated by 2015 there will still be challenges ahead for the UK economy. The medium to long- term prospect of an ageing society and the question of where growth will come from are critical. Meanwhile, the relationship between finance, industry and property in the UK economy remains untackled. Progressives need to remember that there is much more to the UK macroeconomy than simply balancing the books and look beyond the next five years.

German economic policy at a crossroad by Gustav Horn

All seems well. The German economy will end 2010 with production levels recovering. The robust economic development defies all criticism of the effectiveness of economic stimulus packages. It also raises doubts about positions, such as that taken by the German Council of Economic Experts, which see structural obstacles to growth in an allegedly inflexible labour market. Germany’s economy has recovered so well because the former grand coalition government and numerous European and non-European governments, particularly in Asia, have implemented strong stimulus packages.3 Furthermore, in Germany it was possible to stabilise the labour market through high internal flexibility with regard to working hours

3 IMK Arbeitskreis Konjunktur, Wirtschaftspolitik belebt Konjunktur. IMK-Prognose der wirtschaftlichen Lage 2010, IMK Report, no. 45, 2009.

19 Going for Growth and the state’s financial commitment to promote temporary work.4 The latter did not only contribute to continuously high employment levels despite the crisis. It also ensured that income levels of private households remained relatively stable compared with many other economies. The anticipated collapse of private consumption was, thus, avoided. All this shows that Germany has done rather well in tackling the harshest economic slump since 1945. This year’s growth rate is expected to hit 3.7% (see table 1) indicating a strong upswing. This hope is justified, but is not yet a reality. In spite of considerable growth, output has not yet reached pre-crisis levels. Production has not hit full capacity – something one would expect during an upswing. This weakens companies’ willingness to invest. With regard to the 2011 forecast, it remains to be seen whether the strong initial recovery can be transformed into a self-sustaining upswing. Companies and consumers are optimistic. Data on production and order entries, however, indicate the first signs of weakness. The economic environment outside Germany, particularly in the eurozone, is worsening. Notwithstanding a constantly expansive monetary policy, this suggests a problematic recovery. The current economic situation shows a very ambiguous picture. The economy is standing at a crossroads: it can either turn towards a significant upswing, or it can slip into a Japanese scenario of permanent stagnation with temporary recessions.

4 Alexander Herzog-Stein, Fabian Lindner, Simon Sturn and Till van Treeck, Vom Krisenherd zum Wunderwerk? Der deutsche Arbeitsmarkt im Wandel, IMK Report, no. 56, 2010.

20 German economic policy at a crossroad

Table 1 Economic forecast for Germany – key figures Changes compared to last year in %

2008 2009 2010 2011

Gross domestic product 1.0 -4.7 3.7 2.5

Private consumer spending 0.7 -0.2 0.5 1.5

Public spending 2.3 2.9 2.1 1.1

Gross fixed investment 2.5 -10.1 6.9 3.8

Trade balance -0.1 -2.9 1.0 0.5

Exports 2.5 -14.3 15.0 7.4

Imports 3.3 -9.4 14.3 7.0

Employees 1.4 0.0 0.5 0.8

Unemployment rate* 7.8 8.2 7.7 7.0

Unit labour costs 2.4 5.2 -0.9 0.6

Consumer price index 2.6 0.4 1.1 1.3

Deficit† 0.1 -3.0 -3.4 -2.3

*In % of employees † In % of GDP Sources: DESTATIS, ECB; from 2010 onwards IMK’s forecast

21 Going for Growth

The direction it will take will be determined by two factors. First, it will depend on whether wage increases and increased employment in the next year will sufficiently promote the national economy, which would otherwise be strained by the end of the economic stimulus packages, and the austerity programmes implemented by the federal government and the Länder. Second, it will be crucial to see in which way the turbulent developments in the eurozone will influence the economy. If the eurozone can be stabilised, considerable positive effects on German exports can be expected. If this is not possible, German exports – an important pillar of Germany’s strong economy – will suffer. The Macroeconomic Policy Institute at the Hans-Böckler Foundation assumes that both factors needed for a successful upswing will not come into effect in the next year. Wages will only rise cautiously. This is also due to the fact that only a few rounds of collective bargaining that could lead to a widespread wage rise are scheduled for 2011. The turbulence in the eurozone is even more worrying. The debates about sovereign debt crisis have shaken the markets’ faith in the eurozone’s stability while financing national debt is becoming increasingly hard. Much of the reaction in the affected member states has centred around rigorous austerity programmes. These programmes will increasingly strain economic development in the eurozone, which will hit Germany’s exports. Following a rather strong start to 2011, Germany can therefore expect the economy to deteriorate. Average annual growth should still be 2.5%, but it is going to decrease to 1.7% in the course of 2011. A glance at 2012 bodes ill.

22 An American perspective on innovation and growth by Richard Seline

Like Britain, the US is seeking to turn the corner on the great recession of 2009-2010 and understand its impact on the stability of firms and organisations across the country. Rooted in the current debate about economic recovery, rebuilding, and regional innovation on both sides of the Atlantic is a belief that there is formula, a model that works if public and private sector leaders will only adopt the template and execute point-by-point the best practices. Countries, states, counties, and villages have been told that unless a “cluster” can form, start-ups and entrepreneurs are unleashed, the creative ”class” is organised, or academic commercialisation is stepped-up, then economic fortunes are, at best, limited. Strategies are linked to industrial sectors, value-chains, traded export services, and any number of competitive advantages that position institutions, assets, and resources. Unless these linkages are organised precisely from

23 Going for Growth one location to the next, then the circumstances for success are reduced. And then reality strikes: an Internet bubble, a housing bubble, a banking bubble. Billions of resources are exchanged, moved digitally from one unit of government to another, and financial schemes are designed to address short-term gaps in revenues. Then it is back to square one and the fundamentals of economic and enterprise support. Government intervention through stimulus, infrastructure investment, tax cuts and incentives, and policies to spur private sector activity are offered up to Congress, to Cabinet leadership and policy-makers. The US now goes from one peak and trough to the next in economic planning, response, and management. But these waves are no longer in ten or twenty year cycles, but faster and sooner than expected. After the return of “boom and bust”, the same may be true in the UK. Meanwhile, technological discovery and deployment are consistent in their disruptive impacts on industries, governments, and societies. It is not just that Apple’s iPad or the thousands of new apps hitting screens every day are changing the nature of business, news, services, and consumer choice. The impacts are profound on how nations engage their citizens, economic forecasters opine, and public resources are allocated to educate and train. But more often than not, governments fail to understand how to harness the power and potential of innovation. The latest vogue among policy-makers is competitiveness through an innovation-based economy. This idea encourages research parks, incubators, institutes, and collaborative partnership. Commercialisation of academic and government research is encouraged through innovation intermediaries

24 An American perspective on innovation and growth such as knowledge transfer offices who help with patents and licenses. And, of course, conferences, roundtables, summits, and working groups are convened to share these new tactics, new metrics, and new results. Where our two nations fail consistently is to remember where economic activity occurs and by whom it is sparked. First and foremost, economic planning, forecasting, intervention, and investment can no longer reside in Washington, DC nor London. The focus on regionalism – whereby multiple jurisdic- tions of government, academia, and industry are organised on the basis of the flow of goods, services, and transactions – must become the model for delivery of new policies and investments. Centralised planning is no longer a realistic response to the changing dynamics of industries, research departments, entrepreneurs, inventors, and investors. Unleashing the localised talent, know-how, and capacities of networks that are vital to the exchange of ideas, resources, market building, and talents requires a more regional approach. Based on work in the north west of the UK and specifically Greater Manchester, the first hand observations resulting from an eighteen-month partnership have provided the following insights.

Locals know best

With the recent termination of the Regional Development Agencies, an opportunity now exists to invest and spark regional and local civic engagement around the concepts of economic growth, prosperity, and innovation. Once given the authority to act with the correct level of resources and

25 Going for Growth the ability to transcend bureaucracies, local authorities must mount a forceful and sustainable set of initiatives to transform economies and job creation. Regional and local civic leaders must understand how to allocate resources that meet the test of performance, results, and desired outcomes on which both regional and national goals can be aligned. NESTA began to build a process along these lines by sharing knowledge and analysis of innovation systems from London, but encouraging regional and local leaders in Greater Manchester to adapt the approach to the available local capacities and local knowledge.

Innovation networks are vital tools

The centralisation of economic planning from London or Washington, DC is no longer realistic or effective. More than ever before, networks form over, around, through and under the radar of governments and any other institutions that stand in their way. Indeed, no single region, institution, or organisation has all the smarts alone to deal with local challenges. At the regional level in Manchester, public safety officials and private sector transport providers have come together to move large numbers of people safely at major sporting events. This activity is in the public interest but while returning private profit. In the US the current debate about the long-standing investment in federal laboratories, research institutions, and academic-university programmes is focused primarily on the return-on-investment and the ability to solve so-called grand challenges in energy, water, health care, infrastructure, and security. Joining the existing and vital

26 An American perspective on innovation and growth networks of scientific, technological, and inventor strengths must become a national policy encouraged in partnership with regional and local civic leaders. Put simply, government must become more willing to accommodate innovators.

Targeted investments rather than peanut butter funding

A common challenge for the US and UK in rebuilding their economies is identifying where targeted investments will have the intended effect in terms of job creation, prosperity, and long-term growth. This means making difficult and hard choices to stop the spread of resources as if it were peanut butter and thereby making every constituent pleased by the efforts. Uncomfortable and often harsh in terms of the political consequences, civic engagement at the regional and local level has a profound role in determining where to place bets on science, technology, innovation and commercialisation. But who is in charge of the selection process? How does a national agenda achieve success if it is divested to others to determine where to place resources? What if the outcomes are not at the level desired or end up being wrong? These questions and several others often drive reource allocation and investment decisions back to a central authority in order to avoid waste, fraud, and abuse. This is precisely when out- of-the-box thinking should be explored and implemented. Competitions for funding that cause a range of institutions, organisations, and individuals from both academia and industry to partner and collaborate should take place. The focus should be on improving academic and industry

27 Going for Growth commercialisation so that it leads not just to new firms but also to the greater profitability of existing companies. This can be enabled through the establishment of trusts, foundations, and not-for-profit innovation intermediaries that leverage resources through expertise, know-how, networks, analysis and assessment of global markets and opportunities.

Unleash youth and student innovators

The transformation of the future relies on young people and students continuing to benefit from their studies through employment, entrepreneurship, and public service. If they stop believing that academic effort will lead to improved long-term prospects, the more likely it is that several negative factors will occur (protests and criminal behaviour to name two). Apprenticeships, internships, volunteering opportunities, and training programmes must give young people the necessary tools to rebuild the economy – including an experience of entrepreneurialism. In Greater Manchester, the Sport Cluster Team recog- nised that young people and students could be encouraged to investigate new commercial areas as a means to increasing economic opportunity. For example, a Branding and Marketing Degree examined the ties between music, clothing, and sports while a new Global Sports Facility and Management Certificate looked at the need to improve logistics and transportation of fans to sporting events. Using telecommunications technologies, new applications and software solutions, and linking public and private sector knowledge became both an innovation and a job.

28 An American perspective on innovation and growth

Our nations cannot wait for the traditional university pathway to deliver economic benefit and assist with the rebuilding of global competitiveness. Instead, millions of young people and students need to be engaged in designing the future of the UK’s innovation capacity. This could spark a genuine resurgence at the regional and local levels.

Conclusion

When there is a change of government in the UK or US – whether at the local or national level – there is often a break down in the advances made adopting this new approach to innovation. Political victories every two or four years are not a sustainable platform on which to guide a modern economy. Now, more than ever, a bipartisan approach is necessary – recognising the profound benefits that the right public policy can provide. Policy-makers must also be wary of using off-the-shelf solutions to different problems in different localities. Not every state in the US or county in the UK can have a nanotechnology cluster. Instead it is incumbent on policy-makers to truly analyse the issue that is being addressed. Understanding local capacities, using local networks and knowledge, targeting investment, and unleashing the potential of everyone provide the only approach through which innovation will really flourish.

What is business for? by Charles Leadbeater

A business is just a means to an end. That end might be shareholder value, profit or return on equity, but whatever measure is used, the ends of a business, its point, is to deliver financial returns to the owners of the business. All the means that a business employs – technologies, production processes, product mixes, people, forms of organisation, buildings – are contingent and revisable, they come and go. The challenge for managers is constantly to reorganise the means to deliver the optimum ends for the owners. This approach, to see a business as a linear, explicit, causal chain – a value chain – linking inputs to outputs to results for shareholders has become the conventional view of what business should be about. “Share- holder value capitalism” despite the recent setbacks of the financial wing of the movement still acts as a strait jacket on the corporate imagination in the UK and much of the US. Are there any alternatives to this narrow, instrumental and linear view of what a business should be for, and what if anything should government do to promote these alternatives?

31 Going for Growth

Alternative models of capitalism

In the last two decades the main critique of this new conventional wisdom has come in the form of corporate social responsibility, which argues that companies need to take a wider and more responsible view of the means they use to generate returns for shareholders. If a business acts in a way that is too callous or self-seeking then it attracts bad publicity, its reputation and public standing are damaged, that in turn corrupts its brand and so undermines its value to shareholders. Investing in social activities – education, culture, social entrepreneurship – may not make immediate sense in terms of the bottom line but they do so in the long run if they mitigate these reputational, political and public risks. Corporate social responsibility, at least in its most instrumental form, is business with the same ends but pursued with slightly more socially engaged means. In Japan and parts of Northern Europe, there is a deeply rooted version of this socially responsible capitalism. Only a few British companies have ever had this approach and often those stemmed from religious roots in the nineteenth century. Much of the debate about how business should conduct itself has been a contest between these two approaches: the Bolsheviks of shareholder value capitalism against the Mensheviks of corporate social responsibility. This debate has virtually ground to a standstill. Where might we turn to open up the question “what is business for?” in a more interesting and potentially progressive way? A starting point would be to think about the ends of business in a more open and creative way and not just concern ourselves with the means.

32 What is business for?

The best companies make profit as a by-product of creating better outcomes for consumers. They do not focus on the profit as their main goal. Their goal is to improve lives, deliver value, and solve problems. Call this, for the sake of argument, “mission driven capitalism” as practiced by many of the most entrepreneurial and successful companies. They pursue a mission and as a byproduct make money. Their mission is not making money. This is John Kay’s main point in his recent book Obliquity. The best companies focus on doing something useful – creating new drugs to save lives, making high quality and affordable clothes – the profit comes as a by-product of doing something useful. Apple is a mission driven company: to make insanely attractive products. Google has a mission: to organise the world’s information. Facebook’s stated mission is to enable people to share. Companies can lose their way when their mission becomes vague. But they can also lose their way when they follow the money and get obsessed by profit. Britain has too few mission driven companies compared with the high tech sector on the US west coast. Dyson fits this bill; GSK, in drugs; Tesco, the retailer; Rolls Royce, the engine manufacturer; Body Shop in its day, but not many others. British managers are generally frightened to admit they have a mission beyond satisfying the City. One reason social enterprises and companies with green ambitions are growing, is that they speak to this desire for a mission driven capitalism. A powerful mission, however, has to connect to a real need. That means seeing the world from the point of view of the consumer and what they are trying to achieve. People often need complementary combinations of products and services, provided from multiple sources. That is why some

33 Going for Growth of the most successful innovations and the most successful companies rarely push a single product. They develop platforms on which lots of companies can create products. Take the container as an example. Containerisation transformed the trade in physical goods. It made globalisation possible. Yet the container on its own, as a product, would have been useless without container ships, container ports, trucks to carry them to and for, special cranes to stack them. The container is the product; containerisation is the system. The inventor of the container would have got nowhere unless he persuaded lots of other people – shipowners, port owners, trucking companies – to invest in and back his approach. The container system works by creating lots of shared value for everyone involved in the network (and in parallel destroys the value of old ports, trade unions, cranes, trucks and ships.) Innovators often lead coalitions of companies to invest in shared platforms which consumers can draw on to meet their needs. This approach, set out by Michael Cusumano in his recent book Staying Power suggests that really successful companies create not just products (the container) but systems and platforms (containerisation) in which many others can play a role. The most widely cited version of this at the moment is the way that Apple stumbled across the power of the App Store. The legion of third party apps available for the iPhone and iPad is Apple’s biggest competitive advantage. In this world a company has to be part of a system for sharing value with its partners. Go it alone strategies do not work. This suggests a kind of “shared value capitalism” – a company can only make money if it also helps lots of other people to make money and so to some extent gives away value to the rest of the network.

34 What is business for?

A purely selfish approach will not work. The unit of business is the federation, association or network of companies that create value shared by bundling together complementary products. Of course this is far from new. Networks of small firms in Northern Italy have been practising this kind of capitalism for decades as have Japanese and Korean corporate federations. But the spread of network technologies and the web make this kind of shared value capitalism all the more likely. The best example of a third distinctive approach comes from the top end of the French wine industry in Bordeaux where the means of business are the ends. What really matters at the top of the French wine industry is the way of life, the culture, which surrounds the production of the wine. Producers are interested in money. Profit matters. But only in so far as it maintains the way of life and the culture of production – the chateaux and everything that goes with it from the very grand to the small family run businesses. Bordeaux turns the logic of shareholder value capitalism on its head. Profit is not the point of this kind of business; it is just a means to keep it going, so people making the wine can continue to live and work as they have done for decades. The point of the business is to sustain a culture and way of life. Profit is the means to that end. The idea that the way we work and produce might be an end in themselves sounds like a giant step backwards. One of the lines connecting Margaret Thatcher to Tony Blair and Gordon Brown is the idea that we should do what works in the name of consumers and not be trapped by producer interests. The medieval guilds insisted on protecting the way they produced goods and stifled competition and innovation. Academics, professionals of all stripes, and trade unions all

35 Going for Growth like to claim that the particular ways of working that they represent are worth protecting in their own right. Yet as the Marxist philosopher Gerry Cohen pointed out in a brilliant essay The Truth in Conservatism, ways of working are not endlessly interchangeable. Cultures of work may have a particular value embedded in them. Cohen owned the same eraser for 20 years. The fact that newer erasers did a better job did not matter to him. He was attached to his eraser because it was his, they had a history together, it was not just a tool, he did not want to treat it as a disposable. Britain has nothing quite like the French wine industry. However, it does have a lot of small, family-run businesses that are run in part for the lifestyle that they sustain not just the money they make. Many more people are likely to pursue self-employed and entrepreneurial careers for this reason. Coming on top of all of that is the trend towards consumption becoming partly an act of production. Many of the most successful companies are “can” brands: they offer consumers tools to do things, to part produce what they consume, from Apple’s “rip, mix, burn”, to Nike’s “just do it to” and Ikea’s “build it yourself”. If we take seriously the idea that we are all, even if only in minor ways, part co-producers of content, meaning, and information – especially around brands and activities that we are fans of – then we may all be acquiring an interest in the means of production as much as in the goods that are produced. That is true of mass multiplayer games, social network campaigns, fan communities and the most powerful media brands: they all seek to win our commitment by persuading us to help make what they stand for. It is not difficult to imagine the creation of “giant consumer guilds”

36 What is business for? in which we all have an interest in the way of life, associated with a brand or product. Apple is not selling products but an approach to life: the “Apple Way”. Finally it is also possible to imagine a business where the means and the ends of business are constantly interacting, redefining one another. As the ends change so do the means. Linear, mechanical, causal models do not really work, especially not in anything affected by modern media, where companies have to respond in real time to what consumers think, say and do. Witness Gap’s climb-down on its ill-fated attempt to change its logo. The prime example of an activity in which the means and the ends constantly have to adjust to one another is how we learn. The most effective forms of learning involve teachers and coaches constantly adjusting to how pupils are learning, posing new challenges, introducing new information, providing feedback. Learning is a gener- ative activity. As people learn they acquire new skills and so should be capable of setting themselves new questions and new goals. What if we saw the main rationale for business as not to make a profit but to help society to learn: how to make better use of our energy resources; new ways to commu- nicate; new ways to save for our retirement or life in old age. Imagine for a moment that all of business, and especially all of business innovation, is a vast attempt to help us to learn how to live better lives. Then we would pay companies because they were helping us to learn how to live more successfully. Set against that yardstick most companies – for example the financial sector – fail miserably. In the last ten years the financial services industry was awash with useless and damaging innovation. It claimed to have learned how to

37 Going for Growth allow poor people to take out loans to buy houses. In reality it had not. In contrast the Grameen Bank has allowed us to learn how to solve a really tricky problem: how to get loans to people whom banks will not touch. The most valuable businesses enable us to learn to live more successfully. So in truth there are multiple, existing, different models for how we can see business as successful, as mission driven, sharing value in networks, working to protect the culture and way of life that surrounds production, enabling social learning. The idea that a business exists only to earn profits for its shareholders is a feeble and narrow rationale for the role of business in society.

The role of government

What can government do to encourage a shift away from an over-reliance on narrow, shareholder driven capitalism in favour of shared value capitalism, which puts social learning at the heart of its mission? Politicians could lead the way by speaking out far more persuasively about the different values that animate people, even in business life, and the sense of mission that drives so many entrepreneurs. Promoting a cooperation policy alongside competition policy, to encourage companies to explore the potential for shared value creation, might help. As discussed in Stian Westlake’s chapter, innovation is central to modern capitalism and collaboration is central to innovation. British business needs to excel at, and be supported to engage in, creative collaboration. The financial and reporting frame- works under which companies operate need to change. New

38 What is business for?

Labour backed away from even modest change in company law and structure. Creating alternative corporate vehicles, with encouragement for mutuals and employee ownership would help. Reforming finance and splitting the casino side of banks from their utility activities of lending to business would be another step forward. Away from company law, the development of new measures of macroeconomic success and wellbeing should have their business correlates – the most successful businesses are not necessarily those that are the most rapaciously profitable. We need a renewed debate about the importance of quality and satisfying work, as a value in itself not just as a means to earn a wage. Promoting new kinds of business association to speak for these new kinds of mission driven, shared value businesses would help. The Confederation of British Industry and the Institute of Directors do not represent the diversity of young British, entrepreneurial business. The spread and growing attraction of forms of social enterprise needs to be met by new kinds of business study courses which focus on collaboration and ethics as well as competition and making money. Who knows, one day the winner of “The Apprentice” might not be a corporate clone who boasts about their competitive drive and ruthlessness but instead someone who wants to change the world and work collaboratively with people to bring it about. No, on second thoughts, that would be too revolutionary.

Taming the goose that laid the golden egg by Kitty Ussher

When he appointed me junior minister for banks in the early summer of 2007, the then new Prime Minister, Gordon Brown apologised for the fact that the job “did not have much policy in it”. But he urged me to get out and about into the City, stating that they were “a very important group of stakeholders”. It did not take long for all that to change. Within months, far from being an “important group of stakeholders” the bankers rapidly became widely despised in the eyes of the public for apparently having caused the credit crunch and subsequent recession. Politicians from all sides were soon competing with each other to punish them through their rhetoric and taxation. This chapter examines the domestic and international factors that contributed to the credit crunch and subsequent recession. Learning the right lessons from the crisis means understanding that not all bankers are bad, that a re-regulated finance sector can continue to foster domestic growth,

41 Going for Growth and that we cannot expect banks to consolidate their balance sheets and lend at the same time.

Causes of the economic crisis

Two factors were critical in causing the economic crisis. First, the US regulatory environment which permitted risky mortgages to be sold and distributed on such a large scale. Second, management failure in the companies that then mispriced that risk. Once the problem began to emerge in the banking sector there was then a third factor in the UK that made its impact worse, namely the low savings ratio which meant the consumer response was dramatic. Insufficient capital held by the banks to cope in the face of a serious downturn then necessitated large-scale capital raising in a difficult time, which added to market insecurity.

The US regulatory environment

It had become far too easy to borrow money to buy a property in the US. A deliberate loosening of the regulatory environment, coupled with low interest rates, and a celebration of the role of subprime markets to enable greater access to home- ownership proved an explosive cocktail that caused the value of outstanding subprime mortgages to rise by nearly 300 per cent to $1.3 trillion in early 2007, up from $332 billion in 2003.5

5 US Centre for Responsible Lending.

42 Taming the goose that laid the golden egg

The main contributing factors were:

• A clear political decision by the Bush administration to ratchet up the affordable housing goals set by the government for federal housing regulators, Fannie Mae and Freddie Mac; • The Commodities Futures Modernisation Act 2000 that reduced supervision of financial commodities which enabled the rapid rise of credit default swaps leading later to the collapse of the American International Group (AIG); • A relaxation in 2004 by the Securities and Exchange Commission of the “net capital rule” for five investment banks – Bear Stearns, Lehman Brothers, Goldman Sachs, Merrill Lynch and Morgan Stanley. Previously this had placed limited firms’ debt to capital ratios at 12.1. Once removed, firms were free to invest in a far greater volume of riskier assets, causing debt ratios to rise sharply, in the case of Bear Stearns to 33:1. By October 2008, the chairman of the SEC, Christopher Cox, was forced to concede what many would say was self-evident, namely that “voluntary regulation does not work”;6 and • A general failure of the regulators to see the rise in systemic risk in the system. As late as April 2005, Alan Greenspan gave a speech praising the role of computer- based risk models that used backward looking past credit scores (rather than a prediction of future risk) to decide whether loans should be made.

6 New York Times, 2 October 2008.

43 Going for Growth

All of this led to more finance becoming available, which caused house prices to rise and encouraged existing home- owners to raise their mortgages in order to finance consumer spending. So when the US federal funds rate began to rise in 2004, the bubble burst and foreclosure rates rose sharply. The problem was that, in the meantime, the mortgages that should never have been sold in the first place had been secu- ritised and sold round the world. Of course subprime and excessive lending were not exclusively an American preserve. In the UK, the growth of the buy-to-let market in 2000-07 and the easy availability of mortgages that offered more than the value of the property were evidence that things were getting out of hand. However this merely increased Britain’s vulnerability to the effects of the crisis, rather than causing the crisis itself. The transmission mechanism that led to the recession in the UK began in the US rather than in the domestic housing market. In any case, the proportion of toxic assets held by financial institutions that were American in origin vastly outweighed those that originated in the UK, even after accounting for population size. In its estimate of the total value of toxic assets in the global economy, the International Monetary Fund considered that this could rise to $3.1 trillion in US originated assets, compared to $900 billion in assets originating from Europe and Asia combined.7 It follows that had there been greater control over the availability of credit in the US, particularly that secured against property, the crisis could have been avoided.

7 International Monetary Fund, 21 April 2009.

44 Taming the goose that laid the golden egg

Management failure in the banks

Even given the existence of bad debt in the system, it takes a bad manager not to notice it. There is nothing intrinsic about being a financial services company that means it needs to expose itself to excessive risk. Barclays and HSBC did not see the same speculative attacks on their share prices as the likes of HBOS and RBS. Goldman Sachs and Standard Char- tered did not have to file for bankruptcy or be sold overnight like Lehman Brothers and Merrill Lynch. Why? Quite simply because they had made wiser decisions over the years, and as a result – it now emerges – they had had more options of where to go for credit without unsettling the markets. This shows that at the very least, bankers did not collec- tively cause the crisis. It is more helpful to look at it the other way around: not enough bankers succeeded in preventing it. This provides a helpful perspective to the debate on remu- neration. If you were a shareholder in a bank that avoided excessive risk-taking in this global climate of exuberance, would you not feel that your managers were worth what they were paid? Once the bad loans had been made, and some bankers had bought them, the problems were inevitable. But the severity of its impact in the UK was due to a third factor, namely the low savings ratio in the UK economy.

The low savings ratio in the UK

Up until 2007, the British consumer was feeling confident. Low inflation and low interest rates had caused house

45 Going for Growth prices to rise bestowing a feeling of affluence on much of the economy. As a result consumer spending rose, and with it so did levels of personal debt. Indeed by 2006 the savings ratio had fallen below 3 per cent, the lowest it had been at any time since the 1950s. The official government response to this phenomenon at the time was that, like in the 1950s, people were feeling good about life and that this was a reflection of the success of economic policy, rather than something to be worried about. But in the end it meant that once the UK consumer felt the chill winds of the credit crunch they had to reduce their debts before they felt able to spend again. Had there been less consumer debt, this effect would have been less pronounced and so the recession less severe.

Insufficient capital held by British banks

It was not just consumers who lacked a financial safety cushion. Many financial institutions did as well. When the Financial Services Authority ran stress tests on its regulated companies, it emerged that most had to raise capital in the midst of the crisis in order to prevent an even worse fate. Those that were unable had little choice but to turn to the government hence the bailouts in the second half of 2008. As a result of all this activity, the core tier one capital ratio of UK banks had risen from 6 per cent at the end of 2007 to 7.7 per cent eighteen months later.8 These two aggravating factors share many similarities. Had British consumers saved more, and the banks held

8 Lombard Street Research, November 2009.

46 Taming the goose that laid the golden egg stronger reserves, the recession would not necessarily have been avoided. But the consumer fear and instability in the markets would probably have been less, as would the exposure of the taxpayer.

The necessary policy response

It follows from the discussion so far that the unequivocal role of the regulatory authorities is, first, to tighten the amount of lending as a proportion of capital that is undertaken by financial institutions and, second, to mandate greater monitoring of risk within individual firms. Moreover, there should be a counter-cyclical element to this policy, so that the constraints on lending routinely tighten as asset prices rise. So much is already understood and is in the process of being implemented either through domestic or international authorities. Harder to address is the issue of management failure. Better risk monitoring within organisations is a start. But we now find ourselves returning to the perennial issue of the quality of management at board level. There are two specific weaknesses that need to be addressed. The problem is that they often point in different directions. The first is the need to have serious non-executive financial expertise and experience around the boardroom table that is sufficient to challenge the accounting orthodoxies and culture of the firm in question. Unfortunately if an individual exists with the necessary experience, they could well have a conflict of interest by working for a competitor firm, or be so ingrained in the sector that they may find it hard to deviate from the industry’s group-

47 Going for Growth think. The second problem is the lack of diversity on boards which prevents outside experience and voices being heard. These are not new problems and do not apply exclusively to the financial services sector. There needs to be a far wider pool of talent from which head-hunters can recruit from when considering board positions. Moreover it should be easier for individuals to obtain the experience and training necessary to make them more effective participants around the boardroom table. Otherwise boards will continue to be made up of a rotating group of insiders, scattered with a few “diversity candidates” with insufficient experience. Governments should work with the industry, possibly at an international level, to establish a board-level careers’ service where senior individuals, entrepreneurs and leaders from all walks of life can self-refer to receive assessment, experience, advice and training to make them credible candidates for board positions in future.

Curbing British house price bubbles

Turning to the specific weaknesses that made the UK more vulnerable to the effects of the crisis, we first need a serious discussion around the policy tools required to control an asset price bubble in an environment where the Bank of England has a fixed inflation target. This issue is dealt with in more detail in Tony Dolphin’s chapter on rethinking macroeconomic policy. Possible responses include a regulatory response such as stricter mortgage lending restrictions or a drastic increase in stamp duty levels or capital gains tax on primary residences to curb house prices.

48 Taming the goose that laid the golden egg

The advantage of increasing property taxes rather than a regulatory response is that it would not only dampen the boom and so lessen the bust, but would also create a fiscal buffer to deal with falling tax revenues when a slowdown arrives. Either tax or regulation could also have the beneficial side effect that it would divert more capital into the real economy rather than financing an ever-increasing spiral of house price rises. There are many ways that the banking sector can be made to work better for the national interest so that the risks of the next crisis being so deep can be mitigated. But what does not follow from the financial crisis and subsequent recession is that we should “rebalance” from financial services to manufacturing. After all manufacturing already takes up a higher proportion of the economy than financial services, and is equally vulnerable to external shocks, for example through the exchange rate. Moreover in an increasingly competitive world is it really advisable that we should seek to erode one of the areas where we have a comparative advantage? The UK financial services sector employs over a million people, only a third of whom are in the City and Canary Wharf. In the last few years it has contributed between 18 and 28 per cent of the government’s total corporation tax take and its employees have consistently raised over £25 billion through employment taxes to the exchequer, aver- aging around £25,000 each in tax contribution alone. All of this is available to governments to spend on their priorities of the day. It provides liquid wholesale markets that make it easier for UK companies to hedge contracts, raise finance, and obtain world-class professional advice. It provides a broad range of securities for us to invest our pension funds

49 Going for Growth in without exchange rate risk. It attracts some of the best financial brains in the world to support our economic activities. The challenge is not to drive that activity away, but to ensure it is channelled effectively. Conventional wisdom dictates that the most important national priority for banks is to support our economy and lend more to business. This is, in fact, unreasonable. It is counter-intuitive to expect the banks to be out there making new loans in a shaky economic climate at the same time as the regulators are asking them to consolidate their balance sheets, pursue more cautious policies, and build up capital. If it is in the national interest to lend more money into the economy, this needs to be done through the national authorities. In particular, the Bank of England is wrong to be investing practically all of the £200 billion it has pumped into the economy into government bonds which it buys off the secondary markets. This may help the banks, after all they would not sell to the Bank of England unless it was in their interests to do so, but that in turn does not mean that the money will necessarily be recycled into the real economy. It might just as well boost the bonus pool for people working in the wholesale markets side of the banking businesses. It would be far better if a greater proportion of the bonds that the Bank bought were corporate, rather than government. This would create an immediate and direct effect on the ability of UK plc to raise finance. In early 2009 the Bank of England indicated its willingness to consider purchasing corporate issuances but in practice the amount has been minimal. Bankers may no longer be seen as an important group of stakeholders but they should still command significant policy attention from government. At some point in the future there

50 Taming the goose that laid the golden egg will be another banking crisis and it will affect us whether or not Britain is still number one in financial services. But by learning the right lessons, not the wrong ones, from the events of the last few years, we can not only be ready for it, but have channelled the power of the financial markets for the good of the country in the meantime.

Time for an economic challenge strategy by Adam Lent

Introduction: the 1940s revisited

While so much attention is focused on the fiscal crisis, few are seriously discussing the profundity of the challenges facing the wider UK economy over coming decades. These challenges bear some instructive similarities to those faced by the UK in the immediate post-war period. Then as today, major shifts were underway in the global economy with new powerful players shaping the world market in their own image. Then it was the USA, Germany and France; today it is China, India and Brazil. Then as today economies were being disrupted by a major wave of innovation. In the post-war period business was transformed by the rolling-out of the mass production revolution. As the shattered businesses of Germany and France

53 Going for Growth began to rebuild themselves after 1945, they did so in a way that adopted wholesale the obsessive American focus on the productivity and market benefits to be gained from economies of scale and Fordist factory organisation. Again, this process has its analogy today. Companies in both manufacturing and services are being transformed by the rolling-out of web technologies. Just as mass production revolutionised both the operations of companies and the expectations of consumers, so the web is transforming how companies innovate with and respond to customers while those same customers continue to demand ever-greater variety, choice and control.9

What went wrong in the post-war economy?

Given the way the UK economy faces similar challenges, it is imperative to learn from the mistakes of that post-war period. Not least because those mistakes were profound and deeply damaging resulting, as they did, in the troubled decade of the 1970s and the upheavals of the 1980s. Unfortunately, main- stream opinion has learnt the wrong lessons. The dominant narrative has drawn heavily on the work of Corelli Barnett.10 Barnett’s analysis, famously taken up by the New Right, correctly sees an economy where many sectors failed to innovate and where, as a result, British productivity

9 Adam Lent and Matthew Lockwood, Creative Destruction: Placing Innovation at the Heart of Progressive Economics, ippr, 2010. 10 See, for example, Corelli Barnett, The Audit of War: The Illusion and Reality of Britain as a Great Nation, Pan, 2001. But also Corelli Barnett, The Collapse of British Power (Pride & Fall Sequence), Pan, 2002.

54 Time for an economic challenge strategy and growth began to lag behind competitors resulting in the stagflation crisis of the 1970s. While Barnett’s full analysis was complex and sophisticated, it was his critique of the welfare state and trade unionism as a source of economic weakness that Thatcherism and ultimately the wider political consensus chose to adopt. This cherry-picking of Barnett’s analysis meant British politics was ultimately informed by a highly simplistic understanding. It is vital to appreciate this otherwise we risk assuming that the secret of meeting the similar challenges we now face is simply more labour market flexibility. Fortunately, an analytical antidote has been presented in recent years by historians such as Nick Tiratsoo and Jim Tomlinson11 and Geoffrey Owen12. For these authors, the economic malaise that emerged two decades after the war had its origins in two bad decisions – one made by post-war governments, the other by business leaders. The first originates with the Attlee government’s emphasis on the construction of a universal welfare state alongside a system of economic planning designed to guarantee full employment. This approach also shaped economic policy throughout the 1950s under the Conservative governments of that decade. This in itself was not necessarily flawed but the mistake was to relegate the equally pressing economic goal of transforming British business into modern mass producers to the status of a poor policy cousin. While welfare

11 Nick Tiratsoo and Jim Tomlinson, Industrial Efficiency and State Intervention: Labour 1939-1951, Routledge, 1993. Nick Tiratsoo and Jim Tomlinson, The Conservatives and Industrial Efficiency 1951- 1964: Thirteen Wasted Years?, Routledge, 1998. 12 Geoffrey Owen, From Empire to Europe: The Decline and Revival of British Industry Since the Second World War, Harper Collins, 1999.

55 Going for Growth and employment became dominant, epoch-defining commitments enjoying huge resources, industrial modernisation became a secondary concern that struggled against political and business disinterest. The second bad decision was the emphasis British business leaders in some of the key sectors of the UK economy gave to continued trading in Commonwealth markets where they already held a dominant position while largely ignoring European markets. By evading competition with European and American firms, much of British business had little incentive to understand or adopt the vast strides in innovative techniques being achieved by foreign companies as the principles and practices of mass production were rolled out and refined across the advanced economic world. The wider result of both decisions was that while politicians and the wider population basked in the warmth of the “never had it so good” era, the foundations of the UK economy were slowly starting to buckle. By the late 1950s, it was becoming clear that the revolution in UK living standards was not matched by a revolution in productivity similar to that being achieved overseas. The full implications of this failure began to bite in the 1960s when British businesses, finally aware that the Commonwealth market was unable to sustain them, were forced to compete with European and US competitors both at home and abroad. Unfortunately, British business with its anachronistic techniques and products were no match for overseas firms and key parts of British industry lost market share at home while failing to seize it abroad. The oil crises and inflation of the early 1970s delivered a knock-out blow to many British businesses already struggling

56 Time for an economic challenge strategy to compete and so began the sad economic story of a decade characterised by chaotic policy, vituperative industrial relations, and rising unemployment. As such, the reality of the post-war British economy was not so much one of business leaders frustrated in their efforts by militant unions and meddling politicians but one where the intense focus on innovation that characterised the policy and business decisions of the UK’s major competitors was absent in the UK itself.

Competition alone is not enough

It could be argued, and often is, that the best way to drive the innovation, and hence productivity, so needed by British business in the post-war era was free market competition. Indeed, the failure of British businesses to engage with competitive markets during this period seems to uphold that claim. In addition, the experience of the 1980s shows that once sectors are opened up to competition they become more innovative and productive. This argument certainly has much going for it but it is a partial account. The key historical lesson of the post-war period is that competition can only effectively produce significant levels of innovation when adequate government support is in place to drive the investment, training and diversity of businesses that do not naturally occur within a free market. This is not only upheld by the fact that much bolder state-led policies were implemented by European governments in the post-war period but also, ironically, by the experience of the UK in the 1980s.

57 Going for Growth

Thatcher’s approach to different sectors of the economy was far from consistently laissez-faire. More importantly, when she was laissez-faire, the approach was far from universally successful and when she was more interventionist, the approach was far from universally unsuccessful. Efforts at privatisation and deregulation undoubtedly created the conditions for growth and very significant innovation in some important sectors such as media, telecommunications, retail and banking. Other sectors such as textiles, mining, parts of engineering, and ceramics began a precipitous decline when relieved of government backing – a not necessarily inevitable process for those industries when the continuing success, even flourishing, of similar sectors on the European continent in the 1980s is observed. Much of this is well known but what is less widely acknowledged is the way certain sectors thrived with continued government support and even a significant union presence. The aerospace industry was provided with very significant financial support in the form of “Launch Aid” to help Airbus develop the A200 and A300 airliners which went on to be enormously successful products. The ailing car industry (the icon of 1970s failure) was revived with a very deliberate government attempt to woo foreign direct investment aided by the sale of land for new factories at a knock-down price. While the pharmaceutical industry was effectively supported by the decision by government as a major customer of the sector to pay high prices for products through the NHS. In effect sectors that are now widely regarded as cornerstones of the UK economy, thrived as a result of the very “meddling” that Thatcher’s rhetoric might have led one to believe she

58 Time for an economic challenge strategy would never engage in and which would, in fact, prove disas- trous for the relevant sectors and the wider economy.

Developing an economic challenge strategy

What the recent history of the UK economy tells us is that what is required today is no different to what was required in the 1940s – a coherent and timely strategy to meet the profound challenges of an era characterised by shifting global markets and a wave of business transformation. The apparent faith of the current government that this can be achieved largely by cutting the deficit, and hence boosting business and investor confidence, lacks any serious empirical evidence base. Indeed a similar commitment to cut deficits in the 1930s and 1940s did nothing to address the UK’s long- term economic weaknesses. Instead what is required is a combined determination on the part of business and government to seize the benefits of web-based innovation and compete in the most challenging markets. Achieving this, however, requires far more than just political will. As mentioned above it needs state- led intervention in those key areas that drive innovation and productivity but which the market has been shown over many decades in the UK to be unable to deliver fully: business investment, skills and training, and the creation of innovative, high productivity SMEs. Each of these areas will require a suite of policies to resolve their shortfalls but equally there can be little doubt that a major, far-reaching and iconic policy in each area can help shift behaviour, indicate that a new approach is expected by

59 Going for Growth government and set the tone for policy development in other areas. In each case we must learn from what has worked best overseas rather than falling back on ideology or prejudice. In the case of low investment, it is clear that countries with historically higher levels of investment in business development than the UK rely far more heavily on some form of state investment facility. The reason is not complex. The type of cutting-edge business innovation and development that creates new markets and helps transform old ones is often risky and usually takes some time to generate returns. The commercial banking market is unlikely to invest too heavily in this sort of business activity particularly when quicker and surer returns are on offer from the property and financial markets. Germany, for example, established its KfW bank in 1948 with the remit to provide finance for German firms through a combination of public and private funds. The bank is still at the heart of German business investment today. Gerald Holtham’s contribution to this volume discusses this idea of a state investment facility for the UK in more detail. The long-term skills shortage in the UK identified, for example, by the Leitch Report results from a similar fear of risk.13 Companies may complain loudly about a lack of skilled employees but levels of investment in training have long been constrained by fears that upskilled workers will leave their employers or demand higher pay. Given that a far stronger skills base must be a key plank of any strategy to meet our economic challenges, some element of urgent compulsion is necessary. The years spent reorganising training institu-

13 Leitch Review of Skills, Prosperity for All in the Global Economy – World Class Skills, HM Treasury, 2006.

60 Time for an economic challenge strategy tions and channelling taxpayers’ money to employers have delivered uneven and limited results. Ultimately a statutory training levy on employers combined with a system of licences to practice seems the only likely way to bring about a revolution in the UK’s threadbare skills base. The necessary policy framework for a significant upgrading of UK skills is explored further in Andy Westwood’s chapter. Finally there is the goal of creating a vibrant ecology of highly productive SMEs to develop, adopt and refine innovations alongside the bigger players. Again this is an area where the UK has long lagged other economies particularly the US and Germany. Creating this UK version of the German mittel- stand can, in considerable part, be achieved by addressing the problems of business investment and skills mentioned above. However, it is also clear that investment specifically targeted at SME innovation through adoption of the long-standing US approach of licensing and guaranteeing Small Business Investment Companies could prove fruitful. Using the tax system and public funds to incentivise university spin-off companies and create innovation zones around research facil- ities will also be vital. Further ideas to boost the innovative potential of UK companies can be found in Stian Westlake’s contribution to this collection.

Conclusion

The world is undergoing significant economic change. This has always been the case following major financial crises. In the current moment, the key change is the rapid rise in the economic power of the East and Latin America and the

61 Going for Growth unstoppable spread of disruptive business practices based around the technologies of the interactive web. Times of such change are a great challenge to all economies but they represent a particular threat to older economies such as the UK. Emerging nations are less constrained by out-dated practices and sunk costs at a time of innovation and tend to have a drive and confidence lost to the more established. In this context, it is vital that UK business finds a profitable role in the global marketplace before others do. As such, the decisions taken by business leaders and policy-makers over the next few years will determine the success or otherwise of the UK economy for many decades. A failure to focus unerr- ingly and without ideological prejudice on the effective routes to business innovation would be the biggest economic policy mistake that could now be made. Of course, many will argue that the policies proposed here are simply too expensive for a time of major fiscal retrenchment. If that is truly the case then those who claim this, need also to accept the grim reality of the UK’s economic decline in coming years. However, the argument is, thankfully, false. There is no doubt that the policies mentioned above will mean the taxpayer bearing some cost. But these costs are not of a level that makes them unthinkable for the Treasury: in the single billions and no more. Such amounts may require a slight lengthening of the time frame for the abolition of the deficit or maybe a reprioritisation of current spending commitments but the stakes are so high, and the returns potentially so fruitful both for the Treasury and the economy, that the imperatives are strong enough to warrant such relatively minor changes to current plans.

62 PART 2

Essential investment requires state enterprise by Gerald Holtham

The UK economy faces three simultaneous problems. Capital investment is required to improve infrastructure and reduce the country’s carbon emissions. There is a widespread expectation that slow growth will not do enough to reduce unemployment to pre-recession rates. And the government is running a large deficit which is unsustainable and must be reduced over some time frame. As outlined in the introduction, the government is currently giving complete priority to the third problem. It is postponing or ignoring the first, investment problem, while hoping that monetary policy can solve the aggregate demand problem and offset the effect of public spending cuts and tax rises. The UK is already a country with relatively low investment rates compared with similar European countries. Whereas the ratio of gross fixed capital formation in the UK tended to fluc-

63 Going for Growth tuate around 17 per cent in the past decade, in Germany it was 19 per cent and in France 21 per cent. The UK transport system compares poorly with the high-speed railway infrastructure and motorway mileage of its nearest neighbours. And while nuclear power is a divisive issue, French single- mindedness in using nuclear power to achieve self-sufficiency with low carbon emissions has no UK counterpart. Now a substantial effort is needed to make the transport improvements that would prevent UK economic activity becoming increasingly unbalanced towards the southeast corner and to make the energy investment necessary to meet carbon emission targets. Yet instead of a substantial effort we have delay and retrenchment. Moreover, the government’s reliance on monetary policy to maintain aggregate demand is most unlikely to be sufficient. The UK does not face a mere cyclical recession where full employment will soon be restored by the automatic self-righting characteristics of the economy. The world faced a growing problem of effective demand even before the financial crisis, as countries like China, where profits make up nearly 50 per cent of GDP, relied on exports and associated investment to provide much of their dynamism and employment growth. As wages in the West, under the pressure of globalisation, lagged GDP growth, only very low interest rates kept debt growing and enabled spending to keep up with output. The debt bubble has now burst and a possibly long period of adjustment and deleveraging by Western households and businesses is in train. Future attempts to reflate the private debt bubble through easy money are no more likely to work than recent episodes of “quantitative easing”. If governments shy away from taking

64 Essential investment requires state enterprise on the debt that other sectors wish to run down, demand and growth will be extremely slow. Individual countries may try to escape from the problem by depreciating their exchange rates in search of export-led growth. That is the most promising transmission channel from quantitative easing to real economic activity in the UK. However, there are problems with this strategy. First, a sustained devaluation has a time lag, typically three years, before net export volumes show a big effect. Second, depreci- ation risks importing inflation. With the consumer price index already over target, the Bank of England might be reluctant to stay the course. Third, exports will struggle to grow fast enough given that much of the rest of the world and especially Europe are shrinking domestic demand. Given those difficulties it is most unlikely that easy money will drive net exports to the point that a private investment boom would ensue. Econometric work has always found that while the cost of capital is important, the biggest driver of investment is order books and the state of demand. Moreover, even some revival of private investment would not begin to resolve the deficiencies and requirements of UK infrastructure. Although a continuing credit crunch has received much attention from commentators, it is not the core of our present difficulties. Banks are rebuilding balance sheets; they are imposing spreads and fees, including insurance fees, on client businesses that make borrowing difficult or expensive. That cannot help matters. Yet investment would be sluggish even if this were not true. Difficulties accessing capital are mainly a problem for small firms that depend on banks and cannot access the capital market. Those difficulties would become a

65 Going for Growth major constraint on growth only if there were strong demand for investment funds but this is not a general constraint. When banks say they are not getting a lot of viable demand for credit, we can probably believe them.

The case for state-led enterprise

In any event, there is no need for the policy objectives to be in conflict. All three economic problems can be resolved. The real difficulty is that the answer to the UK’s problems requires something deeply unfashionable, namely state action, and indeed state enterprise. Statism is a big insult at present, even on the left. We are all supposed to be enamoured of mutu- alism, co-operation and efforts to reinforce civil society. Those things are all admirable and part of the good, great or even the big society but it is ironic that misplaced centralism has caused the state to go out of fashion – just in time for a crisis that can only really be resolved by state enterprise. But can the state act when it is already running an enormous deficit? Yes but the key word is enterprise. Why does a deficit matter? Because servicing it implies a burden on taxpayers. It involves transferring large sums of money in future from taxpayers to bond-holders, domestic and foreign. If the deficit stays too big too long the debt burden becomes enormous, the transfers become infeasible – and there is trouble. It is often pointed out that what the deficit is used for is what matters. If it is consumption in the current period, future taxpayers have no compensation for the transfer payments they must make. If it is investment, there are assets that, in

66 Essential investment requires state enterprise principle, raise national wealth and standards of living and provide an offset to the obligations of taxpayers. This was the principle behind Gordon Brown’s “Golden Rule”. Yet in certain circumstances, a deficit did not imply any burden on future taxpayers at all, balanced by assets or otherwise. If the deficit does not imply a burden on future taxpayers, it would be a problem only if it was making an excessive call on resources because employment of capital and labour was full and inflation threatened. That is not the current situation and, as it was argued above, is unlikely to be the situation for some considerable time given current imbalances in the world economy. Therefore, at present, a deficit that was not a burden on tax-payers would be no problem at all. Such a deficit arises if the state borrows to invest in assets to provide marketed services, so generating a revenue. Those revenues, not taxes, then service the debt. State investment to provide marketed services is, therefore, the way out of our three problems. It can provide essential infrastructure and support demand while not adding to the burden on future taxpayers. The investment must be in assets whose output would be sold, rather than being provided free at the point of delivery. Railways qualify but not schools; toll roads but not free roads. State enterprise does not need not to imply a dirigiste approach to economic activity or the nationalisation of industries. Indeed it could be organised on thorough-going market lines or on more or less dirigiste lines according to taste. Suppose, for example, the government took a nation- alised bank and announced its debt would have a formal government guarantee. Suppose it then seconded some of its better Treasury economists and got the bank to hire some competent investment bankers. It could then announce that

67 Going for Growth the bank would engage in a multi-billion pound programme of infrastructure projects – especially in relatively depressed parts of the country. The bank would provide finance and take preference shares in joint ventures to, for example, hugely extend high speed rail networks, build tidal power stations on the west coast and, where justified, build relief toll roads. If we wanted to create one million jobs via this programme, assuming the unaided private sector would create the rest, the investment would have to be at least £40 billion, some 3 per cent of GDP. Whatever the precise details of the financial structures created, the essential idea is to stand the Private Finance Initiative (PFI) programme on its head. Instead of getting the private sector to raise expensive finance to build assets and lease them to the public sector, a public sector entity would raise cheap finance to procure assets and lease or sell them to the private sector for operation, thereby servicing its debt. The rationale for the original PFI was held to be the transfer of risk associated with construction or maintenance costs from the state to private contractors. Of course, even if that can be done at an acceptable cost, it can be done simply in the way that construction or maintenance contracts are written and has no necessary connection with who raises the finance – a simple point that eluded the promoters of PFI for years. Currently the government can borrow for 20 to 50 years at an interest rate of about 4 per cent. Indexed debt has a real coupon of less than 1 per cent. Many projects that would be viable at those rates are marginal at best to private financers. An example is the M6 relief toll road around Birmingham, which lost about £25 million last year for its owners. Its oper-

68 Essential investment requires state enterprise ating profit was some £33 million but debt service of£58 million put it into the red. But that debt service implies an effective interest rate of just over 8 per cent. At 4 per cent it pays its way, even before consideration of social benefits like reduced congestion elsewhere. Those low long-term interest rates betray a market belief that idle resources and cheap money will be with us for a long time to come. For the reasons cited above, that expectation is probably right. So this is a wonderful opportunity for the state to make all those infrastructure investments that it normally cannot afford on much better terms than usual. That flow of orders will in turn induce private companies to expand their own capacity to meet the demand – especially if state procurement policies look to foster domestic supply chains and medium scale or smaller businesses. Now this will tackle the problem of deficient demand and help to promote growth through the creation of a new deficit – a largely self-financing deficit. But it will not remove the need to reduce the current deficit, the one that is a burden on future taxpayers. On one hand indeed, by resolving the demand and growth problem, it would permit a faster reduction of the current deficit than would otherwise be wise. On the other hand, to the extent that the policy fosters economic growth, it will cause the current deficit to fall as a share of GDP – the metric that matters if we are trying to assess how big a burden it is. On balance, the government cannot avoid a policy of fairly sharply retrenching current expenditures and with them the current deficit. That is a consequence of the fact that the Labour government over-estimated the trend growth of the economy and allowed public expenditure to grow much faster than the growth of revenues, even before the recession

69 Going for Growth and banking crisis struck. But the consequent demand and employment hole can be filled by state enterprise.

The fiscal implications

In the current excitable state of global bond markets, would such a policy be acceptable to those markets? The answer is surely yes. The deficit which is publicised in most countries and which is the objective of fiscal policy is the general government deficit, as defined in OECD standardised national accounts. Borrowing by state entities for commercial purposes is excluded; the latter sort of borrowing is not included in the Maastricht criteria governing European deficits, for example. The UK is unusual in not making any such distinction and in lumping all public sector borrowing, irrespective of its nature or its means of finance into the public sector borrowing requirement (PSBR). The origin of this practice seems to be the centralisation of public sector borrowing in the UK, which never had post office bonds or railway bonds as other countries did but routed all borrowing through the gilt market. That may well have been economical in that it eliminated spreads between different classes of public bond and led to cheaper finance. Unfortunately, however, it led to the use of the PSBR as the appropriate target for fiscal policy. That was illogical. There must be quantitative restrictions on debt that is to be financed from taxes. But commercial borrowing can expand so long as the expected return (including some risk premium) exceeds the borrowing cost. Treasury officials are rightly concerned that state borrowing or state guaranteed borrowing even for commercial purposes

70 Essential investment requires state enterprise leaves taxpayers bearing some risk. After all the best laid schemes of mice and men, as the poet says “gang oft agley”. When they do, the taxpayer is stuck with the bill. That means when the government guarantees the debt of a state investment bank, if it does not charge the bank for its debt guarantee, it must put the value of that guarantee on its own balance sheet. It can get the actuarial value of the guarantee assessed by independent authorities. Typically it will be around 2 per cent of the balance sheet of the bank or much less. It is appropriate that risk should be acknowledged and, in effect, offset in that way. Contrast that, however, with the current policy of putting 100 per cent on the balance sheet. Given independent risk assessment, the markets would be perfectly content. The UK might even get brownie points for rational policy-making. Some commentators have argued that the government should go further than enabling a state investment bank to invest in infrastructure but should allow it to engage in finance of innovative commercial projects which currently cannot find adequate funding. However, there are strong arguments for not allowing a wide extension of the investment bank’s mandate. Very large infrastructure projects using proven technology may strain the financing capabilities of the private sector but they are not intrinsically all that risky. Projections of future travel or energy demand are subject to error margins but we know there will be substantial demand in any case. Similarly construction costs may be inadequately estimated but rail and road-building technologies are sufficiently established that there will be limits on the errors. In energy, the government has substantial control of the market so is in a position to limit the losses on any given project

71 Going for Growth through influencing energy prices. The risk born by the public sector in those cases is therefore manageable and is likely to be assessed as low by any independent actuary. Once the investment bank moves into more risky or speculative projects, the risk rises and larger reserves would be necessary. If the bank mandate were to be extended to projects other than basic infrastructure it would be appropriate for it to vary the terms on which it lends to reflect assessments of risk. As the bank’s balance sheet extended to riskier projects, it would also be appropriate for the government to limit the effect on its own deficit by charging the bank for its guarantee. Such a broad mandate would also raise the issue of what sort of market failure is being tackled in the case of each project. Before we get to that point and have to consider such questions, there is plenty of basic infrastructure that state enterprise should be looking to finance in order to spread economic prosperity more equally around Britain and to equip the country to develop a greener, more sustainable economy. It is unusual that a policy can solve two of the three economic problems facing the country without exacerbating the third. Yet this does precisely that. All that is required is to put away fashionable prejudice and approach the issues with fresh eyes.

72 An audit of skills, immigration and growth by Andy Westwood

A virtuous circle of skills and growth was critical to the political economy of Labour’s time in office. A liberal, open approach to immigration was a key aspect of labour market flexibility and helped plug gaps in an economy shaped by a legacy of low skills. It was meant to be politically and elec- torally attractive – an economy where people could work their way up, where investment in education would underpin social mobility and improve economic performance. A key Labour party election broadcast during the 2005 general election perfectly encapsulated the policy. “It is really all about human capital”, said Tony Blair. “It is OK to put more investment into public services – the question is how you sustain it?” “Growth” answered Gordon Brown. In time Brown would turn this notion into his infamous “British Jobs for British workers” pledge – an admission that the flexible labour market had driven growth but not obvi-

73 Going for Growth ously so for many in Britain. What had happened? How had the meritocratic dream of skills based growth turned sour? Academics have long argued that Britain is stuck in a “low skills equilibrium” – where jobs and businesses consciously cluster at the lower end of the value chain because too many of our adult workforce have few or no formal skills. Some 7 million adults in England – one in five adults – if given the alphabetical index to the Yellow Pages, cannot locate the page reference for plumbers. That is an example of functional illit- eracy. It means that one in five adults has less literacy than is expected of an 11-year-old child. One in four adults cannot calculate the change they should get out of £2 when they buy two tins of baked beans at 45p each and a loaf of bread at 68p.14

Labour’s early approach to skills

The solution – as in so many areas of Labour’s public sector reform – was based on massive investment and a series of centrally driven targets. Train to Gain, a scheme worth around £1 billion by 2010, provided funding for colleges to train low skilled employees in the workplace. Skills for Life accounted for over £1 billion each year for millions of adults with basic skills qualifications. Spending on apprenticeships also topped the £1 billion mark. And it was not just further education, one third of undergraduates in higher education were mature students – an often overlooked aspect of university expansion.

14 As quoted in the 1999 report of the Working Group chaired by Sir Claus Moser A Fresh Start: Improving literacy and numeracy and in the Leitch Review of Skills’ 2006 report Prosperity for All in the Global Economy – World Class Skills.

74 An audit of skills, immigration and growth

But the investment ultimately did not count for much in either growth figures or votes. The truth is that adult skills – however important to individual life chances or to wider economic performance – was never going to be a vote winner. Educating adults may owe much to traditions in the wider labour movement, but it is not an issue as salient as schools or the NHS. Apprenticeships might have continued under the coalition but adult learning is generally a low priority. Neither business nor the electorate appear that bothered. Two million workers may have got a qualification through Train to Gain and some five million have improved their basic skills but the abolition of the former and the ending of rights to improve basic skills caused barely a whimper. Part of the problem came with the lack of value perceived in vocational learning. Despite Labour’s massive reform of education qualifications – introducing new diplomas, foundation degrees and other vocational qualifications – both business and the wider public remained unconvinced by their practical value. As Helena Kennedy once memo- rably observed, these were largely “qualifications for other people’s children”. Links between skills and growth have perhaps been unconvincing. Too often the promotion and investment in human capital existed only in the abstract. Getting a qualification was not actively linked to the job or the sector in which people worked. Long-standing free market orthodoxy prevented anything other than a “supply driven” race for numbers. The focus on comparative performance and international league tables ensured that policy focused on volume rather than how and where new skills could be deployed. The idea of concentrating on demand and the deployment of

75 Going for Growth skills in specific workplaces and sectors only came about in the final years of the Labour government.

The labour market dimension of an industrial policy

Only a few years ago the thought of an active demand-driven industrial policy on behalf of either Labour or the Conserva- tives was fairly remote. Neither Tony Blair nor Gordon Brown – and certainly not David Cameron – had much time for an active, interventionist state in a free market economy. Picking winners was anathema. Even New Labour’s narrative of an active or enabling state tended towards social, but not economic policy. Then the world was turned on its head in 2008. The story of Britain’s modern industrial policy begins with its abandonment in the late 1970s and the following three decades of free market, monetarist, inactive state policy that underpinned the approaches of the Thatcher, Major and Blair governments. Even Gordon Brown – instrumental in the continuation of the orthodox economic policy approach as Chancellor – was unconvinced by the need to adopt a different approach. In essence Brown as Chancellor, perpet- uated a near Thatcherite economic model, as Simon Jenkins has observed, albeit with major investment in education, science and other growth orientated public services. But a new narrative did eventually emerge, building on some of New Labour’s biggest priorities; investment in UK science had nearly tripled under Labour, as had higher and further education funding in the same period. Skills, science and universities were all the subject of major reviews in the Treasury – the 2006 Leitch Review of Skills, the 2007

76 An audit of skills, immigration and growth

Sainsbury Review of Science and the 2003 Lambert Review of the links between business and higher education. But experience eventually showed that to really reap the benefits, a consciously active approach was needed. Without this there would be no guarantee that British workers or firms would develop the expertise and win the contracts and jobs that flowed from big policy decisions. Peter Mandelson, newly returned from Brussels to the Department for Business in 2008, talked about, “a capable, strategic state – one that works with markets and enables us to get the most out of globalisation”. He called it a “market-based industrial activism aligning regulation, planning policy, migration policy, transport policy and the way government spends money and encourages innovation and entrepreneurship”.15 Together, the Department for Business, Enterprise and Regulatory Reform (BERR) and the Department for Inno- vation, Universities and Skills (DIUS) under John Denham, produced the New Industries, New Jobs white paper in April 2009. In a speech at Loughborough University Innovation Centre Mandelson said about the white paper: “By making key decisions, buying goods and services and regulating, government shapes and creates future markets, new business opportunities and the demand for skilled jobs. That is why our new activism will focus our skills system, the knowledge in our universities and the way we support research through our record investment in science to meet the demands and opportunities.”16

15 Lord Mandelson’s speech to the RSA, 17 December 2008. 16 Lord Mandelson’s speech, Building Britain’s Future – New Industry, New Jobs, Loughborough University Innovation Centre, 20 April 2009.

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As a result, the Labour Government focused on supporting growing sectors of the economy. Pharma- ceuticals and bioscience were mutually dependant on government investment in health and the NHS. Creative and digital industries partly depended on regulation and continuing public investment in the BBC, arts and in our digital infrastructure. High speed rail and Crossrail, defence procurement, low carbon energy and major political decisions like rebuilding schools and hosting the Olympics all underpinned competitive industries, businesses and the availability of skilled jobs. Government procurement accounted for between a third and a half of the overall domestic markets in IT and construction. In June 2009 DIUS and BERR were merged and the Department of Business, Innovation and Skills was formed. Industrial policy, growth and skills were now brought together in Labour’s plans for the post-recession UK economy. But a general election lay between it and implementation of this new approach and Labour did not win.

The coalition government’s rhetorical continuity

During the election campaign, David Cameron said, “We have got to get the economy moving”. He argued that what government spent or did was not the same thing as the economy. Nonetheless, his and other coalition ministers’ words quickly suggested that Labour’s language of industrial strategy had taken a surprisingly firm root. The coalition document declared “business is the driver of economic growth and innovation”. David Cameron’s first

78 An audit of skills, immigration and growth major speech17 as Prime Minister focused on cutting the deficit quickly – reducing regulation, bureaucracy and red tape, shrinking the size and role of the state and supporting new private business growth capable of rebalancing the economy along both sectoral and geographical lines. And like Labour before the election, he also described how the coalition would support “growing industries – aerospace, pharmaceuticals, high-value manufacturing, hi-tech engineering, low carbon technology. And all the knowledge-based businesses including the creative industries.” In Vince Cable’s first major speech, he too began to develop an ideology remarkably similar to Labour’s approach. In June 2010, at the Cass Business School, Peter Mandelson’s successor said: “In some ways we have to be picking winners. We have to make choices about allocating the training budget, or funding certain kinds of science or research, or promoting science, technology, maths or engineering degrees for higher education. We have to make some strategic choices. We cannot avoid that. But the ‘winners’ in this sense are the skills we judge we will need for the future, and the sectors they support. Because while we cannot divine the future, we can recognise in a broad sense what Britain is good at and likely to become good at ... our comparative advantage in economic jargon.” 18 Thus far the rhetoric remains strikingly similar to Labour’s. Cameron has also described his wish to “breathe economic life into the towns and cities outside the M25”. But the jury remains out on the specific policies that the coalition

17 David Cameron’s speech, Transforming the British economy: Coalition strategy for economic growth, 28 May 2010. 18 Vince Cable’s speech to Cass Business School, 3 June 2010.

79 Going for Growth government has put in place. Regional Development Agencies have been scrapped, replaced by a collection of Local Enter- prise Partnerships and a Regional Growth Fund, discussed in more detail in Anna Turley’s chapter. Train to Gain and other forms of investment in skills have disappeared and the higher education sector has been turned on its head with a major shift from state to graduate funding contributions. Spending on science has been frozen but in real terms this 10 per cent cut, combined with uncertainty over capital expenditure, suggests that universities and colleges will be less well equipped to drive either national or local growth.

The dog that barked

And what of immigration? To back up the Conservative commitment of reducing non-EU migration from around 200,000 to the “tens of thousands”, a temporary cap has been put in place. Unlike Labour’s points-based system this is more heavy handed and arbitrary with major curbs now likely on families and students. To fulfil their own rhetoric the coalition will have to crack down heavily on international students – further damaging the ability of colleges and universities to drive local or national growth. And as Nick Clegg pointed out in the election campaign, most of these measures make little or no difference to the much more significant numbers of EU migrants coming into the UK. Even Labour’s points based system was a largely tokenistic intervention on that basis. But was the real human capital story provided largely by EU migrants flooding into the UK to take up the jobs created during the flexible labour market boom? Certainly migrants

80 An audit of skills, immigration and growth appear to have benefitted as much from economic growth and job creation as domestic workers. Around two million workers arrived in the UK during Labour’s time in office – many after the expansion of the EU to include the accession countries such as Poland and Romania. Ill focused, volume based training did not make as much difference as it should have done. Hundreds of millions of pounds was spent on training the migrants themselves – either in technical skills or English language courses. The Labour government took far too long to listen to concerns about migration and too long to develop the role of skills in an active industrial policy rather than as a purely supply-side measure. The UK’s low productivity, low skill economic model ensured that migrants came in waves while the domestic workforce remained significantly underskilled. Only by shifting towards a conscious sector-based, industrial policy – as developed in Labour’s later years – will growth be consolidated into a higher skilled, higher productivity economic model. The same formula must be turned from coalition rhetoric to reality and repeated in the local and regional economies across the country. In turn both must provide a clear context for sustained investment in our poorly skilled working population. Either way we are almost certainly going to have to live with EU migration and unless we make dramatic inroads into our low skilled workforce, we will continue to need it.

Encouraging growth through innovation by Stian Westlake

“Innovation is the outstanding fact in the economic history of capitalist society” – Joseph Schumpeter

Innovation sits at the heart of economic growth. Creating the right conditions for innovation is an indispensable requirement for sustained economic recovery. This chapter argues that there is an important role for government in doing this. This role requires a sophisticated understanding of what innovation is and how it happens. This gives rise not to a single silver-bullet approach, but instead suggests that government needs to implement a range of policies on issues from access to finance through government procurement to education.

83 Going for Growth

Why innovation matters

It is an understatement to say that innovation is important to economic growth. If we consider the long-term story of human material progress – the dizzying rise of living standards in developed countries from around $3 a day in 1800 to over $100 a day two centuries later19 – what we are witnessing is essentially the story of innovation. The steady accumulation of technological progress, new forms of organisation, and new ways of conducting business are what created the relative prosperity that the UK enjoys today. (And for those who doubt that economic growth is an unmitigated blessing, it is worth adding that innovation is also the key to addressing the challenges that growth creates, from anthropogenic climate change to resource depletion to social inequality.) The link between innovation and growth is just as strong if we look at more recent history. NESTA’s Innovation Index suggests that two-thirds of productivity growth in the UK between 2000 and 2007 was the result of innovation20, a finding which has been echoed in recent work by the Organi- sation for Economic Co-operation and Development. It is clear that if we want to see long-term economic growth as we emerge from the recession, we need to enable our businesses, public institutions and citizens to innovate more, and more effectively. But perhaps more than any other area of economic policy, innovation is the graveyard of policy-makers’ ambitions. For

19 Deidre N Mccloskey, The Bourgeois Virtues: Ethics for an Age of Commerce, University of Chicago Press, 2006. 20 NESTA, The Innovation Index. Measuring the UK’s investment in innovation and its effect, 2009.

84 Encouraging growth through innovation every story of an innovative industry that grew as a result of government intervention, such as Taiwan’s semiconductor sector or Israel’s venture capital sector21, there are numerous failed policy initiatives: “winners” picked that somehow never came good (of which Concorde is the most noto- rious UK example), or policies whose benefits accrued to a minority of businesses and were exceeded by their costs (the patent box appears to be an unfolding example22). And even evaluating success is hard. Because innovation is a complex business, there are a host of examples of innovation policy whose benefits have been unclear. For example, Jim Calla- ghan’s attempt to establish Bristol-based Inmos as a global semiconductor giant is widely held to have benefited today’s British chip design industry23. But was it worth the roughly £250 million of public money spent on it? The question for policy-makers is how to distinguish good policy from bad, and when not to make policy at all.

Does government have a role to play in innovation?

Before we look at the issue of what this means for policy- makers, we should consider first of all the biggest challenge to innovation policy: the argument that it is entirely pointless.

21 Yannis Pierrakis and Stian Westlake, Reshaping the UK economy. The role of public investment in financing growth, NESTA, 2009. 22 Rachel Griffiths, Helen Miller and Martin O’Connell, The UK will introduce a patent box, but to whose benefit?, Institute for Fiscal Studies, 2010. 23 Louise Marston, Shantha Shanmugalingam and Stian Westlake, Chips with Everything, NESTA, 2010.

85 Going for Growth

This school of thought posits that all government can and should do is ensure a favourable landscape for business. Any specific policy focused on innovation is at best a benign waste of money and at worst so riddled with unforeseen consequences as to be actively counterproductive. Supporters often point to the fact that over the past century, the most laissez faire country – the United States – profited from the most star- tling innovations. But even a casual examination of the facts suggests this is not the case. The innovation and growth seen in the United States in the last half of the twentieth century was enabled by widespread, if often unsung, government support for the innovation system. The immense amount of public procurement and research undertaken through bodies like the Defense Advanced Research Projects Agency (DARPA) and programmes like the Small Business Innovation Research programme (SBIR) helped kick-start innumerable technology businesses24. The Small Business Investment Companies programme has acted as a multi-billion dollar public-private growth capital fund, helping finance the expansion of businesses from Sun Microsystems and Apple to Federal Express and Costco. It has also helped grow many of Silicon Valley’s leading venture capital investors. As we will discuss later, the United States’ unparalleled public investment in the education of its people over the twentieth century helped it make money out of what it invented. The argument that countries have in the past benefited from innovation without good public policy is, quite clearly, a myth.

24 David Connell, “Secrets” of the world’s largest seed capital fund, Centre for Business Research, 2006.

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What does this mean for policy-makers?

Getting innovation policy right involves finding the right answer to three questions: What is innovation? Who does it? How does it happen? What is innovation? The majority of innovation policy across the world still focuses excessively on the most technical forms of innovation. Innovation is frequently seen as referring entirely or mainly to scientific and technological novelty, and to “new-to-world” discoveries rather than adopting and combining existing ones. Perhaps the most widespread expression of this is the EU’s Lisbon target, which exhorted countries to spend 3 per cent of their GDP on research and development (R&D) by 2010. But these narrow measures profoundly miss the point. R&D is only a small part of the business of creating value from ideas. NESTA’s Innovation Index showed that between 2000 and 2007, R&D represented only 11 per cent of the UK’s investment in innovation. The rest includes all the other “hidden” innovation needed to turn ideas into viable offerings: product and service design, training staff in new skills, software development, and even branding and marketing. R&D is a particularly poor measure of innovation in many of the sectors in which the UK is strongest, such as the creative industries, oil and gas extraction, or (whisper it) financial and professional services. All of these sectors innovate, but book little or no R&D in their accounts. Moreover, innovation involves adoption and refinement of products and processes, as well as new-to-world inven- tions. The iPod, the iconic innovation of the last decade, not only involved plenty of hidden innovation (most notably the

87 Going for Growth business model innovation involved in setting up the iTunes store and the non-technical design of the product itself), but also involved relatively little truly novel technological development. Digital audio players had been widely available before: Apple’s innovation was more about tweaking and combining ideas than about breakthrough discoveries. The fact that innovation involves more than R&D and more than new-to-world breakthroughs is not always a welcome message to policy-makers. R&D is often regarded as an unusually desirable thing for a country’s businesses to do, and has often been at the centre of innovation policy – for example, the R&D tax credits that governments around the world have introduced. R&D is certainly not unimportant. And there is some (albeit mixed) evidence that R&D tax credits do what they say on the tin. But it would be fair to ask why R&D is privileged over the other forms of investment that represent 89 per cent of innovation expenditure. Singapore’s new “Productivity and Innovation Credit”25 offers an interesting alternative: this tax credit encourages not just R&D, but also a whole range of “hidden” innovation, including acquiring intellectual property rights, and training workers to deliver innovative services skewed towards small businesses. Who innovates? Innovation happens across the economy and the country, but its impacts appear to be unevenly distributed. A small number of innovative, high-growth businesses are unusually important to economic growth. Between 2002 and 2008, the six per cent of British businesses that grew the fastest generated 54 per cent of net new jobs in the UK.

/Productivity and Innovation Credit: http://www.iras.gov.sg/irashome 25 PIcredit.aspx.

88 Encouraging growth through innovation

It is hard to generalise about these businesses: they operate across a wide range of sectors, and include both large and small companies and both start-ups and established firms. But they do have one factor in common: they are dispropor- tionately likely to be innovative.26 Moreover, comparison of firm growth in 11 developed countries suggests that this business growth depends on other businesses shrinking or vanishing, and that greater dynamic churn in the business landscape is linked to higher productivity growth.27 These findings are meaningful, particularly for progressive policy-makers. On the one hand, in linking creative destruction with productivity growth, they suggest that innovation has some inescapably inegalitarian effects: the creation of winners and losers is part of the process. On the other hand, by showing that the small minority of businesses that win from innovation create relatively large amounts of employment, it suggests that the rewards the winners reap are widely shared. The importance of growth businesses has implications for government policy. Governments’ attitude to businesses has often focused either on small businesses or new businesses. Public money has followed, whether in the form of tax breaks, finance or business support. But too often this money ends up supporting “lifestyle” businesses that have no intention to grow. If, in fact, it is growth businesses that matter, it makes more sense for public resources to be focused either on barriers that are particularly important for them (such as

26 Albert Bravo Biosca and Stian Westlake, The Vital Six Per Cent. How high- growth innovative businesses generate prosperity and jobs, NESTA, 2009. 27 Albert Bravo Biosca, Growth Dynamics. Exploring business growth and contra- diction in Europe and the US, NESTA, 2010.

89 Going for Growth barriers to finance) or on helping facilitate what these businesses have in common – innovation. How does innovation happen? This question can be approached in several ways: for example at the level of the individual, where the importance of interdisciplinary connections28 and openness to new experience29 have been highlighted, or at the level of individual businesses, where important phenomena such as open innovation30 and user-led innovation31 have attracted attention. But most important from a public policy point of view is the bigger picture: the system within which innovation happens. This system includes the processes through which new ideas come about, the climate in which businesses turn them into new offerings, the markets these offerings compete in, and how the system is financed and resourced. NESTA has found the following model a helpful way to characterise how the system works at a high level:

28 Steven Johnson, Where Good Ideas Come From: The Natural History of Inno- vation, Riverhead Books, 2010. 29 Fiona Patterson, Maura Kerrin, Geraldine Gatto-Roissard and Phillipa Coan, Everyday Innovation. How to enhance innovative working in employees and organisations, NESTA, 2009. 30 Henry Chesborough, Open Innovation: The new imperative for creating and profiting from technology, Harvard Business Press, 2003. 31 Howard Rush, Chris Smith, Erika Kraemer-Mbula and Puay Tang, The New Inventors. How users are changing the rules of innovation, NESTA, 2008, Stephen Flowers, Eric von Hippel, Jeroen de Jong and Tanja Sinozic, Measuring user innovation in the UK. The importance of product creation by users, NESTA, 2010.

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Mobilising resources

Knowledge Enterprise creation

Selection

The model reflects the cyclicality and iterative nature of the innovation system, and provides the context within which businesses innovate. Each circle in the diagram represents a type of activity into the innovation process, with the arrows showing how each activity inputs into the others. “Knowledge creation” includes the development of new ideas, for example in universities or through public research; this process both feeds and is fed into by “Enter- prise”, the process by which businesses turn ideas into new offerings. These new offerings are then tested, most typically in the market, and some succeed – this is the activity called “Selection”. Early adopter customers, or those willing to

91 Going for Growth take risks on new technology, are an important factor here, highlighting the importance of forward-thinking public procurement. Innovations that succeed generate value and profits, some of which can be made available to back the next generation of innovation: the “Mobilising resources” activity. This can take the form of financial investment, where the private sector recycles profits into new projects, or it can take the form of skills or research funding, where the rewards of current innovations are taxed to pay for public investment in them.

What is the role for government?

Given the importance of “hidden” innovation and of innovative, high-growth businesses, there are a number of aspects of the innovation system that government can influence for the better.

Knowledge Creation

It is regularly noted that the UK’s research base, in particular its universities, are among the best in the world, but that we are less good at developing this into viable businesses (in fact, this criticism goes back to Alfred Marshall in the 1910s, if not earlier).32 The previous and current governments have responded to this challenge by the announcement of new Technology and

32 Lambert Review of Business-University Collaboration, 2003.

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Innovation Centres (TICs), based on the translational institutions found in Germany, Taiwan and Korea. This builds on a range of measures taken to encourage university spin-outs and corporate research, particularly under the tenure of Lord Sainsbury as Minister for Science and Innovation between 1998 and 2006 (for example through the University Chal- lenge Funds and the R&D tax credit). The relatively generous flat-cash settlement for the research budget presented in the 2010 Comprehensive Spending Review has been welcomed by many as an excellent investment in the underlying knowledge base. These steps are all encouraging, particularly if the TICs go beyond traditional high-tech industries and focus on areas of distinctive UK strengths, such as the creative industries. But if we are to go further, there are two fruitful avenues for policy-makers to explore. Firstly, universities should focus less on spin-outs and licensing intellectual property, and more on the wider benefits they provide to business from the informal exchange of knowledge and people. Surveys of businesses show that these, rather than intellectual property, are the real benefits universities offer them.33 Secondly, policy-makers should focus not on building new institutions, but on changing systems to encourage more research to take place in the private sector. Public procurement holds the key to doing this, and discussed in the section below on “Selection”.

,Michael Kitson, Jeremy Howells, Richard Braham and Stian Westlake 33 The Connected University. Driving recovery and growth in the UK economy, NESTA, 2009.

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Enterprise

Government policy cannot coerce businesses to innovate. But it can create favourable conditions for innovation. Much public policy in this area has focused on the tax system, through which government undeniably influences the way businesses act. However, it is arguably not through tax but through supporting businesses to work together and removing the barriers to successful clusters that government can most effectively influence business innovation. Tax interventions to encourage companies to innovate have tended to focus on two areas: tweaking corporate tax rules to encourage investment in certain types of assets, or reducing capital gains tax rates to encourage entrepreneurship. As discussed above, there is mixed evidence of the effectiveness of R&D tax credits, and a case to make that other forms of innovation investment are just as worthy of encouragement. Other commentators have argued that innovation can be encouraged by accelerating capital allowances for machinery,34 arguing that this will encourage investment in advanced (and therefore perhaps short-lived) plant and machinery. Still more radical proposals involve equalising the tax treatment of debt and equity finance, on the grounds that the current tax system’s favourable treatment of debt encourages leverage and discourages the radical innovation more associated with equity-financed firms.35

34 For example, the Manufacturers’ organisation: http://www.eef.org.uk/ policy-media/releases/uk/2010/Manufacturers-publish-tax-manifesto-to-drive- rebalanced-economy-.htm. 35 As for example proposed in the 2010 Mirrlees Review Reforming the tax system for the 21st century.

94 Encouraging growth through innovation

The challenge with all these proposals is that they assume an overly narrow definition of the innovation they seek to encourage. Just as the R&D tax credit assumes innovation is mostly about R&D, proposals for accelerated capital allowances (while perhaps beneficial to the UK’s manufacturers) risk overstating the importance of machinery, and equali- sation of the tax treatment of equity and debt (while widely believed to be a worthwhile idea in its own right) privileges radical innovation at the expense of incremental. A more promising, though less dramatic, role for government is to help enable businesses to access the platforms they require for innovation. Most innovations, to make them work, rely on pre-existing innovations, such as technologies, organisational forms, and commercial channels. This may not pose a problem for large businesses, which tend to have access to these enabling platforms, whether through their engineering staff or their sales force. But it does pose a challenge for small companies, or rapidly growing ones, which cannot rely as easily on in-house expertise. Small firms overcome this most effectively when they are well-networked, and find themselves able to work with partners to develop what they lack. The ability of Silicon Valley to generate so many start-ups that grow quickly into global champions is in part a function of the depths of these networks. The role for government here is a subtle but important one. First, it has significant power over the existence of the kind of clusters in which businesses can innovate effectively. Government can have a positive effect by putting in place planning laws that allow clusters to expand, and by getting public institutions important to clusters – especially univer-

95 Going for Growth sities – to help them develop as has taken place around Oxford in recent years. Second, government can help more directly by bringing together businesses to work on innovation platforms. This is one of the most important roles of the Technology Strategy Board, and one that should not be lost in the process of fiscal consolidation.

Selection

Government’s role in how innovations get selected is perhaps inevitably more hands-off. Its most important role is to put in place policy to encourage competitive and large markets. The large domestic market that US businesses can sell to is a major spur to investment and innovation. The government’s European policy has a role to play here. The EU is unfortunately a more effective single market when it comes to machine tools or cheese than when it comes to digital media or business services – which is particularly problematic for the UK given where its comparative advantage lies. The other important area where government can encourage demand for innovation is through its own power as the UK’s largest consumer by being a “lead customer” for innovative goods and services. The US’ experience with the SBIR programme has been mentioned above, but there is scope for the UK to greatly extend its own version, the Small Business Research Initiative36, to cover a much greater proportion of government spending, and to tie this into departments’

36 Kirsten Bound and Ruth Puttick, Buying Power? Is the Small Business Research Initiative (SBRI) for procuring R&D driving innovation in the UK?, NESTA, 2010.

96 Encouraging growth through innovation savings plans. In the longer term, the idea of setting up a dedicated fund for innovative procurement, independent from individual departments, along the lines of the American DARPA, merits more scrutiny.

Resource allocation

The final aspect of the innovation system relates to both financial and human capital and how it feeds into new innovations. The most obvious area for government action is to remove the barriers to finance that innovative businesses face. Venture capital (VC) is one important class of finance for these businesses, and can be a significant driver of economic activity. In the United States, 17 cents in every dollar of revenue earned by a business goes to a firm that was once VC-backed. But VC funding has fallen away in the UK since the global financial crisis. Levels of funds raised in 2009 were down 40 per cent on 2008, which in itself was a bad year.37 The Innovation Investment Fund, a public-private co-investment fund planned by Lord Drayson and Lord Mandelson, is expected to go some way to address this, but further involvement may be necessary, for example encouraging greater activity by businesses angels at the earliest stages of investment. The role of the new Growth Capital Fund in providing expansion capital will also be important, and it is important that the Banking Commission ensures that lending to growth businesses is at the forefront of the settlement reached for the UK’s future banking system.

37 Yannis Pierrakis, Venture Capital: Now and after the dot-com crash, NESTA, 2010.

97 Going for Growth

The other element of resource allocation where government policy matters is the provision of human capital – in particular through education. Claudia Goldin and Lawrence Katz, two Harvard economists, made the compelling observation in their 2008 monograph “The Race between Technology and Education”38 that the most important contributor to US economic growth in the twentieth century was the US’ prodigious investment in education. This education allowed the US to adopt and make money from new technologies quickly – so-called “absorptive capacity” for innovation – and massively increase its productivity. Since 1980, the US has fallen behind countries such as Finland and South Korea in educational standards, and these countries have been innovation success stories. The lesson of this is that serious investment in education (both in quantity and quality) is very important to the innovation system. This is covered in more detail in Andy Westwood’s chapter.

Regional Innovation and Industrial Policy

Finally, it is worth considering the regional dimension to policy. Innovation policy is, after all, made in specific places. Encouraged by the example of Silicon Valley, and driven by the need to escape post-industrial decline, many British cities have sought to make themselves innovation hotspots, and until their abolition, Regional Development Agencies all had innovation strategies.

38 Claudia Goldin and Lawrence Katz, The Race between Technology and Education, Belknap Press, 2008.

98 Encouraging growth through innovation

It is right to be somewhat sceptical of how much these strategies can achieve. Clusters are vitally important to innovation, as discussed above, but are hard if not impossible to start from scratch. And local areas are not always well placed to know what their genuine strengths are. Many cities that thought they had a distinctive cluster in fact did not.39 This is not to undervalue the important work done by cities like Manchester in coolly appraising and then developing their innovative capabilities – but this is an exercise where regions can be hubristic about their capabilities. Government can help by ensuring that decisions about local economic development are taken at an appropriate – and not an overly devolved – level. The Manchester Inde- pendent Economic Review, discussed in more detail in Richard Seline’s chapter, demonstrated the importance of looking at the city-region as a whole when considering innovation resources such as universities and science parks, rather than leaving each local authority to its own devices. This approach also requires giving city-regions meaningful power over planning and development to put their plans into action.

Conclusion

In conclusion, there is no single policy lever that will make innovation flourish, but there is a coherent set of prescrip- tions. Understanding how innovation happens is key. Policy-makers must understand that it involves more than

39 Caroline Chapain, Phil Cooke, Lisa De Propris, Stewart MacNeill and Juan Mateos-Garcia, The Geography of Creativity, NESTA, 2010.

99 Going for Growth

R&D and invention, and is more closely associated with the activities of the small number of high-growth businesses rather than “lifestyle” businesses. Once understood, the focus should be on how to make the innovation system work better. Critical to this are strong university-business links; the right support for clusters and other ways for businesses to access platforms for innovation; harnessing the power of public procurement; expanding markets; removing barriers to finance, especially for risk capital; and investing in the quantity and quality of education.

100 Driving growth at the regional level by Anna Turley

The British economy is not a homogenous entity. It is a dynamic and intricate eco-system with complex and inter- dependent networks of geographical, financial, social and historical relationships. To understand and to drive growth in this country is to understand and drive growth in our regions. Every local place has its own unique history, diverse economic patterns, variable skills base, social networks, and distinct environmental characteristics. This is too often overlooked in relation to economic development in this country. While there will always be national strategic imperatives in economic development, macro-economic policies and central initiatives are limited in what they can achieve. More powers and freedoms in the UK should be appropri- ately devolved to allow policy interventions and investment opportunities to operate more flexibly around more natural economic geographies.

101 Going for Growth

The coalition government has set out a clear signal that it understands this.40 Its emphasis on rebalancing the economy, on a bottom-up approach to collaboration across local authority boundaries, and on liberating business and stimulating enterprise is to be applauded. However, it is important that such radical change actually achieves the intended objective and so this approach demands close scrutiny. The limits to their approach to rebalancing the economy are discussed in Duncan Weldon’s chapter. Meanwhile, the pace of change and the rapid dismantling of the architecture of regional economic development provide serious challenges to success. Alongside this there is the broader contraction in the public sector and a reliance on the private sector to fill the void. All this combines to create a high risk strategy. This chapter will analyse the government’s approach and recommend steps further to enable regional economic development to flourish.

Labour’s approach: strong investment and active government

For decades, economic growth in the UK has been dispropor- tionately driven by London. The economy has been heavily dependent on the financial sector and growth in the property market. Some other areas have developed strong economic clusters such as the creative industries in Manchester and Bristol or green manufacturing in the north east. Other areas with proud histories in manufacturing or mining have

40 White Paper, Local Growth: Realising Every Place’s Potential, 2010.

102 Driving growth at the regional level struggled to replace these industries and many of these areas have become increasingly dependent on public sector growth and employment. This has created an economy in the UK which is spatially unbalanced and leaves certain areas vulnerable and less resilient to difficult times.41 Recognising the economic disparity in this country and the need to rebalance, the previous government sought to drive regional economic growth through Regional Development Agencies (RDAs). Between 1999 and 2007, RDAs invested around £15.1 billion in pursuing economic development and regeneration, and promoting business efficiency, employment and skills. An independent evaluation of RDAs by PwC found that, since their inception, RDAs helped create 502,174 jobs (in excess of their target of 381,041), assisted 56,785 businesses (in excess of their target of 39,852), enabled £5.7 billion of funding from the public and private sector, and helped create over 8,500 new businesses.42 The evaluation also found that RDAs have generated economic benefits at a regional level, demonstrating that every £1 spent by RDAs added approximately £4.50 to the regional economy.43 Other strengths of the RDA model included their ability to pursue a coherent vision for their region which could be turned into a strategy for economic development and investment.

41 Jonathan Clifton, Tony Dolphin and Rachel Reeves, Building a Better Balanced UK economy: Where will jobs be created in the next economic cycle?, IPPR, 2010. 42 Department for Business, Enterprise & Regulatory Reform, Impact of RDA spending – National Report: Volume 1 Main Report, 2009. 43 Idem.

103 Going for Growth

Yet the success of the relationship between RDAs and local authorities was always unclear.44 Some local authorities criticised the decision-making and project management of RDAs and there were question marks over their impact in reducing regional disparities.45 A further criticism levelled at RDAs was that they were not directly democratically accountable, though they had in the past been accountable to Regional Assem- blies.46 There were also doubts about the extent to which the regional and local tiers could work together cohesively. Increasingly strong evidence showed that regional administrative boundaries did not ally effectively with functional economic geographies. The places where people live, work, travel, socialise, and shop tend to have sub-regional footprints, which are captured neither by local authority boundaries nor by regions.47 Sub-regional areas develop certain characteristics related to environmental opportunities, skills and labour trends; prox- imity to major transport or trade hubs; patterns of economic growth; and clusters of industries which make them attractive to particular economic sectors and investors from around the world who base their decisions on an area’s competitive advantage.48 It is vital, therefore, that the appropriate policy

44 Tom Symons and Chris Leslie, Capital Contingencies: Local capital finance in an era of high public debt, NLGN, 2009. 45 Adam Marshall, The Future of Regional Development Agencies, Centre for Cities, 2008. 46 Mark Sandford, Local Authority Leaders’ Boards, House of Commons Library, 2009. 47 Nick Hope, Bordering on Prosperity: Driving forward sub-regional economic collaboration, NLGN, 2009. 48 LGA, Prosperous Communities II: vive la dévolution!, 2007.

104 Driving growth at the regional level and delivery powers are devolved to the sub-regional or pan- local area to ensure that the right environment is created to drive economic development. The last government began to recognise this in its final term in office49 and proposed the development of Multi-Area Agreements (MAAs) which were voluntary collaborations of local authorities and their partners based around more natural economic footprints. Twelve MAAs were ultimately signed with agreement from central government for the devolution of specific freedoms and flexibilities to enable them to deliver their economic strategies.50 Early signs were that this more practical economic collaboration was yielding some benefits even though the devolutionary ambition was not always shared by Whitehall departments.51

The coalition: risk, freedom and enterprise

The new coalition government has taken a radical and delib- erately less central and strategic approach to local economic growth. Believing that the country’s economy became “skewed by artificial boundaries and top-down proscription that did not work”52 they are seeking to “liberalise” economic

49 The Local Government White Paper, Strong and Prosperous Communities, 2006. 50 HMT, CLG and BERR, Review of Sub-National Economic Development and Regeneration, 2007. 51 Nick Hope and Chris Leslie, Challenging Perspectives: Improving Whitehall’s spatial awareness, NLGN, 2009. 52 Eric Pickles, CLG Press Notice, http://www.communities.gov.uk/news/ newsroom/1753574.

105 Going for Growth development53 by stripping out the regional architecture of RDAs, and instead agreeing the first 27 Local Enterprise Part- nerships (LEPs) which will be up and running by April 2012. LEPs are looser collaborations of local authorities and their local economic partners, with strong business involvement. They are intended to be more bottom-up, organic, and focused on stimulating private sector growth and rebalancing the economy. Where the previous government sought to “match the power of government to the creative force of enterprise” to drive industrial, economic and employment growth,54 this government sees its role as less about direct intervention and more as an enabler, liberating the natural market forces of economic development. The recent White Paper Local Growth, Realising Every Place’s Potential criticised the previous government for “going against the grain of markets” with strategies which “stifled natural and healthy competition between places”.55 One of the most welcome aspects of the LEPs is the golden democratic thread provided by the leading role for local government. The government sees local authorities as the driving force behind growth including by providing leadership and co-ordination, using land assets to leverage funding to support growth, directly or indirectly influencing investment decisions through planning, and supporting local infrastructure such as transport, business and employment

53 David Cameron’s speech, Transforming the British economy: Coalition strategy for economic growth, 28 May 2010. 54 Pat McFadden’s speech, The new Industrial Revolution: opportunities in creating a low carbon economy, 25 January 2010. 55 White Paper, Local Growth: Realising Every Place’s Potential, 2010.

106 Driving growth at the regional level support programmes. It also sees a key role for local government in providing high quality services, regulating markets through trading standards, and leading efforts to support the health and wellbeing of the local population. The announcement of a new wave of mayors in twelve leading cities also recognises the importance of strong democratic leadership in our localities. Yet despite this welcome devolutionary approach to sub- national economic development, some serious concerns remain. The bottom-up nature of the LEP process, where local authorities and their partners were invited to come together and propose bids to central government to form the Partner- ships, was extremely challenging to those with little history of collaborative working. Areas that had stronger histories of delivering City Regions and MAAs had already done much of the groundwork. For those embarking upon an exercise like this for the first time, a two-page letter from Eric Pickles and Vince Cable gave little insight, guidance or support in developing bids. There was a lack of clarity over LEPs – what their powers would be, what money (if any) would come with them – and confusion over transition arrangements with RDAs. Research by the New Local Government Network showed that the key ingredients to success in sub-regional partnerships included building up an evidence-base and sound understanding of the sub-regional economy, good leadership with vision and ambition for the partnership, and operational capacity to ensure that the local area is capable of delivery.56 Placing a new “duty to co-operate”

56 Nick Hope, Bordering on Prosperity: Driving forward sub-regional economic collaboration, NLGN, 2009.

107 Going for Growth on local authorities, public bodies and private bodies that are critical to delivery, such as infrastructure providers, is helpful. However, in order to overcome natural barriers to collaboration – such as fear over loss of sovereignty, a lack of clarity over accountability, local political interests or issues around resources – the most powerful tool is devolution of a strong financial or policy-based power to make worthwhile the time-consuming and costly business of partnership.57 Moreover RDAs were backed by substantial financial clout from central government, and with access to sources of funding from Europe which was match-funded by central government. Indeed it is reported that it could cost as much as £1.4 billion to wind them down and complete existing programmes.58 Meanwhile, the LEPs come with no budgets to encourage their formation. The much-heralded Regional Growth Fund of £1.4 billion over three years is nowhere close to the sum given to RDAs, and will not be solely dedicated to LEPs.59 The government has set out some of the roles it foresees LEPs fulfilling, most notably around local transport, housing and planning, as part of an integrated approach to growth and infrastructure development.60 LEPs are also to play a key role in pooling and aligning funding streams to support housing delivery, setting out key infrastructure priorities, and supporting or co-ordinating projects. However, around key issues such as skills and welfare to work (the second most common theme in the 56 original

57 Idem. 58 http://www.ft.com/cms/s/0/f03c2264-e085-11df-abc1-00144feabdc0.html. 59 Department for Business, Innovation & Skills, Consultation on the Regional Growth Fund, 2010. 60 White Paper, Local Growth: Realising Every Place’s Potential, 2010.

108 Driving growth at the regional level bids received by government after rebalancing the economy), there is little evidence yet of the devolution of powers concerning the commissioning or strategic delivery of welfare to work programmes. The recommendation they “work with” local employers, Jobcentre Plus, and learning providers to help workless people into jobs is fairly nominal.61 Nor will the ability to “make representations” on the development of national planning policy mean much when planning is such an integral part of regional growth. For a government that has set such store by its commitment to localism and decentralisation, there are still real concerns about the willingness of Whitehall to let go. In the transition from RDAs, there remain key concerns about what will happen to some of their main functions which are likely to be drawn up to central government and its agencies rather than devolved to LEPs or to local authorities. Inward investment and key sector development will be centralised, and skills funding will be routed through the national Skills Agency straight to colleges and training organisations. These are crucial levers to drive local economies. As the Total Place approach appears to have run into the sand across Whitehall, it is vital that pressure is maintained in encouraging central government to become more integrated and more willing to devolve budgets and powers. The government’s broader public service reform agenda also provides a challenge to Britain’s future growth. The localism agenda, for example, aimed at empowering individuals and communities to have more say over their

61 Nick Hope, The starter pistol has gone off, but will LEPs have the firepower, NLGN, 2010.

109 Going for Growth localities, holds some potential problems to integrated, strategic economic development. On planning, despite a “national presumption in favour of sustainable development on all planning applications”, there is a fear that the bottom-up approach this government is taking – by giving local residents and communities more planning powers and abolishing Regional Spatial Strategies – could be anti-development. The New Homes Bonus is the cornerstone of the government’s framework for encouraging housing growth. It provides some small incentives but it remains to be seen if that is enough to drive regeneration. Alongside this there is rapid and substantial reform across public services that is in danger of fragmenting local delivery and working against moves to create better integration. Direct elections for police commissioners, commissioning directly by GPs, and free schools all provide new, and potentially conflicting, forms of accountability at the local level, which could mean that driving and leading economic regeneration in a place becomes more disparate and difficult. Moreover, the financial challenge faced by our localities through the squeeze on public sector spending, and particularly the local government settlement, means that our localities have a sizeable economic task ahead of them. The government is “confident” that the private sector will fill the gap in employment but between the first quarter of 2000 and the start of the recession, more than a fifth of all job creation came from the public sector.62 The need for private sector rebalancing is particularly urgent in the areas that have benefited most from the expansion of the public sector, suchas

62 White Paper, Local Growth: Realising Every Place’s Potential, 2010.

110 Driving growth at the regional level many of the formerly industrial economies of the north east and north west.63

An alternative way ahead

So while there is much to welcome about the new approach from the government, there are further steps that could be taken to enhance regional economic growth at a time when failure could mean dire consequences socially and economically in our regions. In keeping with its localist approach, the government should introduce a “duty to devolve”.64 Where a LEP has firm evidence that the powers it is requesting can best be exercised at that level to ensure economic growth, and can demonstrate the commitment, capability and firm governance, Whitehall should have an obligation to devolve those powers. The Business Select Committee could take on the role of arbiter, thereby ensuring Whitehall departments are no longer judge and jury on decentralisation.65 Moreover the Total Place approach should be taken forward in a more radical way than the rather limited Community Budgets, enabling more integrated approaches to regional growth. One Total Place pilot found that it can cost

63 Paul Swinney, Kieran Larkin and Chris Webber, Firm Intentions: Cities, Private Sector Jobs & the Coalition, Centre for Cities, 2010. 64 Nick Hope and Chris Leslie, Challenging Perspectives: Improving Whitehall’s spatial awareness, NLGN, 2009. 65 Written Evidence from the New Local Government Network to the Business, Innovation and Skills Select Committee, August 2010, http://www.publications. parliament.uk/pa/cm201011/cmselect/cmbis/434/434vw60.htm.

111 Going for Growth as much as £135 million to spend £176 million on economic development projects.66 LEPs should have full discretion over spending across regeneration, transport and housing in a single capital pot to enable them to deliver what a locality needs for its economic development.67 On funding capital investment, the government’s recent announcement on Tax Increment Financing (TIF), which allows local authorities new borrowing freedoms, is a welcome move. The outlook for capital investment – so crucial to local economic development – had been bleak since budget 2009 halved public sector net investment by 2014. Other capital finance options, such as Section 106 (broader local infrastructure commitments extracted from private developers when planning permission is granted), capital receipts, and private development had been severely limited since the start of the economic downturn, meaning new alternatives were very welcome. The devil will be in the detail, however, and it is likely that borrowing freedoms will not go as far as the more ambitious local authorities would wish. In the US, multiple taxation revenues – such as property, land and sales taxes – are pooled to maximise the use and benefits of the TIF. Local government in the UK would have the option of bringing in council tax, but at present would not have control over the use of uplifts in VAT revenues to finance borrowing, something which should be explored. The government has also announced its determination to look at localising business rates.68 If they are serious about

66 Nigel Keohane and Geraldine Smith, Greater than the sum of its parts: Total Place and the future shape of public services, NLGN, 2010. 67 Nick Hope, Bordering on Prosperity: Driving forward sub-regional economic collaboration, NLGN, 2009. 68 White Paper, Local Growth: Realising Every Place’s Potential, 2010.

112 Driving growth at the regional level economic growth and devolution, local enterprise partnerships should be able to set business rates within their own functional economic area to match economic activity.69 This would allow issues over the rate and equity to be resolved by local authorities and businesses themselves, and give business more clarity on a pan-local basis.

Conclusion

There is much to suggest that this government understands the importance of regional economic growth in driving the UK economy. Progressives should not be drawn into unques- tioning defence of the old regional architecture or dependence on public sector support. However, the scale and pace of this government’s public service reform, its optimistic reliance on the private sector to drive employment and growth, the broader squeeze on public sector spending, and the uncertain commitment across Whitehall to the devolutionary agenda all pose challenges to this approach. This provides a golden opportunity for progressives to shake off accusations of centralist, proscriptive economic policy-making and redefine their vision for local economic growth in our country.

69 Nick Hope, Bordering on Prosperity: Driving forward sub-regional economic collaboration, NLGN, 2009.

113

Rethinking macroeconomic policy in the UK by Tony Dolphin

Despite a major financial crisis and the worst recession since the 1930s, economists have been slow to question the way that macroeconomic policy is conducted in the UK. The Bank of England continues to target a 2 per cent consumer price inflation rate and, after a brief Keynesian interlude, fiscal policy is once again being determined by an accounting rule rather than by macroeconomic aims. This cannot be right. Macroeconomists and policy-makers took credit for the relatively good performance of the economy between 1993 and 2007; they should now be asking what went wrong in 2008 and 2009 and assessing what this means for the future conduct of policy.

115 GoingforGrowth

Rethinking monetary policy

Low and stable consumer price infl ation should remain an aim of macroeconomic policy. Although the Monetary Policy Committee (MPC) has found it more diffi cult to keep infl ation close to its target level over the last three years, it retains a high degree of credibility among wage and price setters and in fi nancial markets. That is not something to sacrifi ce lightly.

Figure 1: UK price infl ation relative to target

Source:OfficeforNationalStatistics

There have been suggestions that policy-makers should target a higher rate of infl ation as a way of signalling that short-term interest rates will stay low and quantitative easing

116 Rethinking macroeconomic policy in the UK

(QE) will be in place, for a long time.70 But such a move would risk higher long-term interest rates if bond investors felt the inevitable increase in inflation expectations would be hard to reverse.71 Others have proposed targeting the price level (on an increasing trend), rather than inflation, on the grounds that an undershoot in inflation in one year would have to be offset with an overshoot in the next. However, this would seem more appropriate for an economy where inflation was currently undershooting the target, not one like the UK where it is stuck stubbornly at around 3 per cent. Here a price level target would imply a period of lower than 2 per cent inflation over the next few years, and the higher interest rates needed to bring this about. This would not be desirable when high unemployment signals that the economy is operating with plenty of spare capacity. In addition to consumer price inflation, macroeconomic policy should support output and employment growth. In the US, the Federal Reserve has a dual mandate: price stability and full employment.72 The Bank of England could be given the same remit. In the short-term, this might not make much difference to the implementation of monetary policy. A majority of the MPC appear willing to tolerate inflation of around 3 per cent because they believe it is the result of temporary factors. But it would create greater clarity if the MPC were formally required to take account of employment and inflation.

:See, for example, Paul Krugman’s argument 70 http://krugman.blogs.nytimes.com/2010/11/01/if-i-were-king-bernanke/. 71 Or require increased QE to hold them down. 72 Although some leading Republicans are arguing that the dual mandate should be ended and that the Federal Reserve should focus solely on inflation.

117 GoingforGrowth

A case can be made for combining output growth and infl ation objectives into a target for nominal GDP growth on the grounds that policy-makers can only control the nominal rate of interest, which determines the nominal growth of the economy. However, there are practical problems with targeting nominal GDP – the data are published with a lag and the fi rst estimate is frequently revised. Nor would it have made much difference to policy between 1993 and 2007. The interest rate path set by the government and then by the MPC during this period kept nominal GDP growth close to 5 per cent throughout this period (assuming a target of 2.5 per cent real growth and 2.5 per cent infl ation as measured by the GDP defl ator).

Figure 2: UK annual nominal GDP growth (%)

Source:OfficeforNationalStatistics

118 Rethinking macroeconomic policy in the UK

Dealing with asset prices

A major problem with the current UK policy regime is its focus on consumer price inflation, with developments in asset prices, particularly house prices, only considered important if they might affect consumer prices. This follows the doctrine of Alan Greenspan (former Governor of the US Federal Reserve) that, since it is very difficult to say when assets are overpriced, policy-makers should not try to stop them increasing and instead should focus on taking action if they fall sharply. This doctrine has been discredited by the events of the last three years, which have shown that the effects of falling asset prices can sometimes be too great for monetary policy to cope with. The coalition government’s response has been to suggest it will “work with the Bank of England to investigate how the process of including housing costs in the CPI measure of inflation can be accelerated”.73 This is not an adequate response. The problem is not housing costs; it is the cost of housing. The biggest failure of macroeconomic policy between 1993 and 2007, and particularly between 1997 and 2007, was the way it let house prices rip. Over the decade to the end of 2007, while consumer price inflation averaged just 1.6 per cent, house price inflation was 11.4 per cent.74

73 The Coalition: our programme for government, 2010, http://www.cabinetoffice.gov.uk/media/409088/pfg_coalition.pdf. 74 Based on Nationwide house price index.

119 GoingforGrowth

Figure 3: UK annual house price infl ation (%)

Source:Nationwide

Moreover, the recent recession was not the fi rst in the UK to be preceded by excessive house price infl ation. The same was true in the early 1970s, the late 1970s and the late 1980s. Policy-makers have a long track record of failing to identify bubbles in the housing market and failing to take steps to arrest surging house prices. Targeting asset prices would not be easy. According to the Halifax, the current ratio of house prices to the average earnings of male full-time employees is 4.6. This is well below the peak of 5.9, reached in the second quarter of 2007, but not very far below the high of 5.0 seen in 1989 at the peak of the last housing bubble. Does this mean house prices are cheap or expensive?

120 RethinkingmacroeconomicpolicyintheUK

Figure 4: UK ratio of house prices to average earnings

Source:Halifax

Houses are the most important asset for macroeconomic policy-makers to take into consideration. Home ownership in England is now 68 per cent75 and housing accounts for 39 per cent of total net private wealth and 64 per cent of non-pension wealth76. Housing equity withdrawal (using some of the equity built up in housing to boost household spending) has been a major feature of the last two housing and consumption booms. But, as the bubble in technology stocks in the late 1990s showed, rapid increases in other asset prices can be a warning sign of economic

DepartmentforCommunitiesandLocalGovernment,English Housing Survey 75 /Household Report,2010,http://www.communities.gov.uk/publications 2008-09 corporate/statistics/ehs200809householdreport. ,OfficeforNationalStatistics,Household wealth in GB in 2006/08,2009 76 http://www.statistics.gov.uk/pdfdir/wealth1209.pdf.

121 Going for Growth problems too, and policy-makers should not focus solely on house prices. Policy-makers should not ignore asset prices simply because it is difficult to assess valuations. The role of asset prices in creating the conditions that have led to previous recessions in the UK makes it imperative that future asset price bubbles are avoided if at all possible. One way around this problem might be to target net wealth. The wealth- to-income ratio tends to be mean-reverting, so policy could be adjusted in response to deviations from the long- run average.77 An alternative approach would be for policy-makers to monitor, target and control the amount of credit in the economy, because excess leverage is the cause of most asset bubbles. Individual banks may be behaving rationally when they increase lending during credit booms, but their collective action produces unwelcome results. There is, therefore, a case for intervention at the macro level to control credit excesses. This could be done, for example, by capping loan-to-value ratios for mortgages to dampen the housing market. Or it could be done across the whole of the financial system. Last year, the Bank of England published a discussion paper on “macroprudential policy”, which, it argued, should be used primarily to control financial stability but could also play a role in preventing asset bubbles.

77 Philip Arestis and Elias Karakitsos have been making the case for this approach for many years.

122 Rethinking macroeconomic policy in the UK

Coping with more than one macroeconomic objective

Increasing the number of objectives of macroeconomic policy from one – low inflation – to several – low inflation, full employment, asset prices and/or debt – would require either a similar increase in the number of policy instruments, or the introduction of greater policy flexibility. If the aim of macroeconomic policy is to achieve a number of targets simultaneously and at all times, then, in theory, one policy instrument is needed for each objective. So, for example, if the short-term interest rate is used to target consumer price inflation, it cannot also be used to target employment. Fiscal policy might be needed to target employment, quantitative credit controls could be used to limit asset price inflation, and the exchange rate could be focused on the trade balance. However, this approach – or something very similar – has been tried before in the UK, during the 1960s and early 1970s, and the results were spectacularly bad. The stagflation period of the mid-1970s beats even 2008 and 2009 as the economic low point of the UK’s post-war period. There are also practical problems with such an approach. For example, if interest rates are being set to achieve an inflation target then, without capital controls, the government would find it difficult to control the exchange rate. In addition, historical experience has shown how difficult it can be to use fiscal policy to “fine tune” the economy and, even if it were possible and desirable, the current budget deficit places a constraint on the government’s room for manoeuvre, at least in the direction of easing policy, for several years.

123 Going for Growth

The alternative is to allow macroeconomic policy-makers more flexibility. Rather than having one policy target or a set of targets, policy-makers would have discretion to decide what message the macroeconomic indicators as a whole were sending and what policy instrument – or instruments – should be adjusted to correct potential problems. Something similar to this approach has also been tried before in the UK. In the mid-1980s policy-makers began to look at a wider range of measures, including narrow money growth, wages, asset prices and the exchange rate, when deciding the appropriate stance of policy (mainly interest rate policy). The results were not good. The “Lawson boom” at the end of 1980s saw strong growth followed by a surge in consumer price inflation and was followed by a deep recession when interest rates were increased to bring inflation back under control.78 Supporters of increased flexibility could argue there is a difference between the 1980s, when policy was set solely by the government, and now when the Bank of England is responsible for monetary policy, and could be made responsible for other aspects of macroeconomic policy too. They could also point out that a wide range of factors are already taken into account by the MPC when it sets interest rates (though only to the extent that they affect the consumer price inflation outlook, not as target variables in their own right).

78 The exchange rate was particularly important at some points during this period. From March 1987 to March 1988 Nigel Lawson, then Chancellor of the Exchequer, followed an informal policy of “shadowing the Deutschmark”, effectively targeting an exchange rate of 3DM = £1 and from October 1990 to September 1992 sterling was part of the European exchange rate mechanism. But at other times policy was set flexibly in response to a range of indicators.

124 Rethinking macroeconomic policy in the UK

But this does not get around the objection that switching to a totally flexible regime would lead to less clarity, increased uncertainty and reduced credibility, compared to the simplicity of the current regime. The best approach to macroeconomic policy in the UK would be to focus on what ultimately matters most – full employment and low inflation – and what has caused the biggest problems in the past – asset prices, particularly house prices. The MPC’s mandate should be extended to encompass full employment as well as low inflation, giving it the same dual mandate as the US Federal Reserve. Much of the time, this would make little difference to the stance of monetary policy and the level of interest rates. But it would remove confusion about the actions of the MPC at times like the present when there is a huge amount of spare capacity in the UK economy but some upward pressure on inflation due to external factors such as higher oil prices. In these circumstances, the dual mandate would make it clear that the MPC should be primarily focused on employment.79 This move should also encourage greater scrutiny of the way the Bank of England and the MPC are thinking, and greater transparency on the part of the MPC about its models and assumptions. It would broaden the policy debate in a way that is difficult with the current singular focus on consumer price inflation. This is not, however, sufficient. The most obvious policy failure in the UK over the years has been allowing the formation of bubbles in asset prices, and house prices in particular. So, the most pressing need is to bring asset price

79 Similarly, when the UK is operating at full capacity, it would be easier to justify higher interest rates, even if, say, a fall in the oil price had resulted in lower inflation.

125 Going for Growth inflation into the policy framework. This could be done in a complex way but much might be gained just by setting – and achieving – a target for house price inflation. Policy-makers should use limits on loan-to-value ratios to constrain developments in the housing market, perhaps combined with more general controls on bank’s capital requirements to limit the total amount of debt in the economy. There is a good case for handing responsibility for controlling house prices to the MPC to avoid political consid- erations clouding decision-making (a Chancellor of the Exchequer might naturally be reluctant to reduce loan-to- value ratios and spike a house price bubble in the last year of a parliament). But this would place a lot of responsibility on one small group of individuals. The alternative of creating a new body to control house prices also has drawbacks centring on the co-ordination of policy. More thought needs to be given to the institutional framework which best allows the co-ordination of policy on inflation, employment and asset prices, without compromising the independence of the MPC.

An active fiscal policy

There would be a limited role for active fiscal policy in this framework. For the next few years the focus will be on deficit reduction in order to create the fiscal space that will be needed in the next economic downturn.80 Thereafter, the Chancellor’s rule that current spending should be planned

80 Though the Chancellor is proceeding too quickly. See http://www.ippr.org/ publicationsandreports/publication.asp?id=781

126 Rethinking macroeconomic policy in the UK to match revenues, after cyclical adjustment, on a five-year horizon is a reasonable basis for policy. It might even be possible to shorten the time horizon in due course. The focus on the deficit after cyclical adjustment is the right one because it allows room for the “automatic stabilisers” to work when the economy is weak or strong, and some thought could usefully be given to finding ways of improving the effectiveness of these stabilisers. But there must also be scope for aggressive fiscal easing during recessions, particularly when the effectiveness of monetary policy is reduced. On this, Keynes was right. In these circumstances, temporary tax reductions, targeted at low-income families, and increases in government capital spending are the best way to support economic activity.

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