A Response to Questions 1 and 2 in the Green Paper Building our Industrial Strategy (Department of Business, Energy, and Industrial Strategy, January 2017) – 30 March 2017. Part of the ‘Go for Growth’ submission from the Economy Forum of the Institute of Ideas.

The questions responded to

1. Does this document identity the right areas of focus: extending our strengths; closing the gaps; and making the UK one of the most competitive places to start or grow a business?

2. Are the ten pillars suggested the right ones to tackle low productivity and unbalanced growth? If not, which areas are missing?

Introduction: set the conditions for brand-new sectors of production

It is welcome that the Government has launched a consultation around ‘Building our Industrial Strategy’. The goal of making such a strategy effective depends first on having a meaningful consultation that explores new approaches. Too many times in the past, in this country and in other advanced economies, ‘modern’ industrial strategies have been launched to little positive effect in the succeeding years. Instead, pre-existing economic trends have mostly continued as before.

This ineffectiveness is usually because governments adopting industrial strategies have at the outset jumped the crucial stage of identifying the fundamental barriers to further economic development. Partly, this is out of a desire to get on and simply do something. Partly, it is because some experts believe that the advanced economies are already at the frontier of most existing technologies. As a result, the focus for industrial policies easily slips into building on what is already in place, and maybe rectifying any shortcomings relative to other advanced countries. This is far from enough to reinvigorate today’s tired mature economies.

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

Unfortunately, this Green Paper risks going down that same path with its emphasis on ‘extending our strengths’ and ‘closing the gaps’. Instead, the government should focus on bringing about what doesn’t yet exist, not on adjusting and extending what does exist. Any country’s economic prospects five, 10 or 20 years hence depend not on its current capabilities – or lack thereof – but on the assets and strengths which have yet to be realised, possibly even to be imagined.

Recall the approach of Adam Smith and other Enlightenment authors at the end of the eighteenth century. They wrote during the early stages of the first industrial revolution; but they could not foresee which technologies and sectors would take off during the early nineteenth century. Smith didn’t anticipate the epoch-changing impact of steam engines or railways, for they were still to be invented when he was writing The Wealth of Nations.

What Smith and his fellow thinkers did was encourage the state to set the commercial conditions in which innovators could thrive and new sectors expand. Similarly today: to give Britain a prosperous twenty-first century, we must acknowledge that it is sectors and businesses that are currently largely unknown and possibly even unimagined that will really drive productivity and employment growth.

Old sectors vs new ones

It is reasonable to identify certain existing sectors that have more potential to develop and expand. The Green Paper, for instance, mentions automobiles and ultra-low emission vehicles, artificial intelligence and satellite technology, aerospace, life sciences, industrial digitalisation and nuclear energy. But it is even more important that an industrial strategy’s sector policy doesn’t limit horizons to what can already be identified. Britain’s future economy will not ensure prosperity for everyone if it remains limited to the economic sectors of today.

A word about sectors: This response does not take the ‘industrial’ in ‘industrial strategy’ too literally. For economic transformation, we are talking about sectors of production which include manufacturing, process industries and extractive industries, but which also stretch from agriculture, through construction, to services.

An effective industrial strategy therefore needs to guard against a mentality that targets initiatives on existing sectors, at the expense of setting the conditions for brand new, still-to-be-born ones.

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

Hence this consultation response is framed as an answer to Questions 1 and 2. This submission believes the Green Paper does not identity the most important areas of focus (Question 1) and suggests other, better areas in which Britain could successfully tackle low productivity (Question 2).

Get serious about public spending on R&D

For the Green Paper, the goal is policies that ‘help to deliver a stronger economy’. The Secretary of State for Business, Energy and Industrial Strategy, Greg Clark, spelt this out further in his foreword. The aim is ‘to improve living standards and economic growth by increasing productivity and driving growth across the whole country’. The importance of productivity for living standards is properly acknowledged, as is the weak performance of productivity growth over recent years. This emphasis on acting to revive economic growth, and especially the growth in productivity, is entirely justified.

In her opening remarks for the Green Paper, the Prime Minister also explicitly recognises low productivity as the British economy’s ‘underlying weakness’. She continues with the clear and unambiguous point that if we want to increase our overall prosperity ‘we have to raise our productivity’. However, the themes taken up in the Green Paper fail to grapple sufficiently with this core problem. That is why the Green paper also falls short in proposing the bold steps necessary to reinvigorate its growth.

The Green Paper’s 10 pillars of industrial strategy do include important proposals that could, in suitable circumstances, make a genuine difference to productivity, even if they often don’t go far enough. For instance, the Green Paper is right to indicate, with Pillar One, that inadequate research and development (R&D) limits the possibility of making the discoveries, inventions and the follow-on innovations necessary for productivity growth over the longer term.

In the UK, both business and public spending on R&D fall far below what is needed. Each has been on a declining trend since the 1980s: for the year 2014, the OECD puts UK business enterprise expenditure on R&D as equivalent to 1.1 per cent of GDP, while government-financed R&D is 0.5 per cent.[1] For the year 2015, the OECD puts Britain’s overall R&D at 1.7 per cent of GDP. This level of commitment represents little more than half the EU’s target of three per cent of GDP by 2020. Compared with R&D commitments in 2015, it is behind China (2.1 per cent of GDP), well behind the US (2.8), and not even in the same race as Japan (3.5) or Korea (4.2). [2]

Our response to the Green Paper favours an increase in public spending on R&D to two per cent of GDP, well over three times the level supported by current plans. Of course, such an increase in government-backed R&D will not guarantee, as an outcome, three times the level of commercial British innovation. But continuing with the current, thoroughly anaemic levels of public R&D will, and in a quite irresponsible way, guarantee relatively low levels of innovation.

The public spending increases already announced by this government for the years until 2020 fall far short of what is needed. These will raise public spending on R&D by 0.1 per cent of GDP. Much more government fidelity to R&D spending needs to be sustained over the next decade. That would help reverse the effects of years of declining spend by successive British governments – and, it should be added, by most British businesses.

Bring back creative destruction

Pillar Four highlights another crucial area for necessary change: the productivity benefits from higher rates of capital investment. But the existing pillars don’t get to grips with why capital investment has been so lacking. Given the relatively low cost and easy availability of business credit, both before and since the financial crisis, the focus in the Green Paper on easing access to funding is misplaced. In some circumstances, it is even counter-productive. The deeper reasons for the shortage of investment that has been such a drag on productivity growth are hardly explored.

The Green Paper does suggest some useful investment measures, not least when it wants more seed and early-stage venture capital funding to help genuine startups – those employing people – to experiment, innovate and grow. Most startups will not succeed, but without more of these risk-taking efforts productivity growth will be handicapped. However, until the structural constraints on business dynamism are dealt with, even these pro-entrepreneurial proposals will be much less effective than they could be. State-backed venture capital funding could simply go to the safest, established startups, leaving younger, riskier firms starved of cash. That would stifle innovation, not foster it.

This point illustrates the most important shortcoming in the Green Paper. Many of its proposals risk perpetuating the productivity problem by supporting existing businesses, rather than by starting a durable, full-on revival of economic dynamism. These two are very different approaches. Acting to soften the impact of failures among individual businesses, helping these businesses survive – that is not the same as acting to reverse economic failure, or, where there is failure, intervening to drive forward development. In fact, reinvigorating an economy means more change, not more stability. The ‘exit’ of many existing businesses is a necessary feature of the advance of a market economy. This has been the historical experience since the first industrial revolution.

Britain’s economy, as several other mature industrial economies, needs to resuscitate the process of creative destruction – the way in which older, less productive firms close down and are replaced by newer, more productive ones. This long-established feature of capitalism has been much less in evidence since the 1980s. Reviving creative destruction will usher in a different culture and business climate from that of the past quarter-century, so that new, high-productivity businesses can set up or expand more easily to take the place of existing lower productivity ones.

Such a return to higher levels of business dynamism will need to go hand in hand with comprehensive measures to assist people during the transition between jobs. These transitional measures are necessary because displaced workers and their families deserve generous public financial assistance as they transfer to good new jobs. After all, these new jobs are unlikely to emerge immediately or in the most convenient locations. The assistance given should include real help to find new jobs and, if required, to move house to be near them, and publicly-funded training in association with the training provided by the new employers. The costs of this aspect of change can be recouped from the stronger economic growth that ensues from economic restructuring.

Although the Green Paper did not discuss creative destruction explicitly, it was notable that Greg Clark did appear to embrace it. In his foreword, he stated that a ‘modern British industrial strategy must make this country a fertile ground for new businesses and new industries which will challenge and, in some cases, displace the companies and industries of today’. Unfortunately, the Green Paper does not pursue this point much. This is a serious omission that undermines achieving the stated objective of a more productive economy. It needs to be rectified.

Not enough diffusion of innovations…

To fix Britain’s dismal productivity demands that we understand its roots. In fact, until this understanding is achieved, spending more on industrial strategy risks making a bad situation worse. Why? Because many public policies have acted to preserve the status quo, to save the existing economy. That has had the perverse if unintended effect of perpetuating low productivity.

The big question is what is holding back the advance of productivity. The answer, in both private and public sectors, is not enough investment in advanced, innovating technologies. The Green Paper recognises this is a long-running problem. The UK has ranked in the lowest 25 per cent of all developed countries for fixed capital investment in 48 out of the last 55 years, and in the lowest 10 per cent for 16 of the last 21 years (p 63). Unfortunately, recognition of this poor record is not matched by analysis of why investment has been inadequate.

In practice, economy-wide productivity growth is the result of interacting factors, all of which centre primarily on business investment:

• First, innovation to develop and deploy new process and product technologies by the leading or ‘frontier’ companies, whether large or small;
• Second, the spread, or diffusion, of these new technologies across the rest of the economy; and
• Third, business churn, or the turnover of Britain’s stock of businesses, as less productive firms downsize or close, while more productive firms – existing and startups – expand.

Out of this triad of productivity mechanisms, the economic problem lies much more in the second and third areas than in the first. Without them, the spread of innovations across whole economies and the establishment of new sectors of economic activity are both constrained. This is the main reason aggregate productivity growth has slowed.

These two areas are where an industrial strategy for today needs to start and give much of its initial focus. Despite Britain’s weakness in private and public R&D, it still possesses plenty of frontier firms that are innovating, even if not as widely or rapidly as in earlier stages of economic development. Many of these frontier firms are likely to continue to do so with or without a new industrial strategy. But in Britain, as in other advanced economies, the other two connected processes of diffusion and business churn have been malfunctioning.

Researchers at the Organisation for Economic Co-operation and Development (OECD) have concluded that the main source of the recent productivity slowdown across the advanced economies, not just in Britain, is a breakdown of the diffusion machine. They found little slowing of innovation by the most globally advanced firms, but rather a slowing of the pace at which innovations spread throughout the economy. Indeed, the OECD discovered that while the productivity growth of the globally most productive firms remained fairly robust in the twenty-first century, the gap between those high-productivity firms (the ‘frontier’ firms) and the rest (the ‘laggards’) had risen. [3]

Complementary micro-level analysis by OECD researchers using company data across 24 OECD countries, including Britain, confirmed a widening of technological, innovation and productivity divergence between the top five per cent of firms and the other 95 per cent. [4] Using data from 1997 to 2014, this study found a slowdown in the usual productivity convergence expected as weaker firms ‘catch up’ by deploying the available better technologies. At the same time the growth-enhancing reallocation of resources from weaker to stronger firms has been less in evidence.

This increasing divergence in productivity both reflects and reinforces a slowdown in the technological diffusion process within national economies. Interestingly, new technologies developed at the global frontier are spreading more and more rapidly across borders to other countries even though their diffusion to all firms within any economy is slower and slower. [5] This indicates that the in-country diffusion slowdown is unlikely to be anything to do with the type of technologies being developed, such as being more digitised or information-based. Instead, the transmission problem is located within the respective national economies.

… not enough business churn

Accompanying the second and third processes, the ‘between-firm’ contribution to productivity – the displacement of less efficient firms by more efficient ones – is substantial. For overall levels of national productivity, it can be more important than the ‘within-firm’ effect, in which individual firms, sometimes by pioneering innovation, sometimes by taking in innovations diffused to them, simply become more efficient. Healthy business dynamism, in the sense of businesses closing and opening, is necessary to facilitate a continuing shift of resources from low productivity to higher productivity areas. Unless Britain’s resources of people and capital can move out of less productive areas to allow more productive ones to establish and expand, then economy-wide aggregate productivity will suffer.

OECD studies of commercial competition show that the between-firm driver of productivity can determine from 45 to 65 per cent of its growth; within-firm effects make up the balance. [6] One study of UK productivity growth found that 79 per cent of growth came from the between-firm effects. [7]

The creative destruction process underpins this between-firm effect, and it has not been working well. Across the British economy, the rate of business liquidation is historically low. Fewer employment-creating businesses are starting up, and too few of these are expanding through capital investment and recruitment as rapidly as they used to.

At the same time, fewer established businesses are investing and expanding. This includes frontier companies, which are somewhat paralysed by operating in a low-growth, sclerotic environment – one that encourages short-termism and aversion to risk.

Weak UK economic dynamism and low business churn can even numb the country’s leading firms in innovation, in sectors such as aerospace and pharmaceuticals. So long as little creative destruction prevails outside the confines of a frontier company, Britain’s technology giants will feel little compulsion really to strike out on a new path in terms of innovation.

Both the processes of innovation diffusion and business churn must be fixed for sustained productivity growth to be achieved. Leading firms need to do more; at an aggregate level, Britain’s business base needs to do better, too. These are not recent problems, and they long precede the 2008 financial crash, so they are most unlikely to heal themselves. Restoring business dynamism must, therefore, remain the watchword of industrial strategy.

Zombie firms and the relevance of Japan’s lost decades

The OECD studies cited above highlight that the major problem accounting for the productivity slowdown is not an absolute disappearance of investment and innovation, but the wider economic atrophy that hinders their spread. This has brought about what many now term a ‘zombie’ economy: too many resources are stuck in low productivity areas and in ‘zombie’ firms. The latter are businesses that are too weak to invest in transforming their basic operations. That slows down the diffusion of innovations. At the same time, zombie firms have enough income from somewhere to survive. In that way, they hold back the between-firm creative destruction effect.

Zombie firms spread congestion across the economy. In turn, that has a dampening effect on the investment plans of startups and existing viable businesses. Aggregate national productivity is held down. First, more low-productivity businesses hang on. Second, fewer higher-productivity businesses set up or expand, because they’re constrained by a sclerotic economy. Further OECD analysis of business churn confirms the decline in dynamism as expressed in a lower rate of businesses setting up. [8] Overall, innovation slows and productivity growth suffers.

The Japanese experience during its ‘lost decades’ since the early 1990s illustrates the contribution from the rise of zombie businesses to falling levels of investment and a weak level of productive transformation. While other specific features of the Japanese economy were also at work, it is striking that investment and employment growth for healthy ‘non-zombie’ firms in Japan fell as the percentage of zombies in their industrial sector rose. One study showed that zombification depressed Japanese business investment by between four per cent and 36 per cent per year, depending on sector of production. In those sectors with the most zombie firms, job creation was especially weak, while those sectors where zombies became more important had the worst productivity growth. [9]

The distortions that the zombie regime brought to Japan included firms having to depress market prices for their products, firms raising market wages as zombies hung on to workers, despite their declining productivity, and, more generally, congesting the markets where they operated.

Ricardo Caballero, Takeo Hoshi and Anil Kashyap explain how normal competitive outcomes, whereby these Japanese zombie firms would shed workers and lose market share, were thwarted. The resulting artificial oversupply that lowered prices and raised wages reduced the profits and collateral that new and more productive firms could generate, thereby discouraging their entry and making investments.

The congestion caused by the zombies delays more productive projects and the entry of more productive firms.[10] Negative perceptions of the risks of business investment and expansion are exacerbated. The artificial maintenance of oversupply made it more difficult both for the stronger incumbent businesses and for new ones to adopt more advanced production methods. Markets crowded by zombies limit the scope for other businesses to build up the financial resources that can allow them to innovate and expand in the future.

Zombie firms in the OECD area

Researchers have discovered that these trends in Japan now apply across many mature industrial economies, including Britain’s. Muge Adalet McGowan, Dan Andrews and Valentine Millot have looked at how the zombie firms now surviving in many countries have repressed productivity performance.[11] Their study uses a quite restricted definition of zombie firms as firms 10 or more years old with an interest coverage ratio of less than one (in other words, the firm is reliant on cash reserves, selling assets or further borrowing to survive) for three consecutive years. Others define zombies more widely as firms making persistent losses, or that are in persistent financial difficulties.

Whatever the definition of a zombie firm, the common theme is that a greater number of weak companies have been surviving, when in previous times they would have closed down – ‘exited’ the market.

Adalet McGowan, Andrews and Millot describe lower exit rates, declining business dynamism and wider productivity divergences. They explain that rising productivity dispersion would ordinarily imply stronger incentives for productive firms to aggressively expand and drive out less productive firms. But we are not in ordinary times. The authors underline how the productivity gap between frontier and laggard firms has risen, while the forces of dynamic adjustment have waned. High-productivity firms haven’t expanded that much; fewer low-productivity firms have gone bust. [12]

The study’s authors sum up the vicious circle like this: ‘Besides limiting the expansion possibilities of healthy incumbent firms, market congestion generated by zombie firms can also exacerbate productivity dispersion, create barriers to entry and constrain the post-entry growth of young firms. Finally, we find that an increase in the capital stock sunk in zombie firms is associated with less productivity-enhancing capital reallocation, measured as the decline in the ability of more productive firms to attract capital.’ [13]

The zombie phenomenon in Britain

Britain well expresses the West’s shift to congested, zombie economies in which creative destruction is muted. In the mid-1970s and early 1980s, recessions in Britain played their traditional role of helping to clear out some of the weaker sectors and businesses.[14] By contrast, subsequent recessions, even the deep one following the 2008 financial crash, were much less destructive. Moreover, while there was visible ‘destructive’ de-industrialisation in the 1970s and early 1980s, Britain saw much less in the way of ‘creative’ re-industrialisation in subsequent years. Between the early 1980s and the years leading up to 2008, both business deaths and business births in Britain dropped by a quarter. Business deaths fell from about 13 per cent of active firms to about 10 per cent, while births decelerated from about 16 per cent to 12 per cent.[15]

Rates of corporate failure and startups have remained low, even during the recessions since the 1990s. In Britain after the 2008 financial crash a higher proportion of businesses than usual were unprofitable and making losses, but fewer went bust. As the Bank of England’s Ben Broadbent described, firms were being kept in business, and retaining their employees, despite making relatively low returns.[16]

The headline figure of company liquidations remained lower in the recession following the financial crash than it had been in the early 1990s recession, despite the six per cent decline of GDP being about three times as deep. The annual rate of company liquidations was 17,000 from 2009 to 2012, lower than the 21,000 liquidations experienced from 1991 to 1994.[17] The absence of a leap in business failures after 2008 occurred despite a post-crash jump in the number of loss-making firms, from about a quarter of businesses in the 1990s to more than a third since the crash.[18] More businesses were losing money, but fewer were closing down.

Andrew Haldane, chief economist at the Bank of England, has applied the OECD’s insights into reduced productivity diffusion to assess the British experience. He reported that the UK picture broadly matched the same widening – he also calls it ‘bifurcation’ – of productivity distribution, with a small set of frontier firms whose productivity growth continues apace but a long tail of laggard firms whose productivity has effectively stagnated. Haldane’s findings are consistent with those of the productivity review chaired by Sir Charlie Mayfield, chair of John Lewis Partnership. The review identified a lengthening tail of companies across all sectors in the UK where productivity performance was falling short.[19] It concluded that the diffusion of best practice productivity methods has been getting worse, noting that ‘the lead of a few is being weighed down by the stagnation of the many’.

Firm-level analysis of a sample of 30,000 companies produced, in Haldane’s words, several ‘striking’ features: ‘First, it is clear that at least three-quarters of all firms in the sample have seen productivity flat-line over the past 15 years. There is a long tail of companies who have, at least in efficiency terms, stood still. Second, it is only firms in the upper echelons of the productivity distribution that have seen any growth and only those in the top 1% or above who have seen rapid growth. And this growth has been rapid, with the productivity of the top 1% of companies increasing by on average around 6% per year since 2002. These are the frontier firms. It is clear that, at the same time as the long tail of companies have been stagnating, they have been sky-rocketing. Or put differently, the distribution of UK firm-level performance has itself been widening or bifurcating over time.’ [20]

Haldane admits he doesn’t have answers to the question of what is preventing the diffusion of processes and technologies used in one firm to other firms operating in a similar region or sector. But finding these answers, he concludes, is ‘key for unlocking the growth and productivity potential of the long tail of companies and hence of UK PLC’.[21] Haldane is correct. This is a fundamental matter for the government to address in developing its industrial strategy.

The widening of productivity divergences and the survival of many low productivity firms reveal that the blunting of creative destruction is a significant factor in Britain. The resulting congestion underpins low productivity growth and impairs the allocation of capital to more productive uses. Further analysis by Alina Barnett, Ben Broadbent, Adrian Chiu, Jeremy Franklin and Helen Miller suggests ‘that frictions to the allocation of capital are likely to be one of the factors that can help to explain the persistent weakness of UK productivity’. [22]

The fact is that failure to deal with the zombie economy will neutralise even the most pro-innovation measures included in the Green Paper. Support for more R&D will be less effective if the resources needed to make use of it are tied up in low-productivity businesses.

In a study off the US experience, Daron Acemoglu, Ufuk Akcigit, Nicholas Bloom and William Kerr showed that industrial policy interventions such as R&D tax subsidies are only really effective when policymakers can ensure the exit of low-productivity incumbent firms. This is necessary to free up R&D resources, including skilled labour, for use by innovative incumbents and entrants.[23] The authors’ conclusion is highly relevant to this consultation. The optimal industrial policy should be to encourage the exit of low-innovation firms, while supporting more R&D by high-innovation incumbents and startups.

To summarise, sustained productivity growth requires having enough of business churn to complement the technological upgrading of existing firms. Too much of the Green Paper addresses the latter requirement, and not enough of it the former.

That imbalance, indeed, could turn into an absolute liability. A zombie economy in which creative destruction is muted discourages all businesses from investing. To the extent that a ‘modern’ industrial strategy remains stuck in the old pattern of sustaining zombie firms, it will, ironically, make the productivity situation worse.

Public policy keeps zombie firms on life support

To some extent, the perpetuation of a low-productivity zombie economy is a spontaneous outcome of slower economic growth. The economic malaise has a self-reinforcing aspect to it. As noted already, the preponderance of zombie businesses clogs up the economy and holds back investment and productivity-enhancing innovation by viable firms, including by frontier companies.

But public policies have played a significant role here in keeping low-productivity businesses on life-support. This policy-induced aspect of productive weakness needs to be openly recognised, not simply on the grounds of honesty, but also because this is something an active industrial policy can seek to change. Policies with unhelpful, if unintended, consequences can be amended or revoked to reverse their productivity-impairing effects.

OECD studies on commercial competition, already mentioned, note that regulations preventing or limiting firm entry and expansion are particularly damaging for productivity and economic growth. Andrews, Criscuolo and Gal also found that public policy might partly be to blame for the productivity slowdown: the productivity gap between frontier and laggard firms was largest where regulation restricted competition and business dynamism. The authors suggest that, in OECD economies, the observed rise in multi-factor productivity divergence might at least partly be due to policy weakness ‘stifling’ the diffusion and adoption of innovation.[24]

Existing policy measures can act to reinforce the zombie economy. Adalet McGowan and Andrews have studied how, in Britain and elsewhere, changes to insolvency regimes have tended to favour company rescue over company liquidation. This has been the direction of change for Britain’s insolvency regime since the late 1980s, not least in the 2002 Enterprise Act. This shift has the obvious advantage of reducing disruption and job losses in the short term, but at the potential expense of prolonging the life of non-viable insolvent firms and curbing creative destruction.[25] When this results in low exit rates, average productivity falls further as growth opportunities for more productive firms are crowded out. The short and long-term prospects for productivity growth are both curtailed.

In their broader analysis of zombie firms, Adalet McGowan, Andrews and Millot suggest that problems of lower exit rates ‘are likely symptomatic of structural policy weaknesses, particularly with respect to insolvency regimes’. Business rate revisions can fall into the same category by often penalising businesses that are seeking to invest and upscale while protecting those that may be struggling in areas that have performed less well.[26] The authors continue that ‘there are reasons to suspect that non-viable firms may also be increasingly kept alive by the legacy of the financial crisis, with bank forbearance, prolonged monetary stimulus and the persistence of crisis-induced SME support policy initiatives emerging as possible culprits’.[27]

Measures of financial stabilisation can have the unintended consequence of holding back creative destruction. The easy monetary policies introduced in emergency circumstances from 2009 helped keep credit markets from freezing up, which could have had grave economic consequences. However, eight years later, these policies, now simply part of the furniture, merely featherbed weak businesses. At just 0.25 per cent, Bank Rate has never been this low in the 300-year-plus history of the Bank of England. Before 2009, the lowest Bank Rate had been set at two per cent, operating during most of the 1930s and 1940s.[28] Rates at today’s ultra-low levels have proved a lifeline for many struggling businesses since the crash. But they have also failed to breathe life into firms that should have been declared dead a long time ago.

Fathom Consulting has highlighted the consequent role of ultra-easy monetary policies for damaging productivity growth. It explains how low central bank interest rates suppress the forces of creative destruction, resulting in the creeping ‘zombification’ of the corporate and banking sectors.[29] Not only do low-productivity firms hold out because of lower interest payments, but very loose monetary policy also encourages bank forbearance. Banks have less reason to recognise losses on non-performing loans.[30]

Adalet McGowan, Andrews and Millot usefully explain how well-meaning policies can later rebound on governments. They conclude that ‘some crisis-induced policy initiatives such as government loan guarantees and low interest rates might have been useful in facilitating credit and preventing firm exit that would lead to mass layoffs. However, given the length of the crisis, the persistence of some of these policies may now be detrimental to productivity growth by distorting credit supply, especially given asymmetric information problems making it difficult to identify unviable firms, and curbing the potentially positive contribution of exit.’[31]

The policy dimension to the collapse of creative destruction also applies to the unintended effect of policies introduced to meet goals other than economic stabilisation. This includes, for example, welfare measures such as Working Tax Credits. These were meant to encourage people to work, rather than rely on out-of-work benefits. Instead, they have often simply subsidised wages in low-productivity jobs, thereby helping to sustain some zombie businesses.[32]

Often with the best of intentions, government policies have buttressed the low-productivity features of the British economy. What once supported existing businesses now act as barriers to innovative business spending. Regulations, government spending and state procurement policies, changes to insolvency rules, easier monetary policies: all these have shored up incumbent businesses, many of which are low productivity, and have conserved the economy as it is. As a result, flatlining has taken precedence over the disruption necessary to ensure sustained productivity growth.

Debating a new idea

An effective industrial strategy, in the sense of one that revives productivity growth, is one that shakes the economy up, not preserves it. Economic renewal necessitates closing down low-productivity, low-profit or loss-making businesses to make way for new sectors and new businesses. Andrews, Criscuolo and Gal argue that a ‘key implication’ of their analysis is that weak productivity performance in OECD countries may persist, ‘unless a new wave of structural reforms can revive a broken diffusion machine’. [33] Such structural reforms should be the primary goal of any new industrial strategy.

On the other hand, a set of industrial policies that acts so as to mollycoddle existing businesses and the status quo economy is worse than doing nothing. It blocks the forces of creative destruction and, by postponing the day of reckoning, can only make it so much worse when, as is inevitable, it arrives.

This ‘alternative’ to creative destruction doesn’t at all prove the old mantra that ‘stability is sexy’. By inhibiting productivity growth, this kind of stability in fact spells disaster.

The discussion initiated by the Green Paper about developing a modern and effective industrial strategy provides an opportunity for the government to popularise a new idea. The idea is simple: saving the existing economy is not only futile, but also a barrier to durable prosperity. Britain hears a lot about technological ‘disruption’ from its friends in Silicon Valley. Equally, an industrial strategy of economic disruption is necessary to lay the foundation for a twenty-first century industrial revolution.

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

Jobs: preparing transitional measures

The closure of zombie firms will lead initially to redundancies. As already stated, a new, recast industrial strategy will thus need to include transitional devices related to employment: financial, training and other measures to sponsor workers and their families through the move from existing employment, or unemployment, into the better, differently skilled jobs of the future. The additional tax revenues generated by the more productive, higher-employment economy that results from these policy changes would more than cover the additional costs to the Treasury.

As Adalet McGowan, Andrews and Millot explain, it is reasonable to expect that, over time, the costs arising from looking after displaced workers will be mitigated by two factors: ‘First, the removal of the zombie congestion implies higher non-zombie employment growth, especially amongst young firms which disproportionately contribute to aggregate job creation…. Second, the exit of zombie firms creates scope for some displaced workers to be reallocated to a job that better matches their skill, which is significant given evidence that highly-skilled labour is trapped in relatively low productivity firms in many OECD countries…. A better matching of skills to jobs makes workers more productive, implying scope for higher wages, and reduces the risk that under-utilised skills will quickly depreciate.’[34]

Bite the bullet: four components of firm but fruitful industrial strategy

1. Review existing economic policies

Existing economic policies need a searching review. They should be modified or rescinded if they interrupt the process of creative destruction. This includes taxation policies, state spending and procurement policies, monetary policies, competition policies, and insolvency legislation.

For example, monetary policies need to be moved quickly out of ‘emergency’ mode. Official interest rates should be raised speedily, if gently, from the current ultra-low levels to about two per cent in the first instance. These steps will require an end to the formal independence provisions of the Bank of England.

2. Review EU and EU-related business regulations

Britain needs a review of all existing economic regulations, again from the perspective of modifying or rescinding them if they interrupt the process of creative destruction, or otherwise inhibit innovation. This requirement could be included as part of the Great Repeal Bill and start with a review of all EU regulations and of British laws and regulations created to implement Britain’s obligations under EU Directives. A review of other national regulations could follow, using the lessons learnt during this exercise.  

3. Recast the proposals in the Green Paper

The existing proposals for industrial policy contained within the Green Paper need to be recast from the framework of encouraging a dynamic of continuous change to replace the zombification of recent decades. Whatever their original goals, all Green Paper policy measures need to be assessed for their possibly unintended effects – sustaining existing low-productivity businesses at the cost of hindering the entry or expansion of more productive ones.

For example, the Green Paper includes the commitment to ensure that all major government procurement projects are structured in a way that supports productivity improvements (p 73). This is a worthy objective. The Green Paper notes that at least some of public procurement procedures remain too complex. The current system continues to privilege larger incumbents at the expense of smaller companies and recent startups.

The current target is to ensure that a third of the UK’s total public procurement spend goes to small businesses by 2020 (p 73). This target should be revised to favour innovating companies, young and old, small and large. The definition of such companies can be based on a combination of objective and subjective factors – age of business; level of R&D spending; net business investment; approaches to transforming production processes or the delivery of services.

4. Transitional measures: help for workers during economic upheaval

Britain needs coherent policies to cover the costs of workers’ displacement and provide wider support to them and their families during the transition to new employment.

These workers will likely require specific training sponsorship for their future jobs. Training unemployed people is, however, no panacea. What matters most is encouraging the investment needed to create new industries and jobs. This should be complemented by assistance with job searching, possible help with relocation, and re-skilling for these new jobs.

It is pointless and counter-productive to train people in skills for roles that might no longer exist. For example, training people today in how to code particular software might sound future-proof. However, current coding methods might be passé in five or ten years. It is important that today’s training emphasises foundation skills and capabilities to facilitate future flexibility and adaptability for the work tasks and activities to come.

Employers are best placed to provide this training in the skills required for the new jobs. Whether for apprenticeships or other work-based qualifications, only employers have the knowledge, technical means and incentives to provide the job specific knowledge-based training the economy will need.[35] The costs can be shared between the company and public spending.

The extra cost to the government for these transitional human arrangements will in time be financed out of the tax revenues arising from the extra productivity, employment and economic growth that the new policies will generate.

Conclusion

In the foreword to the Green Paper, Greg Clark notes that, too often, industrial strategies have become ‘strategies of incumbency’. Existing firms and industries were propped up at the expense of new and growing ones. Later the Green Paper presciently warned against the government unwittingly creating such a strategy of incumbency (p 98).

The test for this government’s industrial strategy is not just to avoid this fate but also to be pro-active to reverse the unwitting effects of years of pro-stability public policies. This is how Britain’s economic renaissance can begin.

Endnotes

[1] Organisation for Economic Co-operation and Development (2014), Business enterprise expenditure on R&D (BERD) as a percentage of GDP. www.keepeek.com/Digital-Asset-Management/oecd/science-and-technology/main-science-and-technology-indicators-volume-2016-issue-1/business-enterprise-expenditure-on-r-amp-d-berd-as-a-percentage-of-gdp_msti-v2016-1-table24-en#.WMFzKxicbOY and OECD (2014), Government-financed GERD (Gross domestic expenditure on R&D) as a percentage of GDP. www.keepeek.com/Digital-Asset-Management/oecd/science-and-technology/main-science-and-technology-indicators-volume-2016-issue-1/government-financed-gerd-gross-domestic-expenditure-on-r-amp-d-as-a-percentage-of-gdp_msti-v2016-1-table12-en#.WMFvGBicbOY

[2] OECD (2015), Gross domestic spending on R&D. https://data.oecd.org/rd/gross-domestic-spending-on-r-d.htm

[3] Adalet McGowan, M., Andrews, D., Criscuolo, C. and Nicoletti, G. (2015) The Future of Productivity, OECD, p 12.

[4] Andrews, D., Criscuolo, C. and Gal, P.N. (2016) ‘The Global Productivity Slowdown, Technology Divergence And Public Policy: A Firm Level Perspective’, Hutchins Center Working Paper 24, September.

[5] Andrews, Criscuolo and Gal, 2016, p 8.

[6] Organisation for Economic Co-operation and Development (2014), Factsheet on how competition policy affects macro-economic outcomes, OECD, October, p 11. https://www.oecd.org/daf/competition/2014-competition-factsheet-iv-en.pdf

[7] Harris, R. and Li, Q. C. (2008), ‘Evaluating the contribution of exporting to UK productivity growth: some microeconomic evidence’, The World Economy, 31(2), February, pp 212-235. http://onlinelibrary.wiley.com/doi/10.1111/j.1467-9701.2007.01087.x/full

[8] Criscuolo, C., Gal, P.N. and Menon, C. (2014) ‘The dynamics of employment growth: new evidence from 18 countries’, OECD Science, Technology and Industry Policy Paper 14, p 30.

[9] Caballero, R., Hoshi, T. and Kashyap A. (2008) ‘Zombie lending and depressed restructuring in Japan’, American Economic Review, 98(5), pp 1946, 1965.

[10] Ibid, pp 1944‒5.

[11] Adalet McGowan, M., Andrews, D. and Millot, V. (2017) ‘The Walking Dead? Zombie Firms and Productivity Performance in OECD Countries’, OECD Economics Department Working Papers, 1372, January.

[12] Adalet McGowan, Andrews and Millot, 2017, p 11.

[13] Ibid, p 30.

[14] Caballero, R. and Hammour, M. (1994) ‘The cleansing effect of recessions’, American Economic Review, 84(5).

[15] Barnett, A., Chiu, A., Franklin, J. and Sebastiá-Barriel, M. (2014) ‘The productivity puzzle: a firm-level investigation into employment behaviour and resource allocation over the crisis’, Bank of England Working Paper 495, April, pp 19‒20, based on Office for National Statistics Business Demography data.

[16] Broadbent, B. (2012) ‘Productivity and the allocation of resources’, speech given at Durham Business School, Bank of England, September, pp 11‒13.

[17] The Insolvency Service, Insolvency statistics. https://www.gov.uk/government/collections/insolvency-service-official-statistics

[18] Barnett, A., Batten, S., Chiu, A., Franklin, J. and Sebastiá-Barriel, M. (2014) ‘The UK productivity puzzle’, Bank of England Quarterly Bulletin, Q2, pp 124‒5.

[19] Mayfield, C. (2016), ‘How good is your business really? Raising our ambitions for business performance’. https://howgoodisyourbusinessreally.co.uk/

[20] Haldane, A. (2016) ‘One Car, Two Car, Red Car, Blue Car’, speech in Redcar, Bank of England, December, pp 14-15.

[21] Ibid, p 15.

[22] Barnett, A., Broadbent, B., Chiu, A., Franklin, J. and Miller. H. (2014), Impaired Capital Reallocation and Productivity, National Institute Economic Review, 228, May.

[23] Acemoglu, D., Akcigit, U., Bloom N. and Kerr W. (2013), ‘Innovation, Reallocation and Growth’, NBER Working Papers, 18993.

[24] Andrews, Criscuolo and Gal, 2016, p 8.

[25] Adalet McGowan, M. and Andrews, D. (2016) ‘Insolvency Regimes and Productivity Growth: A Framework for Analysis’, OECD Economics Department Working Papers, 1309, July.

[26] Helen Dickinson, chief executive of the British Retail Consortium, ‘Tinkering with business rates won’t fix a fundamentally broken tax on investment’, City A.M., 2 March 2017.

[27] Adalet McGowan, Andrews and Millot, 2017, p 6.

[28] Hills, S., Thomas, R. and Dimsdale, N. (2016) ‘Three Centuries of Data – Version 2.3’, Bank of England, June. http://wwwbankofenglandcouk/research/Pages/onebank/threecenturiesaspx

[29] Fathom Consulting (2017) ‘What a year. How did we do?’. http://www.fathom-consulting.com/blog/what-a-year-how-did-we-do-3/

[30] Adalet McGowan, Andrews and Millot, 2017, p 12. See also Acharya, V., Eisert, T., Eufinger C. and Hirsch C. (2016) ‘Whatever It Takes: The Real Effects of Unconventional Monetary Policy’, mimeo. http://pages.stern.nyu.edu/~sternfin/vacharya/public_html/pdfs/Acharya%20et%20al%20Whatever%20it%20takes.pdf

[31] Adalet McGowan, Andrews and Millot, 2017, p 31.

[32] James Ferguson, ‘Tax credits: unaffordable and unfair’, MoneyWeek, 23 October 2015.

[33] Andrews, Criscuolo and Gal, 2016, p 8.

[34] Adalet McGowan, Andrews and Millot, 2017, pp 31–2.

[35] Mieschbuehler, R. and Hooley, T. (2016) ‘World-Class Apprenticeship Standards: Report and Recommendations’, Derby and London: International Centre for Guidance Studies (iCeGS), University of Derby and Pearson Education UK. http://derby.openrepository.com/derby/handle/10545/610516