May’s industrial strategy will fail unless it clears out zombie firms

Published by City A.M. – 4 May 2017

In order to make progress, we need to stop doing some things.

In her foreword to the government’s Green Paper “Building our Industrial Strategy”, Prime Minister Theresa May correctly explained that last year’s referendum was not simply a vote to leave the European Union. It was an instruction to the government to change the way the country works. Her resurrection of industrial policy was one response. However, it will be a phoney one unless a different approach emerges following the end of the consultation process.

Too often in the past, in Britain and in other advanced economies, “modern” industrial strategies have been launched to little positive subsequent effect. The familiar wish list of more research and development, easier funding for startups, modernised infrastructure, and more relevant skills training fails to gain traction. The lesson drawn is that there wasn’t enough of it. So repeat, with a bit more oomph.

But what if the problem lies elsewhere? What if instead of not doing enough of the right thing, governments have been doing too much of the wrong thing? And maybe these wrong things are dooming the right things to impotence.

The test for an industrial policy is whether it drives up productivity, a particularly urgent matter for Britain given that it has experienced no durable increase since before the financial crash. Success therefore turns on generating higher rates of capital investment embodying innovation and technological advances. The challenge is getting to grips with why capital investment has been lacking. The priority is identifying and removing the barriers to the transformation of existing businesses and to the formation of new sectors and high-value jobs.

A big part of today’s productivity problem is the failure of innovation and technological development to spread across the whole economy. Researchers at the Organisation for Economic Co-operation and Development have already concluded that the main source of the 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, they discovered that the gap between high productivity firms and the rest had risen. Why?

The cause, and therefore the focus for industrial policy action, lies in the decay in business dynamism – the process of business birth, growth, decline and exit. Too many zombie businesses are surviving that are too weak to invest in transforming their basic operations, but that have enough income, or ability to borrow, to survive. This holds back the process of creative destruction by which older, less productive firms close down and are replaced by newer, more productive ones.

Zombie firms spread congestion across the economy. In turn, that has a dampening effect on the investment plans of startups and existing viable businesses. Overall, innovation is suppressed and productivity growth suffers.

The key point is that this zombie economy has not emerged spontaneously. Public policies have played a significant role in keeping low productivity businesses going. The application of many regulations, of government spending and procurement policies, changes to insolvency rules, easier monetary policies – all these and more since the 1980s have acted to support incumbent businesses and conserve the economy as it is. By doing so, governments have unintentionally brought about this sclerotic economy.

This policy-induced aspect of productivity weakness needs to be openly recognised, not least because it is something an active industrial policy can change through governments stopping many things. Policies with these counterproductive, if unintended, consequences can be amended or revoked to reverse their productivity-impairing effects.

A successful industrial strategy is one that shakes the economy up, not preserves it. Economic renewal necessitates closing down low productivity, low profit or loss-making businesses to make way for new sectors and new businesses. Avoiding this has been the flaw in those well-meaning but failing industrial policies.

Recasting industrial strategy to enable creative destruction to operate again will not be a painless affair. 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 the new, better jobs.

A national public conversation has to explore why stopping stabilising policies is the counter-intuitive precondition for an economic rebirth. Because without wide popular understanding and backing for this change, today’s governments are unlikely to resist the technocratic impulse to sustain the status quo. Turning off the life support is how Britain’s economic renaissance can begin.