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 previ-
ously a special adviser to Hilary Armstrong MP in the Cabinet
Office and to David Blunkett MP in the Department for Work

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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 confed-

eration. 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 environ-
mental 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 coun-
tries 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 ques-
tions 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 inno-
vation 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 responsi-
bility, 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 regu-
latory 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, immi-
gration 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 compe-
tition 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 admin-
istrative boundaries allied effectively with the relevant
economic geography. Turley praises the coalition’s Local
Enterprise Partnerships (LEPs) for allowing local author-
ities 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 macroeco-
nomic 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 trans-
parency 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 develop-
ments 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 econ-
omies, 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 as a
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 econ-
omies 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 immi-
gration 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 interna-

tional 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 entre-
preneurial 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 encour-
aging 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 devel-
oping 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 manufac-
turing) 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 house-
holds. 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 rela-
tionship 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.

17
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 devel-
opment 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 wide-
spread 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 increas-
ingly 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 part-
nership. 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 organi-
sation 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 ques-
tions 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 institu-
tions, 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 opportu-
nities, and training programmes must give young people the
necessary tools to rebuild the economy – including an expe-
rience 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 nanote-
chnology 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 inno-
vation will really flourish.

29
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 conven-
tional 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 share-
holders. 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 instru-
mental 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 plat-
forms 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 plat-
forms (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, espe-
cially 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 busi-
nesses 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 busi-
nesses 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 asso-
ciation 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 compe-
tition 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.

39
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-regu-
lated 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 mort-
gages 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 envi-
ronment, 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 exclu-
sively an American preserve. In the UK, the growth of the
buy-to-let market in 2000-07 and the easy availability of mort-
gages 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 orig-
inated assets, compared to $900 billion in assets originating
from Europe and Asia combined.7
It follows that had there been greater control over the avail-
ability 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 expe-
rience, 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 candi-
dates 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 macr-
oeconomic 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 bene-
ficial 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 manu-
facturing. 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 activ-
ities. 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.

51
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 chal-
lenges 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 revo-
lution. 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 econ-
omies 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 commit-

ments 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 inno-
vative 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 politi-
cians 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 implica-
tions 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 tech-
niques 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 rela-
tions, 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 signif-
icant 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 univer-
sally 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, tele-
communications, 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 chal-
lenging 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 devel-
opment 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 innova-
tions 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 commit-
ments 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-

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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 infra-
structure 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 improve-
ments 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 suffi-
cient. 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 espe-
cially 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 situ-
ation 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 infra-
structure 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 expec-
tation 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 coun-
tries 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 coun-
tries 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 guar-
antee 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 suffi-
ciently 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 quali-
fication 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 inter-
national 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 expe-
rience 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.

77
Going for Growth

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 deci-
sions 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, pharmaceu-
ticals, 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, tech-
nology, 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.

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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 expend-
iture, 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, indus-
trial policy – as developed in Labour’s later years – will
growth be consolidated into a higher skilled, higher produc-
tivity 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.

81
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.

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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 busi-
nesses, 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.

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 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 conse-
quences 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 wide-
spread, 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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 Encouraging growth through innovation

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 tech-
nical 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

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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 devel-
opment. 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 busi-
nesses 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.

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

PIcredit.aspx.

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 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 busi-

nesses 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 organi-
sations, 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 inno-
vation in the UK. The importance of product creation by users, NESTA, 2010.

90
 Encouraging growth through innovation

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

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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 inno-

vative, 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.

92
 Encouraging growth through innovation

Innovation Centres (TICs), based on the translational institu-

tions 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 institu-
tions, 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”.

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

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Going for Growth

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.

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 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 allow-
ances (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 plat-
forms 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-

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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 inno-
vation 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 govern-
ment’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 inno-
vative 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 inno-
vations. 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.

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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.

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 Encouraging growth through innovation

It is right to be somewhat sceptical of how much these

strategies can achieve. Clusters are vitally important to inno-
vation, 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 inno-
vation 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.

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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 over-
looked in relation to economic development in this country.
While there will always be national strategic impera-
tives 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.

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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 stimu-
lating 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 devel-
opment 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 evalu-
ation 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.

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Going for Growth

Yet the success of the relationship between RDAs and local

authorities was always unclear.44 Some local authorities criti-
cised 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 func-
tional 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.

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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 devel-
oping 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.

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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 organisa-
tions. 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 indi-
viduals 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.

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Going for Growth

localities, holds some potential problems to integrated, stra-

tegic 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 encour-
aging 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 partic-
ularly 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 bene-
fited most from the expansion of the public sector, such as

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 economi-
cally 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 partner-

ships 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.

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GoingforGrowth

Rethinking monetary policy

Low and stable consumer price inflation should remain

an aim of macroeconomic policy. Although the Monetary
Policy Committee (MPC) has found it more difficult to keep
inflation close to its target level over the last three years, it
retains a high degree of credibility among wage and price
setters and in financial markets. That is not something to
sacrifice 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 inflation 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.

70  See, for example, Paul Krugman’s argument: 

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

inflation 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 first 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 inflation as measured by the
GDP deflator).

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 first in the UK

to be preceded by excessive house price inflation. 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 tech-
nology stocks in the late 1990s showed, rapid increases
in other asset prices can be a warning sign of economic

75 DepartmentforCommunitiesandLocalGovernment,English Housing Survey

2008-09 Household Report,2010,http://www.communities.gov.uk/publications/
corporate/statistics/ehs200809householdreport.
76 OfficeforNationalStatistics,Household wealth in GB in 2006/08,2009,
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 govern-
ment’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 respon-
sible 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 devel-
opments 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

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 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 effec-
tiveness 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.

127