It’s understandable that someone of a free-market persuasion is slightly depressed at the moment. On a weekly basis, the Liberal Democrats and the Labour party advocate new punitive wealth taxes. The Labour party is beginning to suggest policies for ‘predistribution’, which sounds suspiciously like a form of prices and incomes policy. And today we have the Business Secretary, having advocated the complete abolition of the Department of Trade and Industry back in 2002, completely about-turning and advocating a hands-on state ‘industrial strategy’ (in rhetoric at least).
The same old myths and the same old justifications for more government planning - requiring ‘a strategy’ to invest in the industries ‘of the future’ (as if government has any idea which these are) – still abound.
In fact, ahead of our Keynes-Hayek event this evening, I happened to be reading the abridged version of the Road to Serfdom yesterday. In there, it clearly sets out the key reason why industrial strategies, or ‘picking winners’ simply doesn’t work:
“as the factors which have to be taken into account become numerous and complex, no one centre can keep track of them. The constantly changing conditions of demand and supply of different commodities can never be fully known or quickly enough disseminated by any one centre.”
There are two further obvious consequences of wider government intervention. For both political reasons and because of coordination, favouring certain sectors mean governments are only ever likely to deal with large companies in industries, giving them an inherent advantage over new competitors and inadvertently creating barriers to entry. What’s more, because government doesn’t have its own money, any money spent on industrial policy naturally has to be taken from other areas of the economy, thereby displacing jobs whilst diminishing the efficiency of the whole economy.
In making the case against an industrial strategy, however, it appears not enough to just use this basic economic logic. So, it’s therefore necessary to examine exactly what effect different industrial policies or industrial strategies have had in the past, and to judge whether Vince Cable’s proposals have actually learnt the lessons, particularly for the manufacturing industries.
Myths surrounding manufacturing
The so-called ‘decline of manufacturing’ is mostly a myth.
Consider the chart below. It shows manufacturing output from the Index of Production since 1948. Manufacturing output has consistently risen since the late 40s, by 148% to 2011. Far from a manufacturing decline, the value that we get from manufacturing has continued to increase.
Why, then, is there a perception that UK manufacturing needs revival more than any other sector of the economy?
As Tim Worstall has previously indicated, the decline in employment in manufacturing is the most likely explanation. Manufacturing employment has fallen sharply over the past 30 years, from 5.7 million in September 1981 to 2.5 million in September 2011. This occurred, however, whilst manufacturing output has been continually rising. This shows that productivity has improved immensely – we are now producing more with far lower labour inputs, which can only be regarded as economic progress, freeing up resources for other sectors.
The process of developed economies shifting away from manufacturing in terms of employment is as natural as the prior shift away from agriculture. Outsourcing employment in lower value-added manufacturing industries to parts of the globe with cheaper labour costs makes sense – it means we can buy cheap goods and put our own resources to other productive uses. What’s more, the idea that we should rebalance to insulate ourselves from financial crises is slightly undermined by the fact that manufacturing output fell more sharply than services after the previous downturn.
Manufacturing has also fallen as a proportion of GDP – from roughly 32% in 1973 to 10% by the end of 2010. This is a worldwide trend. Consumption of manufactured goods as a proportion of total goods is falling because their income elasticity of supply is lower than for that of services. The UK’s relative decline in manufacturing therefore mirrors the experience of other countries (we have a similar manufacturing to GDP ratio as France, for example).
These trends and productivity improvements have meant the UK’s manufacturing sector has changed beyond all recognition. It now focuses on high-tech high value added products, is very low in terms of labour intensity, and is a concoction of extremely niche products alongside very large international companies producing large products with extensive supply-chains.
The evidence on previous industrial strategies
A recent paper by Tim Leunig and Stephen Broadberry of the LSE, prepared for the Cabinet Office, reviewed the impact of all UK government policies on manufacturing since 1945. In terms of overt industrial strategies, the evidence was pretty damning.
Leunig and Broadberry conclude that only in public sector purchasing and the encouragement of foreign direct investment could a credible case be made for significant lasting beneficial effects of government intervention in terms of an industrial policy.
In fact, the most successful policies have been willingness to engage in international trade and the greater use of competition policy, which both combine to improve the efficiency and productivity of the sectors. Tax incentivised R&D can also be significant, whilst of course a highly skilled workforce with good vocational training is pretty useful. These are classic supply-side measures.
Vince Cable’s proposals
The proposals laid out by Vince Cable in the House of Commons, despite this evidence, suggests government should ‘back’ successful sectors, particularly in advanced manufacturing, and support the development of new technologies. This despite the fact that governments fail to pick the right sectors more times than not, fail to know what new technology will be available in future, and ignore unforeseen consequences of their actions.
For example, some types of manufacturing and house-building are known to affect the price of milk. High growth of house-building and manufacturing can lead to a large supply of sawdust, which lowers its price and reduces costs for those using sawdust, such as dairy farmers. This is turn, will affect the relative price for other drinks, and has adverse effects on those supplying alternative substitute drinks.
Would any planner in Whitehall consider these types of effects on relative prices when drawing up industrial policy? I think we know the answer.
What an industrial policy could entail
There is no doubt, however, that manufacturing will have a crucial role to play if the UK is to tap into the growing export markets of the BRIC countries. It would be wrong of politicians, however, to expect a wide-scale manufacturing renaissance with employment increasing hugely in these industries and even through the supply chains – for the reasons outlined above. In addition, it would be mad for the UK to actively seek to move away from services when all economic evidence suggests demand for them is far more responsive to growing incomes than demand for goods. As the Chinese middle-class expands, this will be increasingly observable.
Calls for an overt industrial strategy are therefore misguided. Of course, there are some industries for which the UK government is a direct customer, notably aerospace and pharmaceuticals, where public funds will flow.
But a broader industrial policy has been tried and failed many times. The Government simply does not know what the niche manufacturing industries of the future will be. What the Government instead should be doing is creating a climate which encourages innovative industry to set up and expand here, providing a certain environment to manufacturers who seek to undertake long-term investment decisions, and ensuring a flow of well-skilled and enterprising people emerge from its public education system.
This type of industrial strategy – tackling the barriers to trade and investment on an aggregate level, whilst creating a level playing field – should be what the Government seeks to achieve. Making our tax system competitive for investment and R&D, deregulating, encouraging a cheap energy policy, enhancing and lobbying at an EU level for freer global trade, and increasing competition in the commercial banking sector are the types of policies needed.