Labour Market

A different kind of industrial policy

There seems to be widespread agreement within the political class that the British economy is in need of ‘rebalancing’ following the financial crash of 2008. It is argued that too big a fraction of UK output is generated by the services sector – particularly financial services – and too little by manufacturing industry. Indeed, changing the sectoral and geographical composition of British GDP is one of the explicit objectives of Theresa May’s industrial strategy. The opposition has taken a similar line, with Shadow Chancellor John McDonnell recently promising a ‘manufacturing renaissance’ if and when Labour get elected.

One ought to be wary whenever government and opposition find themselves in agreement on policy, and industrial strategy is no exception. Firstly, accounts of an urgent need for a change of economic model do not do justice to Britain’s actual economic position. Real incomes per head have doubled in the UK since the heyday of industrial activism in the mid-1970s, when manufacturing was a greater share of both output and employment. Recent labour market outcomes have been unambiguously positive, with unemployment back to pre-crisis levels below 5 per cent, labour force participation at an all-time high, and wages growing faster than consumer prices.

Furthermore, the story of industrial decline since the 1980s is only partially true. Whilst manufacturing has indeed fallen as a share of both GDP – from 32 per cent in 1973 to around 10 per cent today – and employment – from 30 per cent to 8 per cent – manufacturing output in absolute terms is at its highest ever – about 20 per cent higher than in the supposed ‘golden age’ of UK manufacturing in the 1960s and 1970s. The reason why manufacturing has become less weighty in national income is not that we are making less. It is that other sectors have grown even faster than manufacturing over the last 40 years.

There are a range of factors driving this trend. Elementary trade theory teaches that economies will tend to – and should – specialise in the things they are relatively good at. Britain is decidedly better than most at drawing up business contracts – English law being vastly preferred by international firms – selling education and consulting services, and intermediating financial transactions. It makes sense to focus on those things – and the bits of manufacturing where British firms excel – and buy other manufactured products from the Germans, Israelis, Chinese, and others.

More generally, economic progress tends to lead to a declining share of manufacturing in countries’ GDP, for two reasons. Firstly, there has, at least until recently, been greater scope for productivity increases – through, for instance, automation – in manufacturing than in services, many of which are labour-intensive and with less substitutability between labour and capital. As a result, prices for manufactured goods have dropped in relative terms, meaning that they count for less in national accounts. Secondly, the income-elasticity of demand for manufactures is low. This simply means that, as our income doubles, we do not necessarily buy double the number of cars, washing machines and televisions. We spend the excess on other things instead, and these are often services such as restaurant meals and foreign holidays.

So, the experience of manufacturing decline in Britain is perhaps more nuanced than commonly assumed. But can government intervention improve matters? The state, for better or worse, currently accounts for about half of national income, and through its profuse legislative activity regulates most of the other half. There is thus a role for the state in helping to improve the UK’s economic performance.

But that role should not, as proposed by some, involve the state in choosing the industries ‘of the future’ that British capital and labour should focus on. The experience of such industrial activism in the post-war period was dismal, with money-guzzling basket cases such as British Leyland and Concorde, topped by labour unrest and macroeconomic instability. Even those countries, such as Japan and Korea, whose industrial policies were once internationally praised later found themselves mired in crises which were either caused or prolonged by government involvement in the allocation of resources. Nor is the state a good entrepreneur: for each successful venture backed by government, there are many more examples of failed projects which the state – under the influence of interest groups – then struggled to get out of.

There is an alternative, as J. R. Shackleton and I propose in a new paper for the Institute of Economic Affairs. The government has a chance to liberate the economy in order to boost its productive potential – a task to which Brexit has only added momentum. Such a ‘horizontal’ industrial strategy would involve the liberalisation of planning rules, which will not only lower housing costs but also the cost of running a business, freeing up funds for productivity-enhancing investment and lowering costs for consumers.

Another area that is ripe for change is energy policy: Britain currently has the third-highest industrial electricity prices in the EU, and the highest for large firms. Prices are made higher by a raft of measures nominally aimed at tackling climate change, but which come at a very high cost. Crude interventions such as the Climate Change Levy, which adds 4 to 6 per cent to industrial electricity bills, should be phased out and replaced by a single, market-driven mechanism to reduce emissions such as a cap-and-trade scheme.

The list goes on: financial services, employment regulation, the tax code can all benefit from deregulation and a removal of barriers to productive activity. A liberalising agenda was at the heart of the UK’s economic renaissance in the 1980s, and it will deliver for post-Brexit Britain, too.

Policy Analyst at the Cato Institute's Center for Monetary and Financial Alternatives

Diego was educated at McGill University and Keble College, Oxford, from which he holds degrees in economics and finance. His policy interests are mainly in consumer finance and banking, capital markets regulation, and multi-sided markets. However, he has written on a range of economic issues including the taxation of capital income, the regulation of online platforms and the reform of electricity markets after Brexit. Diego’s articles have featured in UK and foreign outlets such as Newsweek, City AM, CapX and L’Opinion. He is also a frequent speaker on broadcast media and at public events, as well as a lecturer at the University of Buckingham.

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