The failures of supply-side innovation policy

Longstanding deficiencies in Britain’s innovation policy are hampering our efforts to return to growth

Richard Jones

Technological innovation is the major source of long-term growth in developed economies.  In the UK we’re now in the most persistent period of slow or no growth this century.  So what is the role of technological innovation – or the lack of it – in the UK’s growth crisis?There has been a dramatic relative decline in the research and development (R&D) intensity of the UK over the last thirty years, compared both to established competitor nations, such as Germany and the USA, and rapidly developing countries, such as South Korea and China.  In 1980, the 2.35% of GDP that the UK spent on R&D made it one of the world’s most research-intensive economies.  By 2010, this share had dropped to 1.77%, and the UK is now one of the least research-intensive of the developed economies.

Technological innovation isn’t the same as research and development, and there’s no reason to expect a direct relationship between the R&D intensity of an economy and growth.  But the story underlying this headline reflects wider changes in the structure of the UK’s economy.  These changes have made the UK economy less able to benefit from technological innovation. They’re connected also with a more general failing to invest for the long term.  Rectifying them will surely require much larger-scale interventions than currently envisaged.

Most R&D is applied research, carried out in businesses and government laboratories.  It is in the area of applied research, rather than academic science, that the UK has atrophied; expenditure on R&D carried out in business as a proportion of GDP has fallen from 1.48% in 1980 to 1.11% in 2008.  To put this into context, the corresponding 2008 figures for Germany, the USA, Japan and Korea are 1.86%, 2.02%, 2.7% and 2.53% respectively!

This decline in applied research – the sort that directly translates into new processes and products – has been driven by two features of the recent UK political economy.  The first arises from the structure of financial markets, which has put a premium on achieving shareholder returns in the short term and thus rewarded finance-driven deal-making, rather than patient business-building.  The neglect of long-term R&D should be seen as part of a general problem of misallocation of resources arising from the excessively ‘financialised’ variety of capitalism recently pursued in the UK.

The result can be seen in the fates of two companies that once supported a substantial proportion of the UK’s corporate R&D – the chemicals giant ICI and the electrical and electronics combine GEC.  They have now disappeared after a series of misadventures in corporate restructuring.

Neither ICI nor GEC, even in their heyday, were without their faults, but it’s difficult to argue that the German economy is weaker today because their analogous companies – BASF and Siemens – still flourish.  Conversely, few doubt that, in sectors where a large, R&D-intensive company still remains, the benefits to the wider economy are substantial.  Think of aerospace and Rolls-Royce, and recall the latter’s rescue from bankruptcy by nationalisation in the 1970s.

The second ingredient has been privatisation, particularly in the utilities sector. Arguably, before privatisation, the UK energy industry was characterised by a degree of over-investment, with extensive R&D part of that.  But the reaction by the new owners of this national infrastructure was extreme.  Between 1994 and 2005 the R&D spend of the entire privatised utility sector – comprising the electricity, gas and water supply – fell from £170 million to the astonishingly low figure of £15 million.  The new owners found it more immediately profitable to use financial engineering to extract cash from these assets than to make long-term investments in R&D.

Successive governments have responded to this situation through a supply-side innovation policy. This has evolved with a considerable degree of bipartisan continuity, from the Major government’s ‘Realising Our Potential’ White Paper in 1993, through the Blair government’s 2004 ‘Science and Innovation Investment Framework’, to the current position of the Coalition. The focus has been on developing a strong higher education research base, encouraging connections between research and industry, accelerating the commercial exploitation of intellectual property arising from research through spin-out companies, and taking measures to ensure a supply of trained people.

Nor has this policy framework been without positive results.  Its successes include some substantial inward investment into the UK, which has led to a relatively high proportion of UK R&D being foreign-funded.  The university science base is strong, well connected with industry, and there has been growing spin-out activity.  But this has not been enough.  Business-sponsored R&D continues its relative decline and university spin-outs seem unable to reach the scale required to make an impact on the wider economy.

It is time to admit that supply-side innovation policy is not enough, and that we need somehow to generate the demand for technological innovation that our current political economy doesn’t provide.

In the 1950s and 60s, the UK saw sustained growth driven by technological innovation; it was the demands of defence that drove this wave of innovation.  The effects were long-lasting; in the USA an electronics industry created by defence spending in Silicon Valley led to new opportunities in information technology whose consequences are ongoing.  However, the drivers for digital innovation are now to be found largely in entertainment and advertising.  The characteristics of this current wave of digital innovation – relatively low barriers to entry and a background of rapid but incremental improvement of the capabilities of the underlying hardware – means that rapid progress can be delivered through the market.

It’s important to recognise, though, that not all forms of technological innovation are the same.  It requires much greater investment of time and money in, say, the material and biological domains than in digital innovation.  In other words, building a new nuclear reactor with a novel design is an entirely different scale of endeavour to writing a new iPhone app.  The world-changing technological innovations of the 20th century required state interventions at a scale for which we have now lost our nerve and appetite.

The areas in which society needs innovation now are clear – for example, we need to make low-carbon energy scalable and cheap, whilst in the context of ageing populations healthcare needs to be made more effective and affordable.  It is in these areas that our current, market-focused, political economy is not delivering.  More dramatic interventions are required.

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