The Howard Davies prescription for UK economic growth

It's a bitter pill to swallow but manufacturing on its own isn't going to turn the economy around. Instead, we need to focus on our strengths in pharma, engineering, education and tourism - and rehabilitate the unloved financial sector.

by Howard Davies
Last Updated: 09 Oct 2013

As the economy has slipped back into double-dip territory, the debate among the chattering classes has centred on whether the chancellor needs a plan B and if his deficit reduction strategy risks pushing us further downhill. Wise voices have called for a 'growth strategy', usually without being terribly precise about what it might contain.

In fact, George Osborne will find himself changing strategy willy-nilly, as the recession reduces tax revenue and increases welfare expenditure. So the question is whether he should try to offset that effect with even sharper cuts. My answer would be no, and, indeed, if he can find ways of accelerating housebuilding, and useful infrastructure investment, he should go for them. But I suspect his room for manoeuvre is in practice quite modest, and that in their present skittish mood investors could extract a high price for any dramatic change of policy.

The bigger question we face is what are the long-term strengths of the British economy, and how the Government should attempt to sustain them. I am not a strong believer in industrial strategies conceived in the BIS offices on Victoria Street, but many government policies, and not just the overall fiscal balance, do affect the real economy. Education priorities, regulation, immigration policies, government purchasing, and the rest, all have the power to make or break industries and companies.

 

When the Coalition took office, the broad lines of its strategy were clearly set out. Rebalancing was the buzzword. We needed to shift the economy away from its excessive reliance on finance, a love affair that had ended in tears in 2007, when the girl was found to have maxed out on the nation's credit card.

To replace her, the government proposed to rekindle an old flame, unloved for the past four decades. Manufacturing was back in fashion. George Osborne promised a 'march of the makers' to replace the bankers' ball. Many were sceptical. It is hard to think of an example of an industrialised country that has turned round a declining share of manufacturing in GDP. But there were some grounds for hope of a revival of exports. Sterling devalued sharply in 2008, by 20% or so against the euro, giving British firms a competitive edge.

Sadly, while export performance has improved a little, there are few signs of a sustainable increase in market share. Exporters seem to have taken the benefit of devaluation mainly in the form of wider margins, rather than increasing volume. UK exports have risen by 29% by value since 2007, while US exports have risen by 44% and Chinese by 87%.

It is widely accepted that confidence is the key to recovery, and confidence is severely lacking today. The Economic Optimism Index (the balance of people who are optimistic or pessimistic about the economy) is now at -32. That is not as bad as the -64 we reached in 2008, but it has been slipping recently, and the UK's score is lower than the comparable figure for Spain, Italy or Ireland.

Most people think their children will have a lower standard of living than they did and the population has a very low opinion of British business. Only 4% of those polled by Mori think that British business is a valuable asset for the country, lower than for any other of the 10 options cited. And only 13% of the population think the UK has a strong economy.

What is particularly surprising is that we are far more pessimistic about ourselves than foreigners are. In a global poll about the respective positions of different countries, fully 48% of respondents considered that the UK economy was fundamentally strong. The French were an exception, bless them. They think our economy is rubbish, and that we make nothing any more. The share of manufacturing in GDP is almost exactly the same in the two countries, but let that pass. We are not top of any league tables, it is fair to say, but on the World Economic Forum's competitiveness index we are in 12th position, and many of the countries above us are small Scandinavian countries, or city states like Hong Kong or Singapore.

The Olympics may well boost our international standing further. But of course it isn't enough to win golden opinions. We must find a way of converting these positive views into hard cash, in the form of exports of goods and services. That would be helped by a more positive national mood, but we also need to be clearsighted about the sectors in which we have, or can reasonably hope to attain, a competitive advantage.

Some of them may indeed be in manufacturing, and while it may be a romantic delusion to think we can increase our market share of traded goods faced with highly competitive new entrants from the far east, we should certainly try to maintain the strengths we have, in pharmaceuticals and aeronautical engineering, for example. There is also a case for educating more engineers, as companies in those sectors regularly talk of their difficulty in recruiting suitably trained people.

But it will be a heroic achievement if we cling on to most of what we have. A recent McKinsey study categorises British manufacturers into those that have a genuine technological advantage, or a strong brand image associated with the location of the factory (think Jaguar). Only 14% of our manufacturing employment is in those two categories combined. A further 22% is in goods where it is costly to move the product (think manhole covers), and therefore reasonably secure. But McKinsey believes that over 60% of jobs are vulnerable to cost-based competition from overseas.

There are some recent success stories that show how it is possible to shift into a more defensible niche. I was once a consultant to Austin Rover, as it then was. It became obvious to me then that we had few advantages in the manufacture of large-volume, middle-market cars, while the brand value in names like Land Rover, Jaguar and MG was high. Yet we were starving the value-added brands to try to cling on to volume. That is no longer true, and is an important reason why our car industry is doing rather well just now.

There is little chance, though, that our manufacturing trade balance will improve decisively, unless sterling depreciates a lot more, and given the euro's recent weakness that seems unlikely. So we need to look beyond manufacturing, and explore the service sectors in which we have a strong position, which might be enhanced.

One of those that is more significant than many think is higher education. British universities are second only to American in their position in the global league tables. Overseas demand for places here is huge: almost 100,000 Chinese students come here already. If they spend an average of £20,000 a year on fees and living expenses, that is an invisible export to China of £2bn a year. That represents a lot of pots of Frank Cooper's Oxford marmalade, or Crabtree & Evelyn soap, the British goods one sees most on Chinese shelves.

Is Government policy supporting this activity? Cuts in funding certainly sharpen the incentives for British universities to recruit overseas students. But the way the Government has defined its immigration policy is a problem. The focus is on cutting net migration, and students are included in the figures. So even if all foreign students return home at the end of their studies (most do, in fact), if the total number is growing, that looks like an increase in net migration, as the numbers leaving each year are smaller than the numbers arriving. The new visa policy has been seen overseas as a sign that we do not want more students: US and Australian universities are delighted.

We give out mixed messages on tourism, too, another valuable source of foreign exchange and employment. The Olympics were a terrific showcase, and even the weather obliged for a time, but, as the leaders of our tourism industry have pointed out, the number of Chinese tourists visiting the UK is only about half the number who pass through France. Why? In part because the UK is not part of the Schengen visa regime. So the Chinese have to get a separate visa to come here, and many don't bother, sticking to France, Germany and Italy as stops on their version of the grand tour.

There are other areas where government policy is more supportive. The arts, and the creative sector more generally, are doing well. Spending cuts threaten the viability of some of our best companies, but at least the Treasury thought twice about its tax restrictions on private donations. The licence fee settlement has allowed the BBC to maintain its media leadership, with spin-off benefits in the private sector.

There is an obvious problem, though, when it comes to that part of the service sector that, up to the crisis, did the most to offset our appetite for imported goods: finance. We must acknowledge at once that our b***s (it is wise not to mention them too explicitly) and other financial firms have not helped themselves. Most of the reputational damage they have suffered has been self-inflicted. And they seem not yet to have decided to follow the first law of holes - when you are in one, stop digging. But there are also signs that other countries, whether in Europe or the US, are seeing an opportunity to take advantage. There are troublesome regulatory attacks from New York and Brussels, and some of the political rhetoric has poorly distinguished between genuine regulatory infractions and a vague sense that the banks are convenient scapegoats for the economy's unwillingness to behave as people would like.

Somehow, the Government needs to work towards a new understanding with the financial sector: even companies that managed themselves well through the crisis - insurers and fund managers, for example - feel unloved. They are too important to the economy to be put on the naughty step indefinitely.

Somewhere, there is a new, post-modern British economy struggling to emerge from the wreckage left by the crisis. It will be a differently shaped economy than the pre-crisis debt-fuelled model: indeed, it has to be. But it is not likely to be a 'back to the future' economy, with new metal-bashers sprouting up on brownfield sites in the Midlands. The new economy may take a while to take shape. Recovery from overleveraged booms and busts is always slow. But it is not too soon to sketch out the main lines, and ensure that government policies, across the board, are supportive.

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