Ten principles for an effective business and innovation policy in the UK

Dimitri Zenghelis, Senior Economic Advisor, Cisco

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Innovation as a driver of growth

This paper set outs ten key principles for the design of an effective UK Business Policy which encourages innovation[1]. Such a policy must begin by recognising that innovation lies at the heart of corporate and economic success in rich countries; especially those such as the UK, which are not blessed with cheap mineral resources and unable or unwilling to provide cheap labour.  Thankfully, national output and growth are functions not just of the amount of people, capital and materials thrown into the production process, but the processes, techniques, and technologies with which these inputs are used. This element is termed total factor productivity (TFP). Growth accounting shows clearly that economic growth in most rich countries such as the UK stems almost entirely from growth in TFP[2].  

But knowledge and innovation are dynamic concepts. Of course, people can use a fixed stock of ideas, which can be found in books, journals, or online. Firms can use the same formula or designs at the same time, or duplicate them in the production process. Countries can, in principle, catch up with the technology leaders by free-riding on the available knowledge. Once a firm or an economy embarks on a high innovation, high productivity path, that path tends to reinforce its technological lead. New equipment enables new ideas and better technologies. For example, investing in computers induces bright ideas on how to use them. This fuels increasing returns to scale in production, where investment in knowledge begets increased output and resources for further investment; a virtuous-growth spiral known as endogenous growth.[3] Policymakers should therefore focus on the factors that generate knowledge and induce innovation if they are to drive economic growth. 

In fact, national policies and institutions have struggled to keep pace with the speed and ease with which information can now be accessed, especially the challenges associated with ‘globalisation’ in a more integrated world[4]. There is no previous example of a new technology whose price has fallen so fast, or which has diffused through the economy as rapidly, as innovations in computers and mobile communication.[5]

The effects of ICT are comparable and probably bigger than those of steam or electricity. Rapid technical change is always disruptive, but by boosting productivity and resource efficiency, new technologies afford a welcome opportunity to promote sustainable growth. It is also revolutionising social interactions, redesigning institutions and transforming the way politicians engage with voters[6]. Although harnessing this revolution will be beneficial to society, like most ‘change’, it is not all ‘win-win’ and there will be losers and dislocation, especially among low- and medium-skilled workers. This presents a clear role for government to re-skill and retool workers.

Enabling markets and correcting market failures

For all the problems in the financial sector in recent years, the market remains the most efficient way to distribute scarce resources in any economy and drive innovation in their use. It effectively coordinates the vast amount of information needed to match supplies and materials with the things consumers want to buy. This means recognising that the overarching role of business and innovation policy is to promote competition and enhance market efficiency.

Taking the lead in a competitive level playing field requires supportive and ‘enabling’ government intervention. This yields the first six priorities:

• First, it requires stable and credible economic institutions. Rules-based property rights, macroeconomic stability and policy certainty are preconditions for business investment and innovation.

• Second, it requires regulations to limit the power of natural monopolies and ensure an open level playing field for competition. Markets work best when power is diffused, barriers to entry are low, and firms are responsive to consumer choices. Competitive domestic markets unencumbered by protectionism create the disciplines that will drive success in global markets.

• Third, horizontal government support is required to promote innovation and competitiveness. Public investment in human capital is necessary to provide an appropriately educated and skilled workface capable of utilising the latest ideas and technologies.

• Fourth, enhancing competitiveness requires effectively planning and supporting the construction of essential infrastructure and networks, where the value of joining a network depends on how many others are on it (e.g. electricity grids, public transport, broadband, community-based combined heat, power and insulation schemes). These increasingly require government frameworks to drive incentives to kick-start the network and help foster successful innovation clusters.

• Fifth, the efficient provision of long-term finance and risk capital means overcoming agency problems so that investors and entrepreneurs have a common understanding of opportunities and risks in order to maximise the productivity of capital. This requires effective corporate governance that incentivises and rewards long term value creation over short term value extraction in speculative markets. There are unexplored ways of doing some of this better, for example through new risk sharing and securitisation instruments, and this discussion forms a key part of the design process for effective innovation policies[7].

• Sixth, public intervention is required to address market failures by establishing property rights and laws to spur markets and foster innovation[8]. This is because increased complexity means a growing number of public goods, market failures and missing markets where  uncoordinated markets driven by individuals pursuing their own self interest are unwilling, or unable, to undertake the necessary investments alone. At the heart of these ‘failures’ lie information and ownership issues which prevent the setting up of a working market.[9]

Markets work best where no one has a monopoly of power; where information is symmetric and when buyers and sellers both know what they are getting into; where barriers to entry are low and where coordination failures can be overcome, and where they reflect all the costs of production, including social and environmental costs. For example, without properly valuing natural assets, it is hard to prevent overuse and depletion of scarce resources, especially ones that are owned in common, such as fish in the ocean or clean air. The absence of appropriate pricing of environmental goods means they are over-consumed, and we are unable to easily measure their value. This has distorted the development of advanced economies to make them far too hungry for such resources.

Providing strategic direction and instilling credibility

But policy is about more than correcting market failures; it is about governments helping to create new markets, for example through clear policy signals on how to connect urban development and induce resource efficient investment. Just as a space race, the military-industrial commitment or the “war on cancer” can induce innovation, so the setting of smart connectivity or green innovation challenges can be expected to create substantial knowledge-spillovers, boosting Schumpeterian innovation and productivity across a broad number of sectors[10].  

Governments can provide clarity on what are our vision of the future is and how to get there.[11] This means regulations and standards at the product level; defining outcomes and letting entrepreneurs figure out how to get there. South Korea and China have understood the logic of this approach. China has moved decisively to embrace high technology low-carbon growth, notably in its stimulus package of 2008-2009 but also, and more importantly, in its outline for the 12th five-year plan^[12]. This plan sets strong targets. China and other countries recognise that investment flows to the pioneers of the revolutions^[13].

Even in the present uncertain environment with a lack of ambitious and coordinated global green policies, renewable energy generation and energy efficiency investment is surging, having quadrupled since 2004 according to Bloomberg New Energy Finance (BNEF). New investment in clean energy surpassed investment in conventional energy generation in 2010, rising to between US$180 and US$200 billion. HSBC forecasts the global low-carbon energy market (revenues) will triple to US$ 2.2 trillion p.a. by 2020 (HSBC, 2010). According to BIS, the UK low-carbon and environmental goods and services sector had sales of £116.8 billion in 2009-10, up 4.3 per cent from the previous year and placing us sixth in the global league table.

A seventh priority is therefore setting strategic directions and demonstrating government commitment to a sector. This can give companies confidence to invest in physical capital, and individuals’ confidence to invest in skills development.

Unfortunately, in an uncertain macroeconomic environment, firms and households are seeing greater value in hoarding cash against future uncertainties than investing it in productive capacity[14]. The recent surge in private saving and collapse in investment in the rich world has driven real risk-free interest rates below zero over a twenty year horizon. When households, businesses, banks and now government are all retrenching simultaneously, cutting investment, shedding labour, restricting credit and storing money, pessimistic expectations become self-fulfilling.  A clear and credible policy steer can help break the vicious cycle. For example, the Government could incentivise low-carbon investment by itself taking on elements of the policy risk which it ‘controls’, for example through setting up a well capitalised public investment bank. By backing its own policies, the Government can stimulate additional net private sector investment, and thereby make a significant contribution to economic growth and employment.

Governments need to take risks

At this point, one might be tempted to argue that governments should stick to broad-based horizontal policies and leave risk-taking and innovation entirely to the private sector and not to bureaucrats. But the evidence suggests the contrary. Innovation relies on risk being taken by the public sector too. In the US, government played a central role in financing or buying many of the innovations behind the ICT revolution is increasingly being recognised. Silicon Valley venture capitalists took the credits, but they were standing on the shoulders of federal government investment and support over many years[15].  Americans have made huge interventions in markets through vehicles like DARPA, the Small Business Innovation Research programme, and the National Institutes of Health.

As Mariana Mazzucato argues, Google owes much of its success to state-funded investments in the internet, and to the US National Science Foundation grant that funded the discovery of its foundational algorithm. Apples iPad has built on state-funded innovations in communication technologies, GPS and touch-screen display.  GSK and Pfizer both benefited from the $600bn the US National Institutes of Health has put into research that has led to 75% of the most innovative new drugs in the last decade. She points out that in these instances, what she terms the “Entrepreneurial State” took on the greatest risk long before the private sector dared to enter. In biotech, venture capital entered 15 years after state investment in the knowledge base. The term nanotech was coined by scientists in the NSF long before business understood its potential returns.

Among these organisations there's a willingness to fail. In the UK and elsewhere, incentives in the public sector often militate against risk. The competence of policymakers and public officials is commonly judged on how well they avoid expensive disasters. Indeed, the UK public sector seems to have been particularly conservative by international standards (with some notable exceptions such as the NHS which, with a clear national mission, supported innovation on pharmaceuticals, helping make this one of the most innovative and successful sectors in the UK). Partly as a result, the UK languishes low in the OECD rankings for R&D spending as a proportion of GDP[16]. As in the private sector, there’s a balance to be struck between risk and reward. A chief executive of a successful company who took no risks would be deemed a failure. So it should be with government.

This yields the eighth priority which is for institutional reform to enable greater public risk taking in support of vital innovation the private sector might not undertake. This requires a framework in which key institutions are distanced from politics. Even in the US, public sector risk-taking takes place strategically at arm’s length from Federal and State Government (which is possibly why its significance is so often over-looked).

Credible policy must be open, flexible and transparent

An effective Business Policy should recognise that intervention is the opposite of distorting when applied to sectors where market failures are corrected or necessary new market signals created. But the intervention needs to be well-designed in order to avoid replacing market failure with policy failure[17].

In a rapidly changing economic environment, policymakers must embrace uncertainty on a number of fronts; for example technology costs, tastes and preferences, resource depletion rates and climate science, to name a few. So the ninth priority is that policy be sufficiently stringent to change behaviour, predictable in order to contain policy risk, yet simple and flexible in evolving to changing circumstances while limiting compliance costs[18]. This requires that it be based on clear rules for review and revision, where the public sector responds to surprises in a predictable manner. Most importantly, government must convince business that it will not renege on its commitments once investment costs are sunk. It can do this by setting credible long term policies while underwriting elements of the policy risk[19].

Policies should be as neutral as possible, to allow a broad range of technologies to emerge and compete, and to avoid the problem of governments ‘picking winners’. However, governments cannot avoid making some choices, given that there are a range of technological options that will be available over the coming decades and some technologies have specific barriers and opportunities that may require targeted assistance[20]. So choices should be well-informed, open and transparent, in collaboration with civil society and the private sector.

The final priority is that in order to enable innovation, policymakers must resist the temptation to be respond to lobbying skewed in the interests of existing companies resistant to change as opposed to young companies (or companies that do not yet exist) who threaten to destroy them. Institutions must be designed to resist pressures for protectionism, be outward-facing and open to a changing global economy. 

An effective business policy requires governments to innovate in creating new rules and institutions which provide a platform for competition and innovation. It must provide horizontal support to the market, address market failures and steer businesses, civil society and other governments towards effective innovation recognising the central role of network technologies in enabling and accelerating knowledge creation and driving innovation. Policy choices made today will determine the institutions, technologies and infrastructures that drive our economies for decades. This adjustment will be disruptive and will require bold leadership and substantial early investment. But in the world of innovation, it is often the high hanging fruit that proves the ripest.

Dimitri Zenghelis is a senior economic advisor to Cisco systems. He was formerly Head of Economic Forecasting at HM Treasury and is currently a senior visiting fellow at the Grantham Research Institute on Climate Change and the Environment at London School of Economics and an Associate Fellow at Chatham House. The views are those of the author and not the organisations he is affiliated with.