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Building the entrepreneurial state

How the state can create markets as well as fix them.

Industrial policy is back on the agenda, not least due to the leaked letter this week by Vince Cable to the Prime Minister asking for a growth policy with a more "compelling vision" of the future. This is good news so long as the discussion moves beyond the fear about "picking winners". There is no point in talking about innovation, if economic policies focused on austerity prevent key investments which can increase productivity and human capital.

There are five strategies that could drive a visionary industrial growth policy for the UK.

1. Do something different

As Keynes wrote in 1926 in The End of Laissez Faire, "The important thing for government is not to do things which individuals are doing already, and to do them a little better or a little worse; but to do those things which at present are not done at all."

His key insight was that private business investment is volatile and pro-cyclical: too much during booms and too little during busts. To avoid recessions turning into depressions, government needs to focus on counter-cyclical policies -- the opposite of what is happening today. But the focus on "doing something different" is not just about counter-cyclical measures. It is also about the need for government to focus on policies that cause types of economic activity that would not have happened otherwise. Industrial policy is about making this happen in the areas of productivity enhancing investments that lead to growth and innovation.

2. Transform animal spirits into investment

Since investment is driven by "animal spirits" (the gut expectations that investors have on the future state of the economy), a key role of government is to get that investment moving. Large reductions in corporate tax rates did not increase investment in the 80s nor will they today (they simply change income distribution). Government-led investments that open up new technological and market opportunities will. This includes not only properly funding education and research infrastructures but also providing early financing for innovative firms, and new key technologies, which private venture capital has proven too risk averse to fund. Without the state there would have been no internet revolution, biotech revolution or nanotech revolution. Without the state, the green-tech revolution is still-born.

One of the failures of current UK policy is the assumption that firms want to grow, and all they need is a "nudge" in the right direction. While the Green Investment Bank is surely a positive development, it assumes that the willingness to invest is there and all that is needed is some co-financing. But "green" investment is currently confined to incremental areas, and the government is not stepping in to fill the gap. The UK's investment of £12.6 billion in this area in 2009/10 is, according to PIRC, "under 1 per cent of UK Gross Domestic Product; half of what South Korea currently invests in green technologies annually; and less than what the UK presently spend on furniture in a year".

3. Market making not market fixing

What I have called the "entrepreneurial state" is not about fixing markets but creating them. The state has acted in the past as catalyst, lead investor and creator (not just facilitator) of the knowledge economy. This requires far-sighted investments in technologies that are too risky for the private sector, such as offshore wind and carbon capture and storage. It also involves the creation of clear policy signals that increase business confidence in areas that are otherwise seen to be too high risk, such as feed-in tariffs for solar energy (recently cancelled in the UK causing even more uncertainty and less investment).

A more entrepreneurial role for government extends beyond procuring innovative products to making them directly in public labs when the private sector is reluctant to step in. Indeed, 75 per cent of the New Molecular Entities with priority rating in the pharmaceutical industry have originated in public sector labs, because private pharma is more interested in the low risk "me too" drugs. It is the large amounts of US public funds for life-sciences research (via the National Institutes of Health) that has enticed Pfizer and GSK to leave the UK for the US. From 1978 through 2004, NIH spending on life sciences research totalled $365 billion.

4. Rebalancing indicators of performance

Creating markets is also about shaping the indicators that are used to measure economic performance so they reward rather than penalise the most innovative companies. In this sense, "rebalancing" is not necessarily about sectors. It is more about redirecting "indicators of performance" away from short run financial towards long run "real economy" measures. Firms investing in expensive R&D and human capital will have a higher risk profile, since innovation is so costly and uncertain. The most innovative companies have suffered the largest increases in the cost of credit. . Furthermore, the focus on boosting stock prices through share buybacks (Fortune 500 companies have spent $3 trillion on buybacks over the last decade) has been shown to be directly related to lower investments of these companies in human capital and R&D. These are tradeoffs which industrial policy must combat.

Battling against these problems includes devising policies that nurture "patient capital" that can protect the flow of credit to the most innovative companies. In Germany this occurs through the state-backed investment bank - KfW, which works alongside the regional Landesbanken as well as the large network of savings banks. Innovation in Brazil, which has surpassed the UK as the world's fifth largest economy, has been directly funded by the Brazilian Development Bank. In the UK, a National Investment Bank could today be formed relatively quickly out of the nationalised RBS (an idea included in Cable's leaked letter). Selling it off would be a wasted opportunity.

5. Being first matters

China recently announced that it is spending $1.5 trillion over the next five years in seven new key industries (including environmentally friendly technologies and new generation IT). Its industrial policy is its growth policy -- its economic strategy. Similarly, after the crisis hit in 2008, Germany increased its government funded R&D spending by 10 per cent, while the UK has since cut it by the same amount, signalling very different visions of what will drive post-crisis recovery.

In the UK, outside of the eurozone, such investments should be even easier. The money can be created through quantitative easing(already happening), but instead of ending up hoarded in bank coffers it can be directed through a National Investment Bank into productive investment in key new sectors. The time is now not only because it is the right way out of the crisis (fiscal stimulus has been shown to be stronger when directed to new technologies rather than "shovel ready" projects), but also because the history of innovation tells us that being first matters. The US is still the leader today in IT as Germany is still the leader in machine tools. Leaders in green technology today include China, South Korea, Germany and Finland. Not making a mark today in what promises to be the "next internet" - green technology will mean the UK stays behind for years to come.

Mariana Mazzucato is Professor of Economics and RM Phillips Chair in Science and Technology Policy at the University of Sussex. She is the author of The Entrepreneurial State.