Can Britain make it?

Manufacturing can play a big part in reviving the economy. But it has been handicapped by short-termism from investors—and ministers
September 21, 2011

Britain needs to rebalance its economy—and for that, it needs a stronger manufacturing sector. Economic growth in the decade up to the crash of 2008 was driven by government and household spending—both fuelled by debt—and by what turned out to be unsustainable expansion in the City of London. As a result, Britain became by some measures the most heavily borrowed nation in the developed world, and was left with a financial sector that was much more likely to shrink than to grow in the years ahead.

To restore the balance and get back to stable growth, the country needs to shift away from the consumption of goods and services and towards activities that can help us create wealth and pay our way in the world. That of necessity means a greater emphasis on private-sector investment and trade, and since manufacturing accounts for more than three-fifths of British exports and a big chunk of private investment, its role becomes pivotal.

Are British manufacturers up to the task? The answer is yes, but economic policy will need to be reset to bring about change on the scale that is required.

In big picture terms, the sector is a lot stronger than most people think. It’s true that its share of the economy has shrunk over the years, but that’s what happens when countries become more affluent: people start to spend more on services than they do on products. Largely as a result of their different histories and cultures, Germany and Japan still have very big manufacturing industries, but the sector’s share of the British economy is roughly the same size as it is in the US and France, accounting for a bit over 11 per cent of gross domestic product.

Britain remains well up in the top ten of manufacturing nations, more or less where you would expect it to be for a country of its size and wealth, and output hit an all-time peak just ahead of the crash. Since employment in the sector had slumped by nearly a half in the previous decade, that meant there had been a productivity miracle over the period, which has shown up in just about every industry. To take one example, Britain now has some of the most competitive motor vehicle plants in the world, way ahead of other European countries in terms of vehicles produced per worker.

Britain has more leading global aero-space firms than France, Germany, Italy, Spain and the Netherlands combined, and its skills in high value engineering are evident elsewhere in the way its manufacturers dominate world motor sports. Pharmaceuticals and life sciences are other research intensive industries where Britain again punches well above its weight.

And there are obvious opportunities ahead. For one thing, well over £100bn will have to be spent by 2020 on energy generation and transmission: rebuilding the country’s nuclear power plants, cranking up its offshore wind capacity, and replacing its old coal-fired power plants. For another, the sharp devaluation in sterling since the summer of 2007 means that British products can be priced much more competitively in the international marketplace.

But start to look more closely at what has happened in the past years and the picture becomes bleaker. Manufacturing’s share of the British economy has declined more rapidly than in other leading industrialised nations, and a high sterling exchange rate hammered its share of world trade in the decade to 2007, during which time growth in Britain’s manufacturing exports was the slowest in the OECD area.

Big companies have become increasingly concerned about the health of their domestic suppliers, as component making has shifted offshore: the British content of JCB’s famous backhoe loaders fell from 96 to 36 per cent between 1979 and 2009. Some large firms worry that weaknesses in the supply chain could reach a point where their own businesses will have to move elsewhere.

There are question marks over other traditional areas of strength: Pfizer is only the latest of the big pharma companies to cut back its research activities in Britain. The overall figures for business investment in research and development (R&D) compare poorly with competitor nations, and despite an early lead, British-based companies are no longer at the cutting edge of technology in the big projects that are getting under way in nuclear power and offshore wind.

One striking feature of the past decade has been a rapid increase in foreign ownership of British manufacturers. By 2007, over 30 per cent of manufacturing employees were working for foreign affiliates, and nearly 25 per cent of business R&D funds were coming from abroad, more than five times the proportion in Germany. Of course foreign owners can and do make a great contribution to the British economy. But this shift in ownership does hint at a broader malaise in the sector, which can be illustrated by looking at what’s happened to one particular group of businesses.

Back in the 1980s, a good number of leading building material manufacturers such as Blue Circle and Redland were headquartered in Britain and active all over the world making cement, concrete, roofing tiles, plaster board, aggregates and the like. Today, nearly all of them have been acquired by companies from France, Switzerland, Mexico and elsewhere. Why might that have happened?

One thing these industries have in common is that they are capital intensive: it costs a lot to build a cement kiln. And if you talk to the foreign companies that bought them, most will say that they had been surprised by the poor condition of the assets they had taken over. There had not been enough investment in recent years, they say, and the time horizons of the British managers were much shorter than their own. The Brits wanted to maximise profits over the next year or two, and weren’t too bothered about what happened thereafter. By contrast, their new owners have invested more, which has increased productivity and created more successful businesses.

If the British have indeed become less willing than their peers to invest for the long term in capital intensive projects, it is no wonder that their manufacturing sector has shrunk faster than elsewhere, and that they have expanded their activities instead in those areas of the services sector which require less capital.

The big question is why this might have happened. There are several possible explanations, but the most compelling is summed up by the BBC’s Evan Davis in his stimulating new book Made in Britain. His argument, put simply, is that “countries that consume too much tend to have a smaller manufacturing sector than they otherwise would.” By any standards, the British love to consume rather than to save.

Thus Britain is near the bottom of the developed countries’ league table in terms of the proportion of household disposable income that is put aside for the future: we prefer to spend it instead. Indeed household savings in the five years leading up to the crash were actually negative—collectively, we were spending more money than we earned—compared with savings rates of 10 to 12 per cent of disposable income in countries like Germany and France. Among OECD members, only Greek households were more profligate during this period.

Because we don’t save much, we don’t have as much as others to invest: Britain is also at the bottom of the league table for investment rates expressed as a share of GDP: 16.8 per cent, compared with 21.9 per cent for France (and an extraordinary 41.1 per cent for China).

As well as constraining investment, Britain’s consumption-driven growth may also help to explain why the sterling exchange rate rose sharply in the late 1990s, and stayed higher for longer than most people expected. With loose fiscal policy and families spending up to and sometimes beyond the limit, it was left to monetary policy to keep the lid on inflation. Nominal interest rates were held well above those in the eurozone, making sterling look like a very good bet at a time when the economy was performing well. And that was bad news for Britain’s manufacturing exports.

As Davis observes, it cannot just be a coincidence that the two manufacturing leaders in the developed world, Japan and Germany, have traditionally been big savers and investors. The manufacturing giants in the developing world, China and South Korea, have similar characteristics. And Britain is at the opposite end of the scale.

In a low investment economy, it’s no surprise that investors concentrate on sweating their existing assets, rather than building new ones. And this links into another feature of British business life which has been particularly damaging to manufacturers over the past couple of decades: the growing cult of shareholder value.

Put crudely, this is the view that companies exist only in order to maximise the returns to their shareholders. What started off as a simple idea has, in some cases, led to wild consequences. It’s encouraged managers to focus too much on the short term, since it’s hard to demonstrate the value of long-term investment to today’s shareholders. It’s encouraged companies to take on high levels of debt, and to spend large sums of money buying back their own shares rather than investing for the future. And since managers have been heavily incentivised to increase shareholder value, it has encouraged absurd levels of executive compensation.

Manufacturers have been especially vulnerable to these extremes, in part because their large book of fixed assets has led to all kinds of clever—and not so clever—corporate manoeuvring in the name of shareholder value. ICI and GEC were for decades two of Britain’s most important manufacturing companies. Both were destroyed within the space of a few years by inept financial engineering. They tried to reshape their activities in a radical way by selling and buying businesses, and paid a high price for their failure.

A recent analysis by Andy Haldane and Richard Davies of the Bank of England showed significant evidence of short-termism in the way that investors value shares across all industries, a pattern that had been increasing in the recent past. In other words, investors were placing little value on projects that paid off over the long term.

This, the Bank analysts concluded, was a market failure that would tend to result in investment being too low. Consequently, long term projects, which lie at the heart of the manufacturing sector, suffer disproportionately. Manufacturers in Britain are at the sharp end of this trend, since they are more heavily exposed to the stock market than their counterparts in Germany and France, where more companies are privately owned.

Too much consumption and not enough investment. Too great an emphasis on shareholder value and the short-term. And there’s a third problem for British manufacturers, which has been the absence of any form of industrial policy at government level. Over the past 30 years, the view has grown that any intervention by government in the workings of the economy is likely to be damaging.

This has brought benefits, such as a heavy flow of foreign direct investment in a whole range of sectors. But it has also had costs. Market failures have been ignored. There’s not been enough serious thinking about where Britain’s comparative advantages might lie in the manufacturing sector. The government departments in charge of business have not played a consistent role. It has constantly been reshaped and rebranded, and bizarrely enough by far the biggest item in its budget today is higher education. Meanwhile, the policy area which is of most interest to industry, namely energy, is located in a department that is more concerned with the environment than with the economy.

All this makes it hard to achieve the necessary shift of resources to production and exports, and points to the need for policy changes in three broad areas. Fiddling around with micro level growth initiatives— a few tax breaks here or there, or special funding for favoured sectors— won’t make the difference. What’s needed is a much bigger rethink about how the economy works.

In opposition days, George Osborne used to talk about the need to turn Britain into a nation of savers and investors rather than one of consumers and borrowers. He has had other things on his mind in the past year, but this big idea ought to be informing all his actions as he thinks about how to get Britain moving in the years ahead. Only if we start to save and invest more will we get the necessary rebalancing away from those activities that encourage consumption towards those that support investment and trade.

There are no quick fixes, but here are some ideas to consider. For a start, the corporation tax system encourages companies to borrow, since interest costs can be set off against tax, whereas dividends are paid to shareholders after tax has been deducted. There’s a case for tweaking this balance so as to build up the equity finance that’s needed for long-term investment.

Capital allowances could be made more generous. Public spending should be skewed to favour investment in those bits of the national infrastructure—roads, energy and the like—that help to make manufacturing competitive. More should be done to encourage citizens to save for their retirement.

Policy should also be directed at encouraging managers and investors to think more about the long term. Managers’ fiduciary duties could be expanded to cover constituencies beyond just the shareholders, and to recognise explicitly long-term objectives. Executives’ pay packages could be redesigned with the same goal in mind. The tax system could be modified to encourage investors to hold shares for the longer term, and those regulations which have encouraged pension funds to run down their equity holdings year after year should be reappraised.

Then there’s the question of the shape of government. When he was put in charge of the Department of Business, Innovation and Skills, Vince Cable said he was determined to turn it into a ministry for economic growth, rather along the lines of the German Ministry of Economics and Technology. Since then, he too has had other things on his mind. But if Britain is to strengthen its manufacturing sector, it needs a strong government department concentrating all its efforts on supply side reforms, on understanding and reinforcing the country’s comparative advantages, and on addressing the big long-term questions that preoccupy industry, such as the future supply of low carbon energy at competitive prices.

With economic growth faltering in Britain and around the world, the big risk in the coming months is that politicians will waste time and money by announcing short-term growth initiatives that will make no difference to the country’s long-term competitive performance. Instead, they should set their sights much higher. Britain has the manufacturing strengths that are required to rebalance the economy in a new and more sustainable direction. What is needed now is a policy framework to make this happen.