Rebuilding the UK’s innovation economy

The UK’s innovation system is currently under-performing; the amount of resource devoted to private sector R&D has been too low compared to competitors for many years, and the situation shows no sign of improving. My last post discussed the changes in the UK economy that have led us to this situation, which contributes to the deep-seated problems of the UK economy of very poor productivity performance and persistent current account deficits. What can we do to improve things? Here I suggest three steps.

1. Stop making things worse.
Firstly, we should recognise the damage that has been done to the countries innovative capacity by the structural shortcomings of our economy and stop making things worse. R&D capacity – including private sector R&D – is a national asset, and we should try and correct the perverse incentives that lead to its destruction. It would have been against the national interest for Pfizer to take over AstraZeneca, and it’s good that politicians have started to recognise that. The key point to recognise is that our shrinking R&D base is part of a bigger problem of short-termism, in which the structures of our capital markets and the reward structures for company managers excessively reward good financial performance in the present at the expense of longer term prospects for growth. A number of authoritative figures have diagnosed this problem in recent years, including the economist John Kay, in his report for the government, UK equity markets and long-term decision making, the Bank of England’s Andrew Haldane, in his paper The Short Long, and the fund manager Andrew Smithers (see for example Poor productivity is no puzzle).

The role of the financial services industry needs a special mention. There’s a notable coincidence between an increase in share of GDP accounted for by the financial services industry and the onset of slower growth – present everywhere in the developed world but particularly marked in the UK (as pointed out in this recent Economist article Counting the cost of finance). A well functioning financial services industry would promote growth and innovation by effectively directing capital to the places where it can most effectively be used. But a dysfunctional financial sector may be closer to what economists Daron Acemoglu and James Robinson call an extractive economic institution, distorting politics and suppressing the innovations that will lead to long-term economic growth for the benefit of elites.

Rebuilding our innovation economy, then, is an integral part of the broader task of rebalancing our model of capitalism to encourage long-term value creation and to discourage short-term rent-seeking.

2. Recognise and maintain our strengths
Secondly, we should build on what we have that is positive. International comparisons reveal that the UK’s academic research base is highly competitive and cost-efficient (see for example the recent government report International Comparative Performance of the UK Research Base – 2013). This is a real achievement, and reflects the value of a stable, long-term science policy framework, though of course a continuation of the real-terms squeeze in funding we’ve seen for the last four years will put this at risk. This academic research base has become increasingly connected with industry through collaborative and contract research (up 45% in real terms in the last ten years, according to the HE-BCI statistics), and many universities now have very effective and focused technology transfer operations which make the most of their IP through spin-outs and licensing.

But we do need to recognise that supply side science policy isn’t enough. The 10 year Science Investment Framework produced by the Labour government in 2004 contained a hard target – that, by 2014, business R&D intensity would rise from its value then of 1.12% to a target of 1.7%. As we’ve seen, far from rising towards that target, it has actually fallen, to 1.09%. There’s been a lot of effort devoted to the task of changing academic culture to make it more focused on the potential “impact” of research, more collaborative with the private sector and other “users” of science. But there’s no point driving scientists to be more collaborative with applied researchers in the private sector, if the private sector doesn’t have the R&D capacity to collaborate with.

3. Build capacity
So the third step has to be that we need to actively build capacity in industrial R&D, and build up the absorptive capacity of the economy for new technology.

There is a positive correlation between general government spending on science and industrial R&D capacity. Old arguments that state spending on research “crowds out” private sector research spending, implausible to start with, have been discredited by econometric studies (see for example this recent report by Haskel, Hughes and Bascavusoglu-Moreau: The Economic Significance of the UK Science Base). One mechanism for this connection is obvious – the strength of the science and skills base is one of the most important factors taken into account by multinational companies as they choose the locations of their R&D facilties. The UK has an extraordinarily high proportion of industrial R&D carried out and funded by overseas companies. This is positive for the UK’s overall R&D capacity, but carries the risk that these investments can be quite quickly reversed if perceptions change about the commitment of the UK to maintaining science spending. Given that total UK government spending on R&D has fallen by 8.9% in real terms since 2009, this must be a real danger now.

In addition to general support for the science base, recent governments have moved more in the direction of funding more translational, applied research in collaboration with industry. The Technology Strategy Board has been developed as a funding agency for “industry-led” collaborative research and development, and “Catapult Centres” have been established physical faciities for translational research, loosely modelled on Germany’s much-envied Fraunhofer Institutes. This approach works well in sectors that are already strong in the UK, such as aerospace. But by stressing being “business-led”, these initiatives have a tendency to support the existing business base rather than building additional new capacity. That’s where effort needs to turn to now.

Of course, as soon as one talks about governments seeking to build industrial capacity, one faces the charge of attempting that much ridiculed activity of “picking winners”. The point, though, is not so much to pick winners, but to identify the problems that we know we will need new technology to overcome. These are problems that governments cannot avoid addressing, and for which they are already committed (explicitly or implicitly) to spending enormous sums of money to mitigate. Identifying such problems is not difficult. Here are just a few examples.

We know that the spectre of infectious diseases is returning, as microbes develop resistance to our existing antibiotics. And yet we are not developing new antibiotics to replace them; the Prime Minister has recently, quite correctly, drawn attention to the urgency of the need to correct this failure of markets.

We know that our ageing society will face huge human and social costs as incurable neurodegenerative diseases like Alzheimers become even more common. Social, technical and medical innovations are urgently needed to deal with this.

And we know that we need to decarbonise our energy supply – but the existing low-carbon alternatives are just too expensive. Even the so-called “climate realists”, who believe the potential impacts of climate change to be over-stated, agree that we should be carrying out more energy R&D. But few people realise the extent to which we have, in the last 30 years, scaled back such efforts, nor do they recognise the systemic problems that have led to the collapse of energy research. Our liberalised energy markets can’t deliver the R&D we need to give us cheap solar energy and cheap nuclear power, at scale, so we can get the economics of low carbon energy to work for us.

To be clear, here I’m not primarily talking about academic science; what is needed is directed R&D focused on delivering products. For some of these products – for pharmaceutical and medical innovations – the government will be the main customer, as well as being the direct financial beneficiary of savings in areas like the social care budget. In the case of energy, the costs will be imposed on future customers through long-term guaranteed prices . For example, the Hinckley Point deal, for just one nuclear power station, will result in the transfer of several tens of billions of pounds from domestic and business electricity users to the overseas providers of the technology and finance. Instead of simply standing back and paying these bills (or imposing them on future taxpayers and customers),the government should use its power as the purchaser or guarantor to make sure new technologies are developed for the which the UK can capture significant value. This will need new types of public-private partnership.

The erosion of the UK’s capacity to technologically innovate was not inevitable – it was the unintended consequence of a series of political and policy choices over decades. We need to reverse this loss of capacity. This needs to be done as part of a broader rethinking of the variety of capitalism the UK economy is currently based on. Without this rethinking, we will be condemned to continue on our current trajectory of low growth, poor trade performance and ultimately, loss of national sovereignty.

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