Doubtful remedies

THE Government has belatedly recognised that Britain's emaciated manufacturing base badly needs fattening up. But its first tentative steps back along the road to an interventionist industrial policy do not inspire confidence. The remedies tried so far - a lower pound, more export credit guarantees and increased capital allowances - may do more harm than good.

The need to strengthen the manufacturing base should be self-evident: Britain has a large and growing trade gap while the economy is still struggling to pick itself up off the floor. The sustainability of a recovery worth the name depends on the trade deficit remaining under control as spending picks up. Manufacturing is the part of the economy whose output is most likely to be exported or to face competition from imports, so its performance is crucial.

Unfortunately, Britain has a chronic tendency to import manufactured goods, exacerbated by the 4 per cent fall in industrial capacity during the recession. Professor Nick Crafts of Warwick University argues that the pound's real exchange rate, adjusted for inflation, will have to fall by 1.5 per cent a year during the 1990s, to make British goods cheaper in foreign markets, if the current account deficit is to remain sustainable. (Nick Crafts. 'Can Deindustrialisation Seriously Damage Your Wealth?' Institute of Economic Affairs, 1993.)

The virtuous way to meet this challenge, exemplified by France, is with a stable exchange rate and lower inflation than your competitors. But Britain's departure from the exchange rate mechanism means a sliding pound is more likely. More exports will be needed to buy a given quantity of imports, which Professor Crafts believes could cut British living standards by 0.4 per cent a year.

The Government appeared to recognise this argument in the Autumn Statement and the Budget. It cut premiums for export credit guarantees and extended export cover by pounds 2bn. But this simply encourages exporters to concentrate on developing country markets where there is little security of payment. The Government would do better to level the playing field by negotiating multilateral cuts in export subsidies than to waste taxpayers' money buying goods for foreigners who cannot pay themselves.

The Government may also try to help manufacturers by capping any rise in the pound as the Bundesbank cuts German interest rates. This is particularly attractive to economists who believe the main reason the trade deficit stayed so large in the recession was that the Government pigheadedly kept the pound uncompetitive in the ERM.

But the long-term trend suggests deeper structural problems than an overvalued pound. Britain's trade in manufactures has been in decline for almost all the post-war period, moving into deficit in 1983. This cannot be explained by a rising real exchange rate.

Complex structural problems are also suggested by the differences in trading performance between industries. Chemicals, professional instruments, aircraft, specialised machinery and iron and steel do well. Textiles, furniture, paper, road vehicles and office machinery do not.

There are no simple divisons between successful and unsuccessful sectors - there are winners and losers among both basic commodity and high-technology industries.

It will be some time before the 12 per cent fall in the pound since Black Wednesday feeds through fully to higher demand for British products. Imports should shrink and exports grow as British goods become relatively cheaper. But it is less clear whether the devaluation - even augmented by a further fall in the pound - would encourage many British companies to make things they did not produce to start with.

A 'competitive' exchange rate policy might even have a damaging effect, reducing the incentive for firms to innovate. The management guru, Michael Porter, of Harvard Business School, argues that companies gain advantage over competitors because of pressure and challenge, not because governments give them an easy ride. German industry has grown much more than Britain's since the war despite a strong mark.

Professor Porter's argument also suggests that government subsidies for particular sectors - or for investment in general - may be counter-productive. State aid to the British manufacturing industry between 1986 and 1988 was twice the level in Germany at 2.6 per cent of gross value added. When the German government has tried large-scale subsidies in high-technology industries it has been no more successful than Britain.

Rather than sector-specific subsidies, the Government opted in the Autumn Statement to increase capital allowances, providing a general short-term incentive for investment.

This approach has been lent credibility by recent developments in the theory of economic growth, which suggest that national output consistently grows faster than the inputs of worker hours and capital equipment used to produce it because investment embodies technical progress in designs.

Technical progress means that investment benefits the whole economy, not just the individual company carrying it out. For similar reasons, education and training may also have broader benefits that could be used to justify public subsidy.

But the evidence is not conclusive. Professor Crafts argues that that the positive spillover from investment is limited and that Britain went a long way in catching up with German productivity in the 1980s without a significant contribution from education and training.

These uncertainties suggest that the Government should avoid subsidies, but try to remove unnecessary obstacles to investment while capital allowances subsidise it. Ideally, investment should not be influenced either way by taxes, which should simply be levied on the amount people spend or earn.

The main deterrent to adequate higher education and training is people's inability to fund it by borrowing against the security of the higher incomes they expect. The Government could offer loan guarantees to those wishing to invest in their skills.

Such changes would not yield quick results. Meanwhile, the best contribution the Government could make to industry would be to avoid policy errors that push the economy from boom to bust. On the evidence of the past 14 years, we will probably be disappointed.