22/08/2013 09:46 BST | Updated 22/10/2013 06:12 BST

UK's Poor Trade Performance Highlights Need for Active Industrial Policies

The Office for National Statistics has just published an interesting analysis of trends in the UK's trade performance since 2007. It seeks to understand why, despite the 25 per cent depreciation of sterling between Q3 2007 and Q1 2009, the balance of trade in goods and services has been broadly unchanged (and in substantial deficit) since the depreciation.

The analysis looks at several possible explanations for this poor performance, including the growth of global supply chains, developments in the financial sector, commodity prices, the relative price movements of exports and imports and developments in overseas demand. Although the authors of the report say that 'evaluating the relative importance and impact of these factors is beyond the scope' of their analysis, it is clear that what happened in the financial sector has had a major impact on the UK's overall trade performance.

Before the financial crisis, an increasing proportion of the UK's exports was accounted for by exports of financial services. This left the trade position vulnerable to the effects of the global financial crisis in 2007 and 2008. The volume of exports of financial services fell sharply in 2008 and 2009 and has continued to fall at a more moderate pace subsequently. This has been a significant drag on the overall trade performance.

What the ONS analysis is not able to highlight, however, is how the dominance of finance over a number of years before the crisis led to a reduction in the ability of UK industry to respond to sterling's depreciation. Outside of a small number of very successful industries, such as aerospace and automobiles, the UK lacks the capacity to produce significantly more goods for export.

This is the result of two periods of what economists call 'Dutch disease': the prominence of one part of the economy leading to a crowding out, through the exchange rate, of activity in other parts. In the 1980s, the culprit was North Sea oil; in the 1990s and 2000s it was the finance sector. In both cases, the strength of these sectors caused sterling's exchange rate to be overvalued, resulting in lost competitiveness for much of the rest of the economy. One consequence was that manufacturing employment in the UK shrank at a more rapid pace that in comparable countries, leaving us with a more concentrated economy.

This is one reason why George Osborne's 'march of the makers' remains elusive. There are not enough 'makers' left in the economy to generate the export-led growth that he hoped for.

What is needed is a more active industrial policy. For too long, while other countries have supported industries where they have a competitive advantage, policy makers in the UK have used the country's bad experience with industrial policies in the 1970s to justify a hands-off approach. It is this unwillingness to act, combined with the effects of North Sea oil and the 'financialisation' of the economy, that have brought us to where we are today: running a current account deficit of almost 4 per cent of GDP despite a 25 per cent depreciation of sterling and a weak domestic economy.

A three-pronged approach is now required:

1. Don't do anything that makes it less attractive for large multi-national companies to favour the UK over other countries. We might not like the attitude of some of them to paying corporation tax, but changing the economy will take time and we will be reliant on them in the interim. The government's crude net immigration target is one example of what not to do.

2. Support the development of domestic clusters of industries. A well-connected ecosystem between large, mid-sized and small firms would encourage innovation and help to broaden the UK's industrial capacity.

3. Identify industries where the UK has the capabilities needed to have a bigger global presence and focus industries policies - in terms of the traditional drivers of growth like skills and infrastructure - on specific support for developing those areas.

The hollowing-out of the UK's industrial capacity has been going on for most of the last 33 years. If policy makers were not already aware of the problem, the relatively poor trade performance of the economy since sterling's depreciation should be the wake-up call they need. An active industrial policy is required to reverse these trends. Only then will the prospect of export-led growth become a real possibility.

Tony Dolphin is Chief Economist at IPPR