• Andrew O'Brien

Smithians versus Schumpeterians – The next battle for the Conservative’s future

Updated: Aug 23

The Conservative Party is facing another major economic crossroads. Over a decade ago, when faced with the financial crash and Great Recession, the Conservatives went down a Hayekian road of austerity and “withdrawing” the state to free up the private sector. Given political leadership by George Osborne, ‘expansionary fiscal contraction’ was the order of the day. Although George Osborne never used that phrase specifically, it was very much the spirit of his 2010 ‘Emergency’ Budget where he called for a new economy “where the state does not take almost half of all our national income, crowding out private endeavour.” The “boosters”, like Prime Minister himself, that wanted a more strategic state to grow the economy out of its deficit were on the losing side.

In the end, austerity did not really work. The deficit was still there over a decade later, although supporters would say that “current spending” was brought into balance. Growth never dramatically increased or took hold. Productivity didn’t significantly improve. Wages and living standards took over a decade to recover.

We are now at another crossroads. Brexit was already going to force the issue. COVID-19 has simply created even greater pressure.

Within the Conservative Party, two broad schools of thoughts will be battling to shape the future direction.

On the one hand you have the “Smithians”. These firmly believed in Brexit, with the promise of liberalisation of trade and the chance to sign more deals around the world. Liberalisation and deregulation must be the order of the day. They look back to British history and see the country at its best when it was a swashbuckling, free trading nation. Their touchstones are Britain’s “First Empire” in North America and Australasia, the repeal of the Corn Laws and standing up for Free Trade against protectionism in the 19th Century. They draw inspiration from Adam Smith and David Ricardo (although Smith would certainly not agree with everything his self-declared disciples currently say). Think Conservatives like Dominic Raab, David Davis and Dan Hannan.

These Conservatives focus on trade deals because they are conceptually wedded to “Smithian” growth. First popularised by Adam Smith, this model suggests that free trade encourages greater specialisation which improves productivity and increases the pool of wealth. This Smithian model is heavily tied to the Ricardian concept of “comparative advantage”, which explains that countries trade with each other because specialisation creates more wealth than if individual nations try to manufacture everything themselves. This Smithian framework is why these types of Conservatives tend to favour low taxes and deregulation as a way to protect advantages in key sectors. It also explains why some, like Davis, continue to argue that the needs of the German Automotive industry will eventually force Germany to push hard for a strong free trade deal with Britain following Brexit regardless of what the EU thinks. In the Smithian model, if you have a comparative advantage in an area (like the automotive industry), then you will want to do everything you can to sustain it.

The post-COVID future for these Conservatives will be the UK to push for free trade around the world, to protect and strengthen the UK’s comparative advantages in areas such as financial services and aviation. For these Smithians, you want to keep the costs of production, including labour, down as much as possible and keep regulation as light touch as possible.

On the other hand, you have the “Schumpeterians”. They focus on technological dynamism as the route to growth, with new products revolutionising markets and creating “spurts” of growth. In the Schumpeterian model productivity and wealth comes primarily from technological advancement and the ability of entrepreneurs to build up businesses which can successfully exploit these advances. These Conservatives look to Britain’s role in the Enlightenment and Industrial Revolution, the world changing advances in science and technology that gave the country a head start over Europe and the rest of the world. These Conservatives want the UK to focus on the industries of the future like robotics, life sciences and battery technology. Think Conservatives like George Freeman and Neil O’Brien as well as advisors around the Prime Minister, such as Dominic Cummings.

Smithians and Schumpeterians are not necessarily opponents. Exponents of free trade will tell you that it forces companies to be more competitive and invest in new technology because those that cannot compete on global markets will disappear. Free trade encourages the reallocation of capital to more productive uses. In their mind, free trade puts more force into Schumpeterian gale. It was this synthesis that Margaret Thatcher deployed successfully to unite Conservatives during the 1980s.

But differences between these two camps can emerge. When nations start to embrace protectionism, free trade doesn’t necessarily mean survival of the fittest, but merely the better protected. Advocating more trade and liberalisation feels like a hiding to nowhere. Moreover, when times are tough and workers are under pressure, what does a party of government do? Stick to free trade and policies to keep production costs down (which often include keeping wages down) or do more to stimulate domestic production and technology to create better jobs and boost competitiveness?

It was division over whether to back Smithian growth or promote domestic industries which split the Conservatives back in first three decades of the 20th Century. Tory Prime Ministers like Baldwin and Chamberlain would never have called themselves Schumpeterians (Schumpeter’s great work Capitalism, Socialism and Democracy didn’t even appear until 1942), but their embrace of protectionism and domestic industry was a reflection of Schumpeterian thinking. In introducing the Import Duties Bill in 1932, Chamberlain championed the ability of protection to stimulate new industries in the Empire and, implicitly, in Britain.

The world that we find ourselves in after Brexit and COVID-19 will create new tensions. Protectionism is back on the march. Coronavirus has raised the risk factor of large supply chains. Talk about a “Fourth Industrial Revolution” has also raised the stakes. The Conservatives return to “industrial strategy”, after spending the 1980s ripping it up, reflects a growing concern that the winners and losers for the coming decades will be based on which countries succeed in the technological race.

Smithian crusaders will want the UK to throw its efforts into defending free trade and keeping the UK as cheap, importing, deregulated, highly specialised economy. They are not worried about who develops the technologies of the future, so long as there is easy access to it and cheaper goods flow to all. Their policies will aim to get Britain easy access and rapid diffusion of technological breakthroughs that take place elsewhere.

Schumpeterians will not necessarily oppose trade deals but will want political focus to go on stimulating and supporting new industries, increasing R&D, boosting the skills and talents of British workers and championing entrepreneurs. If trade deals threaten to undermine new industries (by allowing the dumping of goods) or hamper the ability of the state to invest in the future (through rigid application of state aid) expect conflict. An early sign of this can be seen in the increasing concern on Conservative backbenches about the dominance of China and the need to “rebalance” trade away from it.

The Prime Minister will want to ride both horses, like any good political leader. And with the right balanced policy package, Smithians and Schumpeterians can be brought together – as Thatcher did, albeit under Smithian leadership. Whatever this new consensus is, it will not be the same as Thatcher developed and which has held, for the most part, for the better part of forty years.

"Globalisation has meant that there are increasingly diminishing returns for Smithian growth...[t]he government has estimated that a free trade deal with the United States would only generate 0.2% boost to GDP over 15 years."

Globalisation has meant that there are increasingly diminishing returns for Smithian growth. The global economy has never been more integrated, as COVID-19 has showed us. The government has estimated that a free trade deal with the United States would only generate 0.2% boost to GDP over 15 years. Even Economists for Free Trade, a pro-Brexit group, estimated that a mass of deregulation and greater competition would only boost UK GDP 0.5% per annum over 15 years. We shouldn’t be snooty about this given that UK growth has struggled to keep above 2% per annum in the past decade, it is hardly game changing. Although trade liberalisation is a simple and seductive policy call, it isn’t guaranteed to generate results.

We are entering another Schumpeterian moment. As economic historians, such as Joel Mokyr, have pointed out, it was the huge technological explosion in the late 18th and 19th Centuries, not Smithian models, that dramatically increased growth and living standards. We saw a similar surge in the early 20th Century with electrification and again after the Second World War. Smithian policies to improve trade certainly made a contribution, but it was a marginal one.

Although Smithians may not want to hear it, where things are made and developed really does matter. Strong domestic industries are critical to living standards. One has only to compare the differing trajectories of countries like South Korea and Nigeria in the 20th Century to see the importance of industrial and technological development.

"A more strategic state will be required if Britain is to stay ahead of its competitors. British business will also need to be encouraged to stop exploiting the easy gains of Smithian growth and invest into research and new technology."

Trade has its role to play in keeping goods flowing and encouraging competition, but Conservatives will need to look elsewhere if they are going to turbocharge the economy. A more strategic state will be required if Britain is to stay ahead of its competitors. British business will also need to be encouraged to stop exploiting the comparatively easy gains of Smithian growth and invest into research and new technology. Productivity enhancing policies are the order of the day. Schumpeterians will also need to avoid the trap where technological gains accrue only to the owners of capital, not workers.

The Prime Minister is well placed to forge this new consensus. He has a strong reputation on promoting free trade but is also known to be keen on technological progress. What he must not do is assume that this consensus will be tension or risk free. He will need to forge this new settlement, it won’t be given to him on a plate. It will also be a difficult balancing act to undertake. Only time will tell who will win out, the Smithians or the Schumpeterians.

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