January 14, 2009 | posted by Michael Baxter in innovation, new deal |

For some time now this column has argued that if the government is going to try and kick start the economy with new money, than this money needs to be focused on investment. Rather than somewhat irrelevantly knocking a bit off VAT, money should be lent to business.

This morning, it seems the government will announce an idea along those lines. It would be churlish not to give it some credit for this.

The government has taken a step in the right direction.

But, it’s a doddery step.

Its seems there are three bits to the government’s plan. £10bn is be made available to extend the existing loan guarantee scheme. Previously this scheme was only for small businesses and up to a limit of £250,000. Now the scheme is to be extended to medium sized firms, and up to a limit of £1m.

It is difficult to criticize the ideology behind the loan guarantee scheme. If your business needs a bank loan, and your business plan ticks all the boxes, but you have insufficient capital to be able to offer as security against the loan, then the government can step in and provide its guarantee.

It is understood that the Body Shop and Waterstone’s were both funded by schemes of this type during their start up phase.

The second tier of the government plan comes in the shape of £1bn to be made available for more risky ventures.

The third form of the government initiative will be a £750m fund, to be made available to small firms with a good and sound business model, but which have overextended themselves with debt. The government will invest money into these firms, in exchange for equity.

So that’s the idea, what are the problems?

First off, the extension of the loan guarantee scheme does not provide any new money in the short term. Sure, if a business that a bank lends to under this scheme goes bust, the government has to chip in, but to begin with it is just making a promise. So, from a bank’s point of view it means it can make less risky loans, but it will still have to come up with the cash. There is a danger, then, that the money the banks supply under this scheme will be taken from elsewhere.

The problem with any kind of government subsidy or investment programme is the danger of crowding out. Only if the plan entails new money, money not currently available to banks, will such a scheme have a significant effect. Under normal circumstances this may not be a problem, but these are not normal circumstances. There is this thing called a credit crunch. When credit is crunched, the ultimate solution is more credit, not measures designed to influence how existing credit is used.

There is also a moral hazard issue. Right now, companies that have carefully managed their finances are at an advantage. Maybe during the boom their growth was not quite as impressive as it could have been, they put prudence first. It has been argued here before, during economic downturns there can be great opportunity. This is when well run businesses with the right products can grab market share and enter the recovery in a position of strength.

This is why recession can be a good thing – in the long term.

So there is a real danger the government schemes could actually dampen the one positive benefit of a recession.

Somehow then, it has to ensure the businesses that receive government help are businesses that really are deserving of this help.

But the real issue with the government plan is this. But before we start let’s just say the comments that follow may be a little unkind. After all, at the time of writing the government has not formally announced its proposal.

What is required now is not support for old ideas, but support for new ideas.

As has been argued here many times, innovation, which requires risk, is the building block of future prosperity. Right now we are seeing a reaction against risk. New businesses with bold ideas are finding it even harder than normal to secure funding.

People can be ingenious. The labour pool is awash with original ideas. Ideas that can not see the light of day because of insufficient funding, made worse by the credit crunch.

Back in the 1980s, Mrs Thatcher had her enterprise allowance scheme, in which people who had been unemployed for an extended time could claim £40 a week while they set up a business. According to an article in yesterday’s Telegraph, the government is introducing a similarish scheme, entailing a £750 up front payment, and a certain amount of advice. But frankly, if you are going to take the plunge, and move into the world of self-employment, you need more help than that. Setting up a business, whatever it is, whether you are set to run a one man window cleaning business, or set to develop a new algorithm for a search engine, is scary.

For too long the UK has been too geared towards the High Street. Napoleon may have said Britain was a nation of shopkeepers 200 years ago, but his comments were most apt during the year building up to the credit crunch.

A downturn like this does represent opportunity. It represents opportunity for new businesses to emerge, and for older businesses to change, and come out the other end with fantastic new products and services.

The government needs to do all it can to encourage this. What it should not do is subsidise older businesses whose business models are no longer right.