One of the UK government’s vaunted benefits for a hard Brexit is the greater freedom it will have to boost its use of state aid. It might have to do a lot more beyond the grants it has already provided in the wake of the Covid-19 pandemic.

In an interview for the political online magazine Project Syndicate, Willem Buiter, visiting professor at Columbia University and former Citigroup chief economist, said the end of the Brexit transition will “likely bring a significant and persistent negative aggregate supply shock... the supply shock will come mostly from supply-chain disruptions, a significant decline in foreign direct investment and the end of the UK’s infinitely elastic supply of labour from the rest of the EU”.

A 2016 study by Swati Dhingra and colleagues at the London School of Economics’ Centre for Economic Performance concluded foreign direct investment would suffer a 22 per cent fall over a decade from Brexit. A big problem that comes with a drop in foreign investment, economists have long argued, is that the arrival of these operations tend to help indigenous companies through the establishment of clusters that promote local suppliers. The government may find itself pumping money into other industries that are affected by a drop in inward investment. A rich irony of this recently adopted stance is that the Conservative administration of the 1980s, together with The Netherlands, pushed for the rules that now permeate the EU state-aid structure in order to prevent national governments from doing just that.

Though it took a couple of decades to solidify, the outcome of that historic lobbying is that the EU is unusual in the way it has defined and implemented rules on state aid. Even in the US, individual states have the latitude to provide funding and tax breaks to companies without an overarching set of rules set by the federal government. The outcome of this could be seen with the interstate bidding war over where Amazon would build its second headquarters, offering more than 10,000 jobs. Some 200 cities submitted offers of incentives rising to as much as $9bn at one stage: all for the third largest company by market capitalisation in the US. Amazon finally settled on a more modest half a billion dollars from the state of Virginia. Such bidding wars obscure the fact there is some coordination between states and the federal government. Arizona took advantage of the Trump administration’s willingness to pull more advanced manufacturing into the country for Taiwan Semiconductor Manufacturing Corporation to build a semiconductor fab there.

Though there are reasons to employ state aid during economic shocks, economists who are often heavily in favour of free-market approaches frequently warn against it. A major risk is a tendency for aid to focus on declining industries. A 2002 paper by Richard Baldwin and Frédéric Robert-Nicoud for the US National Bureau of Economic Research argued owners and managers of established companies facing losses tend to lobby far harder for aid than those expecting success in the future. A further issue is that ailing industries are more visible because they have more employees in each location than the many start-ups spread around a region.

Aid focused on individual companies is not necessarily focused on the past. Previous UK governments have tried to favour sunrise industries. Into the first half of the 1980s, though it had an ideological resistance to state aid, the Thatcher administration decided to continue the funding of Inmos, conceived under Callaghan’s Labour government. Overall, the Bristol-based company received approximately £100m as it first established a presence and market success in specialist memories for graphics before turning to processors in anticipation of a shift to parallel processing, albeit this time way too early for the market.

Although Inmos itself faded from the scene, the legacy of that investment did live on. Before Inmos was set up, there was a small electronics-design presence in the area courtesy of a design office for Fairchild Semiconductor. However, it is easy to trace the heritage of many of the start-ups established since the 1990s, a number of which were acquired to form the UK design centres for a variety of larger overseas electronics companies, to Inmos.

The clustering effect from the government investment is mirrored in France, Germany and Benelux, where the kernel is typically a research institute such as CEA-Leti, Imec or one of the Fraunhofer Institutes. The giant Silicon Valley cluster itself was originally the recipient of significant state aid for R&D under a system that remains peculiarly American, and may well become the target again.

In effect, the Atlantic Ocean divides two models for government intervention in private R&D. On the eastern side, there is the system of pre-competitive grants awarded to multi-organisation groups operated by the EU under a series of initiatives such as the current Horizon 2020 programme and its Horizon Europe successor. On the western side, a group of organisations that began with the Advanced Research Projects Agency (ARPA), formed as a response to Soviet Russia’s Sputnik launch, is the key provider of applied R&D funding.

As part of its ambition to break with European procedures, the Johnson administration has made no secret of its plans to transplant the ARPA structure to the UK. Although adviser Dominic Cummings has argued strongly for such an agency in recent years, the international fascination with the US approach to R&D funding is hardly new. Russell Group universities chief executive Tim Bradshaw, who contributed to a white paper on the subject published by Policy Exchange at the start of 2020, penned a brief that recommended emulating the model for the CBI in 2006.

One key to its relative popularity is that ARPA can provide a way for research-oriented start-ups to gain access to the huge US military procurement machine, which spends almost $150bn a year. The deployment of government procurement is one of the features that backers of the idea writing for the Policy Exchange white paper want to see replicated in a UK ARPA.

On mainland Europe, there have been similar calls. Though industrial giant Siemens has been busily buying companies to support its software operation with a focus on ‘digital twin’ technologies, researchers are increasingly concerned that European countries risk falling behind in information technologies. Some, such as Dalia Marin, professor of international economics at the Technical University of Munich’s School of Management, argue that the European Union needs its own version of DARPA, the current defence-focused research agency, in addition to the Horizon programmes. She claims that for countries such as Germany, such an agency would help drive R&D more likely to be useful to start-ups and help meet the Nato 2 per cent of GDP target for defence spending.

An open question is the degree to which a defence focus is required for an ARPA-like institution. When the Trump administration took power a decade after the establishment of the energy-focused ARPA-E, some officials were keen to disband the agency on the basis that it was doing work the private sector would just as readily take on whereas the government itself had no direct need for its output.

A significant factor in favour of the defence-oriented ARPAs lies in the dual-use nature of many technologies. As with the space programme that spawned the original ARPA in the late 1950s, many fans of the agency’s approach point to its role in creating the basis for the modern internet and in launching the constellation of satellites that form the heart of the Global Positioning System. Both are responsible for trillion-dollar markets thanks to an army of companies embracing the technologies. Despite lacking the ready customer of the DoD, ARPA-E has helped some companies get to market. ARPA-E provided initial funding of just under $4m in mid-2011 to start-up Smart Wires to fund the construction of prototypes that lowered the risk for venture capitalists who were expected to step in after successful demonstrations. Since then, the company has raised more than $130m from the private-equity market and the company is now providing its power-flow control technology to a number of grid operators, including the UK’s National Grid Electricity Transmission company.

A number of concepts have gone outside energy, including Agrivida and Ceres, which used biotechnology to improve crop production. However, a report compiled by the National Academy of Sciences found it difficult to assess ARPA-E’s overall success since its creation.

A criticism of the ARPA approach typically used by economists who back free-market policies is that the programme managers have, like politicians or anyone else, limited visibility of what a particular project is worth long-term because there is no market that might put a price on the innovations. However, arguments against the supposed value of ‘market price’ can be made against venture capital investments as they are subject themselves to imperfect information, which leads to bidding wars long before the viability of a start-up’s approach can be demonstrated.

Though the verdict for R&D-focused state aid is more positive than for corporate subsidies aimed at sustaining existing business, the question of what works best in practice remains hard to answer. As with venture capital, getting any outputs relies on providing cash to many potential duds in the hope something good will emerge.