Qualms about Industrial Policy

Qualms about Industrial Policy

Qualms about Industrial Policy

“Industrial policy” can be distinguished from a “business-friendly policy” by the amount of targeting involved.

Industrial policy chooses the industries that will be favored with some some combination of subsidies, tax breaks, and trade protectionism–sometimes even the companies that will be favored. Common examples in a recent US context include attempt to favor cars, steel, semiconductors, electric vehicles, and solar panels. On the other side, a business-friendly environment seeks to create a set of education, infrastructure, tax, R&D, regulatory, and other possibilities that give many different kinds of businesses a chance to compete, innovate, and thrive, but steers away from picking either industries or firms.

The world economy seems to be entering an era of industrial policy, and Finance & Development (published by the IMF) has offered a couple of readable essays on the subject recently. Ruchir Agawal wrote “Industrial Policy and the Growth Strategy Trilemma” (published online March 21, 2023). Douglas Irwin has now followed up with “The Return of Industrial Policy” (forthcoming in June 2023 issue)

It’s perhaps useful to state what should be a obvious fact about industrial policy: It can’t be a simple way for governments to create economic prosperity. Otherwise, every country could just choose the industries in which it wants to succeed, and then use industrial policy to achieve prosperity. Thus, it’s no surprise that it’s easy to compile a list of industrial policies that went sideways.

For example, back in 1991 Linda Cohen and Roger Noll published a book called The Technology Pork Barrel, which was based on case studies of US attempts to build infant industries in supersonic planes, communications satellites, a space shuttle, breeder reactors, photovoltaics, and synthetic fuels. I remember back in the 1980s when Japan announced with great fanfare the “Fifth Generation” computer project, which then went away with out fanfare. I remember when Japan was the shining example of how industrial policy worked in the 1970s and into the 1980s, but somehow it abruptly stopped being a shining example when Japan’s economy entered three decades of stagnation starting in the Brazil decided that it would become a computer-producing power in the 1970s and 1980s, and when Argentina decide that it would become a global electronics superpower. I remember the economic disaster that was the industrial policy of the Soviet Union. I remember the places around the world that have tried to be the next “Silicon XXXX,” generally without success.

Was the US economy in the 19th century an industrial policy success story? Irwin argues “no”:

The belief that richer countries were successful because they protected manufacturing gave respectability to industrial policy. That turned out to be a misreading of history. Despite high tariffs, the United States developed as an open economy—open to immigration, capital, and technology—and one with an exceptionally large domestic market that was fiercely competitive. Furthermore, the high-tariff United States overtook free-trade Britain in per capita income in the late 19th century by increasing labor productivity in the service sector, not by raising productivity in the manufacturing sector (Broadberry 1998). In Western Europe, growth was related to the shifting of resources out of agriculture and into industry and services. Trade policies designed to protect agriculture from low prices likely slowed this transition in countries such as Germany.

Was Korea’s economic success due to industrial policy? Irwin again argues “no”:

The experience of successful East Asian countries has given it a positive gloss, but even here standard history can mislead. In 1960, South Korea was saddled with an overvalued currency and exports of just 1 percent of GDP. The country’s ability to import depended almost entirely on US aid. After devaluing its currency in the early and mid-1960s, Korea’s exports became more competitive and exploded, reaching 20 percent of GDP by the early 1970s. The main policy involved setting a realistic exchange rate that allowed exports to flourish along with cheaper credit for all exporters, not targeted industries (Irwin 2021). Industrial policy did not really start until the Heavy and Chemical Industry Drive of 1973–79, which was later terminated because of its excessive costs and inefficiency. But Korea’s rapid growth had already been unleashed before the industrial policy era.

What about China’s efforts to create a domestic airplane industry? Agarwal writes:

However, the recent Chinese experience with the COMAC C919 aircraft shows that industrial policy is far from a silver bullet. Driven by the conviction that a great nation should have its own airliners, China has invested heavily in developing its commercial aircraft to challenge the dominance of Boeing and Airbus. Despite investing up to $70 billion in the Commercial Aircraft Corporation of China (COMAC), China’s state-owned manufacturer, the project has been delayed by more than five years as a result of regulatory, technological, and supply-chain hurdles. The delays were compounded by the special licensing requirements for technology parts exports to China imposed by the Trump administration in 2020. The C919 also hasn’t been certified yet by any major aviation authority outside China, partly due to safety issues. Thus, despite industrial policy success with its domestic high-speed rail network during the 2010s, China has not been able to replicate this achievement in the competitive global aviation industry.

Or China’s efforts to efforts to create a domestic shipbuilding industry? Irwin writes:

China illustrates how industrial subsidies can be an inefficient way of spending scarce resources. In 2006, China identified shipbuilding as a “strategic industry” and began massive production and investment subsidies, mainly through cheap loans. Evidence suggests that these policies did not produce large benefits but were wasteful (due to excess capacity) and distorted markets (forcing more efficient countries to adjust by reducing their output). China’s global market share grew at the expense of low-cost producers in Japan, South Korea, and Europe but without generating significant profits for domestic producers (Barwick, Panle Jia, Myrto Kalouptsidi, and Nahim Bin Zahur. 2019). The subsidies were dissipated through the entry and expansion of less efficient producers, which created excess capacity and led to increased industry fragmentation. The loans were political in the sense that state-owned enterprises rather than more efficient private producers received the bulk of the support. The shipbuilding industry did not generate significant spillovers to the rest of the economy, and there was no evidence of industry-wide learning by doing. … China did not get rich through industrial policy but by improving productivity in agriculture, allowing foreign investment in manufacturing, and unleashing the private sector. 

The problems with industrial policy are well-known. If an idea seems like a money-maker, entrepreneurs and existing companies will invest their own money to make it happen. Thus, industrial policy only comes into play when politicians–who are not investing their own money–decide that some idea that they do not believe the private sector is supporting sufficiently is nevertheless certain to be a money-maker and a job creator. Sure, sometimes a blind squirrel finds the acorn. But choosing among the leftover ideas that private capital doesn’t see as worth funding is not likely to be, on average, a winning idea. Sure, at least some private firms and sources of finance will react to government subsidies, and accept the cash. In doing so, such firms will be focusing on how to attract political favoritism, which is not identical with deciding how best to produce high-quality products at lower costs. And explicitly favoring some industries or technologies or firms will implicitly disfavor others.

Nevertheless, here we go again. Agarwal notes the recent effort to create US industrial policy around semiconductors and clean energy, which follow on the efforts of the Trump administration to practice industrial policy in favor of steel and aluminum. Agarwal continues:

Meanwhile, Japan is providing subsidies worth more than $500 million to 57 companies to encourage them to invest domestically—as part of its efforts to reduce reliance on China. Similarly, the European Union is scaling up its industrial policy—including by setting aside €160 billion of its COVID-19 recovery fund for digital innovations such as chips, batteries, and climate adaptation. In response to massive subsidies in the US Inflation Reduction Act, Italy’s economy minister recently called for a common EU approach to support competitiveness and protect strategic production.

The real challenge with industrial policy is to be hard-headed and selective: that is, not choosing industries where it might be nice to be a global leader, but choosing those where the conditions of the time and place and technology have all come together in a way where a certain country at a certain time is ready to take the next step.

Consider solar energy panels as an example: in particular, China’s leading role in the global economy as a producer of low-cost solar panels. Yes, China has favored its solar industry. But the US was favoring photovoltaics back in the 1970s and 1980s. Japan went through a stage of favoring solar panels in the 1980s and 1990s, and so did Germany in the 21st century. In other words, China’s industrial policy success as a provider of solar panels was built on research and investments in other major economies over a period of decades, which didn’t work out very cost-effectively at the time for those other countries, combined with China’s skills in low-wage, low-cost manufacturing. Conversely, China’s failed industrial policy in shipbuilding, airplanes, semiconductors, and others are examples of where China chose industries where it might have been nice to be a leader, but disregarded the signs that, given existing technology and realities of China’s economy, China was not well-positioned to be a leader in those areas.

I’ll give Agarwal the last word here:

Former US Treasury Secretary Lawrence Summers recently said he liked his industrial policy advisers the same way he liked generals. “The best generals are the ones who hate war the most but are willing to fight when needed. What I worry is that people who do industrial policy love doing industrial policy.” In this context, the Trilemma reminds policymakers to take a cautious approach to industrial policy—while focusing on long-term growth, stability, and international cooperation. … Just like salt in cooking, a pinch of industrial policy can be helpful, but too much can overpower, and prolonged excess can harm.

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Timothy Taylor

Global Economy Expert

Timothy Taylor is an American economist. He is managing editor of the Journal of Economic Perspectives, a quarterly academic journal produced at Macalester College and published by the American Economic Association. Taylor received his Bachelor of Arts degree from Haverford College and a master's degree in economics from Stanford University. At Stanford, he was winner of the award for excellent teaching in a large class (more than 30 students) given by the Associated Students of Stanford University. At Minnesota, he was named a Distinguished Lecturer by the Department of Economics and voted Teacher of the Year by the master's degree students at the Hubert H. Humphrey Institute of Public Affairs. Taylor has been a guest speaker for groups of teachers of high school economics, visiting diplomats from eastern Europe, talk-radio shows, and community groups. From 1989 to 1997, Professor Taylor wrote an economics opinion column for the San Jose Mercury-News. He has published multiple lectures on economics through The Teaching Company. With Rudolph Penner and Isabel Sawhill, he is co-author of Updating America's Social Contract (2000), whose first chapter provided an early radical centrist perspective, "An Agenda for the Radical Middle". Taylor is also the author of The Instant Economist: Everything You Need to Know About How the Economy Works, published by the Penguin Group in 2012. The fourth edition of Taylor's Principles of Economics textbook was published by Textbook Media in 2017.

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