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Industry by Design?

Posted by hkarner - 20. März 2017

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Christopher Smart, a senior fellow at the Mossavar-Rahmani Center for Business at Harvard University’s Kennedy School of Government, was Special Assistant to the president for International Economics, Trade and Investment (2013-15) and Deputy Assistant Secretary of Treasury for Europe and Eurasia

Industrial policies come in many shapes and sizes, but some strategies to nurture domestic firms and industries have clearly worked better than others. Understanding why may hold the key to creating the conditions for contemporary growth and development

MAR 17, 2017 Project Syndicate

In the nationalist form favored by populists like Trump, but also by less mercurial leaders, like British Prime Minister Theresa May, industrial policy is seen as a means to reclaim control over the forces of globalization, which supposedly favor “globalist” elites and no one else. But industrial policy also “returned” in the immediate wake of the 2008 global financial crisis. With markets having clearly failed, governments across the West took far-reaching measures to save various industries and firms from bankruptcy, boost economic activity and create jobs.

In reality, debates about industrial policy, like industrial policy itself, never really went away. Governments have always tried to foster conditions for industrial success at home. And a dispassionate, technocratic industrial policy is increasingly considered crucial for guiding technological innovation and diffusion, and for confronting problems such as climate change.

Still, even those who view industrial policy as a panacea concede that it has a mixed history, with notable successes punctuated by spectacular failures. Many Project Syndicate commentators have been participating in – and often leading – these debates for years. As policymakers around the world increasingly consider whether and how to intervene on behalf of the “home team,” they would do well to consider the most important arguments about the proper role of, and best practices for, industrial policy in the twenty-first century.

Hand Up or Dead Hand?

Justin Yifu Lin, Director of the Center for New Structural Economics at Peking University and a former World Bank Chief Economist, defines “industrial policy” as “any government decision, regulation, or law that encourages ongoing activity or investment in an industry.” Given this broad definition, it “should come as no surprise” that “most countries, intentionally or not, pursue an industrial policy in one form or other.”

In every country that has moved from an agricultural to a modern economy, Lin observes, “governments coordinated key investments by private firms that helped to launch new industries, and often provided incentives to pioneering firms.” And, writing in 2010, Lin correctly predicted that, “As economies around the world struggle to maintain or restore growth in 2011, industrial policy is likely to be under a brighter spotlight than ever before.”

But where Lin sees promise in properly executed industrial policies as a way to fuel development and growth, Michael J. Boskin, who chaired President George H.W. Bush’s Council of Economic Advisers, worries that such policies can be taken too far. Industrial policy, Boskin notes, is naturally “appealing to politicians, who can favor key constituencies while claiming to be helping the economy as a whole.” But, he warns, “allowing governments to pick industrial winners and losers is just as bad an idea today” as it was in the 1970’s and 1980’s, when “industrial policy failed miserably.”

Boskin underscores this point by citing the example of Japan, which pursued a much-ballyhooed industrial policy in the 1980’s to “micromanage” its economy. It worked until it didn’t, and Japan ended up with “a burst asset bubble, a lost decade, three recessions, and by far the highest public debt-to-GDP ratio of any advanced economy.”

But even those who see potential in industrial policy would agree that it should not take the form of micromanagement or propping up specific firms and industries. For Harvard University’s Dani Rodrik, “industrial policy is a state of mind rather than a list of specific policies.” What successful policymakers understand, Rodrik argues, is “that it is more important to create a climate of collaboration between government and the private sector than to provide financial incentives.”

Indeed, says Mohamed A. El-Erian, Chief Economic Adviser at Allianz, one of the key challenges “facing Western governments today is to enable and channel the transformative – and, for individuals and companies, self-empowering – forces of technological innovation.” Fortunately, says El-Erian, there are tools available, including “well-designed public-private partnerships, especially when it comes to modernizing infrastructure. But there also needs to be “disruptive outside advisers – selected not for what they think, but for how they think – in the government decision-making process; mechanisms to strengthen inter-agency coordination so that it enhances, rather than retards, policy responsiveness; and broader cross-border private-sector linkages to enhance multilateral coordination.”

The key question governments should keep in mind, according to former Chilean Finance Minister Andrés Velasco, is whether they are pursuing horizontal or vertical industrial policies. The former, he writes, “provide the inputs that a broad range of firms, across different sectors, need for their growth and development,” including “transport infrastructure, trained engineers, and a labor force proficient in English”; the latter, by contrast, “favor a particular sector.”

Development Dos and Don’ts

But Velasco adds an important caveat: “[T]he line between horizontal and vertical policies is inevitably fuzzy.” This has been particularly true in developing countries over the past few decades. While many economists have advocated policies aimed at the private sector, education, and good governance, rather than massive public investments in infrastructure, Rodrik points out that Ethiopia, India, and Bolivia have made notable achievements with old-fashioned government spending on roads, power plants, and the like.

Similarly, Mexican President Enrique Peña Nieto reports that his government is “channeling more than $460 billion toward building and modernizing thousands of kilometers of roads and highways, as well as expanding and improving our mass transit and railway systems.” But for Peña Nieto, a successful industrial policy must also involve investing in “education, the business environment, and connectivity”. Mexico, he points out, is one of the few countries to acknowledge a citizen’s right to broadband access. Accordingly, it has been pursuing a policy to extend high-speed Internet service to libraries, schools, and public squares.

Meanwhile, the Inter-American Development Bank has drawn lessons from contrasting approaches to industrial policy in East Asia and in Latin America. As IADB President Luis Alberto Moreno observes, import replacement and support for high-priority sectors yielded impressive results for South Korea, but largely failed in Latin America and the Caribbean. Industrial policies fell short where governments bowed to political pressures from industries that had no chance of becoming competitive.

Moreno thinks that industrial policy can still deliver for Latin America, so long as its leaders keep three questions in mind: whether there is “a clear market failure that justifies government intervention”; whether “the proposed policy [will] be effective in remedying the market failure”; and whether “the institutions necessary to execute the policy” have been established. Lin, for his part, offers a clear-cut lesson for all developing countries: industrial policies fail when governments do not “align their efforts with their country’s resource base and level of development.”

Made in China

Despite its lack of transparency, widespread corruption, and endemic waste, China is the most frequently cited industrial-policy success story in recent decades, owing to its breathtaking economic growth. According to Rodrik, China’s “phenomenal manufacturing prowess rests in large part on public assistance to new industries.” While China’s “state-owned enterprises have acted as incubators for technical skills and managerial talent,” he writes, “local-content requirements have spawned productive supplier industries in automotive and electronics products.” At the same time, China has established export incentives that allow domestic firms to “break into competitive global markets.”

But, as James Zhan of the United Nations Conference on Trade and Development warns, China’s model is not necessarily an option for other developing countries. He points out that “China’s growth rate has been boosted over the last two decades by the country’s demographic and land-resource ‘bonuses.’” While this helped China “to maximize the benefits of globalization,” Zhan argues, “[m]any other developing countries simply cannot emulate this success in all respects.”

In a more recent commentary, Wing Thye Woo of the University of California, Davis, points out that the Chinese “economy’s health seems to be waning,” and that Trump’s protectionist approach “could pose a direct challenge to [China’s] growth model.” Woo describes the “steady deceleration of economic growth” in recent years as an “albatross around Chinese policymakers’ necks.” Nonetheless, he concludes that Trump’s “America first” mindset will ultimately be a boon to emerging countries. “China stands to benefit enormously – particularly in geopolitical terms – if it can emerge as a source of sustained economic dynamism.”

Toward that end, President Xi Jinping has doubled down on China’s “one belt, one road” initiative, which Fudan University’s Zhang Jun describes as a Marshall Plan-like “undertaking that will establish the physical and institutional structure for closer trade and investment relations with countries in the Asia-Pacific region and beyond.” In Lin’s view, OBOR has clear geopolitical motivations, but it also fits with China’s ongoing industrial policy, because it “will fuel the emergence of new markets coveted by more developed countries – including China – while creating space in China for higher-value-added industries to take hold.”

Still, as China continues to climb the global value chain, it will most likely need to adjust its approach. And, with industrial policy emerging from the shadows across most advanced economies, there will be plenty of examples for China to follow – or avoid.

Crisis Management

In the fall of 2008, when financial markets seized up and the world economy appeared to be on the brink of collapse, governments scrambled to make up for lost demand. Western policymakers, in particular, urgently needed to reinvigorate economic activity after bailing out banks, automakers, and other industries. But as the crisis swept Europe, Elie Cohen of France’s Centre Nationale de la Recherche Scientifique bemoaned the fact that uncoordinated industrial policies had “created distortions and irregularities up and down the Continent.” National industrial policies and European Union competition rules, he argued in 2010, can coexist only if European governments “work together when implementing industrial policy” and “do much more to promote innovation and competitiveness.”

Things have not improved much since then. In 2015, Michael Hüther of the Cologne Institute for Economic Research lamented Europe’s lack of an even-handed competition policy, noting that “EU governments have different, often contradictory, strategies for their respective manufacturing sectors.” Still, German industrial policy has been more effective than its French counterpart. France, Hüther notes, “wants to create national champions by selecting specific sectors for special support,” which forced it to acquire a stake in the automaker Peugeot as an act of “industrial patriotism.” Germany, by contrast, has tried to create “a competitive framework that enables ‘hidden champions’ to emerge as global leaders.” By supporting a major airport hub in Frankfurt, Germany has also helped the country’s flagship airline succeed.

In the United Kingdom, where the government recently released a policy brief for its new industrial strategy, Paola Subacchi of Chatham House is hopeful that “political leaders have learned some important lessons from history.” Rather than pursuing broad economic strategies, policymakers are focusing on “‘targeted interventions’ designed to create positive incentives, correct market failures, and address social, geographical, and sectoral imbalances.” But she also echoes Cohen and Hüther’s call for more coordination, and warns European governments not to assume that implementing “ad hoc policies that strengthen their ‘invisible hand’” in the near term “will somehow end up fitting neatly into a coherent framework.”

Few are making that assumption about economic policymaking in the US, where Trump began conducting his own brand of industrial policy before he was even inaugurated, by pressuring Carrier not to move around 1,000 jobs from its Indiana plant to a factory in Mexico. As Rodrik recently noted, “Trump’s policy style represents a sharp break from that of his predecessors.” But Trump’s approach is different because it lacks “transparency, accountability, and institutionalization,” not because it can be described as a form of industrial policy, per se.

The Innovation Imperative

For many Americans, the term “industrial policy” smacks of government planning and thus remains off limits in mainstream US political discourse. But Rodrik reminds us that the US has long been the leading exponent of government-assisted growth and innovation. “The US owes much of its innovative prowess to government support,” he writes. “The Internet, possibly the most significant innovation of our time, grew out of a Defense Department project initiated in 1969,” and the US government remains the “world’s biggest venture capitalist by far.”

Mariana Mazzucato of the University of Sussex turns Rodrik’s defense of the virtues of sound industrial policy into a full-throated paean. Policymakers should “rethink the conventional wisdom about state intervention,” Mazzucato argues. Indeed, she believes that governments should be “actively creating new markets, instead of just fixing them,” and lists a variety of examples of how the state has played an “‘entrepreneurial’ role envisioning and financing the creation of entire new fields, from information technology to biotech, nanotech, and green tech.”

Of course, as with all entrepreneurship, the state will sometimes fail. The US Department of Energy was maligned for extending a $535 million loan guarantee to the solar-panel manufacturer Solyndra, which eventually went bankrupt. But that same, now-profitable DOE program also helped develop the Tesla Model S electric car, which has been a roaring, pollution-free success. For Mazzucato, the problem with the current approach is not that the state is playing a role in innovation; it is that the profits from successful investments, including blockbuster drugs, are too often privatized, while the losses from failures are borne directly by taxpayers. But, as Boskin reminds us, this dynamic is often reversed in the case of basic research. “Private markets invest too little in basic science,” he writes, “because private investors are unable to appropriate the returns.”

This points to a role for industrial policy that few would dispute. Indeed, Nobel laureate economist Joseph E. Stiglitz reports that “average returns to the economy from government research projects are actually higher than those from private-sector projects,” owing to the government’s heavy investment in “important basic research.” For Stiglitz, economic growth is driven not just by technology, but by learning how to put innovations to work in “other economic activities.” Thus, “the point of industrial policy,” he argues, is to “identify sources of positive externalities – sectors where learning might generate benefits elsewhere in the economy.”

Going Green

To Boskin’s mind, “the appropriate place to draw the line conceptually is at pre-competitive, generic science and technology,” whereby governments “fund R&D until it reaches the stage where private firms could appropriate (the bulk of) the benefit.” And yet, some innovations, such as new forms of renewable energy, may be desirable, but not yet competitive or profitable. “On its own, Mazzucato notes, “the free market will not develop new sources of energy fast enough” to reorient economies away from fossil fuels and toward renewable energy sources. That is why confronting climate change and achieving a clean-energy future “will require the intervention of a courageous, entrepreneurial state, providing patient, long‐term finance that shifts the private sector’s incentives.”

Columbia University’s Jeffrey D. Sachs echoes this point. “Private electricity producers,” he points out, “will not invest in large-scale renewable energy generation if the government does not have long-term climate and energy policies or plans for spurring construction of long-distance transmission lines to carry new low-carbon energy sources to population centers.” As the UN Environment Programme’s Achim Steiner and Pavan Sukhdev of Yale University put it, policies to facilitate the coming “Green Economy” are “not a luxury, but a clear imperative on a planet of six billion people – and nine billion by 2050.” And countries ranging from Spain, South Korea, and India to Kenya, Uganda, and Thailand are already making “green investments” that have created jobs, spurred growth, and generated “environmental gains as well.”

Meanwhile, China, one of the world’s largest polluters, has been incorporating climate goals into its economic model. According to the People’s Bank of China’s Ma Jun and Simon Zadek of Singapore Management University, China intends to “facilitate green investment” with “a wide range of new financial instruments, including green credit, green development funds, green bonds, green equity index products, green insurance, and carbon finance.” And Stiglitz also recognizes the potential for green finance, particularly in Japan, where he recommends that it be combined with a large carbon tax to “stimulate enormous investment to retrofit the economy.”

The Corporatist Specter

Most Project Syndicate commentators agree that governments have some role to play in national economic development, but they also acknowledge the dangers of overreaching. As Rodrik puts it, “success in industrial policy” reflects “not the ability to pick winners, but the capacity to let the losers go.” Moreover, industrial policy, especially in democracies, “needs be carried out in a transparent and accountable manner, and its processes must be open to new entrants as well as incumbents.”

In the US, Nobel laureate economist Edmund S. Phelps worries that this is no longer true, and that obstacles to new entrants have sapped “America’s innovative spirit.” With the government now exerting “control over much of the private sector,” Phelps argues, “a private actor with a new idea often needs government approval to start up; and firms that enter an existing industry must compete with incumbents that usually already have government support.”

Like Rodrik, Phelps expects that Trump’s approach will only make matters worse. He sees Trump’s berating of corporations as an “expansion of corporatist policy the likes of which have not been seen since the fascist German and Italian economies of the 1930s.” And “more interference in the business sector to protect incumbents and block newcomers,” he predicts, “will clog the economy’s arteries, most likely preventing far more innovation than it stimulates among the established insiders.”

The US, often viewed as the heartland of resistance to industrial policy, has actually been a pioneer. But, as other governments and world leaders hone their own industrial policies in the coming years, they will most likely have to seek inspiration elsewhere.

 

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