Towards a more productive debate

With the discrediting of orthodox policies, and the exposure of the double standards of the rich countries, industrial policy is no longer taboo. Ha-Joon Chang argues for an acceptance that industrial policy can work, at least some of the time, and for ‘outside of the box’ thinking on how to make it work better.

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For the last three decades, industrial policy – or, more precisely, selective industrial policy, where the government intervenes in a way that discriminates between industrial sectors – has been off the mainstream policy agenda. In the English-speaking developed world where neo-liberalism originated, industrial policy came to be denounced as ‘picking losers’ in a misguided attempt to ‘pick winners’. With the intellectual and political shift towards neo-liberalism at the World Bank and the IMF, structural adjustment programmes (SAPs) dismantled existing industrial policies through trade liberalization, privatization, and deregulation of domestic business activities and foreign direct investment – or what are commonly known as the Washington Consensus policies. The rise of Japan and other East Asian economies forced a debate on industrial policy between the late-1980s and the mid-1990s, but even then it was dismissed as something that worked only because of the unique political and cultural conditions of the East Asian countries, such as an exceptionally capable bureaucracy. When the East Asian economies got into trouble, with the bursting of Japanese financial bubble in the mid-1990s and the Asian financial crisis in 1997, industrial policy was blamed as one of the key causes of their economic problems, and declared defunct.

However, the continued economic problems in developing and transition economies that had faithfully implemented orthodox policies – rising income inequality, repeated financial crises, and, above all, a slowdown (or sometimes a collapse) in growth – badly dented the reputation of the Washington Consensus. By the early 2000s, even the main proponents of the Washington Consensus started modifying their positions, even though they fell short of changing anything fundamental. Some others have talked of a post-Washington Consensus, although there is no consensus on what the term exactly means.

Even in this retreat of the free-market orthodoxy, the rejection of selective industrial policy – and all the policy measures that go with it, such as tariff protection, subsidies, regulation on foreign investment, state ownership of industrial and financial firms – continued. Many who were critical of free-market orthodoxy drew the line at selective industrial policy, and argued that, while there is a case for industrial policy, it should be of ‘general’ kind that does not discriminate across sectors – education, training, infrastructure, etc. Selective industrial policy, for many, still remained ‘beyond the pale’.

However, the tide may be finally turning. The 2008 global financial crisis has exposed the limits of the free-market orthodoxy even further. Up until then, many people had assumed that orthodox policies worked in the rich countries, especially the Anglo-American ones where they originated. The problem, the critics argued, was that these policies had been imposed on developing countries where they are not suitable. But the 2008 crisis has shown that these policies are not suitable for the rich countries either. With the crisis blowing up in the United States, the United Kingdom, and the smaller economies that had most aggressively pursued neo-liberal strategy based on financial deregulation (Ireland, Iceland, Dubai, Latvia, etc.), there is a shift in opinion. As the former British business secretary, Lord Peter Mandelson, quipped, there needs to be more “real engineering” and less “financial engineering”, recognizing that selective industrial policy has an important role to play in the process.

At the same time, the government bail-out of GM and Chrysler in the USA, and the subsidies provided to the automobile and other industries by the governments of other developed countries, has exposed the double standards that these countries had applied in advising developing countries not to use active industrial policy.

Of course, it is too early to tell whether all of this – the discrediting of orthodox policies, and the exposure of the double standards of the rich countries – will lead to a revival of industrial policy. However, it is undeniable that the terms of debate on industrial policy have changed. Industrial policy is not a taboo any more. There is an open acknowledgment, even among critics and sceptics, that the declaration of the demise of industrial policy may have been premature. People are increasingly accepting that at least some economies need to rebalance their economies away from the over-blown financial sector, and that this may require active industrial policy. With the exposure of the double standards of the rich countries, developing countries are going to have an easier time defending their industrial policy against criticisms by donor governments and the international financial institutions. This may also affect the evolution of the World Trade Organization and other elements of the world trading system.

Understanding industrial policy

Industrial policy is such a contentious thing that people cannot even agree on its definition, but most of us would define it as “targeting”– or “selective industrial policy”. Industrial policy in this sense is usually associated with the East Asian economies (Japan, the Republic of Korea, Taiwan province of China, and Singapore) during their “miracle” years, between the 1950s and the 1980s.

In the early days of the debate on industrial policy – in the late 1970s and the early 1980s – some denied its very existence on the ground that the East Asian countries did not spend much on subsidies. However, it was subsequently revealed that industrial policy in East Asia involved a lot more than handing out tariffs and subsidies to internationally uncompetitive, domestic-market-oriented industries. The range of policy tools deployed was very extensive, including: direct and indirect export subsidies; policies to ensure scale economy; policies aimed at restricting “excessive competition”; regulation on technology imports; requirements imposed on foreign direct investment; state provision and/or subsidizing of research and development (R&D) and worker training.

Moreover, industrial policy was not a practice confined to late-20th century East Asia.

First, successful industrial policy experiences in the late 20th century are also found in many European countries (national industrial policies in Austria, Finland, France, and Norway; regional industrial policies in Germany and Italy). Even in the case of the US, there was a lot of “hidden” industrial policy through federal R&D programmes. Despite its free-market rhetoric, when it came to R&D spending, the US government has been more interventionist than many of its competitor governments.. Throughout the post-World War II period, the government’s share of total funding in R&D in the US was 40-65%, compared to around 20% in Japan and Korea, and less than 40% in Belgium, Finland, Germany, and Sweden. It is notable that most of the industries where the US has an international technological lead are the industries that have been receiving major government R&D funding through military programmes (e.g., computers, semi-conductors, aircraft) and health projects (e.g., pharmaceuticals, biotechnology).

Second, in the 19th and the early 20th centuries, when they were developing countries themselves, all of today’s rich countries practiced protectionism and deployed industrial policy through subsidies, public ownership, regulation of foreign direct investments, and a deliberately lax intellectual property rights regime. For example, Britain and the US, countries that most people think invented free trade, were among the most protectionist countries in the world during their respective catch-up periods (mid-18th to mid-19th century, and mid-19th to mid-20th century, respectively). France, Austria, Finland, Norway, Singapore, and Taiwan used state-owned enterprises extensively during the post-WWII period. The US, Japan, Korea, Taiwan, and Finland heavily regulated foreign direct investment when they were at the receiving end of it. The Netherlands and Switzerland, two countries that did practice (nearly) free trade, refused to introduce a patent law until 1912 and 1907 respectively (on the grounds that a patent, as an artificially-created monopoly, is incompatible with the principle of free trade)

Third, contrary to the popular perception, developing countries did not do poorly when they more actively pursued industrial policy during the import substitution industrialization (ISI) period in the 1960s and the 1970s. In fact, during the period, they grew much faster than in the ‘age of imperialism’, when they were forced into free trade and laissez-faire industrial policy through colonial rule or ‘unequal treaties’ (which deprived them of their tariff autonomy). Under colonial rule or unequal treaties, the economies of many developing countries contracted or at best grew at anaemic rates. Their growth performance in the ISI period was also much better than that in the more recent period of neo-liberalism, when they used less industrial policy. For example, during the 1960s and the 1970s, per capita income in Latin America and Sub-Saharan Africa grew at 3.1% and 1.6% per year respectively. These rates fell to 1.1% and 0.2% between 1980 and 2009.

Individually, the above sets of evidence, as well as the evidence about the East Asian experience that we discussed earlier, do not prove anything. However, taken together, they raise some difficult questions for the sceptics of industrial policy. If industrial policy was not confined to East Asia in the late-20th century, it becomes difficult to downplay its role in East Asia by resorting to some region- and time-specific “countervailing forces”. Even if many countries that have used industrial policy did not succeed, the fact that few of today’s rich countries have become rich without industrial policy prompts us to ask whether a good industrial policy may be a necessary, although not sufficient, condition for economic development. Looking at all these sets of facts together, we are bound to wonder if industrial policy is so bad, how is it that in every era the fastest growing economies happen to be those with a strong industrial policy: Britain between the mid-18th and mid-19th centuries; the US, Germany, and Sweden between the late 19th and the early 20th centuries; East Asia, France, Finland, Norway, and Austria in the late 20th century; and China today.

How to do industrial policy better?

While there is actually much stronger empirical evidence for industrial policy than most people think, the debate rages on, and probably never will be conclusively resolved. But the good thing is that we do not need some absolute “proof” of its merit, either way, in order to take the debate forward. As far as we can agree that industrial policy can work, at least some of the time, we can still have a productive debate on how to make it work better.

Targeting – selective v. general industrial policy

Many argue that industrial policy should be of a “general” (or “functional”), rather than a “selective” (or “sectoral”) kind,that it should provide things like education, R&D, and infrastructure that benefit all industries equally, rather than trying to “pick winners”.

One problem with this view is that in a world with scarce resources, there are no truly general industrial policies that affect every industry equally. R&D subsidies favour R&D-intensive industries; infrastructure investment is location-specific; and we cannot train engineers that are equally useful for all industries.

Now, if targeting is inevitable, can we at least say that less targeted policies are better? Unfortunately not – targeting has its merits and problems. Indeed, in social policy many people think the more targeted a policy, the better it is. Instead of debating whether we should target, we should debate what the optimal degrees of targeting are for different types of policies.

Can the state ‘beat the market’?

One classic argument against industrial policy is that, given the limits to information and capabilities, the state cannot “beat the market”. However, there are quite a few examples in history where government officials made decisions that blatantly went against market signals, only to build some of the most successful businesses in history (e.g., the Japanese auto industry, the Korean steel-maker POSCO, and the Brazilian aerospace company Embraer).

Moreover, in order to explain these success cases, we do not need to assume that government officials are omniscient, or even that they are cleverer than capitalists. Many (although not all) of the “superior” decisions made by the state were made because the government officials could look at things from a national and long-term point of view, rather than from a sectional and short-term point of view.

Instead of debating whether the state can beat the market, we should be debating how to improve the personnel and organizational conditions of good state decision-making.

Political economy

Another set of objections to industrial policy may be described as “political economy” arguments where critics have rightly questioned the commitment of the political leadership to economic development, the coherence of the state machinery, and the ability of the state to discipline the recipients of its supports.

Political economy problems need to be taken seriously. However, we should not let the best to be the enemy of the good. If we wait for the perfect state to emerge, we will never get anything done. In the real world, successful countries are the ones that have managed to find “good enough” solutions to their political economy problems, and went on to implement policies. In order to take the debate forward, we have to discuss how pragmatic improvements can be made to a country’s politics.

We have to improve our understanding of issues like: how effective political visions can be formed and deployed to inspire various individuals and groups to act in a concerted manner; how to build nations and communities out of disparate groups that may even have a very long history of mutual hostility and mistrust; how to work out social pacts and build lasting coalitions behind them; how to partially accept but improve the customs and organizational routines in the bureaucracy; and how to minimize socially-harmful lobbying and bribing, while maximizing the flows of information between the state and the private sector. In order to fully address these issues, we economists need to go beyond the usual boundaries and work with practitioners (politicians, government officials, businessmen) as well as academics from other fields (political science, sociology, anthropology, psychology, cultural studies).

Bureaucratic capabilities

However willing and strong the state may be, and however “correct” its vision may be, policies are likely to fail if the government officials implementing them are not capable. Difficult decisions have to be made with limited information and fundamental uncertainty, often under political pressure from inside and outside the country. This requires decision-makers with intelligence and adequate knowledge.

In this context, people have argued that “difficult” policies, like (selective) industrial policy, should not be tried by countries with limited bureaucratic capabilities. And it is for this reason that the World Bank’s East Asian Miracle report of 1993 recommended the South-east Asian countries (Thailand, Malaysia, and Indonesia), where industrial policy was quite circumscribed partly in recognition of relatively low quality of their bureaucracies, as models of industrial policy for other developing countries.

At the general level, I cannot dispute the proposition that we need capable bureaucrats in order to design and implement good policies. However, this sensible point is often exaggerated into the policy world equivalent of the “do not try this at home” warning that is shown on TV when dangerous stunts are performed.

The first problem with this “do not try this at home” argument is that there is no basis for the assumption that industrial policy is more difficult than other policies. Second, another implicit assumption that industrial policy requires a sophisticated knowledge of economics is also unwarranted. The industrial policymakers of East Asia were not economists – they were lawyers in Japan and South Korea, and engineers in Taiwan and China – and until the 1970s what little economics they knew was usually of the “wrong” kind – Marx, the German Historical School, Schumpeter, you name it. Third, the “do not try this at home” argument assumes that high-quality bureaucracies are very difficult to build, and that the East Asian countries were exceptionally lucky to have inherited them from earlier eras. However, high-quality bureaucracy can be built pretty quickly, as shown by the examples of South Korea and Taiwan themselves. Fourth, there is also “learning-by-doing” in policy. Without “trying”, you will never master difficult policies. And lastly, the fact that something is “difficult” cannot be a reason not to recommend it. After all, developing countries are routinely told to adopt “best practice” or “global standard” institutions used by the richest countries, even though many of them clearly do not have the capabilities to effectively run such institutions. To be more productive, rather than bemoaning the lack of bureaucratic capabilities in developing countries, we need to have more debate on how to improve them.

Performance measurement

Especially when industrial policy is comprehensive, objective performances become difficult to measure, as virtually all prices are “distorted” and are also subject to manipulation. But rather than debating whether setting and enforcing effective performance targets is possible (as it certainly is), we should concentrate on questions like:

• what performance indicators should be used for which industries?;
• how do we set credible performance targets without becoming too rigid about them?;
• lhow does the government listen to the private sector without becoming beholden to it?; and
• how do we operate with a long, but not infinite, time horizon?

Export-related industrial policy

Exports have critical roles to play in the conduct of industrial policy in developing countries. To put it bluntly, economic development is impossible without good export performance. Economic development requires the importation of advanced technologies, which need to be paid for with foreign currencies, which in turn have to be acquired, mainly from exports.

Now, saying that exports are the key to economic development is not to say that developing countries should adopt free trade. Export success requires significant industrial policy, even for comparative advantage-conforming industries, as export markets have high fixed costs of entry, which smaller firms and farmers may not be able to bear. Direct export subsidies can offset the entry costs, but these are now banned by the WTO, except for the LDCs, so help should be provided through other channels. These may include state marketing help, risk-sharing schemes, initiatives to help small exporters to meet quality standards, and policies to help cooperatives among exporters.

In the longer run, if a country is to continue the momentum of its export success, it is not enough to rely on its comparative advantage-conforming industries. Sooner or later it will have to upgrade its export industries into comparative advantage-defying industries, which requires even stronger industrial policy.

We have to move away from the sterile debate on openness and growth, and explore how free trade, export promotion (which is, of course, not free trade), and infant industry protection can be best integrated with each other.

Changing global environment

Many people argue that the recent changes in the global business environment (such as the rising importance of FDI and the increasing industrial concentration) and changes in global trade and investment rules have made it virtually impossible to implement industrial policy.

It is true that the range of industrial policy measures that developing countries can use has become considerably smaller, compared to the heyday of industrial policy in the 1960s and the 1970s. However, there is still room for manoeuvre for countries that are clever and determined enough. Moreover, especially in the context of the recent world financial crisis, the global business landscape can change significantly, opening up unexpected possibilities of moving up and across global value chains for at least some developing countries. As for the global rules of trade and investment, it is not as if they are some unalterable laws of nature. They can be, and should be, changed, if they are found wanting. Of course, the policy space is in practice highly constrained by the conditions attached to bilateral and multilateral aid and loans, and bilateral and regional trade and investment agreements, which are more restrictive than the WTO. Having said that, I would argue that, as far as all these are man-made rules, we can change them, should we agree that they need changing.

Conclusion

My main purpose here is to plead for “thinking outside the box”, and to find the common ground for people on both sides of the industrial policy debate. I believe that once the adversaries abandon theoretical grand-standing, and focus on more practical issues, there are vast and fertile middle grounds to explore.

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Ha-Joon Chang teaches economics at the University of Cambridge, UK. He is the author of several influential policy books, including Kicking Away the Ladder: Development Strategy in Historical Perspective, and has served as a consultant to the World Bank, the Asian Development Bank, and the European Investment Bank, as well as to Oxfam. He was awarded the 2005 Leontief Prize for Advancing the Frontiers of Economic Thought.