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Welcome to another edition of #ideasthatmatter. Today, we will be discussing Industrial Policy. The first question we should try and answer is; what makes Industrial Policy an Idea that Matters?
One of the most fundamental questions in economic history and development is how did rich nations become rich? Studying this question has led scholars in the social sciences to develop many theories, and collect large sets of historical data in trying to find an answer.
This search has turned up multiple answers with varying explanatory power - one of which is INDUSTRIAL POLICY.
Industrial Policy as an idea in itself is an outgrowth of what is known as the Industrial Revolution - a period in the mid to late sixteenth century when the production of goods became mainly driven by machine technology, starting in Britain and Western Europe.
The application and adoption of technology in production moved a lot of the workforce from farm to factory, and it also raised the productivity of workers by orders of magnitudes compared to the past.
Soon after, nations around the world from China, India, the U.S, to Egypt started modernizing their process of making goods like textiles. This modernization of industries is what is meant when a nation is said to be "Industrialized".
Hence, Industrial Policy is a deliberate push by both state and private actors of a nation to industrialize its economy.
What caused the Industrial Revolution remains an open question - but the enrichment effects on nations made it a model worth copying for relatively poorer nations.
But, careful examination of economic development since the Industrial Revolution has shed more light and nuance on how industrialization works, and the role of industrial policy.
The first thing to point out is that despite widespread adoption of technology and modern industrial process during the Industrial Revolution, the productivity effects for nations still diverged.
This clearly implies that reaping the benefits of of industrialization requires more than adopting the modern machinery of production.
The second thing of note is the role of the state. Governments have always been involved in economic production since humans became domiciled and learned to defend territories.
This need to defend their settlements and livelihoods from invaders is a strong incentive to invest resources in finding new ways to fend off an attack or even for an invading force to gain superiority in the battlefield.
Constant warfare and state involvement is held by some scholars as the reason why some states developed governing capabilities earlier than others (see last week's thread). https://twitter.com/IUntrapped/status/1350352321654513664?s=19
The first wave of global boom in transportation (by sea) and trade was financed by state investment in expedition and funding the research or curiosity of explorers.
However, despite the fact that the scientific knowledge that birthed inventions and their application to economic production benefited from government investment, the Industrial Revolution itself was led by private businessmen and factory owners.
Regulation favoured capital (factory owners) in the early days of the Industrial Revolution, but there was no active state involvement beyond that in Western Europe and the United States.
Still, the industrialization wave was sweeping through the world and many countries modernized their production process regardless of the structure (state owned or private) of its industries.
A notable example was the Soviet government bringing in American engineers, architects, and entrepreneurs (Henry Ford) to help modernize its factories amid rising poverty after seeing the enrichment of America during the second phase of the Industrial Revolution.
The question of productivity differences still remained. Why are some states getting rich faster or seeing much larger benefits from industrialization than others?
Some of the answers came over a century afterwards and there is much that is still unanswered. But it became clear that there is more to industrial policy than merely modernizing the production process.
State investment may have been limited in the process of Industrial Revolution, but government (with active business support) intervened by trying to engineer advantages for its industries.
The earliest attempt was trying stop the spread of inventions to other countries, but when this failed, the tactics changed towards the control of trade. Countries started banning the import of manufactured goods like textiles to protect their local industries.
This control of trade have led some scholars (like the 18th century German economist Friedrich List) to theorize that the protection of local industries from competition from imports is the key factor to economic development.
Protectionism from this era continues to offer evidence to many contemporary scholars as the secret ingredient in the cocktail of industrial policy.
Reality, however, is not so simple. Much like with technical upgrade of factories and industries, protectionism showed different results in each country. This, atleast, suggests that its role as a primary factor in industrial policy is overstated.
The triumph of the Industrial Revolution and manufacturing spurned many other theories of industrial policy like the infamous Import Substitution Industrialization, with a central policy prescription to replace all foreign imports with domestic production.
Many countries during the early to middle twentieth century tried out this model of industrialization, to devastatingly disappointing results. Sadly, this idea has refused to die and sometimes finds itself to the highest levels of policy making even today.
Still, there are many nagging questions about Industrial Policy begging for answers. What is the role of the state? Did industrialization fail in the Soviet Union because of the outsized role of the state? How much does foreign competition from imports affect local industries?
If the deployment of the latest technology does not guarantee productivity gains, then what does? These are few of the many highly relevant questions.
The rapid (relative to Western Europe and U.S) industrialization of East Asian Tigers (Japan, South Korea, Taiwan, Singapore, and China) did provide some pointers on Industrial Policy.
Starting with the establishment of the Ministry of International Trade and Industry (MITI) in Japan in 1949, a model of industrial policy focusing on export industries and abandoning the ill-fated import substitution model.
Other notable examples were the Heavy and Chemical Industries (HCI) policy started by South Korea in 1968, and China's deployment of Special Economic Zones (SEZs) starting with Shenzhen in 1978.
The industrialization move by the East Asian Tigers led to fast income rise and sharp decline in poverty for the people of these nations.
Equally important is that the experience of the region served as a useful test case for some of the unanswered questions about Industrial Policy - and it makes it imperative to understand the nuances of this idea.
The first lesson from the EA experiment is that the state can go beyond its regulatory powers to set a course in economic development. However, the role of the state is not to command and control the economy it was not the state that killed the Soviet economy, it was incentives.
In our opinion, the role of the state in the EA context can be broadly said to consist of two functions. 1) Creating pro-market institutions when there are none - industrial policy in these nations is often accompanied by market reforms like liberalizing pricing.
land reforms and policies specifically targeted at attracting investment. 2) Allocative efficiency - nudging or directing state and private investment towards a sector. In short these two functions serve to create new markets where none existed.
Investors may find it more profitable to invest in real-estate and financial services when they come to Shenzhen (it worked in HongKong), but that may not be in the best interest of a backward fishing village - which Shenzhen was before 1978.
So the local government- under the umbrella of a central government that is reforming the country - carefully constructed incentives in terms of land, labour, and pricing policies that encouraged investors to invest in manufacturing.
An important takeaway from the EA experience and the role of the state is adaptibility. State actors quickly discarded policies that appears not to be working and doubled down on the ones that showed positive results.
This was done with accountability and without sentimental attachments to favoured sectors or cronies. Something to keep in mind when considering border closure.
Second lesson from the EA experience is that the role of protectionism (tariffs etc) can be strategic, but it is usually secondary. Anyone who claims that protectionism was the primary driver of EA industrialization is either genuinely misinformed or plain ideological.
After Import substitution was abandoned, industrial policy in EA became very focused on exports. Protectionist measures were used to facilitate transfer of technical know-how to the local industries, but the game was always about exports.
South Korea for example, also had multiple exchange rate regime, but the special windows were created specifically to help export manufacturing import needed inputs.
A good evidence of this point is other East Asian nations (Malaysia, Indonesia, the Philippines) who also pursued industrial policies around the same period but were less disciplined about exports and succumbed to state capture.
They quickly lagged behind their peers in the North in less than two decades.
There are so many other nuances to industrial policy that can only be covered in a more detailed format (some are in this post reference to the first ever post on Ideas Untrapped), but perhaps the biggest takeaway is that industrial policy alone does not make a nation prosperous.
It is just another useful tool in the policy toolbox of any government serious about the prosperity of its people. Note that it is a tool that can be so easily misused out of ignorance and one very sensitive to corruption.
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