Neoliberals are vigilant, always on the look-out for any wayward move. In an August issue of the news magazine, The Economist briefly surveys what is happening around the world, uncovering what it sees as an alarming trend toward industrial policy in Europe, the US, Japan and elsewhere. It lists examples of governments supporting private companies in a bid to promote the growth of selected sectors and companies (that’s what industrial policy amounts to in rich countries). Throughout the story it lectures the big bad State for being naughty and not learning from past lessons.
Why is it naughty? Because it is making the big mistake of dabbling in markets, instead of backing off and letting business take care of itself. That’s why. Sound familiar? Essentially, The Economist’s assault on industrial policy can be broken-down into three related parts:
—Industrial policy, or any government policy for that matter, does more harm than good. The numerous attempts by governments everywhere to intervene have nearly always failed and ended up in the dustbin of history. It is a shameful waste as scarce resources and taxpayers’ money are sunk into a financial black hole.
—Industrial policy entails picking winners and aiding them. That could only backfire because government couldn’t possibly be smarter than markets and usually backs the wrong horse. Similarly, protectionism in developing countries doesn’t work.
—As the flipside to that, since markets know best it’s more efficient to let business decide who the winners will be. To illustrate this ‘home truth’, The Economist goes on to say: “no bureaucrat could have predicted the success of Nestlé’s Nespresso coffee-capsule system—just as none foresaw that vacuum cleaners and tufted carpets …..would have been some of America’s fastest growing industries in the 1970s.”
In short, The Economist’s position is that free markets—commonly defined as those without regulation or government intervention—are always best. And intervention by government such as industrial policy or regulation is doomed to fail because the market is no longer free. (I am belabouring the point as there seems to be some confusion among the public on basic definitional issues.)
The Economist cites as examples companies that had been picked in the past by governments and had since fallen by the wayside—Minitel (a French communications network), British Leyland (car producer), etc. In Spain the solar energy project backed by the state is struggling: “some green industrial policies have backfired already. The fixed-price subsidy system for solar energy has been a disaster,” costing the government huge sums of money.
Although it mentions a few cases of success, The Economist’s overall thrust is that there are far more losers than winners in intervention or industrial policy. Take Britain, for example. Its “long list of disasters, from cars to semiconductors, is etched in the public’s memory. France’s biggest blunder has been its attempt to construct an info-tech industry.” On the strength of the argument summarized here, The Economist triumphantly takes a bow and rests its case. Amen.
Mercifully, at least it knows that it’s best not to lead us deep into the fairy land of neoclassical economic theory where ‘general equilibrium’ reigns supreme–forever and ever. Don’t even ask me to take you there; you will deeply regret it.
The marathon debate
Are you convinced by The Economist’s case? I hope not because it is seriously flawed. Before taking a shot at its argument, however, let me briefly lead you through the big picture to put it in context.
The Economist is not saying anything new. The big debate about the state has been raging among economists for more than two centuries. The quarrel is about whether it is wise for government to poke its nose in markets. You would think a super-marathon like this would have ended long before now. It hasn’t. That should tell you something about how painfully slow progress is made in big economic issues. Don’t believe anyone—Nobel Prize winners included—who tells you otherwise.
To cut a long story short, the squabble ended in stalemate with no clear conclusion either way. As you can imagine, both sides obstinately stick to their positions unwilling to give ground. In the past, many battles had been fought but maybe none was fiercer than on the free trade versus protectionism front. This clash is especially relevant to industrial policy.
As in the big debate, both sides are caught in an eternal deadlock. In one corner of the wrestling ring are the neoliberal economists—The Economist is in this camp—clinging to their beloved model which postulates that free trade benefits every one. Facing them are the dissenting economists who hit back by insisting that because market failures are not uncommon, especially in developing countries, intervention is needed to protect ‘infant’ industry.
How to cheat in an argument
After the theoretical posturing, both sides proceed to bash each other by showing cases that support their respective positions. The fight drags on, with no end in sight as the evidence does not definitively favour one side or the other. But they continue to fight anyway, selectively citing examples to support their assertions.
The free traders would go through the data and point to failures in the African and South American countries where protectionism was a disaster, proclaiming that there’s no alternative to free trade and markets. The non-conventional economists respond by pulling out detailed studies on several fast-growing countries such as Taiwan, South Korea, Brazil and, in earlier periods, Japan, the US and European countries, where protected industries had become winners, thereby ‘proving’ their claim that protectionism works.
In this context, it is worth pointing out one thing to set the record straight. It is a myth that western countries had developed through free trade. Ha-Joon Chang, a Korean political economist teaching at Cambridge, has shown in his books that most of them had industrialized through infant industry protectionism (a form of industrial policy).
In its jabs at industrial policy, The Economist is perpetuating the same trick, using the age-old tactic of showing selective evidence. By giving detailed coverage to the losers and almost ignoring the winners, it creates the impression that industrial policy is hopeless. So beware when you read economics articles and books or when officials here in Hong Kong make sweeping statements about the efficacy of free markets.
I, too, can play the game of giving examples that prop up a theory. I could re-emphasize success stories in state intervention and ignore the failures, but it just isn’t fun anymore. Moreover, it’s foolish to fall into the old trap and perpetuate the pointless contest. Going down that road won’t convince the disbelievers; nor would it move the debate forward. All through this article, I only bring up cases in passing to clarify or dispute the claims made by The Economist. Those examples are enough to show that there are many success stories in industrial policy.
Besides selective use of evidence, The Economist resorts to other tricks to mislead and misinform. It is not above firing a cheap shot if that serves its purpose. In trying to show that China’s economic success rests entirely on free markets and private business, it comments: “the likes of Li Shufu, who runs Geely, the car firm that bought Volvo, are entrepreneurs, not bureaucrats.”
No one disputes that private enterprise is an important part of China’s success. That isn’t what the debate is about. It’s about whether the state plays a pivotal role in the Chinese economy while allowing business room to operate. The way The Economist sees it, government (bureaucrats) and markets (entrepreneurs) are diametrically opposed. That’s simply not the case.
The Economist is also guilty of telling half-truths. Rather defensively, it shows a small part of the story while covering up the bigger picture. For instance, it cites as example the mistake made by MITI (The Ministry of International Trade and Investment in Japan) to stop Honda expanding from motorbikes into cars. (Bad boy, MITI; that puts the score at government 0 markets 1).
But it conveniently omits mentioning that MITI was instrumental in laying the groundwork for Japan’s economic take-off in the post-war period. It omits to tell how the mighty Honda, Toyota, Mitsubishi, Sony, etc. were given a strong helping hand by the state both before and after they began their aggressive export drive. I leave the revision of the final score to you.
Being a severe critic, The Economist jumps at every chance to scold the ‘bad boy’. It tells us that “Japanese industry, which has a leading position in nuclear power, got a shock when South Korea unexpectedly won a contract to supply four reactors to the United Arab Emirates. One reason was deemed to be lack of marketing support from government ministers.”
Another cheap shot! Is that supposed to be a disaster? So Japanese bureaucrats screwed up a deal. That can happen to anyone, private companies included. Also, since the Koreans scooped the contract, shouldn’t the Korean government get a pat on the back? That’s not all. In its account, The Economist focuses on the slip-up without placing it in the wider context. It ‘forgets’ to point out that both the Japanese and Korean nuclear power industry had received heavy government backing before turning into major players on the international stage.
Learning to walk
The Economist admits that in Brazil “the likes of Petrobras (oil), Vale (mining) and Embraer (planes) were indeed created by the government.” It then hastens to add: “they have all flourished because they were privatized, to a degree, and forced to compete with foreign firms in the 1990s. Part-privatization and competition created in a short time what decades of industrial policy had failed to do.”
Once again, this type of interpretation is inaccurate and misleading. It downplays the importance of the protectionist period when the Brazilian companies were struggling to walk before they could run. At the same time it over-emphasizes the role of opening up to foreign competition and privatization. The implication is that if only government does away with industrial policy (learning to walk is unnecessary) and forces the companies to compete internationally right from the beginning (just start running), then all would be well.
That may be so to neoliberals who regard as sacred the ‘laws’ of free markets, but it is an absurd prescription for any developing country. The simple truth is: You can’t run before you have learned to walk. In other words, it takes time to build up competitiveness. It is no coincidence that nearly all the Asian and South American export powerhouses have pursued some form of industrial policy before their overseas expansion.
(Hong Kong is the only exception but then unique historical factors made it possible for the territory to leap straight into international markets in the 1950s. HK is of course no longer a real exporter as nearly all production by local companies is done in China. Its demise as a production centre is due to the free-market leaning of the government and the rapid growth of China’s production capability. In the absence of an industrial policy, there had been no enticement for HK companies to climb the industrial ladder, and the only option was relocation to the mainland to take advantage of low wages.)
Without an industrial policy, developing countries find it hard to press ahead. The past two decades saw unrelenting waves of trade liberalization and privatization across the world under the globalization banner, forcing nearly everyone to join the race. Yet no developing country has been able to follow the footsteps of the mega stars—China, Brazil and the other Asian ‘tigers’. Simply pushing companies to compete internationally, as recommended by neoliberal economists, doesn’t work.
To be fair, I must add that other economists who believe toddling ‘babies’ (the protected industries) eventually grow into great runners if given enough time are also mistaken. Many remain stunted and never grow up especially if they aren’t properly fostered. Protectionism doesn’t always work. Industrial policy is thus all about striking a balance, a delicate balance between nurturing the infant and inducing it to run at the right time. I will come back to this point later.
A country’s development, of course, is a lot more than adopting an industrial policy. In nearly all the developed nations, the state had always played a key role, orchestrating the economy and society in a bid to move the country forward. That is obvious to anyone who studies history or political economy, and it is now slowly sinking in, even among economists. Justin Lin, a Chinese economist, says: “the historical record indicates that in all successful economies, the state has always played an important role in facilitating structural change.”
The statement in itself is nothing new, at least not to those who read history. But coming from the chief economist of the World Bank, which has all along been a champion of free markets, it signals a welcome break from the old deadlock I mentioned earlier. Let’s now turn to China, a living example of dynamic structural change.
China’s economic miracle
It is no exaggeration to say that since China woke up some 30 years ago, it had made colossal strides, so much so that it is now beginning to shake the world. If you are not convinced just read or watch foreign news media with international coverage. The Economist (in fact almost all analysts) takes China’s status as a giant for granted.
Where we differ is in the interpretation of its dramatic rise. To neoliberals like The Economist, “the overwhelming reason for China’s miracle is that the state released its stifling grip and opened the country to private enterprise and the world.” Really? Need I say this is another confusing half-truth that misinforms more than it enlightens. So if China could achieve a miracle by opening up, surely the same would happen to other countries that follow the same road.
The last time I checked, I didn’t spot any other country that has been clocking up an average 8% GNP growth over the past 30 years, although a lot of developing countries are just as, if not more, open than China to private enterprise and the world. Did I miss the miracle countries or something? Am I making an unfair comparison?
What about Russia? The country also shook loose of the “stifling grip” of the state and began restructuring round about the time China opened up. In fact, Russia went further even than China in embracing markets, subjecting itself to ‘shock therapy’ and extensive privatization. This prescription, formulated by neoliberal economists for the Russian government, was designed to turn Russia into a free-market powerhouse. The therapy shocked the patient alright because the economy was in a semi-comatose state for several years before beginning to recover.
In privatization Russia did get rid of a large part of state assets, off-loading them to former KGB agents at rock-bottom prices. The windfall profits turned these ‘entrepreneurs’ into billionaires now living off rents from the privatized semi-monopolies. Meanwhile, the poor at the bottom of the heap got little to show for the radical economic reforms. In terms of performance, Russia is not even close compared to China and is certainly no miracle economy. Why didn’t the miracle happen there?
Why didn’t it happen everywhere in developing countries that opened up? The Economist would be hard-pressed to find an answer to these questions. Common-sense observations indicate that markets alone isn’t enough to generate extraordinary success. There is something special about the forces at work that are propelling China forward at breathtaking speed.
The grey dragon
Although central planning had been dropped (after Deng Xiaoping took the helm in 1978) it was replaced by a different set of controls and measures. State intervention is still substantial and extensive. For this reason, China’s development has been described as state-led.
That is clearly contrary to the textbook free-market model and makes nonsense of The Economist’s simplistic assertion that the Chinese economy soared after the government released its grip. In reality, the state allows markets to operate while playing a strong directive role in the economy. The Chinese dragon is neither black (state-controlled) nor white (free market); it is grey! That is what confuses neoliberals like The Economist.
While neoliberal dogma prefers to set things in terms of black or white, policymakers would do well to recognize the developmental path of China. Instead of denying that intervention can work, they can learn much from studying the dynamics of how markets and government accommodate each other.
None of this is meant to suggest that the Chinese government has been perfect in balancing between freedom for enterprises and the need to steer them in strategic directions. Indeed, mistakes were made, some pet projects failed, corruption is a problem and red tape time-consuming. But overall, the state has got the important things right, as borne out by China’s economic performance.
Unable to reconcile China’s success with strong state intervention, The Economist simply turns a blind eye to anything that contradicts its position. It refuses to admit or mention that the government has made extensive use of industrial policy. But it is undeniable that the Chinese government:
—actively creates and subsidizes selected industries to climb the industrial ladder;
—intentionally undervalues the currency (renminbi) to discourage imports (this is a form of protectionist barrier) and promote exports;
—provides incentives such as investment and subsidies to successful companies who start to export (after they have learned to ‘walk’).
This type of industrial policy, plus the other extensive controls and regulations, would be condemned as grave errors by The Economist and neoliberals, yet China surges forward.
New chapter of competition
Indeed, the emergence of the dragon is testing the cherished free-market model to its limits. In the 1980s China began exporting cheap textiles, toys and plastic household items. From this humble beginning, it has since been making inroads into nearly everything—from cars and ships to airplane wings and parts, electronic appliances and semiconductors, rocket launchers and machine tools. The list is endless. Against the dragon’s onslaught, western manufacturing is crumbling.
What is scary to the west is the speed at which China moves up the industrial ladder. Starting from labour-intensive production, it has moved on to capital-intensive, medium-tech industries, and now shifts gears and moves into high tech, mounting raids on that exclusive domain of the developed countries. All this within the space of 30 years. And the Chinese juggernaut shows no sign of slowing. Complete de-industrialization of the west now looms on the horizon.
No wonder governments—from Bonn to Washington and Tokyo—are deeply worried. While their economies stutter along China powers ahead at top speed, challenging them on every front. Competitive pressures are mounting to a critical point, forcing governments to accept that free markets have not helped much in coping with the dramatic advances of China.
That is the underlying force compelling the west lately to promote industry with the aid of industrial policy. As usual, economic reality, rather than sermonizing about markets, is dictating changes. It is understandable, too, that The Economist tells governments off for ‘misbehaving’, but it can’t stop the battleground from shifting to new terrain. More state intervention is on the way in the new chapter of intensifying competition.
What conclusions can we draw about industrial policy? Clearly, there have been successes as well as failures. Industrial policy can work, sometimes spectacularly as in China and other East Asian countries (not to mention many western countries before they industrialized). It has failed miserably too in other cases. Endless theorizing and squabbling about the efficacy of free markets, free trade or state intervention is therefore futile. There is no silver bullet or magic prescription. To move the age-old debate forward, that must be accepted as a starting point.
Once this is recognized, we can step out of the deadlock and ask a fresh set of questions. Why does intervention work in some cases and not in others? Why was industrial policy or protectionism viable in some countries/industries but not in others?
These can be modified to a pose more general questions: Under what conditions does intervention/industrial policy work? What are the circumstances that would make failure likely?
This pragmatic approach is more rewarding than slinging mud at each other as economists have been doing. Answering those questions will give a better understanding of what it takes to plan and implement an effective industrial policy, pointing the way forward in policymaking.
I don’t pretend for one minute to have the complete answers to the questions. As far as I know, this is still largely uncharted territory. Way back in my post-graduate days I had done a little thinking and research in this area while completing a study for the United Nations on a related but different topic. At that time only a handful of scholars were working on linked issues. The paper I wrote is lost but I remember a few ideas. Here are some of them.
Protectionist or industrial policy in developing countries could work if certain conditions are met:
—the set goals have to be realistic. The country’s industrial capability must be taken into consideration before deciding to foster a sector by means of import barriers or subsidies. Over-ambitious industrial policy usually ends in disaster. It would be crazy, for example, to build a petrochemicals plant in a country with no experience in chemical engineering.
—a gradualist approach is best to progress the protected sector from the production of simpler parts and components to more sophisticated parts or processes. The progression must be carefully planned in advance; bottlenecks and technical problems need to be anticipated before the project begins;
—every measure must be taken to ensure that the protected sector (infant) ‘grows up’ to compete internationally; tariffs in place to protect the companies are to be eventually phased out over a period of time, inducing the companies not to depend on protection; subsidies for exporters could be provided as an incentive for them to begin exporting as soon as possible;
—all relevant expertise in production, engineering, economics, logistics, etc. must coordinate closely as a team to work out a feasible plan and identify likely problems right from the beginning; it needs to continually monitor the project(s) and liaise with the protected companies to ensure progress; the team needs to be attached to a government department/authority with power to act and assist;
—commitment on the part of the government bureaucracy to industrial policy must be elicited if possible.
Those are some of the tentative ideas I came up with after a quick survey of selected sectors. I won’t list the rest. Very often, industrial policy failed because even basic conditions listed here were not met or thought through before projects began.
As to industrial policy in developed countries, protection isn’t really a relevant option, and chances of failure might even be higher. The same approach—asking the questions posed above—should also lead to interesting answers, though I have not explored this field in any detail.
A step in the right direction
More recently, Lin, the World Bank chief economist, has offered suggestions in his paper on how developing countries can pursue an efficient industrial policy. Essentially, Lin’s idea is that a country must stick close to its “comparative advantage” in protecting industry. For example, low-income countries, which have a comparative advantage in labour-intensive production (because they have cheap labour), are advised to focus on this area and not deviate too far from it (into capital-intensive or high-tech industries).
His proposal is in line with the first and third (he also discussed this) conditions I listed above, though Lin’s suggestion is dressed up in the language of economics. The six-step process he outlines in his paper goes into details on how to single out the sectors that fit a country’s comparative advantage and should be targeted for protection. All of this is a step in the right direction. The other conditions listed above have less to do with economics than with project planning and administration, but they are also important to ensure success of industrial policy.
At last, some progress is made (if the World Bank follows Lin’s suggestions) and some economists are taking a pragmatic approach. But that is only a start. Much more research needs to be done to understand the conditions under which industrial policy would work (or fail). The conditions I outlined are far from complete.
The question as to how far a country can deviate from its comparative advantage and take on more ambitious projects to climb further up the rungs of the industrial ladder is open to debate. Lin and Chang have discussed this recently at length. In my opinion, the answer depends on subjective judgment and the economics tradition or ‘school’ one follows.
To sum up, The Economist‘s story on industrial policy does more to mislead than to inform by telling many half-truths and giving selective examples that back its ideological position—government can do nothing right; free markets are always best. The most instructive lesson you can learn from it is how to cheat in an argument by copying its tricks.
In China state intervention has been substantial and extensive. Its success is testing the free-market model to its limits as western manufacturing crumbles against the dragon’s onslaught. Governments in the west are now reinstating industrial policy in a desperate attempt to stay ahead in the race.
The state had played a pivotal role in nearly all successful economies in the past. Industrial policy has also worked spectacularly in China and other East Asian success stories. There is thus little doubt about the critical role of the state in the development of an economy. While that much is clear it would be a big mistake to conclude that intervention is the silver bullet. For it clearly has failed miserably in many instances too.
Universal statements about the efficacy of free markets or government intervention are therefore indefensible. A new approach is needed to break free from the age-old deadlock theorists have been trapped in.
Instead of arguing endlessly about whether free markets are better than intervention or vice versa, economists should move on and look at the conditions under which government intervention or industrial policy is likely to work or fail. (Actually, I know I am asking too much but that’s another story.) I have made a few suggestions along those lines, as has Justin Lin, but they are far from complete.