Traditional economic theory viewed industrial policy as a bad idea because the allocation of resources is too complex to be centralized. Economists like Adam Smith have stressed how the market can solve coordination problems that would be complex if they were to be made through the planning of agencies. The market uses human self-interest to tackle the incentive problems that coordination involves; self-interest in government bureaucracies cannot deliver the same effect.
Economists have long doubted the ability of the public sector to develop the market because of information and incentives:
· Governments cannot create decentralized information processing that markets generate.
· Governments do not have the necessary information to pick winners. Even if they did, they may not have the incentives to do so. If they tried, they would cause rent-seeking behavior that may hinder the achievement of the initial plans.
It was proposed that the three essential things for economic growth are: a system of property rights and contract enforcement, sound money and openness to trade, investment and ideas. Once broad-based, sector-neutral and independent interventions are in place, an economy can enjoy self-generating growth. Traditionally, government intervention is tapped to address market failure like market incompleteness, coordination failures, or negative externalities. Hence, the concern of government failure must be equalized with the risk of market failure. However, intervention must be avoided if there is neither a clear understanding of failures nor a strategy to address information and incentive problems.
To develop the best practice in economic policy, a more accurate description of the nature of the potential market failures must be in place.
Stylized Facts
Poor countries export poor-country goods; rich countries export rich-country goods
Rich countries tend to diversify their products. Since they tend to export the goods they do relatively better (comparative advantage), it will be helpful to explore what happens to the composition of exports at various levels of development. Hausmann, Rodrik and Hwang (2006) developed a measure of the income level of exports, EXPY[1]. It was discovered that there is a strong positive relationship between a country’s level of income and the level of income implied in its exports.
Rich countries are apt to export goods exported by other rich countries. As development progresses, physical, human and institutional capital builds up and the products for export become more intensive.
As development takes place, countries change their export package. In conventional trade theory, products and the transition of goods have no chief significance. But if goods are complicated, more advanced countries are likely to grow more rapidly. And since they already have an upgraded export package, their income level can catch up more easily. Hausmann, Hwang and Rodrik (2006) found that a more sophisticated export package in 1992 predicts growth over the following 11 years, controlling for other determinants of growth. Countries converge to the level of income implied by their exports (countries become what they export).
Under the conventional comparative advantage theory, a country that exports goods that are more sophisticated than what its income level indicated has misallocated resources; the country is expected to perform poorly. Since this is not observed in reality, it appears that structural transformation is filled with market failures.
Market failures that impede structural transformation
Coordination failures happen when the return of one investment depends on whether some other investment is also made. One solution is for the government to provide a guarantee to the investors involved. This can be costless ex post for the government since they will profit when the investments take place.
IT is observed that spillovers are a source of market failure. Spillovers in self-discovery make the returns of private entities lower than the social benefits because if the new venture fails, they bear the whole cost. This makes the market incentives for self-discovery low. To address this, a subsidy must be provided. Labor training is also a source of spillovers. Firms find little incentive in providing the optimal amount of training to their employees because other firms will have more reason to pirate them. To avoid inadequate training investment, it must be subsidized.
As coordination failures and spillovers are pervasive in new activities, structural change can take place by developing new activities that use existing factors and capabilities that the economy has developed for other purposes.
Each new activity requires custom-made inputs—some private, many public
Since specific inputs are not expected to support other potential activities, development will be path dependent on opportunities brought by inputs of existing industries. The existence of other supporting markets will determine the way a market is organized. The transaction costs of buyers or sellers depend on the way different markets and institutions are organized and how they interact. The way functions are organized will vary immensely. Each market will also require a set of rules and norms that establish roles and responsibilities. Some rules may be required legally or imposed by convention and sustained by reputation. The roles of the government are specific to address the particular issues of an industry.
Back to self-discovery: is there a stairway to heaven?
New activities must use existing capabilities – markets, physical and human assets, norms and institutions – that were developed for other previous activities. The degree of similarity of those needs may vary extensively between activities. As Hausmann and Rodrik (2003) have discussed, capabilities are specific to each activity. Production needs more than just broad asset categories.
Hausmann and Klinger (2006) adopted an outcome-based measure instead of identifying unknown commonality of inputs to find the distance between products. They based their measure between two products on the conditional probability that countries have comparative advantage in both products. If the resources needed to produce two different products are similar, countries that are good at one are will also be good at the other. They found that there is a great heterogeneity in the product space. The development of comparative advantage in new products is affected by how far the products in which a country already has comparative advantage are from potential new ones. Firms tend to explore a product that is similar to existing ones. A country upgrades its exports over time based on the position of the country in the product space[2].
It is important to note that there is a positive relationship between the level of development (as measured by GDP per capita) and the value of unexplored products, the relationship shows heterogeneity. Also, there is a positive relationship between the income level of exports and the value of unexplored products. This suggests a positive feedback loop: if a country is able to improve its exports, it becomes even easier to further improve exports.
Upgrading within product vs. between products
In forthcoming work, Jason Hwang reported the following observations after examining the within-product distance to the quality frontier:
· Once a good is exported, there appears to be unconditional convergence to the frontier within that good.
· Productivity convergence at the product-level takes place at a fast rate, usually in excess of 5 percent. This implies that the process of learning and improving within product is universal and fast.
· When a country moves to a new product it moves at a greater distance to the frontier than its average distance in the existing products it has been exporting.
Once an activity develops, it is much easier to work out the coordination failures and accumulate the specific capabilities that it requires. However, moving towards new products without the requisite capabilities can only be done at lower qualities. Moving between products is more likely to impede development since improvements within products seem to be much easier.
Growth collapses and “open forest”
Hausmann, Rodriguez and Wagner (2006) observed that growth collapses are often triggered by export collapses. The duration of the succeeding crisis, however, is strongly influenced by the size of the product space (forest). Development involves the expansion and enhancement of productive capabilities, which are both complex and specific. Because of this, new activities tend to use capabilities that were developed beforehand for other activities; this makes structural transformation path-dependent. Such dependence imply that a market-based structural transformation will be too slow as it will involve jumps that are fewer in number and shorter in distance than would be socially optimal.
Market vs. Public Inputs
There are no markets for government rules and infrastructure provision. Since these specific capabilities complement market-based inputs, an inadequate supply of them will upset overall productivity. The question of how government intervention will be coordinated if it cannot follow the self-organizing properties of the market arises. This is further complicated by the fact that the government faces activities that require different kinds of interventions and the fact that there are no clear price signals to advise or evaluate what it is doing right, what it is doing wrong and what things it should start doing.
The industrial policy predicament
Different activities require a large set of specific inputs and capabilities. The provision of market inputs takes care of itself. Prices give signals regarding the attractiveness of different options so that firms and consumers are able to choose what to do and how to proceed.
Under the traditional view, inputs that are not supplied by markets are few, broad and have no major interactions between them. They are expected to be financed with taxes and a fiscal position that is consistent with sound money. These inputs can be allocated to different government agencies for their implementation.
The view discussed above is not descriptive of reality. The different areas of participation are very specific and they have deep interactions with each other and with the different markets. Processes are often complex and hard to design. Moreover, the market mechanism does not direct to the provision of these inputs. Effective price signals and profit-making bureaucracies do not exist.
Because of this, industrial policy is needed to make sure that the necessary inputs are provided. The government cannot focus on broad-based support alone because the necessary public inputs are complex and specific. Specific policies are required.
The ideal scenario is for the government to provide all the necessary inputs. However, this solution has two major problems: First, it is unaffordable. The government will overwhelm its resources if it is to address all requirements. Second, the list of interventions is unknown ex ante.
The fact that the provision of required inputs is costly indicates that choices have to be made. It is not that choosing is desirable; it is inevitable. Governments often act in ways that suggest that they are aware of this point, although they sometimes fail to adopt the general logic.
The interaction between governments and markets is deeper and more complex than is often assumed. The public and the private sector must cooperate. This cooperation will be helpful only if the relationship is grounded with the rest of society. Otherwise, the constraints on cooperation will be huge.
Parsimonious vs. strategic industrial policies
Structural transformation will be heavily dependent on the position of a country in the product space. For some countries, the product space is upscale and general support for investments may be all that is needed for a successful industrial policy. On the other hand, countries with a poor product space will require specific public inputs that are useless to other potential activities. It would be ideal to provide the inputs for all potential new activities. However, government resources are limited. Again, choices must be made.
Jumps to new parts of the product space may not indicate the required inputs. Under this case, foreign direct investors may play an important role. These stakeholders know what kinds of things the activity needs. They can provide valuable information to define the problems and possible solutions.
The perennial problems
The provision of publicly-provided inputs and capabilities are faced with information incentive problems.
Eliciting information
Since the public inputs are diverse and dispersed, it may be hard to determine what inputs are most valuable. Existing economic activities and potential investors possess information that can be very valuable but are inaccessible to the government on its own. Because of this, the government must rely on mechanisms that reveal information. Firms reveal their preferences by lobbying the government directly or through trade associations. They sometimes participate in the political process by funding elections and lobbying members of the parliament and the administration. The work of George Stigler further suspects that the motives behind public regulation of market activities originate from rent-seeking and creates barriers to entry to limit competition and protect incumbents.
To address free-riding on the lobbying efforts of others, potential improvements may be shared with those that exert effort by providing information and engaging in the policy process. Trade associations may be a cooperative solution to the free-rider problem among private participants because they have the incentive to ensure the provision of the correct publicly-provided inputs. Since the relationship between the government and the lobby groups can be a great source of information but also of problems. It is, therefore, important to follow the following:
· Open architecture. The government must not predetermine who it will deal with in terms of sectors or activities. The potential areas of attention should evolve with as opportunities arise. Choice must only be made when the maximum amount of information has been revealed.
· Self-organization. Forcing investors into a single channel of communication with other activities and regions and requiring them to all agree on their common requirements may bias the requests towards the items they have in common and away from the more specific and most valuable requests.
· Transparency. It is important to have an environment where the requests that private sector groups pose to the government are biased towards those that are socially productive. One way to have this is to make the requests public knowledge and by promising to independently evaluate the request from the point of view of the public interest.
One way to set up entities that possess the three characteristics is by creating windows, groups that receive requests. To encourage self-selection of productive initiatives, requests must be taken off the table ex ante. This can be done by focusing on requests that increase productivity. Another way is to focus only on new activities to ensure that policy serves the needs of structural transformation.
Addressing the incentive problem: How should the government organize itself?
Although governments are hierarchical organizations, the complexity that it can handle is limited. Hence, constant reorganizations are necessary to balance clarity and simplicity.
Each government activity needs different specific inputs. However, such inputs are under the jurisdiction of different agencies. It is tempting to centralize decision making and control in a clear hierarchy. This is either done by function or done by sector. The two solutions are expected to collide with the inability of the authorities to deal with high complexity.
It is useful to find network-like arrangements that deliver required assets although the network is not aware of all the things that are going on. Trade associations may play a role that is similar to that of the account executive in a global bank, coordinating between a particular sector of activity and the numerous public institutions that are involved. Departments and ministries may also play the role of account executive, maintaining a conversation with particular industries and trying to coordinate the different government agencies involved. Development banks, beyond their financing function, may be in the role of identifying opportunities and hurdles.
There are two classes of organizations: the instrument-based organizations that focus in the management of policy instruments and the coordinating bodies that make sure that the correct mix of policy instruments is implemented. The former comprises entities that collect knowledge about the management of a given policy instrument. On the other hand, since the latter is organized by area of activity, the important question now is how to assure that they have the capacity to coordinate the instrument-based organizations while respecting their autonomy. Creating competent activity-based coordinators that possess political or budgetary discretion is one way to create an institutional network that can address the complexity.
Concluding Remarks
Economic activities need specific capabilities, some of which are provided privately through markets and some provided by the state. The government is faced with the problem of supplying the needed capabilities because it cannot rely on the market mechanism for information and incentives. Even the creation of a structure that can do this for existing activities is in itself difficult. It requires an environment of cooperation between public and private entities. The problem becomes even more difficult when it is coupled with the need for structural transformation. In the process of development, countries need to not only increase output per worker in existing activities, but also to transfer resources to higher productivity activities.
Incentives to add specific capabilities for new activities are filled with coordination failures. The process of structural transformation is limited by the capabilities given by previous activities and the ability of markets to move to new ones will depend on potential activities that can use the existing capabilities. Unless resolute action is taken to move towards new activities, countries may not be able to solve market failures that deter structural transformation. Therefore, industrial policy becomes an important part of development strategies.
One difficulty with industrial policy is that the government cannot rely on markets for information or incentives. To address this, there must be a governance architecture that is based on a range of public agencies that deal with the underlying complexity of problems. There must be an open architecture approach that sanctions stakeholders to self-organize and achieve discipline through transparency. An institutional design must be implemented where some entities are organized around policy instruments while others are focused on attending to the needs of areas of economic activity. Structural transformation will stem most likely from an open-minded, experimental approach that also evaluates what is working and what is not, not from one that depends on first principles or best-practices that worked somewhere else. Although industrial policy is hard, that is no argument against its use. To drive economic development, governments need well-formulated strategies to provide the specific inputs that markets need in order to stimulate structural transformation.
Source:
Hausmann, Ricardo and Dani Rodrik, “Doomed To Choose: Industrial Policy as Predicament” paper prepared for the first Blue Sky seminar organized by the Center for International Development at Harvard University (2006).
[1] EXPY is the weighted average of income levels of different commodities of different countries, where the weights are the share of each commodity in that country’s total exports. Income levels, PRODY, are the weighted average of the incomes of the countries exporting each traded commodity, where the weights are the revealed comparative advantage of each country in that commodity.
[2] The value of unexplored products are measured by weighting their PRODY by its distance (difference) to existing products.
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