Some economists used to believe that government intervention is necessary because market failures are pervasive. They were opposed by other economists arguing that government intervention leads to failure and that the market must be left alone. Empirical studies have not been able to support either of the two contradicting views. Import substitution, planning, and state ownership have produced some successes, but they also led to failures and crises. Economic liberalization and opening up benefited export activities, financial interests, and skilled workers, but they also resulted in growth rates that were no better than those experienced under bad policies.
It is widely recognized that market forces and private initiative drives economic development. It is also acknowledged that developing societies need to include private initiative in a framework of public action that encourages restructuring, diversification, and technological dynamism beyond what market forces could generate on their own.
An intelligent intermediate stand between the two extremes mentioned above involves market forces and private entrepreneurship at the driving seat of economic agenda; in addition, governments are also expected to perform a strategic and coordinating role beyond simply ensuring property rights, contract enforcement, and macroeconomic stability.
The objective of this paper is to develop a framework for conducting industrial policy that maximizes its potential to contribute to economic growth while minimizing the risks that it will generate waste and rent-seeking.
In addition to implementing appropriate policies, the task of industrial policy revolves around obtaining information from the private sector on significant externalities and their remedies. It involves collaboration between the private sector and the government with the goal of revealing the significant obstacles to restructuring and the corresponding interventions to remove them. Analysis must focus not on the policy outcomes but on getting the policy process right. In the end, the private and public actors must solve problems together; each side learning about the opportunities and constraints faced by the other, and not about whether the right tool for industrial policy is.
The main theme of this paper centers on the idea that industrial policy is a discovery process. The government can obtain useful information from the private sector while maintaining its autonomy from private interest. This is possible when the government is engaged in an ongoing relationship with the private sector, a situation termed by Peter Evans as “embedded autonomy”.
A second key theme of this paper is that innovation in the developing world is restricted not on the supply side but on the demand side. Innovation is challenged by lack of demand from its potential users in the real economy, the entrepreneurs. The demand for innovation is low because they sense that new activities are not very profitable.
Why Industrial Policy?
After studying the patterns of sectoral concentration and diversification in a large cross-section of countries, Jean Imbs and Romain Wacziarg (2003) discovered that as poor countries get richer, sectoral production and employment become less concentrated and more diversified. This goes on until production patterns start to become more concentrated. If sectoral concentration is graphed against income per capita, a U-shaped curve will be obtained. This result goes against the logic of comparative advantage and specialization. Their findings suggest that comparative advantage is not the driving force of development, but mastery over a broader range of activities.
Without directed government intervention, diversification is unlikely to happen because of information and coordination externalities. Most significant examples of productive diversification are a result of rigorous government action and of public-private collaboration. This can be observed in Taiwan’s successful assistance to the orchid industry after a continuous drop in the prices of sugar, its main product. This is also true in Latin America as it is of East Asia.
Information Externalities
Diversification entails self-discovery, discovery of which new activities can be produced at low enough cost to be profitable. Self-discovery means experimenting with new product lines and exploring technologies from established producers abroad. However, although this process has great social value, it is very poorly compensated. If entrepreneurs fail in this venture, they bear the full cost but if they are successful, they have to share the value of discovery with other producers who can follow their example. Because of this, only a few entrepreneurs engage in this activity in low-income countries.
Hausmann and Rodrik (2004) showed that countries with nearly identical resource and factor endowments specialize in very different types of products, once one looks past broad aggregates like labor-intensive commodities. Whole industries often grow from experimental efforts of solo entrepreneurs. Country evidences indicate that imitative entry through managerial and labor turnover was the key mechanism that enabled industry growth. Klinger and Lederman (2004) provided more systematic evidence on the market failures that hinder self-discovery. They revealed that their measure of self-discovery in a country is positively associated with the height of entry barriers: the more costly are government regulations that impede business formation, the higher the rate of self-discovery in exports.
The best, albeit difficult, policy response to the informational externalities is to subsidize investments in new, non-traditional industries. Hausmann and Rodrik (2003) recommended a carrot-and-stick strategy. Because self-discovery requires rents to be provided to entrepreneurs, a subsidy of some kind must take the form of a carrot – like trade protection or the provision of venture capital. Rents must be subject to performance requirements or to close monitoring to ensure that mistakes are not perpetuated and bad projects are phased out. There has to be a stick to discipline opportunistic action by the recipient of the subsidy.
Even under the optimal incentive program, some of the investments that are promoted will fail. This is because optimal cost discovery requires equating the social marginal cost of investment funds to the expected return of projects in new areas. The realized return on some of the projects will be low or even negative, to be compensated by the high return on the successes. A good industrial policy will prevent failures from using up the economy’s resources. The technique for the government is not to pick winners, but to know when it has a loser.
Coordination Externalities
Many projects require simultaneous, large investments in order to become profitable. Successful and profitable new industries may not develop unless upstream and downstream investments are taken simultaneously. Rodrik (1996) showed that coordination failures can arise whenever new industries exhibit scale economies and some of the inputs are non-tradable. The coordination failure model places emphasis on the ability to organize the investment and production decisions of different entrepreneurs.
Sometimes, coordination can be achieved within the private sector, without the government playing a specific role when the industry in question is highly organized and the benefits of the needed investments can be localized. But more commonly, with a budding industry and an unorganized private sector, government intervention will be required.
Coordination failures do not require subsidization, and overcoming them does not need to be costly. Once the simultaneous investments are made, all of them end up profitable. Therefore, none of the investors needs to be subsidized ex post, unless there is an additional reason for requiring subsidization. The secret is to get investments made in the first place. This can be achieved either by true coordination or by designing ex ante subsidies that do not need to be paid ex post. A bailout can be implemented for this. Like what Korea did, the government can guarantee investors if the project fails but if it succeeds they are not required of any cash transfers from the government. This, however, introduces moral hazard.
Andres Rodriguez-Clare (2004) once noted that all industries have the characteristics that could produce clusters. Many industries can operate at some level without clusters. This implies that what need support are not specific sectors per se, but the type of technologies that have scale or agglomeration economies.
Hence, the policies that overcome coordination failure share an important characteristic with those focused on information externalities. These interventions must be targeted on activities, rather than on sectors per se. Activities that are new to the economy are the ones that must be supported, not those that are already established.
Back to Reality
Industrial restructuring seldom takes place without substantial government assistance. When non-traditional export success stories are isolated, industrial policies, public R&D, sectoral support, export subsidies, preferential tariff arrangements, and other similar interventions will be uncovered beneath. The part of such policies in East Asia is well known and it holds for Latin America as well. The difference, however, between East Asia and Latin America is that industrial policy has not been as rigorous and coherent in Latin America as it has been in East Asia. Because of this, the transformation has been less deeply rooted in the former than it is in the latter.
Institutional arrangements for industrial policy
Two main issues that disturb the conduct of industrial policy include the following:
· The public sector has even less information than the private sector about the location and nature of the market failures. The policy setting should be one where information about opportunities and constraints can be gathered from the business sector on an ongoing basis. As Peter Evans puts it, industrial policy-making has to be embedded within a network of linkages with private groups.
· Industrial policy is open to corruption and rent-seeking. Incentives designed to help private investors enter new activities can end up serving as a mechanism of rent transfer to devious businessmen and bureaucrats. The natural response is to insulate policymaking and implementation from private interests, and to shield public officials from close interaction with businessmen.
These issues require two opposing solutions. The challenge now is to find an intermediate position between full autonomy and full embeddedness. Moreover, the process must be democratically accountable and must carry public legitimacy.
Recent literature on institutional innovation emphasizes the limitations of the principal-agent model of governance in environments of volatility and deep uncertainty (Sabel 2003, 2004). Solving problems involves social learning—discovering where the information and coordination externalities are and shaping the objectives of industrial policy and the process of targeting. In this setting, the principal-agent model does not work very well. What is more appropriate is a flexible strategic collaboration between public and private sectors that will elicit information about objectives, distribute responsibilities for solutions, and evaluate outcomes as they appear. Addressing bottlenecks will necessitate a trial-and-error approach to policymaking.
Elements of an Institutional Architecture
Political leadership at the top. The success of industrial policy often depends on the presence of high-level political support. Economic restructuring needs a political advocate who has the ear of the president or prime minister and can stand as equals with other members of the economic cabinet. This raises the profile of industrial policies and enables problems of economic transformation to receive a hearing at the highest levels of the government. It also provides coordination, oversight and monitoring for the bureaucrats and the agencies entrusted with carrying out industrial policies. In addition, it identifies a clear political principal who is accountable for the consequences of industrial policies. This political advocate could be a cabinet-level minister, the vice-president, or the president.
Coordination and deliberation council(s). Coordination or deliberation councils within which the information exchange and social learning can take place are needed. These are private-public bodies that include relevant groups or representatives. These councils would obtain information on investment ideas, achieve coordination among different state agencies when needed, push for changes in legislation and regulation to eliminate unnecessary transaction costs or other impediments, generate subsidies and financial backing for new activities, and bundle these different elements of support along with appropriate conditionalities. They can be created both at the national and sub-national or sectoral levels.
Mechanisms of transparency and accountability. Industrial policies need to be viewed by society at large as part of a growth strategy that is geared to expand opportunities for all, rather than as giveaways to already privileged sections of the economy. Promotion activities must be transparent and accountable. Ideally, the operation of the deliberation/coordination councils should be published and the decisions announced. Public resources spent in support of new activities must be fully accounted for.
Ten design principles for industrial policy
1. Incentives should be provided only to activities that are “new” to the domestic economy. “New” refers to both products that are new to the local economy and to new technologies for producing an existing product.
2. There should be clear benchmarks/criteria for success and failure. The absence of a clear guideline of what constitutes success and observable criteria for monitoring it might produce failures. Ideally, the criteria for success should depend on productivity and not on employment or output.
3. There must be a built-in sunset clause. Every publicly supported project needs to have an automatic sunset clause for withdrawing support after an appropriate amount of time has elapsed.
4. Public support must target activities, not sectors. Targeting activities rather than sectors structures the support as a corrective measure to specific market failures instead of generic support for a one sector.
5. Activities that are subsidized must have the clear potential of providing spillovers and demonstration effects. Public support must be given to activities that have the potential to crowd in other, complementary investments or generate informational or technological spillovers.
6. The authority for carrying out industrial policies must be vested in agencies with demonstrated competence. Promotion activities must be lodged in competent agencies instead of creating new agencies from scratch. The location of competence may predetermine the tools used. And in the case where administrative and human resources are scare, it is better to employ second-best instrument effectively than to use first-best instruments badly.
7. The implementing agencies must be monitored closely by a principal with a clear stake in the outcomes and who has political authority at the highest level. Close monitoring of the promotion activities is essential as it guards not only against self-interested behavior on the part of the agencies, but also helps protect the agencies from capture by private interests.
8. The agencies carrying out promotion must maintain channels of communication with the private sector. Ongoing contacts and communication are important to allow public officials to have a good information base on business realities.
9. Optimally, mistakes that result in “picking the losers” will occur. If governments make no mistakes, it only means that they are not trying hard enough. The objective should be not to minimize the chances that mistakes will occur, but to minimize the costs of the mistakes when they do occur.
10. Promotion activities need to have the capacity to renew themselves, so that the cycle of discovery becomes an ongoing one. Agencies carrying out these policies have the capacity to reinvent and refashion themselves. Some of the key tasks of industrial policy will have to be phased out while new ones are taken on over time.
An illustrative range of incentive programs
It was emphasized earlier that industrial policy should be viewed as a process designed to probe areas where policy actions are most likely to make a difference in a particular country. To understand more about what industrial policies entail, the following illustrative programs are presented:
1. Subsidizing costs of “self-discovery”. Since upfront investments and technological advancements are filled with externalities, the economic argument for subsidizing them is strong. Governments can cover the costs of the early stages of the cost discovery process through a “contest” whereby private-sector entrepreneurs would bid for public resources by bringing forth pre-investment proposals. The criteria for financing such studies would be that (i) they relate to new activities; (ii) they have the potential to provide learning spillovers to others in the economy; and (iii) the private sector entities are willing to submit themselves to oversight and performance audits.
2. Developing mechanisms for higher risk finance. Business development and self-discovery require longer term and riskier forms of financial intermediation. governments will need alternative sources of finance through: development banks, publicly funded venture funds, public guarantees for longer term commercial bank lending, or special vehicles that direct a share of public pension fund assets to a portfolio of higher risk investments.
3. Internalizing coordination externalities. Governments must have the capacity to identify coordination failures and attempt to resolve them. This can be done through coordination and deliberation councils. These efforts need to be undertaken both at the national level as well as the regional and sectoral levels. Chambers of commerce and industry and farmer and labor associations can play a useful constructive role. Also, the government’s relationships with private-sector entities need to be socially legitimized through mechanisms of accountability and transparency.
4. Public R&D. Technological innovations should be well integrated with private sector activities and are targeted to their needs. Programs that work best are likely to be those that are responsive to private sector demands.
5. Subsidizing general technical training. As new activities are expected to eventually encounter a shortage of adequately trained personnel, training for vocational, technical and language skills must be subsidized. It may be desirable to offer subsidies or matching grants to private firms or institutes to co-finance their training efforts since public trainings have a lousy reputation in developing countries.
6. Taking advantage of nationals abroad. Expatriate workers not only offer remittance income to their home country, but also entpreneurialism, skills, and exposure to business in the developed world. Governments can encourage their return and use them to cultivate new domestic economic activities.
The Exaggerated Rumors of Industrial Policy’s Death
Industrial policies have run rampant during the last two decades especially in economies that have sought orthodox reform. Anytime a government consciously favors some economic activities over others, it is already conducting industrial policy. By this standard, the recent past has seen more than its share of industrial policies.
For exporters, export processing zones (EPZs) are the most visible form of discrimination. Incentives offered to foreign direct investment are also common as practically all countries in the world have some government agency charged with attracting foreign investment and a program of tax holidays and other subsidies directed at foreign firms. Exports and foreign investment were believed to be prone to positive externalities and spillovers that is why policy makers try to correct these externalities through subsidy deployment. However, economic research provides little support for this presumption[1]. In addition to EPZs and foreign investment, countries have also engaged in credit facilities and tax incentives for favored sectors.
This shows that industrial policy has not disappeared. The challenge now is for countries to reorganize the machinery that is already in place in a more productive manner. What is needed is not more industrial policy, but better industrial policy.
Is Industrial Policy Still Feasible?
There has been a drive to discipline national economic policies through multilateral, regional, or bilateral agreements. These disciplines enforce restrictions on the ability of developing countries to conduct certain types of industrial policies. The rules of the World Trade Organization (WTO) are a leading example of such restrictions. Export subsidies are now WTO-illegal (for all but least-developed countries), as are domestic content requirements and other performance requirements on enterprises that are linked to trade, quantitative restrictions on imports, and patent laws that fall short of international standards.
Regional or bilateral agreements expand the range of disciplines beyond those that are found in the WTO. The U.S. has promoted tighter restrictions in the areas of investment regulations, intellectual property protection, and capital account. A number of international codes and standards have also restricted the use of industrial policy. And IMF conditionality often goes beyond monetary and fiscal matters to prescribe policies on trade and industrial policy.
Not all international disciplines are harmful. For instance, transparency is fully consistent with the sound industrial-policy architecture. Also, regional trade agreements can be a useful vehicle for industrial policy programs when designed appropriately. Governments with a strategic sense of their economic priorities can put international agreements to good use, and transform potential constraint into opportunity.
Among existing international disciplines, probably the most noteworthy is the one that limits the use of export subsidies. At present, existing policies in many countries are probably too biased towards exporting. Empirical literature does not suggest that exports generate positive externalities that would justify their subsidization. Conditioning subsidies on exports, on the other hand, ensures the incentives are reaped by winners rather than the losers. As such, export subsidies are a nice example of performance-based incentive policies.
Another area where international rules may have some significance is in intellectual property. Richard Nelson (2003) stressed that the ability to copy technologies developed in advanced countries has been one of the most important elements determining the ability of lagging nations to catch up.
Discussions of the multilateral trade regime are increasingly paying attention to the question of “policy space” for developing countries (Hoekman 2004). Developing nations should advocate “policy space” in future trade negotiations. The purpose of international rules should not inflict general rules on countries with different regulatory systems, but to accept these differences and regulate the interface between them so as to reduce adverse spillovers (Rodrik 2001).
Concluding Remarks
Industrial policy is an interactive process of strategic cooperation between the private and public sectors which, on the one hand, serves to elicit information on business opportunities and constraints and, on the other hand, generates policy initiatives in response. The point is to discover where action is needed and what type of action can bring forth the greatest response. It is pointless to obsess about policy instruments and modalities of interventions. What is much more important is to have a process in place which helps reveal areas of desirable interventions. Governments that understand this will be constantly on the lookout for ways in which they can facilitate structural change and collaboration with the private sector. As such, industrial policy is a state of mind more than anything else.
Much of industrial policy is concerned with the provision of public goods for the productive sector. In this sense, industrial policy is just good economic policy of the type that traditional, orthodox approaches propose. The ability to provide these public goods effectively is an important part of the social capabilities needed to generate development. That requires good institutions. Institutional development is important for the contemporary orthodox development agenda.
Source:
Rodrik, Dani, “Industrial Policy for the Twenty-First Century” paper prepared for UNIDO (2004). [1] Subsidizing exporting can do very little to enhance overall productive or technological capacity as big, healthy firms are the ones who undertake exportation. Also, studies have been able to find very little systematic evidence of technological and other externalities from foreign direct investment, some even finding negative spillovers.
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