Why industrial policy is back

AMBRIDGE — After decades of relegation to the fringes of economic thinking, industrial policy is making a comeback. With more countries enacting measures to support certain industries and establish new ones, the revival of industrial policy was a major topic at this year’s meeting of the World Economic Forum in Davos.

The United States’ $280 billion CHIPS and Science Act is a case in point. The new legislation aims to expand the US semiconductor industry in order to reduce America’s dependence on China and ensure its technological supremacy. Similarly, the Biden administration’s misnamed Inflation Reduction Act (IRA) includes $370 billion in energy-transition subsidies.

European Union countries, up in arms about the US programs’ discrimination against foreign suppliers and violation of international and EU rules prohibiting industry-specific state subsidies, plan to respond by relaxing their own subsidy rules. Meanwhile, one-third of the 1.8 trillion euros ($2 trillion) in investment funding in the NextGenerationEU Recovery Plan will finance the European Green Deal, introduced in 2019, which will help member states invest in clean-energy projects. And the trend is not confined to Western countries: Indonesia imposed a ban on nickel-ore exports to promote its electric-vehicle battery industry.

Such policies have existed since the dawn of the Industrial Revolution. In recent decades, however, economists have questioned their usefulness. Governments should not be picking winners, the argument goes, but rather let the market allocate resources across industries in a way that reflects consumer preferences and technological possibilities. By the same logic, policymakers should intervene in the market only when they have sufficient information that some externality is causing the market to malfunction. And even then, the detractors would say, governments might make matters worse by adding their own failures, for example, policy capture by rent-seeking players, to those of the market. With the Reagan-Thatcher revolution and the emergence of the so-called Washington Consensus in the 1980s, these arguments became enshrined in a new orthodoxy.

But economic theorists have since come around to recognising the value of industrial policies. We now know that there are many cases where government intervention is justified. The question, then, is not whether industrial policies should exist, but how they should be managed.

For example, learning by doing was seen as a large and important phenomenon that required policy interventions long before economists caught on. There is ample evidence that many firms and industries improve over time as they accumulate production experience. In 1936, the aeronautical engineer Theodore Wright formulated what is now known as Wright’s Law, which states that costs decline exponentially with accumulated production. During World War II, the US Army used this law in its procurement contracts to reap the cost savings. But the idea entered economics only with a paper by Kenneth Arrow published in 1962. It has since been used to justify infant-industry protection, advanced market commitments, and subsidies like those included in the IRA.

Market power is another imperfection that requires government intervention. To that end, the CHIPS Act enables the US to counter China’s dominance. The fear is that China can use this dominance as an economic weapon, in the same way that the US uses its dominance of the financial system and certain technologies to sanction other countries. The CHIPS Act seeks to reduce the American economy’s vulnerability to Chinese pressure.

All of these interventions are about tilting market prices to make certain industries, such as semiconductors or renewable energy, more profitable and hence larger than they otherwise would be. But another form of government intervention concerns the complementarity between public and private goods. For example, cars require roads, traffic lights, driving rules, and cops. Trains need tracks and stations. Electric vehicles require widely available charging stations. And all industries rely on workers with specific skill sets. These inputs are affected explicitly and implicitly by government policies, which are essential to creating the right conditions for growth and widely shared prosperity.

The only way governments can supply the right mix of public goods is to engage with as many industries as possible. Industrial policies are not about picking winners, but about ensuring that the supply of public goods enhances productivity as much as possible. Because they cannot rely on the invisible hand of the market to coordinate the actions of thousands of public agencies and the effects of millions of pages of legislation, governments must be embedded and engaged. That is why in democratic countries, there are so many business chambers and lobby groups trying to influence the provision of public goods in ways that enhance their industries’ value-creating opportunities. To be sure, these groups may also engage in rent-seeking, but democratic competition can keep such behaviour at bay.

None of this is to say that every government should imitate the expensive policies that seem to be in vogue these days. Policymakers should focus on their countries’ current problems and choose the most appropriate solutions. Copying other countries’ solutions to problems you do not have, or focusing on trendy issues that are not really important, is a recipe for inefficiency, if not disaster.

For example, diversifying into new industries, a key goal in many countries, requires identifying the public goods that these industries require and helping them through the learning process. As decarbonization leads to the emergence of new markets and industries, governments are trying to figure out how to be part of the green transition. Other countries may want to reduce regional inequalities, or to integrate their universities into a vibrant innovation ecosystem, or to accelerate development by addressing long-standing failures in the provision of key inputs such as electricity, water, mobility, training, and digital services.

To address these challenges, governments must have access to all the policy tools that could help them find solutions. Dismissing these tools as “industrial policy”, as some are wont to do, does not make them any less necessary.

Ricardo Hausmann, a former minister of planning of Venezuela and former chief economist at the Inter-American Development Bank, is a professor at Harvard University’s John F. Kennedy School of Government and Director of the Harvard Growth Lab. Copyright: Project Syndicate, 2023. 

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