Sunday, September 20, 2009

The relevance of industrial policy

World Bank's Chief Economist Justin Yifu Lin has kicked off a debate with his version of new-structuralist economics that favors an active role for governments in promoting industrial policies that works with a country's comparative advantage. Critics like William Easterly, who favor the markets and entrepreneurs to do the job of allocation of scarce resources and industrial development, feel that governments cannot identify the sources of comparative advantage and even if they do cannot have in place the incentives to support those sectors.

Justin Lin argues that "comparative advantage should drive policy. The optimal economic structure is endogenously determined by the endowment structure - resources, labor, capital, and hard and soft infrastructure - and differs for each country at different stages of development." He claims that the role of the state is to "develop the required infrastructures and use industrial policy to facilitate the upgrading to industries that are consistent with the country’s comparative advantages". He feels that the market can handle static efficiency, but can’t handle the transition from one stage of exporting to another, like from lighter to heavier industry. Under such circumstances, governments can be guided by following those countries ahead of it on the technological ladder and put in place policies to achieve those objectives. I am inclined to favor Justin Lin for a number of reasons.

First, it is not as simple as merely identifying the comparative advantage and then promoting it by supporting government and private firms in the identified sector. The East Asian economies had in place a comlementary set of policies - education, health care, infrastructure, etc - which addressed the backward and forward linkages that are necessary to sustain any industrial policy. These policies and resultant institutional structures and ancillary markets underpinned the East Asian success story. Unfortunately, most developing economies are sorely deficient in these basic pre-conditions.

Second, even if the basic pre-conditions in terms of development of human resources are met, in the absence of pro-active government interventionary support it will be difficult for the fledgling domestic industries to survive the onslaught from the more efficient and cheaper external competitors. Such support through an effective industrial policy is important to establish a level playing field, especially in the inital few decades of industrial development till a threshold of economic maturity and development is reached. The industrial and economic development paths of all the major economies of the world across history, without exception, has followed this trajectory.

Third, identifying comparative advantage is not about picking specific products and services (like women’s cotton suits or ceramic toilets or building a national car), but locating borader areas of competence and advantage like labor intensive manufactures in the first stage among East Asian economies and subsequent movement up the production chain. Similarly, the Indian government realized the comparative advantage conferred by its large pool of skilled and English speaking manpower and put in place policies, however flawed, to promote sectors like software and bio-technology. Countries at different stages of development will have industries locate at different segments in the spectrum.

Industrial policies are about promotion of savings, provision of access to timely and adequate finance, policies to develop human resources and endow them with requisite technical skills, facilitate easy access to capital goods, judicious use of export subsidies and other support to provide a level-playing field against foreign competitors, atleast till the domestic firms find their foot-hold.

Finally, there is a thin line that differentiates good and beneficial industrial policy from protectionism. However, this cannot be held against industrial policies, since protectionist barriers have been a constant in the economic landscape of even market-friendly developed economies like the United States. Protectionism has never been the exclusive preserve of governments.

In the circumstances, it endows on economists to help policy makers design appropriate policies that take into account each nation's comparative advantage. They can help stitch together the most effective and least distortionary set of policies and construct the institutional architecture that aligns incentives with the achievement of the pre-defined policy objectives. They should also study the conditions under which such industrial policies are likely to be successful in different economies.

Prof Easterly's example of the corruption in giving driver's licences in India is surely irrelevant to the debate about government's role in initiating industrial policies. Inefficiencies and distortions in the implementation of policies, which are not uncommon even in the developed economies (witness the extent of inefficiency and incentive distortions in the US health insurance market), cannot be taken to abandon government intervention of any kind.

To answer Prof Easterly, poor country governments certainly have a comparative advantage, atleast over its its nascent or under-developed private sector and its market structures, in discovering their comparative advantage.

Update 1 (18/4/2010)
Dani Rodrik on the return of industrial policy, "British Prime Minister Gordon Brown promotes it as a vehicle for creating high-skill jobs. French President Nicolas Sarkozy talks about using it to keep industrial jobs in France. The World Bank’s chief economist, Justin Lin, openly supports it to speed up structural change in developing nations. McKinsey is advising governments on how to do it right."

He has three important pre-requisites for a successful industrial policy.

1. Industrial policy is a state of mind rather than a list of specific policies. Its successful practitioners understand that it is more important to create a climate of collaboration between government and the private sector than to provide financial incentives. Through deliberation councils, supplier development forums, investment advisory councils, sectoral round-tables, or private-public venture funds, collaboration aims to elicit information about investment opportunities and bottlenecks. This requires a government that is 'embedded' in the private sector, but not in bed with it.

2. Industrial policy needs to rely on both carrots and sticks. Given its risks and the gap between its social and private benefits, innovation requires rents – returns above what competitive markets provide. That is why all countries have a patent system. But open-ended incentives have their own costs: they can raise consumer prices and bottle up resources in unproductive activities. That is why patents expire. The same principle needs to apply to all government efforts to spawn new industries. Government incentives need to be temporary and based on performance.

3. Inustrial policy’s practitioners need to bear in mind that it aims to serve society at large, not the bureaucrats who administer it or the businesses that receive the incentives. To guard against abuse and capture, industrial policy needs be carried out in a transparent and accountable manner, and its processes must be open to new entrants as well as incumbents.

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