Industrial policy works - evidence from Korea

A friend points to a paper by Jaedo Choi and Andrei A. Levchenko which draws attention to the long run welfare enhancing effects of industrial policy. 

Using a natural experiment and unique historical data during the Heavy and Chemical Industry (HCI) Drive in South Korea, we find large and persistent effects of firm-level subsidies on firm size. Subsidized firms are larger than those never subsidized even 30 years after subsidies ended. Motivated by this empirical finding, we build a quantitative heterogeneous firm model that rationalizes these persistent effects through a combination of learning-by-doing (LBD) and financial frictions that hinder firms from internalizing LBD. The model is calibrated to firm-level micro data, and its key parameters are disciplined with the econometric estimates. Counterfactual analysis implies that the industrial policy generated larger benefits than costs. If the industrial policy had not been implemented, South Korea's welfare would have been 22-31% lower, depending on how long-lived are the productivity benefits of LBD... A firm receiving the average subsidy between 1973 and 1979 had a 919% larger sales growth between 1982 and 2009, amounting to a 8.6% higher annual growth rate over this period... Most of the total welfare effect (between one half and two-thirds) is due to the long-run impact of subsidies on productivity through LBD.

The HCI Drive was abruptly announced in 1972 and terminated in 1979 and had pronounced regional variations. This makes it amenable to study as a natural experiment. The policy instrument itself was the allocation of foreign credit. The Korean government strictly regulated access to foreign capital, and once firms got approval to borrow abroad the government guaranteed the loan thereby allowing them to borrow at cheaper rates than locally.

The problem with industrial policy is less the underlying theory and more the discipline of its implementation. As Joe Studwell has shown with the contrasting fortunes of North and South East Asian economies, the former succeeded with the same set of policies that the latter failed miserably. Like in South East Asia, history informs that it's very likely that any industrial policy can get captured by domestic vested interests and thereby become a fig leaf to perpetuate inefficient domestic manufacturers. This is the biggest threat to the production linked incentive scheme that government of India has initiated.