Thoughts on the return of industrial policy

Off-shoring and outsourcing, Chinese imports, and technology-biased changes have depleted the manufacturing base in many developed countries. Besides, the Chinese dominance of the manufacturing supply chain poses serious risks. Industrial policy is therefore becoming the new norm across developed countries. This post will examine some aspects of this change. 

Manufacturing's share of the economic output has been declining across the world.

In order to reverse this trend, in the span of less than a year, the US has passed three legislations - Infrastructure Investment and Jobs Act in late 2021, Inflation Reduction Act and Chips and Science Act in August 2022. These policies are being considered critical to incentivise investments

“The IRA really underpinned the business case to stay here,” adds Jorg Heinemann, chief executive of EnerVenue, a US battery company building a $264mn factory in Kentucky. “Take away the IRA, now it becomes a much more difficult equation . . . the pull of Asia would have been difficult to resist.”

History may well remember this speech by President Biden in Chicago that unveiled a new economic policy making paradigm, Bidenomics, as formally announcing the return of industrial policy.

The economic vision for this country: the economy that grows the economy from the middle out and the bottom up instead of just the top down. When that happens, everybody does well. The wealthy still do — (applause) — everybody does well. The poor have a ladder up, and the wealthy still do well. We all do well. 

This vision is a fundamental break from the economic theory that has failed America’s middle class for decades now. It’s called trickle-down economics — fundamental economics, trickle-down. The idea was — it’s the belief that we should cut taxes for the wealthy and big corporations... I’m tired of waiting for the trickle-down. It doesn’t come very quickly. Not much trickled down on my dad’s kitchen table growing up. And it’s a belief that we should shrink public investment in infrastructure and public education — shrink it; that we should let good jobs get shipped overseas. And we actually have a tax policy that encourages them to go overseas to save money. We should let big corporations amass more power while making it harder to join a union... Under trickle-down economics, it didn’t matter where you made things, as long as you helped the company’s bottom line, even if that meant seeing jobs and industries go overseas for cheaper labor... Trickle-down also meant slashing public investment on things that helped drive long-term growth and helped America lead the world in innovation...

Bidenomics is about building an economy from the middle out and the bottom up, not the top down. And there are three fundamental changes that we decided to make with the help of Congress and been able to do it: first, making smart investments in America; second, educating and empowering American workers to grow the middle class; and third, promoting competition to lower costs to help small businesses... We’re supporting targeted investments. We’re strengthening America’s economic security, our national security, our energy security, and our climate security... We’re now investing in key industries of the future, making targeted investments to promote domestic production of semiconductors, batteries, electric cars, clean energy... Biden economics means the industries of the future are going to grow right here at home... addressing the 40-year decline in unionization by supporting project labor agreements, collective bargaining, prevailing wage laws, that’s the reason today Americans’ support of unions is higher than it’s been in 60 years.

Initial signs appear to show a revival. Manufacturing investments have taken off, almost doubling in the last two years.

But the scale of these policies from the US has generated severe backlash (and emulation) among its competitors, 

Ever since the Biden administration passed the Inflation Reduction Act and the Chips and Science Act for clean energy and tech last year, there has been a mutinous mood among some American allies in both Europe and Asia at the scale of the new US subsidies. What the US sees as a strategy to reverse deindustrialisation in deprived areas, allies have interpreted as a thinly veiled exercise in protectionism because it encourages companies to shift plants and customers to Buy American...

After several decades when the US has used its influence at institutions such as the World Bank and the IMF to pressure governments to cut back subsidies, many have been quick to call hypocrisy over Washington’s new embrace of industrial policy. Europeans, in particular, are anxious about the competitive threat and the risk of seeing some of their industrial base migrate to the US. Yet as the dust has settled in recent months, the reaction has shifted from anger to a search for ways to catch up. The EU, Japan and South Korea have all introduced subsidies for their tech and clean energy sectors, in order to attract new investment or prevent more companies from shifting to the US...

Many of the incentives are focused on businesses that assemble products in the US, which encourages companies to move production there. And not only do they qualify for the massive subsidies on offer from the Biden administration — they can also benefit from lower energy costs and taxes. Meyer Burger, a Swiss-based solar technology company that has three plants in eastern Germany, warned last month that it would build its new solar cell factory in the US rather than Germany unless Berlin provided more financial support... The IRA has prompted an investment spree by Japanese manufacturers with Panasonic, Toyota, Honda, Bridgestone and others announcing additional spending plans in the US... South Korean companies have also been among the largest investors in green technologies in the US since the IRA was passed last year... by 2026 Korean battery makers will stand to collect an annual collective subsidy from the US taxpayer of upwards of $8bn from the IRA’s “advanced manufacturing production credit” alone.

And others too are following the US in adopting the green transition industrial policy

Analysts stress that European countries have already developed a green agenda that incorporates tens of billions of euros of subsidies. While the US regime offers subsidies worth $7,500 an electric car, for example, the average in the EU was already €6,000 per vehicle in 2022. Under the €800bn NextGenerationEU Covid-19 recovery programme, member states are required to commit at least 37 per cent of spending to the green transition. This comes on top of a regulatory framework that uses a carbon price, via the EU Emissions Trading System, to drive up investments in renewables and greener technologies... The European Commission last year relaxed its strict state-aid rules, giving member states more leeway to help their companies get through the turbulence triggered by Russia’s invasion of Ukraine... 

The new “temporary crisis and transition framework” (TCTF) allows EU countries to provide subsidies to companies making things like solar panels, wind turbines, heat-pumps and the electrolysers needed to produce green hydrogen, as well as carbon capture and storage projects... The TCTF framework is now being used to help solar companies, too... South Korea has responded to the US subsidies with a semiconductor package of its own, the so-called “K-Chips Act”. Passed in March, the legislation boosted tax credits for companies investing in manufacturing of “national strategic goods”, including semiconductors.

This is an interesting point about the contrasting nature of their policies,

Businesses praise the relative simplicity of the US offer, which focuses on uncapped tax incentives targeted at manufacturers. By contrast, EU attempts to forge a convincing green industrial policy have been undermined by a patchy regulatory framework and complex processes for accessing multiple pots of money... “The risk is that the EU’s response to the IRA will in the end be too little, too late,” says Südekum, the German academic. “The programmes are too complicated and are getting bogged down in details.”

It cannot be denied that the scale of the intervention is staggering and poses dangers of distortions, inefficiencies, and wastages,

Nowhere have the risks of such a contest been more obvious than in the case of Intel’s big new German investment. The chipmaker had announced plans last year to invest €17bn in two new fabrication plants or fab in the eastern German city of Magdeburg. The German government had promised to subsidise the project to the tune of €6.8bn. But then Intel said it wanted more, citing higher energy and construction costs. In the end, the government agreed to raise the level of subsidy to €9.9bn, though Intel also announced it was increasing the investment volume from €17bn to €30bn. “There’s a lot of subsidy shopping going on at the moment,” says Moritz Schularick, head of the Kiel Institute for the World Economy in Germany. “Companies can say to politicians here: ‘we get more funding in the US’, and that can convince them to shell out even more money.” 

Many orthodox economists in Germany have expressed horror at the level of subsidies being offered to companies like Intel. Such support — and the mere suggestion of “industrial policy” — is an affront to German “ordoliberalism”, with its rejection of state intervention in the economy and its abhorrence of subsidies or tax privileges. Habeck admits that subsidies go against the grain of “pure economic theory”. But the Europeans had no choice but to match the huge incentives on offer in the US and China, which are attracting billions of dollars in investment. “We have to decide: do we continue to act according to what’s in our textbooks?” he told the Süddeutsche Zeitung at the end of June. “If we do, we won’t have any of the key industries of the future.”

The Economist has questioned the wisdom of such large scale industrial policy-based push into manufacturing, and described it as manufacturing delusion. It's perhaps right about the scale and speed of the shift and for sure a significant share of these subsidies are likely to be inefficiently deployed. 

But such wholesale condemnation of industrial policy is misleading. For example, it scorns at US government efforts to support the semiconductor industry citing the unsuccessful Japanese attempts in 1980s to subsidise the memory chip manufacturing industry. This is plain wrong since the Japanese semiconductor industry was dominant in the seventies and eighties thanks to its industrial policy of the seventies. Further, the current dominance of TSMC and Samsung are in no small measure due to industrial policy in Taiwan and South Korea. 

Yes, it'll be inefficient and more expensive (the US chips are expected to be 30% costlier than Taiwanese) to manufacture in the US. But without it, there's no chance of de-risking and diversifying arguably the most strategically important industry. And it's fanciful and foolish to believe that China will not weaponise any control it manages to achieve with its own industrial policy on semiconductors over this industry. This becomes a real threat also given the excessive industry concentration in Taiwan and TSMC. And given its capital intensive nature, industrial policy support is essential for semiconductor manufacturing to stand any chance of flowering in the US. Even with such support, its success would be long-drawn and a host of other complementary factors. 

In the aggregate objective function of the semiconductor industry (one that takes into account the interests of all stakeholders and not just sellers and buyers), efficiency and price are not the only considerations. Others like resilience, restoring local manufacturing capabilities, strategic diversification, and having control over strategically important industries ought to be equal or even more important existential parameters. Foremost, national interests often dictate a control over certain industries. 

Critics of the manufacturing push are also making the mistake of underestimating the importance of making things to the economy as a whole. In the guise of moving up the value chain and specialising in knowledge based industries, academics and experts have provided the ideological cover for shifting away from activities involving human labour and making things. Such excessive shift in one direction has negative implications for general economic resilience and strategic autonomy (the pandemic and now the reliance on China for critical minerals and technologies for green transition are examples), ability to create the good jobs necessary to accommodate a large portion of the population unable to do these knowledge-based jobs, and for economic productivity growth and technology diffusion in general. 

Then there's the point of being able to specialise in cutting-edge manufacturing-associated services when there's no experience of manufacturing itself available to learn and internalise the nuances and details that are critical for high-quality design. It's not surprising that Tesla, the most successful EV company, one that seeks to be primarily an EV platform company, has, unlike others, vertically integrated the entire supply chain including battery manufacturing. Germany's technological superiority, for example, is built on the foundations of its mittlestands that make equipment and devices. An IT industrial ecosystem that's detached from the underlying physical processes that it seeks to manage is unlikely to be able to maintain its dominance for long. Manufacturing and associated services have to co-exist to be able to innovate on a sustainable basis. 

The scepticism and criticism about industrial policy are based on anecdotal examples (read Solyndra) and narrow project-specific costs-benefit assessments (for example, Economist quotes the example of a $1 billion New York State-built solar-panel factory rented out to Tesla for $1 per year, which has returned only 54 cents in benefits per dollar spent). Both suffer from serious limitations. The former is a case of what's newsworthy is what captures the mood of the times and gets reported. The latter makes the mistake of overlooking the general equilibrium benefits of such efforts. 

In this context, we should bear in mind that India's efforts at boosting mobile phones and semiconductor manufacturing will certainly have inefficiencies and wastage. But the alternative of not doing anything and allowing foreign competitors to move in and make outside (or assemble inside) and sell in India is not good for the country's economic prospects. It robs the country of opportunities to expand its capital base. Given all the available trends, the magazine's dismissal of India's PLI scheme as having generated only a low-value assembly of mobile phones looks certain to bite back. 

Delusions about industrial policy in terms of just picking winners and throwing money being enough to reshore manufacturing investments are certain to end up in tears. On the same lines, leaving market forces to play out and maintaining the globally integrated supply chains are just as likely to leave everyone with deep regrets. The need of the hour is an embrace of calibrated industrial policy - where critical industries are identified and targeted with industry-wide support, tariff and other barriers are complemented with export competition, and generally, tax concessions and subsidies that target outcomes. 

Adam Posen of the Peterson Institute is disturbed by the scale of industrial policy and its combination with protectionist trade and investment policies. I think there's some cause for concern. He prefers that government confine itself to funding R&D, worker training, infrastructure provision, and regulation of innovation, and refrain from directly engaging to subsidise sectors and companies. And the industrial policy in the US might be a case of too much being pumped in too quickly with the near certainty of leakages and wastage. And the protectionist push might be used by the domestic industry to perpetuate inefficiencies. 

Some of his concerns are baffling,

The real damage from decoupling and conflict between the US, China and other economic blocs is reduced productivity growth. We would see less diversification both financially and in inputs, including of ideas and business practices, along with less competition, which directly diminishes productivity. We would also see further restrictions of migration, foreign direct investment, flows of information and technology once economic nationalism is entrenched. So, if we continue down this path, we’re looking at a meaningfully bleaker outlook for average growth in the world. It’s going to be harder for the developing world to break through except through political pandering to China, EU or US, which they cannot depend on. There’ll be the occasional country that has a temporarily critical mineral supply or whatever which will try to play off the three in a bidding war, but that never lasts as an advantage. The lasting large magnitude decline in average global productivity growth will hamper our response to climate change.

Do we even have an alternative to decoupling? Can a good faith economic integration continue with Xi Jinping's China? Does he even realise the consequences of Chinese hegemony and control over strategic industries? What's the basis for the confidence that the current trends on Chinese dominance in every imaginable emerging and critical industry will be a force for global good? Is there any practical basis for assuming that global economic growth prospects will be better in an integrated world economy? This is pure ivory-tower opinion-making. 

Then there are some purely self-serving arguments,

For all the talk about how ashamed so-called neoliberal economists should be about trade and inequality, the fact is, the people pushing for manufacturing jobs in specific places in the UK or the US are immorally slighting just how important trade, cross-border investment, migration, and technology transfer has been to billions of people in the developing world. This isn’t just about China. This is hundreds of millions of people in India. This is people in Poland, Turkey, Indonesia and Vietnam, and southern Africa and large parts of South America.

Really? These same developing countries are and have been among the loudest proponents of calibrated globalisation and trade liberalisation, and have always been active users of industrial policy. In short, the West is now embracing what these countries have all along preached and practised. It's plain disingenuous to now use them to justify the orthodoxy. 

One way to frame the protectionist push is to formulate it as an adjustment towards a more prudent and fair real-world balance between domestic and foreign competitors, a levelling of the playing field that had become lop-sided in favour of foreign competitors (especially the deeply subsidised Chinese imports). The push towards industrial policy too should be viewed as a corrective to the market-knows-best paradigm that has dominated policy-making in the developed world (and among international institutions) for a few decades. It's flawed to blindly believe that comparative advantage will promote mutually beneficial outcomes without local content requirements, levelling the playing field with subsidies and concessions, incentivising local job creation etc. 

On the same lines, the current focus on anti-trust activity should be seen as a recalibration of the prevailing policy of overlooking corporate size and anti-competitive actions on the grounds that consumer welfare is all that matters. Or the blind faith in the private sector's willingness and ability to support important public objectives like the green transition should be corrected with one where the public sector is complemented by the private sector. 

There's a subtle and important difference between the recalibration proposed above and a wholesale shift towards protectionism or regulation or government-knows-best industrial policy approaches. The worry is that those advocating the former come to be used as the Baptist by the latter bootleggers! But when faced with choices involving strategic national interests, these risks may be worth taking. 

Update 1 (20.08.2023)

Indonesia's decision to ban nickel ore exports should count as an industrial policy success

In refusing to sell its raw nickel to the world, Indonesia has drawn more than $14 billion in investment, primarily from Chinese companies, into smelters that process it into products used to make stainless steel and E.V. batteries. Since the ban was introduced in 2014, Indonesia’s exports of nickel products have multiplied more than tenfold, exceeding $30 billion last year, according to government data. The European Union asserts that its companies are being deprived of a fair chance to import nickel ore. It brought and won a case at the World Trade Organization, gaining the power to apply punitive tariffs on Indonesia’s exports even as the country appeals. 

Luhut Binsar Pandjaitan, Indonesia’s coordinating minister for maritime affairs and investment, likens that position to a perpetuation of the colonial era, when the Dutch, Portuguese and British hauled spices, sugar and other lucrative commodities back to European entrepôts. The nickel export ban is a corrective, he said, the means of securing the value of extraction for Indonesians... Government officials say they welcome investment from any place that brings capital and know-how. Chinese firms arrived early, recognizing the importance of nickel in the emerging realm of electric vehicles.

Indonesia is now lobbying with the US to include Indonesia among the list of friendly countries so as to enable US manufacturers using nickel from Indonesia access the tens of billions of dollars in tax credits that are being offered by the Biden administration to spur electric vehicle manufacturing.