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Revisiting the Industrial Policy Question in East Asia

Summary:
Many of the world's main economic growth success stories are clustered in east Asia, including Japan, South Korea, Taiwan, Malaysia, Singapore, and now of course China. Of course, everyone wants to claim credit for success stories: in particular, it's clear that the governments of these countries have often intervened in their economies, and so they are commonly cited as examples of how "industrial policy," rather than just a "free market," is needed for rapid growth. Reda Cherif and Fuad Hasanov resurrect these arguments in "The Return of the Policy That Shall Not Be Named: Principles of Industrial Policy" (IMF Working Paper WP/19/74, March 2019)As a starting point to sorting out these arguments, it's useful to point out that any proposed dichotomy between "industrial policy" and the

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Many of the world's main economic growth success stories are clustered in east Asia, including Japan, South Korea, Taiwan, Malaysia, Singapore, and now of course China. Of course, everyone wants to claim credit for success stories: in particular, it's clear that the governments of these countries have often intervened in their economies, and so they are commonly cited as examples of how "industrial policy," rather than just a "free market," is needed for rapid growth. Reda Cherif and Fuad Hasanov resurrect these arguments in "The Return of the Policy That Shall Not Be Named: Principles of Industrial Policy" (IMF Working Paper WP/19/74, March 2019)

As a starting point to sorting out these arguments, it's useful to point out that any proposed dichotomy between "industrial policy" and the "free market" is a gross oversimplification.  It is widely agreed that for sustained growth, a country must address economic fundamentals like high rate of investment in physical capital, education, and health; macroeconomic stability; a well-functioning legal infrastructure that supports an environment friendly to starting and running businesses; pro-competition policies; openness to trade; support for research and development and intellectual property, and so on. Government will play a prominent role in many of these areas, so they cannot be characterized as "free market." However, these policies do not provide direct favors to any existing company or industry; indeed, they may set the stage for types of growth that disrupt or even bankrupt existing companies and industries. Thus, they are not really "industrial policy," either.

If a government decides to carry out policies that favor certain particular industries, rather than just being satisfied with preparing the ground for growth to occur, it will need to make three choices: what industry to favor, what policy tools will be used to favor those industries, and how to decide when these policy tools should be ended (in particular, when the tools have not worked).

Cherif and Hasanov describe their preferred version of industrial policy in this way:

We argue that the success of the Asian Miracles is based on three key principles that constitute “True Industrial Policy,” which we describe as Technology and Innovation Policy (TIP). ... (i) state intervention to fix market failures that preclude the emergence of domestic producers in sophisticated industries early on, beyond the initial comparative advantage; (ii) export orientation, in contrast to the typical failed “industrial policy” of the 1960s–1970s, which was mostly import substitution industrialization (ISI); and (iii) the pursuit of fierce competition both abroad and domestically with strict accountability.
They argue that an emphasis on economic fundamentals is a "snail crawl" approach to growth, while their version of targeted industrial policy is the "moon shot" approach.

You can read their essay for the details of the case in favor of this approach. Here, I'll just point out that the arguments here come in two main categories: the question of whether government are in fact likely to enact the specific type of industrial policy being recommended; and the likely marginal effect of such an industrial policy, over and above a policy of sound economic fundamentals.

Concerning the question of whether a government can enact should enact a policy to favor specific industries, it's wroth emphasizing that their three standards for industrial policy are quite specific, and by no means a blanket endorsement of widespread government intervention in the economy.

For example, their preferred form of industrial policy pushes domestic producers into "sophisticated" industries they would not otherwise have tried. Thus, this argument for industrial policy does not offer support for policies that favor production of existing goods, or for just helping industries as they currently exist to earn higher profits. It does not favor an industrial policy aimed at saving existing jobs. Thus, the challenge is whether government can

Their second goal focuses on the idea that successful industrial policy should focus on expanding export sales, not on trying to replace imported products. Thus, they are explicitly disavowing the "import substitution" approach to economic development that has historically been popular in Latin America and elsewhere. For their preferred type of industrial policy, "tariffs are neither necessary nor sufficient to succeed," although tariffs were often used in combination with more direct financial and credit incentives.

The third goal emphasizes that this growth of "sophisticated" industries should involve both fierce competition, both at home and abroad. The focus on domestic competition means that this approach does not favor government nationalization of an industry, or trying to create a "national champion" firm to compete in foreign markets. As they write: "While specific industries may get support, intense competition among domestic firms was highly encouraged in domestic and international markets," 

When they mention "strict accountability," what they have in mind is that industrial policy in the 1970s and 1980s in places like South Korea and Taiwan set up specific targets that had to be met for a firm to benefit from industrial policy. These targets might involve a certain level of export sales that had to be reached, along with certain levels of investment or R&D effort, or setting up chains of domestic suppliers. "Accountability" means that if these pre-determined targets were not met in a timely manner, the benefits from the industrial policy could and were cut off.

The notion that this very specific kind of industrial policy can benefit an economy isn't especially new. Cherif and Hasanov mention a prominent book-length report on this subject published by the World Bank back in 1993, The East Asian Miracle: Economic Growth and Public Policy.  The report argues that by far the main causes of rapid growth in the countries of East Asia were high levels of investment in physical capital, human capital, and technology, occurring in a context of an economy that emphasized market incentives, including intense domestic competition and macroeconomic stability. However, the World Bank report also took care to note (citations omitted): 

In most of these economies, in one form or another, the government intervened--systematically and through multiple channels--to foster development, and in some cases the development of specific industries. Policy interventions took many forms: targeting and subsidizing credit to selected industries, keeping deposit rates low and maintaining ceilings on borrowing rates to increase profits and retained earnings, protecting domestic import substitutes, subsidizing declining industries, establishing and financially supporting government banks, making public investments in applied research, establishing firm- and industry-specific export markets, developing export marketing institutions, and sharing information widely between public and private sectors. Some industries were promoted, while others were not. ... 
At least some of these interventions violate the dictum of establishing for the private sector a level playing field, a neutral incentives regime. Yet these strategies of selective promotion were closely associated with high rates of private investment and, in the fastest-growing economies, high rates of productivity growth. Were some selective interventions, in fact, good for growth? ...
Our judgment is that in a few economies, mainly in Northeast Asia, in some instances, government interventions resulted in higher and more equal growth than otherwise would have occurred. However, the prerequisites for success were so rigorous that policymakers seeking to follow similar paths in other developing economies have often met with failure. What were these prerequisites? First, governments in Northeast Asia developed institutional mechanisms which allowed them to establish clear performance criteria for selective interventions and to monitor performance. Intervention has taken place in an unusually disciplined and performance-based manner. Second, the costs of interventions, both explicit and implicit, did nor become excessive. When fiscal costs threatened the macroeconomic stability of Korea and Malaysia during their heavy and chemical industries drives, governments pulled back In Japan the Ministry of Finance acted as a check on the ability of the Ministry of International Trade and Industry to carry out subsidy policies, and in Indonesia and Thailand balanced budget laws and legislative procedures constrained the scope for subsidies. ... Price distortions arising from selective interventions were also less extreme than in many developing economies. In the newly industrializing economies of Southeast Asia, government interventions played a much less prominent and frequently less constructive role in economic success, while adherence to policy fundamentals remained important ...
I quote here at some length to emphasize that it has been a commonly held and conventional World Bank view for some time that certain focused, disciplined, and strictly accountable industrial policies with an export-push focus can work. It's also possible that some of the most important interventions in these economics were policies that were anti-free market but not industry-specific, like "keeping deposit rates low and maintaining ceilings on borrowing rates to increase profits and retained earnings" or "establishing and financially supporting government banks."

But overall, the practical policy question is whether one wants to encourage governments of developing countries to enact "industrial policy," given the risk that the approach may be neither focused nor disciplined nor accountable. After all, the world is full of countries that have announced the implementation of industrial policies that were not only unsuccessful, but often wasteful and  counterproductive. 

The other main question about industrial policy is how to decide whether, for example, most of the rapid growth in east Asia was due to the extraordinary gains of those countries in economic fundamentals and how much was due to specific industrial policies. The 1993 World Bank report argued that overall, some of East Asia's industrial policies succeeded, others failed, and overall the industry-specific policies didn't much affect the direction of growth. The report says: 
Most East Asian governments have pursued sector-specific industrial policies to some degrce. The best-known instances include Japan's heavy industry promotion policies of the 1950s and the subsequent imitation of these policies in Korea. These policies included import protection as well as subsidies for capital and other imported input. Malaysia, Singapore, Taiwan, China, and even Hong Kong have also established programs--typically with more moderate incentives--to accelerate development of advanced industries. Despite these actions we find very little evidence that industrial polices have affected either the sectoral structure of industry or rates of productivity change. Indeed, industrial structures in Japan, Korea, and Taiwan, China, have evolved during the past thirty years as we would expect given factor-based comparative advantage and changing factor endowments ... 
Of course, it's very hard to separate out different factors that contribute to a country's economic growth and draw lessons that can apply to other countries. Cherif and Hasanov make a case that for Hong Kong, Korea, Singapore, and Taiwan, the industry-targeted incentives were a key and central component. I'm skeptical. My own (only lightly informed) sense is that this case is stronger case for Korea than for the other three. Also, it seems unlikely that the industry-specific incentives would have accomplished much if the strong economic fundamentals had not been in place. 

One way or another, when explaining the growth pattern of specific economies, it's hard to rule out an element of luck. Cherif and Hasanov are quick to note that when countries have enacted something close to their preferred version of industrial policy, but perform poorly, it could just be a result of bad luck or bad timing. Fair enough. But it may also be that the the East Asian economies benefited from good luck in taking certain policy steps at just the right historical moment. 

At the current historical moment, where political currents are running strongly against an expansion of international trade and the technologies of automation and information technology are transforming manufacturing, it's not clear that import substitution policies in the style of East Asia--focused on exports of increasingly sophisticated manufacturing products--is a workable development strategy for the near future. 

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