The Industrial Policy Revolution I

Knowledge validation has never been a painless process. It often takes a major, disastrous historical event for even the most self-evident ideas to gain wide recognition. It is therefore not surprising that the Great Recession of 2008–09 — whose global economic and social cost is still yet to be quantified -has led to a rethinking of many aspects of what might be thought of as the conventional wisdom in economics.

Throughout human history, people have held their political leaders responsible for the general social and economic conditions of their nations. Fairly or unfairly, some leaders have been hailed as national heroes while others have been thrown out of power or even punished more harshly depending on the level of collective happiness or anger. But never in modern history has the leader of an industrialized country been convicted by courts for his stewardship of the national economy. Yet, that is what happened recently when former Iceland Prime Minister Geir Haarde was prosecuted and found guilty of failing to manage his country’s economy appropriately prior to and during the 2008 global crisis. While he was cleared for the most serious charges and barely escaped jail sentence, his reputation and political legacy were forever tarnished. The irony of the story is that he had long been viewed as instrumental in transforming Iceland from a fishing and whaling backwater into an international financial powerhouse before the global crisis.¹

Industrial policies — meaning policies by which governments attempt to shape the sectoral allocation of the economy - are back in fashion, and rightly so. The major insight of welfare economics of the past fifty years is that markets by themselves in general do not result in (constrained) Paretoefficient outcomes (Greenwald and Stiglitz, 1986).

This fascinating paper looks at one of the most important issues in the economics of technological change: the wedge between the social and private returns from innovation. The authors explore the implications of this important gap — often ignored in discussions of industrial policy — for the promotion of firms and technologies.

Developing countries can grow rapidly by absorbing known technologies from more advanced countries. Yet developing countries often find it difficult to absorb even relatively simple technologies even when they have the resources to buy the relevant machines and have workers with the appropriate levels of formal education who are willing to work for relatively low wages. The reasons are often contracting problems that prevent critical investments being organized. A number of potentially relevant contracting failures are well known but a particularly important one is underempha- sized. Developing countries typically lack the organizational and technological capabilities embedded in firms that are necessary for using new technologies to produce competitive products. Building organizations that can competitively use the new technologies is a difficult task that is subject to significant contracting failures. Developing the appropriate organizational capabilities involves the exertion of significant effort in the acquisition of tacit knowledge, a process that is difficult to observe and control. This exposes financiers to significant contracting risks that can result in non-investment or the failure to achieve competitiveness. In general, solutions to contracting failures require properly designed corrective policies and appropriate governance capabilities on the part of the state. Developing countries typically have limited governance capabilities and limited potential of developing these capabilities in every direction.

1. The paper rightly emphasizes the key problems of technological, and particularly organizational, capabilities in the acquisition of tacit knowledge and organizing the relevant production and learning processes and their financing in the early stages of development. It gives illustrations from two successful cases of sector-specific financing mechanisms from countries otherwise quite deficient in economic governance-one from the car industry in India and the other from the garment industry in Bangladesh.

2. The contrast with the East Asian cases of industrial policy has been drawn in terms of state capacity which is often missing in South Asia. But the concept of state capacity is a little circular; one often measures state capacity ultimately in terms of some outcome variables, and, thus defined, capacity cannot explain those outcomes. The East Asian state often carried out a policy of contingent rents which induced private agents to act in certain ways. But the successful cases from South Asia cited in the paper are also linked to some arrangements of rents (largely generated by content protection in the case of the Indian car industry and quota rents in the case of the Bangladeshi garment industry), though clearly those rents were not by themselves sufficient in generating the private efforts and investment in learning.

The financial crisis and recession that began in 2008 opened the door to massive public interventions in the western economies. In many nations, governments responded to the threats of illiquidity and insolvency by making huge investments into troubled firms, frequently taking large ownership stakes.

The 2009–11 period revealed Brazil’s capacity to stay on the growth path, which had characterized the national economic performance from 2005 up to the first hint of damaging effects of the international financial crisis on the country in the second half of 2008. Not only was it possible for the country, by means of incisive anti-cyclical initiatives, to diminish the severity of the crisis, but the government’s determination and the array of instruments available were also reinforced to prioritize the long-term nature and maintain the growth of investment ahead of GDP. In fact, the proportion of Gross Fixed Capital Formation (GFCF) in GDP rose from 17.4 percent in 2007 to 19.3 percent in 2011, despite the fall posted at the end of 2009. From the perspective of sustainable development, however, this level is clearly insufficient. It is essential to further raise the rate of investment in Brazil, without which it will be difficult to maintain the recent growth trajectory and to strengthen the competitiveness of Brazilian firms.

Clearly one cannot deny the influence of BNDES on the Brazilian economy, its fundamental contribution in the provision of longer-term finance, and its pronounced counter-cyclical lending during the recent global financial crisis, and all of those points are well made in the paper. What is less clear is whether this model is replicable and advisable for other developing countries, whether BNDE’ influence will adversely affect (or has adversely affected) the provision of long-term finance by private financial institutions, and whether counter-cyclical lending by state banks reaches the borrowers who are most worthy of credit.

Policymakers and academics often maintain that foreign direct investment (FDI) can help in the development efforts of host countries. In addition to supplying capital, FDI can be a source of valuable technology and know-how and foster linkages with local firms that can help to jumpstart an economy.¹ While academics tend to treat FDI as a homogenous capital flow, policy makers, on the other hand, seem to believe that some FDI projects are better than others. National policies toward foreign direct investment (FDI) seek to attract some types of FDI and regulate other types in a pattern which seems to reflect a belief among policymakers that FDI projects differ greatly in terms of the national benefits to be derived from them. UNCTAD’ World Investment Report 2006 for instance describes “quality FDI” as “the kind that would significantly increase employment, enhance skills and boost the competitiveness of local enterprises.” Policymakers from Dublin to Beijing have implemented complex FDI regimes with a view to influencing the nature of the FDI projects attracted to their shores. Sean Dorgan, Chief Executive of Ireland’s Industrial Development Agency, for example, claims that “the value of inward investment must now be judged on its nature and quality rather than in quantitative measures or job numbers alone.” Chinese officials have openly stated that the new challenge for the country is to attract more “high quality foreign direct investment.”³

This paper explores the notion that not all types of foreign direct investment are created equal. In particular, the paper makes two important contributions. First, the authors document a persistent use of industrial policy in targeting certain forms of incoming foreign investment. Countries favor some types of foreign investment over others through tax holidays, regulations, investment promotion, and facilitation of entry. Second, the authors then identify whether targeted foreign direct investment (FDI) results in higher growth. They find that it does. They also find that FDI in credit-constrained sectors or sectors with more human capital leads to higher growth. These results are robust to correcting for endogeneity of FDI.

Science fiction and fantasy writer Vera Nazarian famously observed that “luck is not as random as you think. Before that lottery ticket won the jackpot someone had to buy it.” Many economic theorists have neglected that wisdom and mistakenly reduced the existence of clusters (defined as geographical concentrations of interconnected companies with close supply links, specialist suppliers, service providers, and related industries and institutions) to an almost banal phenomenon that randomly occurs whenever private firms gather by accident in someplace, start trading together, and eventually realize that it is more profitable even for competitors to stick together in a specific location. Clusters have thus been viewed merely as byproducts of economic development.

Developing countries face a long list of seemingly insurmountable obstacles to industrialization, including but not limited to underdeveloped financial systems and a lack of formal institutions. Since pooled resources are necessary to build factories and to purchase manufacturing equipment, financial development has been widely regarded as a key instrument for industrialization (Goldsmith, 1969; Raj an and Zingales, 1998). Entrepreneurs are afraid to make business deals unless the underlying contracts are trustworthy. Thus building a sound legal system is also crucial for ensuring the functioning of market economy (North, 1990). A common view among donors and policy makers is the necessity of creating these fundamental institutions.

The disappointing economic performance of the past two decades under the Washington Consensus of the 1980s and 1990s and the impact of the 2008 global financial crisis have resulted in the revival of industrial policy as a keyword in development literature. New literature in the same vein includes the works of Cimoli, Dosi, and Stiglitz (2009), as well as those of Lin (2012), Lee and Mathews (2010), and Wade (2012). Industrial policy is a broad concept. According to Johnson (1982), it refers to policies that improve the structure of a domestic industry in order to enhance a country’s international competitiveness. Variants of industrial policies existed in successful countries, such as the UK from the 14th to the 18th centuries, the USA and Germany in the 19th century, Japan in the late 19th century, and Korea and Taiwan in the late 20th century (Cimoli et al., 2009).

This paper looks at the question of economic development from the perspective of countries seeking to transition from middle to high income. The so-called middle-income country trap (that is, countries succeeding in growing to middle-income level but not being able to sustain that growth to become high income) provides the background and motivation to the paper.

Latin America has long been a laggard in terms of economic catch-up, on repeated occasions over its history it has witnessed less developed countries leapfrogging it in economic growth and development (Coatsworth, 1998; Dominguez, 2008; Devlin and Moguillansky, 2011). The post-war period has been no exception, with countries in East Asia only being the most notable.

In their recent publication, Breeding Latin American Tigers: Operational Principles for Rehabilitating Industrial Policies (2011), Robert Devlin and Graciela Moguillansky managed to transcend the old and endless discussion about the desirability of implementing industrial policies, and focused instead on characterizing how a group of countries successfully implemented industrial policies and were able to close or substantially narrow the development gap with more advanced economies. The authors make a major contribution since they analyze the complexities of consensus building, institutional development and policy implementation, thereby identifying lessons that are extremely valuable for industrial policy practitioners.

Up to the 1970s, Brazil implemented an industrial policy aimed at substituting imports that was consensually acknowledged for being active and strong.¹ Such activeness was the result of the broadness and depth with which the Brazilian state was willing to intervene in markets, taking on a leading allocating role in the economy. The strength of the industrial policy at that time stemmed from the meeting of three essential conditions to boost it: (i) co-existence with a favorable macroeconomic environment; (ii) intensive use of classic instruments (tariff barriers, financial and fiscal incentives for prioritized sectors in two National Development Plans); and (iii) use of stateowned companies (some existing since the 1950s, some created in the 1970s).

I am grateful for the opportunity to comment on this paper discussing industrial policy and Brazil’s economic development. Over the past ten years, Brazil has made remarkable progress in achieving macroeconomic stability and high growth, while at the same time markedly reducing poverty. Indeed, over the period 2004–10 growth more than doubled to over 4.2 percent (from about 1.9 percent during the period 1996–2003), while inflation fell sharply from a peak of 15 percent in 2003 to an average of 3 to 5 percent during 2004–10. Most remarkably, poverty declined from 35 percent in 2000 to 22 percent in 2009. The paper draws appropriate attention to the role that industrial policy has played in fostering growth and to the need for sound principles of implementation to effect the expected results.

Many in the developing world have interpreted the global financial crisis as the death knell for the Washington Consensus, and are taking a close look at more proactive policy alternatives that depart from the standard package of liberalization, privatization, and stabilization and focus on developing local capabilities to add value and manage risks (Winters et al., 2010). Industrial policy, in particular, has once again become a hot topic (Cimoli, Dosi, and Stiglitz, 2009; Ohno, 2009).

There can be no denying Korea’s remarkable industrial prowess sustained almost without interruption from the mid-1960s onwards. It is the stuff of legend and the subject of countless articles and book-length publications. Other developing countries, many of which were on a par with Korea in the 1960s and now lag far behind, have sought to learn from Korea’s experience and to adapt the policies it followed — thus far with limited success. But the interest has not waned and in recent years it has risen to a new pitch as a number of middle-income countries find that their industrial momentum is faltering and conventional market-based incentives are proving less effective in the post-financial crisis environment.