Economic Theory

What the communitarian Right gets wrong about industrial policy

Early last month, former Foreign Secretary William Hague praised Onward’s The Case for Conservatism, emphasising its call for an ‘active state’. At the heart of its calls for more government is a desire for industrial strategy, particularly in ‘cutting edge’ areas like AI and – the ever vaguely defined – ‘skills’.

This triggered an interesting interaction on Twitter between Guido Fawkes and Onward’s Gavin Rice. It went like this:

Guido: “Billions wasted in malinvestment by the ‘active state’ seem to have been overlooked. Billions taken from taxpayers who could have better deployed that capital. Remember George Osborne getting excited over the graphene wonder material. Taxpayer millions poured into it. Result?”

Rice: “The point we make…is that Britain spends a lot on current / revenue spending (health, welfare, pensions) but very little on productive investment (infrastructure, seeding high value industries, R&D) – unlike rival economies. ‘Big state/small state’ row is dumb.”

Guido: “Government spending on infrastructure is very different. Getting into R&D and picking hi-tech winners is not something that has gone well in the past. Politicians are not venture capitalists.”

Rice: “I wonder why South Korea was able to go from zero to having one of the largest steel manufacturing firms in the world from a zero base with no natural advantage? Also, you talk as though a laissez-faire approach towards trade & industry has been going really well.”

It shouldn’t surprise readers that I’m firmly with Guido on this issue. Nonetheless, protectionism and industrial strategy – like most bad ideas – are back in vogue. In Donald Trump and Joe Biden, America has had its two most trade-sceptical Presidents in decades. Trump withdrew the United States from the Trans-Pacific Partnership and expanded tariffs, notably on goods from the People’s Republic of China. Biden has done little to reverse this and has heartily embraced industrial policy through his Inflation Reduction Act.

The European Union has responded to America’s new policy reality by moving squarely towards its own industrial strategy. In the UK, ideological communitarians and a decent number of the serious sensible centrists in right-wing circles have been pressing the UK to get in on the act. Despite their repeated insistence that they are not ‘motivated by ideology’, the policy prospectus for innovation and productivity is, as on every single other issue, more government planning and spending.

Industrial strategy remains a bad idea and Rice’s arguments in that short exchange are not new. They embody the same old conceptual and empirical flaws in the case for industrial strategy.

Why Haven’t We Been Making Productive Investments?

Rice correctly points out that the UK government does a lot more day-to-day spending than long-term investment. The solution, he implies, is to simply make productive investments. But if the answer is so obvious, why haven’t we been doing that already? A big part of the answer is that politicians have little incentive to prioritise long run investments over the short term.

NHS spending is a good example of this. Imagine you are the Health Secretary drowning in headlines about the health system’s annual winter crisis. With a constrained budget and your job on the line, are you likely to focus more attention on placating the headlines by constructing an NHS winter rescue package or investing money in a riskier, more complicated long-term capital investment project which you will never get credit for anyway?

The patterns of UK health spending illustrate the impact of these bad incentives clearly. NHS spending has risen significantly since Tony Blair came to power. Spending as a percentage of GDP levelled off and declined slightly during the Coalition years, but spiked during the Covid-19 pandemic and has since fallen but remains higher than the pre-pandemic average.

At the same time, the value of capital per healthcare worker in the UK has fallen and capital investment in UK healthcare has been below the OECD average in all but four years since 2000. The number of doctors, nurses, and ambulance staff has increased but the number of hospital beds, MRI & CT scanners, and reserve capacity have either fallen or stayed at their comparatively low levels. The Institute for Fiscal Studies estimated that governments planned to raise NHS budgets by an average of 2.7% p/a, only to end up hiking spending by 4.1% p/a.

Generally speaking, the more politicians are in charge of economic decisions, the more they will trend towards prioritising the short-term over the long-term. See also pensions policy for further evidence.

Knowledge Problems

The other key – and insurmountable – issue is the knowledge problem. This is the observation that a single agent or group of agents is, and can only ever be, privy to a small amount of the sum total of knowledge in the economy. Free markets, therefore, will deliver better economic outcomes than central planning because they create the incentive structure and information structure (prices) to take advantage of the dispersed knowledge in society.

This principle was most famously articulated by economists Ludwig von Mises and Friedrich von Hayek as part of their argument against comprehensively planned economies based on the supreme difficulty (or impossibility) of economic calculation.

American economist Don Lavoie systematically applied and extended their arguments to non-comprehensively planned (or mixed) economies. The economy is not, Lavoie observed, a straightforward program of inputs and outputs. Economic growth and efficiency cannot be boiled down to simple conversations about changing incentives and establishing new equilibriums. Even in a mixed-market economy, planners will be unable to generate, aggregate, and understand the information necessary to comprehend the dynamic, ever changing nature of economic activity.

This is especially important to remember when it comes to innovation, research and development, areas which Onward want to see more state intervention. Here, we are talking about the cutting edge of innovation and economic progress, the stage of production at which risks of failure are highest. In a free market, entrepreneurs put their own capital on the line (and defer economic benefit to the future), and raise capital from investors who expect returns and will manage risks accordingly. A verdict on the product is rendered by consumers as expressed through the ebbs and flows of the price system.

When the government intervenes using taxpayers’ money, it artificially covers up the inherent risks of a project. The government does not generally need to recoup the money and make a profit on any given project because it can always count on coercive taxation and a unique borrowing arrangement to keep it afloat. Pumping that money into a project reduces the appearance of risk for both decision makers in the subsidised company and for private capital investors, which encourages malinvestment. This is compounded because the government’s lack of a profit and loss mechanism makes it likely that it will continue to pour money into a project that would otherwise be non-viable.

One area which highlights these issues and where the government feels free to pursue longer-term industrial policy and does so is the Net Zero transition. Since the Climate Change Act 2008 enshrined the first legally binding carbon emissions targets, government intervention into the energy market and investment in green technology has ratcheted up significantly.

In these areas, we see the incentive problem of long-term government investment again. Building onshore wind capacity was, until recently, effectively outlawed by the planning system. The government would not radically shake that up for fear of angering its NIMBY voters, so long term renewable investment was relegated to a second order priority. See also nuclear power construction and investment in water and transport infrastructure.

We also see the knowledge problem very clearly. The pre-2008 ‘Dash for Diesel’ was an environmental policy catastrophe. It was thought that diesel vehicles were more environmentally friendly due to emitting less carbon dioxide than petrol vehicles. What was overlooked by policymakers was the impact of increased nitrous oxides (which diesel emits at far higher rates). By the mid-2010s, the impact had become well understood and the policy was widely considered to have failed.

Or take Britishvolt, the company that was going to create a car battery gigafactory in Northumberland which would supercharge Britain’s green automotive industry. Boris Johnson and Kwasi Kwarteng championed the business and pledged almost £100bn of taxpayers’ money to the company in a bid to encourage more private sector investment. In 2022, the company folded and its assets transferred to an Australian company which sold them on towards more productive ends.

Thankfully, Britishvolt collapsed so spectacularly that it didn’t even meet the relatively soft targets on which government funding was contingent. The complexity and fragility of the EV battery production process was not acknowledged at all by policymakers. Likewise, the fact that the high costs of land, labour, energy, and regulation in the UK (a set of problems made far worse by government policy) make it inconceivable for the UK to overcome the advantage of other countries such as China in manufacturing cutting-edge battery technology.

Consider also the government’s energy strategy over the past decade. Fossil fuel production has been burdened with interminable taxation and regulation, and green technology extensively subsidised. This policy mix has been one of the most significant contributors to the rise of household energy prices, which has been taking place since 2000, long before Russia’s invasion of Ukraine. The UK may be able to power a carbon-free grid one day. But that day is unlikely to come soon as the technology simply isn’t there yet and nuclear capacity would still take decades to replace fossil fuels even if the government relaxed some of the regulatory impediments to its production tomorrow.

So the incentive problem tells us that politicians are unlikely to prioritise prudent long-run investment over short-term spending. But on the occasion that this problem is overcome, Net Zero policy shows us that industrial planners can prioritise the long-term too much and actually cause us to regress in the short-run.

Deciding what resources to deploy for short-term and long-term priorities – and how to do it – is a delicate, ever-evolving balancing act. Successfully doing so requires an awful lot of trial and error. For that process of trial and error to serve a productive purpose, it must be undertaken by actors who are incentivised to drive innovation and flexible enough to adapt to unpredictable developments. Centralising power, resources, and decision-making into the hands of a few government ministers and their industrial cronies is never going to be the optimal solution.

Is Britain the problem?

Industrial policy is neither a bold nor new idea. As Onward’s paper acknowledges, British Leyland is a classic example of UK industrial policy failure. British Telecom, British Aerospace, and Concorde are just a few more examples. These failures are not limited to Britain.

America’s long-running attempt to protect domestic shipbuilding has been catastrophic. Its forays into supercomputers, ‘clean coal’, and ethanol have delivered lacklustre outcomes, each for different reasons. In France, one of Europe’s leading lights of industrial strategy, attempts to invent a domestic version of the internet in the 1990s and – along with Germany – create a ‘Google killer’ search engine ended disastrously.

Nor has industrial policy been the silver bullet for developing countries, as the neo-interventionists now often argue. The extensive mixture of subsidies, tariffs, and licence requirements which made up India’s post-independence industrial strategy failed to boost its domestic manufacturing sector, killed incentives to raise efficiency, and kept prices artificially high. After liberalising its economy in 1991, the country attracted more foreign direct investment and saw the birth of service-based sectors.

Attempts to cultivate and protect Brazil’s automotive production industry have hiked prices and caused innovation to stagnate. In countries with weak or corrupt institutions, industrial policy has been characterised by significant corruption.

But What About Asia?

So you might not be sold on the theory. You might argue that the British state has some particular problems and capacity shortages which make it poorly suited to industrial strategy. But does that mean it’s always a bad idea? After all, as Gavin Rice pointed out in the Onward-Guido Twitter exchange, South Korea seems to have had some success with industrial strategy, especially in cultivating a nuclear power industry.

Onward’s The Case for Conservatism argues that:

“Some of the most successful economies in the world have historically operated a balanced approach to national economic development, combining state capacity, tactical protectionism and market forces.”

Industrial strategy, they argue, has allowed those countries to create high quality jobs (sometimes in areas where they lack an obvious comparative advantage), whilst creating strategic industries which insulate them from relying on foreign countries for imports.

This argument rests on very crude empiricism. If you look at the data, it is indeed true that the ‘Asian Tigers’ countries (South Korea, Japan, Singapore, and Taiwan) did spend significant public money on industrial strategy in the 1960s, 70s, and 80s and did experience economic growth at the same time. This does not, however, represent the full picture.

To do so, we need to ‘see the unseen’. The question is not whether a given pound of government spending generates some kind of economic growth, but whether that one pound could have created better outcomes if spent differently. In context, the question is not whether a country’s economy developed during periods of industrial policy, but whether it would have performed similarly or better without such interventions. This is never an easy task, but it’s much more important to determine the success of government spending than simply drawing an empirical association.

We can point to some evidence from South Korea that its industrial policies were sub-optimal. Columbia University Professor Arvind Panagariya’s Free Trade & Prosperity: How Openness Helps Developing Countries Grow Richer and Combat Poverty argues that the impacts of South Korea’s export-oriented industrial policy between 1954 and 1973 were modest overall – slightly orienting the economy towards exports compared to the counterfactual neutral policy mix.

The best performing sectors in the South Korean economy during the 1960s and 70s were labour intensive industries like clothing, footwear, and plywood, which were not supported by the state. The government’s mixture of subsidies and tariffs were mainly targeted at boosting capital intensive heavy and chemical industries. Between 1974 and 1982 (the era of peak industrial strategy), productivity in these industries lagged far behind those of unsupported, labour-intensive sectors.

It was only once the government ended support for heavy and chemical industries in 1983 and began the process of privatisation that productivity began to rise. This evidence supports the Cato Institute Adjunct Scholar Razeen Sally’s argument that “At best, [South Korean industrial policies] altered the sectoral composition of output and exports and did not seriously impair growth. But they had no discernibly positive effect on the productivity of targeted sectors or on aggregate growth…”

But there is also plenty of evidence that the policies were actively harmful. South Korea’s economic policies were the most interventionist of the four main Asian Tigers. Its economy also grew the slowest among them.

A 1991 analysis from economists Jaime de Melo and David Roland‐​Holst explained that industrial policy had made the Korean economy highly concentrated (“For example, in 1982, the top fifty Korean firms accounted for 37 percent of total sales, while the corresponding figure for Japan is 27 percent for the top one hundred firms and for Taiwan 16 percent for the top fifty firms.”).

They found that unsupported industries which were exposed to international competition priced significantly more competitively than protected domestic industries. Their analysis concludes that economic liberalisation (and the subsequent elimination of policy-induced advantages for large firms) could have boosted national welfare by between 4.9 and 10% of GDP. The welfare gains shown in their model are disproportionately centred on producer and consumer goods. The hypothetical gains in heavy industry are much smaller and in some of their modelled scenarios, negative. This is strong evidence that industrial policy misallocated economic resources to heavy industry at the expense of other goods.

We can see the unintended consequences of attempting to tilt South Korea’s economy towards manufacturing and strategic industries to this day. Global demand has rebalanced between goods and services consumption after the goods glut caused by the Covid-19 pandemic. Demand for the cars, electronics, and shipping containers which the Korean economy is artificially dependent on exporting has declined, causing the country’s economic slowdown. The Cato Institute’s Scott Lincicome summarised the issue nicely when he wrote: “So much for that mercantilist ‘resiliency,’ eh?”.

Germany’s overexposure to manufacturing exports has created the same problem in recent years. As its economy has slowed, malinvestments from China’s extensive industrial planning of transport infrastructure, private investment, and labour markets are also now being revealed.

The Core Problem

As with most policies, evaluating industrial strategy is not as simple as deciding whether it always or never ‘works’. Yes, you can point to some industrial strategies in some place at some times that have worked to achieve certain reasonable goals. For the most part, empirical evidence tells us that industrial strategies have been catastrophic failures. In South Korea and other East Asian countries, this hasn’t been universally true but we can point to evidence that the nation would have been better off with neutral free trade policies.

The key problem is that, unlike actors within a free market, top-down planners have no systematic means of determining the success or failure of the project. Dr Bryan Cheang summed up this final, fatal flaw in his new paper:

“Inevitably, through the law of large numbers, with heavy state funding of R&D projects, some will end up being successful. In other words, lacking such a systemic mechanism, the various cases of successful mission-innovation cannot be easily replicated. The market process contains a feedback mechanism that punishes entrepreneurs for their failures, but state actors (and voters, by proxy) lack the same level of risk as private actors, and so comparatively lack the same corrective pressures as actual entrepreneurs when faced with failure.”

2 thoughts on “What the communitarian Right gets wrong about industrial policy”

  1. Posted 07/03/2024 at 06:16 | Permalink

    It is fair to say that industrial policies have acquired a bad reputation because all this talk about creating and protecting national champions, and picking winners, has only diverted attention from the most pressing issue for government – how to deal with the problem of lack of competitiveness in both, the domestic market and in global markets.

    Time and again, the UK government has made it absolutely clear that it would like to see the competitiveness of British industry improved significantly, so that the UK can pay its way in the world, post-Brexit.

    The problem with intervening in the market with public funds is that the decision to do so is in the hands of elected politicians who are highly susceptible to cronyism – the nexus between the governing elite and the business elite that contrives to put the interests of business first, ahead of the wants, needs and expectations of ordinary citizens. This is because the twin evils of lobbying and corruption rear their ugly heads every time taxpayers’ money crosses the boundary between the public sector and the private sector.

    It is, as the economist Randall Holcombe puts in his book “Political Capitalism” a “system in which the economic and political elite cooperate for their mutual benefit.” The political elite tilt the economic playing field in favour of the economic elite, privileging them through subsidies, regulatory protections and targeted tax breaks. In exchange, the economic elite then help to ensure that the political elite remain in power. The rest of us pay the bill for this quid pro quo through higher taxes, higher prices, and a less efficient, less dynamic economy.

    On the other hand, it is right to say that the job of government is to foster an environment which causes the private sector to innovate, grow, create jobs and make a profit. It is not the job of government to create jobs.

    It is the misinterpretation of this responsibility, on the part of some well-meaning people that has persuaded them to support the idea of an industrial strategy, which entails the government intervening in the market with public funds, to stimulate economic activity, tackle climate change and boost productivity.

    However, this means that people in the pay of the State get to choose which industry sector receives the subsidy, and which does not – leaving them exposed to the charge of favouring the privileged few (usually those who shout loudest in the corridors of power) at the expense of the many, thereby tilting the playing field towards the same selected few and entrenching economic power, possibly for decades to come.

    Additionally, there exists an extremely high risk that public funds committed in this way will not deliver the return on investment as advertised, or worse still, squandered altogether because:

    (a) Civil servants in Whitehall who are charged with negotiating the contract details are ill-equipped to deal with the private sector, which means that they will be duped into spending taxpayers’ money on poorly conceived projects – only for this to come to light years later, when some Select Committee of the House of Commons produces a report on its findings.

    (b) The internal business process used to select recipients for state support is susceptible to manipulation and distortion by parliamentary lobbyists in the pay of those private sector players who can afford to spend the most.

    (c) It is certain that the final decision on the choice of recipients, which is in the hands of the governing elite, will be made not in the national interest but to serve the interests of career politicians (or their financial backers).

    So, until these fundamental problems are addressed and dealt with, the government should be wary about intervening in the market with public funds.

  2. Posted 11/03/2024 at 11:21 | Permalink

    I agree, nor am I confident that the state performs any better in its more traditional interventionist area of infrastructure development. See for example my IEA Blog:

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