Speech delivered on the second day of the Forum: "The Role of the State in the Dynamics of Structural Change - Industrial Policy"
Ladies and Gentlemen,
How to promote economic growth has been a main topic for economic discourse and research since the publication of Adam Smith’s The Wealth of Nations in 1776. Theories and empirical evidence show that market mechanisms are essential for valuing the basic ingredients for production and providing the right price signals and the appropriate incentive system for efficient allocation of resources.
But the historical record also indicates that in all successful economies, the state has always played an important role in facilitating structural change and helping the private sector sustain it across time. In fact, the governments in high-income countries today continue to play that role. However, the sad fact is that almost every government in the developing world has attempted, at some point in its development process, to play that facilitating role, but most have failed.
As such, active economic policies by developing countries’ governments to promote growth and industrialization have generally been viewed with deep suspicion by economists, and for good reasons: past experiences show that such policies have often been extremely costly in public resources and too often failed to achieve their stated objectives.
One can argue however, that these pervasive failures in developing countries are mostly due to the inability of governments to come up with good criteria for identifying industries that are appropriate for a given country’s endowment structure and level of development. In fact, governments’ propensity to target industries that are too ambitious and not aligned with a country’s comparative advantage largely explains why their attempts to “pick winners” resulted in “picking losers.”
The main lesson from development history and economic theory is straightforward: the government’s policy to facilitate industrial upgrading and diversification must be anchored in industries with latent comparative advantage so that, once the new industries are established, they can quickly become competitive domestically and internationally.
Each country at any specific time possesses given factor endowments consisting of land (natural resources), labor, and capital (both physical and human). The endowments in a country are given at any specific time but changeable over time. Therefore, the optimal industrial structure in a country, which will make the country most competitive, is endogenously determined by its endowment structure. For a developing country to reach the advanced countries’ income level, it needs to upgrade its industrial structure to the same relative capital-intensity of the advanced countries.
A firm’s objective is to maximize profit, not to exploit the economy’s comparative advantage. It will follow the economy’s comparative advantage in choosing its industry and technology in the development process only if the relative factor prices in the economy reflect the relative abundances of factors in the economy. The relative factor prices with such nature will exist only in a competitive market system. Accordingly, an efficient market mechanism is therefore a required institution for the economy to follow its comparative advantage in the process of dynamic development.
However, in spite of the importance of the market mechanism, it is also desirable for the government to play a pro-active role in facilitating industrial upgrading and diversification in the development process.
The Recipe for Success—or Failure
There is wide consensus among economic historians on the important role played by the state in facilitating structural change and helping sustain it across time and across developed countries.
However, while there have been a few successes in East Asia, most of these attempts have failed to deliver the expected results. Yet, the governments in developing countries will likely continue to attempt to play the facilitating role in spite of the widespread failures. Therefore, instead of advising the governments in developing countries to give up playing this role (which is what classical and neo-classical economists tended to do), it is more important to better understand why some countries have been able to succeed while most others have failed so that it is possible to advise the governments to do the right things and avoid the mistakes.
Two main lessons can be drawn from these successful cases of state-led structural change strategies.
First, it appears that these governments implemented policies to facilitate the development of new industries in a way that was consistent with the country’s latent comparative advantage as determined by endowment structure. Therefore, their firms, once established with government support in information, coordination, and sometimes limited subsidies, have turned out to be competitive.
Second and even more important, to ensure that they would tap into their latent and evolving comparative advantage, the governments targeted mature industries in countries that were, on average, about 100 percent higher than their own level of per capita income, measured in purchasing power parity. When Britain applied industrial policies to catch up to the Netherlands in the 16th and 17th centuries, its per capita income was about 70 percent of that of the Netherlands. When Germany, France, and the U.S. used industrial policy to catch up with Britain in the 19th century, their per capita incomes were about 60 to 75 percent of that of Britain. Similarly, when Japan’s industrial policy targeted the U.S.’s automobile industry in the 1960s, its per capita income was about 40 percent of that of the U.S. When Korea and Taiwan-China adopted industrial policies to facilitate their industrial upgrading in the 1960s and 1970s, they targeted the industries in Japan instead of the U.S., and for a good reason: their per capita incomes were about 35 percent of Japan’s and only about 10 percent of that of the U.S. at that time.
Failures occur when countries target industries that are too advanced, far beyond their latent comparative advantage. In such circumstances, government-supported firms cannot be viable in open, competitive markets. Their survival depends on heavy protection and large subsidies through various means such as high tariffs, quota restrictions, and subsidized credit. The large rents embedded in those measures easily become the targets of political capture and create difficult governance problems.
A Framework for Growth Identification and Facilitation
Some basic principles can guide the formation of successful industrial policy.
The first step is to identify new industries in which a country may have latent comparative advantage, and the second is to remove the constraints that impede the emergence of industries with latent comparative advantage and create the conditions to allow them to become the country’s actual comparative advantage. Here, we propose a six-step process:
First, the government in a developing country can identify the list of tradable goods and services that have been produced for about 20 years in dynamically growing countries with similar endowment structures and a per capita income that is about 100 percent higher than their own.
Second, among the industries in that list, the government may give priority to those in which some domestic private firms have already entered spontaneously, and try to identify: (i) the obstacles that are preventing these firms from upgrading the quality of their products; or (ii), the barriers that limit entry to those industries by other private firms. This could be done through the combination of various methods such as the Value Chain Analysis or the Growth Diagnostic Framework. The government can then implement policy to remove those binding constraints and use randomized controlled experiments to test the effects of releasing those constraints so as to ensure the effectiveness of scaling up those policies at the national level.
Third, some of those industries in the list may be completely new to domestic firms. In such cases, the government could adopt specific measures to encourage firms in the higher-income countries identified in the first step to invest in these industries. Firms in those higher-income countries will have incentives to reallocate their production to the lower-income country so as to take advantage of the lower labor costs. The government may also set up incubation programs to catalyze the entry of private domestic firms into these industries.
Fourth, in addition to the industries identified on the list of potential opportunities for tradable goods and services in step 1, developing country governments should pay close attention to successful self-discoveries by private enterprises and provide support to scale up those industries.
Fifth, in countries with poor infrastructure and an unfriendly business environment, the government can invest in industrial parks or export processing zones and make the necessary improvements to attract domestic private firms and/or foreign firms that may be willing to invest in the targeted industries. Improvements in infrastructure and the business environment can reduce transaction costs and facilitate industrial development. However, because of budget and capacity constraints, most governments will not be able to make the desirable improvements for the whole economy in a reasonable timeframe. Focusing on improvement in infrastructure and business environment in industrial parks or export processing zones is, therefore, a more manageable alternative. Industrial parks and export processing zones also have the benefits of encouraging industrial clustering.
Sixth, the government may also provide limited incentives to domestic pioneer firms or foreign investors that work within the list of industries identified in step 1 in order to compensate for the non-rival, public knowledge created by their investments. The incentives should be limited both in time and in financial cost. They may be in the form of a corporate income tax holiday for a limited number of years, directed credits to co¬-finance investments, or priority access to foreign reserves to import key equipment. The incentives should not and need not be in the form of monopoly rent, high tariffs, or other distortions. Therefore, the risk of rent seeking and political capture can be avoided. For firms in step 4 that discovered new industries successfully by themselves, the government may award them with special recognition for their contributions to the country’s economic development.