The Economic Foundations of Industrial Policy

Editor’s note: Marc Fasteau (CPA Board Member) and Ian Fletcher (CPA Advisory Board Member) authored this important piece describing the economic basis of successful industrial policy. A book will be coming soon. 

[Marc Fasteau and Ian Fletcher | June 15, 2020 | Palladium Magazine]

And yet, the current ferment is in danger of ending up like previous versions in the 1970s, 1980s, and 1990s: nowhere. Conceiving and marshalling the political will to adopt and effectively administer a sound industrial policy will require a solid, defensible theory of its economic foundations, and such a theory has not been put forth. The absence of such theory was a major factor dooming previous efforts, and without it, the U.S. will continue to be restricted to one-off tactical moves, against only the most obvious problems and using only the most obvious solutions. It will not be able to undertake the coordinated, strategic-scale, all-of-government solutions it needs.

Mainstream contemporary American economics takes a dim view of industrial policy. As Paul Krugman correctly wrote in the early 1990s, when American worries about the Japanese challenge were still fresh, and there was a surge of interest in industrial policy,

Economists have been extremely negative about the idea of industrial policy even in principle. The general presumption of most economic theory is that the best industrial policy is to let the market work – that decentralized incentives of the marketplace will push resources to the places with the highest expected return, and that no second-guessing of market decisions is necessary or desirable.^[1]

But there is an alternative view of the economics underlying industrial policy, a view whose intellectual components are consistent with mainstream economics but which leads to pro-industrial policy conclusions. While mainstream economics holds that the market is always, or with only a few exceptions, best, this alternative view holds that economic success requires not only a) letting the market work, but also b) systematically exploiting the market’s shortcomings. And because such exploitation, by definition, involves things the market can’t do, state intervention is often the only way to accomplish it. This implies governments should pursue the systematic and strategic exploitation of the market’s shortcomings to support the growth of certain economic activities, and industries, which are especially beneficial to the competitiveness and growth of nations.

This alternative theory is closer than mainstream economics to how real-world businesses function. Businesses necessarily make money by exploiting market shortcomings, because perfectly competitive markets squeeze profits towards zero. Everybody wants perfect markets when they are the buyer, but imperfect markets when they are the seller. The consumer-side view of economics and the producer-side view thus differ. One way to understand the alternative approach is thus to grasp that while mainstream economics is biased to take seriously almost entirely the former, the alternative view gives both more equal consideration.

Why Markets Can’t Do Everything

The shortcomings of markets are a large topic, with many of them having little relevance to industrial policy. Those that concern us here are:

1. Externalities
2. Time horizons
3. Systemic effects
4. Fundamental innovations
5. Static vs. dynamic efficiency
6. Increasing returns

Because each of these creates at least the possibility of a market producing a suboptimal economic outcome, they create, in principle, the possibility that competent governmental interventions could produce something better. So, let us examine them in detail.

#1: Externalities

An externality occurs whenever an economic activity “leaks” costs or benefits elsewhere, without the entity performing the activity incurring the cost or benefit itself.

Some externalities are negative, such as environmental pollution. This reduces the value of the environment without this cost being borne by the firm doing the harm. The classic governmental responses are regulations and fines for polluters.

Other externalities are positive, such as a company developing a new technology that will create value all over the economy. Due to the limits of the patent system and other constraints, that firm may not be able to fully capture that value. The classic governmental responses include tax credits for, and direct investments in, research and development.

Research and development also exemplify the problem of appropriability, which refers to when a firm does something that generates economic value but cannot fully capture this value as profit. One example is training personnel who may then go to work for another company. The classic governmental response? Everything from free public schools to subsidies for worker training. Another appropriability problem occurs when a firm invests in upgrading its supplier companies, which will then be able to sell to anyone, not just the company paying for the upgrades. Governments have responded to this by funding technology extension services that help small and medium enterprises upgrade themselves.

#2: Time Horizons

Short-term investing can accomplish some economic tasks, but many of the most important investments must be long term, and there is nothing that guarantees capitalists will have long time horizons. But without long-term investments, whose payoff may not come for years or even decades, businesses won’t develop the next generation of technology, but will stick with variations on what already exists. Companies with short time horizons will cede market after market to rivals with longer time horizons. Entire industries can be out-competed by foreign rivals with time horizons artificially lengthened by foreign industrial policies.

Short-term thinking may be perfectly justifiable for the firms engaging in it, and even more so for managers compensated for short-term results. But society, as opposed to any one firm, goes on forever, so it has good reasons to prefer long time horizons. Thus, one part of industrial policy is about lengthening effective time horizons, with tools such as more readily available, cheaper, and more patient capital. Said capital is often generated by the many, often hidden, policies governments use to coerce, or incentivize, people and firms to save more. Other policies concern corporate-governance structures that favor patient investing. Governments also do things like offer tax credits, or incentivize banks to lend preferentially to projects expected to have long-term payoffs for the economy as a whole, and fund high-risk technological research whose expected payoff is too far in the future to interest private firms.

#3: Systemic Effects

Systemic effects refer to aspects of the economy that are not optimizable at the level of individual economic actors such as people and firms. Many things areoptimizable at this level, which is why market economies work. But a market economy, by definition, is not centrally planned, so it will have a hard time achieving outcomes that can’t emerge naturally from the actions of its individual profit-seeking players. As a result, even if every individual player does what’s best for itself, an optimal result for the economy as a whole will not result.

For example, “quality of demand” refers to the fact that firms selling anything from jewelry to jet engines to exceptionally sophisticated customers will be driven by their demands to excel. Competitive pressure to respond to these demands will drive producers to upgrade their capabilities, not just maximize profits while standing pat. But no individual customer will see a financial reward commensurate with the benefits that the higher quality of their demand confers on the whole economy. As a result, markets alone will not always induce optimal quality of demand, and governments have therefore deliberately pushed their nation’s industries to upgrade more aggressively than immediate profitability would have caused. Quality of supply has an analogous logic.

#4: Fundamental Innovations

Per-capita economic growth means that the economy produced more goods and services on Tuesday than it did on Monday because something changed. But what? Adding capital will grow an economy, but how should the money be invested? Simply buying every mechanic in a factory a second wrench won’t make that factory more productive. They need something they don’t already have, something that will enable them to produce more output with the same amount of labor. A better wrench, or perhaps some automation. In other words, better technology.

Technological advance, in developing nations, can mean adoption of technologies already existing elsewhere. But in developed nations, which by definition already use existing technologies close to their full potential, this means creating new technologies. As a result, in developed economies, innovation is necessary for growth in per capita output.[2]

Unfortunately, free-market economics lacks a good explanation for why and how technology advances. It is on reasonable ground explaining advances developed by the private sector under free-market conditions. But the most important technologies have tended to originate elsewhere: in government laboratories, in publicly supported non-profits like universities, and in government-sanctioned monopolies like AT&T. The Internet itself, for example, as opposed to the websites on it, was created to enable government scientists to share data. Jet engines were first used in military aircraft and only later adapted for use in commercial airliners. Most fundamental technologies, the ones with vast effects throughout the economy, are not directly ownable or saleable. And before they can be deployed, they must pass through long stages of risky and expensive development with no supporting revenue stream. Because the market can’t optimize their creation, the most economically crucial technological advances, especially since WWII, have not been produced by it.

#5: Static vs. Dynamic Efficiency

With respect to economic growth, nations face not one question, but two:

1. What is the most productive thing to do today, given the current state of their productive resources?
2. How can they transition to a higher state of the productive resources tomorrow?

Markets, through the efforts of private businesses, are generally good at achieving the former, so-called “static” efficiency. But they are much less good at the latter, “dynamic” efficiency.  This is clearest in developing nations: growth is clearly about turning Burkina Faso into South Korea, not about being the most efficient possible Burkina Faso forever. But it is also true for developed economies.

Static and dynamic efficiency are not only different, but also can conflict. In other words, it can sometimes be rational to do things that are inefficient in the short run because there is a long-run payoff. For example, nations sometimes impose protectionism for infant industries, forcing their consumers to buy more-expensive domestically produced goods, to get a lucrative new industry off the ground. This difficult but fruitful tradeoff between static and dynamic efficiency is, in fact, the single most important theoretical basis of industrial policy.

#6: Increasing Returns

Increasing returns means that for a given increase in inputs, the increased value of output exceeds the increased cost of the inputs. For example, if producing a product requires a machine plus raw materials, then cost-per-unit will consist of a fixed cost per unit for the raw materials, plus a cost for the machine which falls as its cost is spread over more output. So, 10% more money spent on inputs might deliver, say, 11% more value of output, 11% more money 12% more, and so on. The opposite of increasing returns is diminishing returns: after a certain point, 10% more money for inputs delivers only 9% more value of output, then 8%, and so on.

In industries where increasing returns are present, the market will not be free. This is clearest in the extreme case, increasing returns that go on forever, costs dropping ad infinitum with each additional unit. (A search engine like Google is probably the thing closest to this in the real world.) In this case, the most efficient outcome is one producer for the entire planet, because two producers would each produce half as much, and therefore have higher costs.

A free market will initially deliver this one-producer outcome, because whenever one producer has slightly higher volume, it will have lower costs, be more competitive, gain volume, lower its costs more, and inexorably drive its rivals out of business. But then the free market will come to an end, because there will be a monopoly. Any new firm entering the industry, unless it can do so with the same production volume as the incumbent, will not be competitive.

Most increasing returns are not this extreme, but the more increasing returns are present in an industry, the less free the market will be. There will be so-called “imperfect” competition: not one single producer, but only a few, so that each firm will be big enough for its actions to affect the entire market. In other words, an oligopoly. Increasing returns naturally tend to make the industries in which they occur oligopolistic.

Advantageous Economic Activities

Increasing returns are the first of a set of characteristics of what we will call “advantageous” economic activities. These characteristics tend to coincide, reinforce each other, and build up cumulative causation. (That’s when something happens because of multiple causes over time.) To wit:

• Increasing returns
• Pricing power
• Technological dynamism
• Dynamic rent seeking
• Synergies

Economic activities with these characteristics produce dynamic efficiency, causing an economy to repeatedly gain in productivity and thus grow. The more a nation’s economy consists of such activities, the more prosperous it will be today, and the better its growth prospects will be for tomorrow.  Industrial policy, at root, is about increasing the quantity of such activities in an economy.

Pricing power occurs whenever a firm can choose to charge more, and sell less, or charge less, and sell more, as opposed to just having to accept the market price. (The latter happens when there are many small competitors: each will be able to sell as much as it likes at the market price, but nothing if it goes a penny over.) Pricing power requires there be some factor present that reduces competition, so pricing power tends to appear when there are increasing returns.

Pricing power means, obviously, that sellers get a higher price than they would under perfect competition. It can come from being the only coffee shop on the block, but the pricing power relevant to industrial policy is the result of producing things that are hard to produce, such as jet engines or smartphones. When only a small number of highly skilled firms can produce a given product, an oligopoly will develop, and its members will have pricing power. In fact, whenever know-how is the major production cost in an industry, which is generally intrinsic to cutting-edge industries, there will necessarily be increasing returns, because once that know-how has been paid for, each additional unit of product amortizes its cost over more output.

Next, technological dynamism. “Hard to produce” usually means needing sophisticated technology. And because technology ages over time, what was once cutting-edge inexorably becomes commonplace and easy to produce. So, what one really wants as a producer is ongoing technological change, so that one can stick forever with the difficult, relatively new, technology that results in pricing power. This logic creates an incentive to produce this technological change oneself, through R&D.

Pursuing profits in this way is called “dynamic rent seeking.” (The term “rent,” in the peculiar usage standard in economics, means profits that exceed what a free market would grant.) Dynamic rent-seeking is based on continual innovation and upgrading to hold onto the rent. Its opposite is static rent seeking, which means seeking some privilege, such as a legal monopoly, which enables charging a premium without doing anything to earn it. Static rent-seeking does an economy no good, but dynamic rent-seeking increases productivity and thus produces economic growth.

Finally, synergies. Some economic activities, when they first emerge or later improve their productivity, enable other activities to emerge, or improve their productivity. For example, cheap, mass-produced steel, whose first major market was railroad rails, made skyscrapers possible. Vacuum tubes originally flowered as an industry to build radios, then enabled the construction of televisions. Computer chips were created when computers were room-sized, but eventually became small and powerful enough to enable smartphones. Smartphones, in turn, enabled ride-hailing services. Jet engines developed for military aircraft enabled in turn passenger jets, mass tourism, and ultimately… Disney World.

When synergies are present, advances in one part of the economy tend to push forward other parts, too. This is important for long term economic growth because there is a limit to how much any one industry can grow, simply because there is a limit to how much of any one product consumers will buy.

When are synergies absent? Consider single-export economies, producers of bananas or petroleum: a nation may be poor if it produces only bananas, or rich if it produces only petroleum, but either way, it has no good path to producing anything else.

Advantageous Industries Produce Growth

Advantageous economic activities are activities, not industries per se. But economic activities take place in particular industries. Some industries are “tightly packaged:” one must perform all, or nearly all, of their activities, to perform any of them. Others are “loosely packaged:” some of their activities can be delegated to other firms, or geographically scattered, so a country can host some but not others. Thus, in the case of tightly packaged industries, the pursuit of advantageous activities means pursuing the entire industry.

Advantageous industries have six key characteristics:

• High income-elasticity of demand
• Susceptibility to repeated improvement.
• Competition not on pure price
• Capacity to absorb investment
• Path dependence
• Human capital accumulation

Advantageous industries tend to produce products for which income elasticity of demand is high. For example, people buy more (and more expensive) cars as their incomes go up. They do not buy more milk. As a result, demand for such products can rise along with the overall income growth of the economy. Therefore, productivity gains in making such products don’t just drive down their price, as output can rise along with productivity. Productivity gains largely accrue to producers, in the form of higher profits and wages, rather than just to consumers in the form of lower prices. (The latter is what happens with products of relatively inelastic demand, such as commodity foodstuffs.)

Advantageous industries tend to produce goods susceptible to repeated improvement, such as computers or airplanes, while disadvantageous industries produce goods whose character is basically fixed, like fruit or t-shirts. When a product exhibits meaningful variety, producers can establish mini-monopolies in specific niches, leading to dynamic rent-seeking. Product variety also increases opportunities for innovation, both because inventing new varieties is itself an innovation, and because innovation can now advance on multiple fronts.

Advantageous industries tend not to compete on pure price. (Price is obviously a factor with anything sold for money, but it is relatively less important in such industries.) They tend, instead, to compete on quality, technology, reliability, reputation, marketing, service, variety, style, under-standing of buyer needs, rapid innovation, vendor financing, managerial sophistication, and customer relationships. These forms of competition make competition based on cheap labor much less relevant, especially cheap foreign labor, a crucial determinant of a traded industry’s ability to raise its workers’ incomes.

Advantageous industries tend to have a high capacity to absorb investment. Buying another $1,000,000 worth of tractors for a coffee plantation that already has them won’t increase its productivity much. But putting $1,000,000 into improved production machinery in a television factory will. Advantageous industries tend to activate a virtuous cycle, in which innovation absorbs capital and repays it by raising profitability, generating more capital and repeating the cycle. Economy-wide growth often involves a multi-industry virtuous cycle, in which the upgrading of one industry causes others to upgrade and so on.

Advantageous industries tend to exhibit “path dependence.” That is, having advantageous industries makes it easier for a nation to acquire otheradvantageous industries. For example, nations that produced radios were better equipped to start producing televisions, because they had already mastered key technologies like the vacuum tube. As a result, economic growth is path dependent: what nations can produce tomorrow depends on what they produce today. This is why much industrial policy, historically, has centered on using various policies, from infant-industry protection to outright cash subsidies, to break into industries expected to lead somewhere. Quintessentially, this has meant getting out of agriculture and raw materials and into manufacturing (especially of products sophisticated for the time) although a small segment of advanced service industries has been entering the advantageous category since the late 1970s.

Advantageous industries tend to experience human capital accumulation, because they use technology the workers must have training to operate. They thus create a premium on more skilled, not just the cheapest possible, workforce. This human capital, manifested in the workers themselves, encourages better treatment of labor, for the same reason factory owners do not let valuable machinery rust away. Advantageous industries thus make at least possible the “countervailing powers,” like bargaining leverage by unions, that spread the profits of industry beyond its owners. Such leverage is not guaranteed, but workers can’t bargain for a share of profits that aren’t there. Rising worker incomes also provide the purchasing power to sustain growth, and as incomes rise, consumers demand better products, driving the industries of the nation (which will generally depend in large part upon domestic sales) to upgrade.

It is not guaranteed that any given advantageous industry will have all six of the above qualities. They are, however, interlinked, mutually dependent, and do tend to appear as a package. For example, technological advance is linked to expanding production because it is much easier to invest in new, better technology when one is adding new machinery to expand production. And expanding production is linked, of course, to elastic demand. Remember, finally, that the advantageous industries that count are big industries, like cars or airplanes, or groups of many small industries that together amount to a lot, not tiny niche industries.

Disadvantageous Industries

Advantageousness vs. disadvantageousness is not binary, but rather a sliding scale from very advantageous to very disadvantageous, with many industries falling in between. In disadvantageous industries, all or some of the six previously discussed dynamics are absent – or, worse, run in reverse. Such industries not only tend to have low wages and profits today, but also do not lead to better industries tomorrow. For centuries, “disadvantageous” has meant most agriculture, natural-resource extraction, and services like retail. And since the mid-1970s, low-skilled manufacturing has been inexorably joining this category.

Agriculture and natural resources generally exhibit diminishing, not increasing, returns, as once the best land and most accessible resource deposits have been exploited, increasing production means turning to inferior land and deposits. Such industries rarely have any way of acquiring pricing power, as they generally produce undifferentiated commodities. Because income elasticity of demand for their products is low, productivity growth tends to flow to consumers, in the form of lower prices, rather than to producers, in the form of higher wages and profits. American farmers, for example, use advanced technologies from genetically engineered seeds to satellite positioning systems for their tractors, but struggle to stay solvent.

Fields such as retail and restaurants have far less scope for productivity improvement than manufacturing: a 1950s diner isn’t that different from one today, while a 1950s auto assembly line would be so uncompetitive today that nobody would build one. Technological innovations in disadvantageous industries tend to come from other industries: farmers don’t themselves invent satellite-navigating tractors or genetically engineered corn. As a result, when innovation does occur, it tends to just increase the productivity of all producers at once, driving down the price. Agricultural prices also tend to be volatile: soybean or banana prices can fall or rise by 50 percent year-to-year, but not car prices.

Disadvantageous industries generally lack synergies with other industries. When the Santa Clara Valley in California (better known today as Silicon Valley) specialized in plum production before WWII, this brought about a prune industry and a fruit-canning industry, but little more.  When the same region became a center for aerospace and defense electronics, this led to transistors, then integrated circuits, then computer hardware, computer software, and, contemporaneously, a venture capital industry feeding on and nurturing all these industries. The output of all these industries are worth many, many times what the region’s fruit production once was.

The presence of advantageous industries in an economy generally improves wages in even that economy’s disadvantageous industries. For example, growth of manufacturing in a developing nation raises the incomes of the nation’s farmers, as rising manufacturing wages create more demand, and thus higher prices, for farm goods that are consumed locally because of transport costs and perishability. Advantageous industries often also help set a “wage floor” for all local industries, preventing unemployed workers from crowding into disadvantageous industries and dragging down productivity due to these industries’ diminishing returns.

Underdeveloped nations are poor because their economies are predominantly composed of disadvantageous industries, and they can’t find a way up and out of such industries. Developed nations are not wealthier because they engage in the same economic activities as developing nations, only with greater productivity: they engage in fundamentally different economic activities because they have fundamentally different industries. (Commodity agriculture, for example, does exist in developed nations, but is a small percentage of GDP and employment.) Nations that used to be poor and agricultural, like South Korea in 1960, didn’t become rich by finding ways to produce rice and fish (South Korea’s main industries then) with 20 times the productivity. These nations used proactive industrial policies to break into industries, like steel and cars, where 20 times the per-worker productivity of a rice-growing peasant farmer is the norm.

Note, finally, that having a lot of advantageous industries is not the same thing as merely being rich, as small-population states with large natural resources, such as Argentina in 1900 (beef) or Kuwait today (oil), can have high per-capita incomes. But the resource-based model doesn’t scale: there has never been a large nation that was rich purely on the strength of natural resources, because no nation has ever had enough resources. But advantageous industries, on the other hand, can scale, and when their ability to scale is exhausted and their products commoditized, they lead to new industries.

The Dynamics of Advantageous Industries

The core justification for industrial policy is that, for any given nation, the market alone will not automatically generate the optimum amount of advantageous activities and industries. This is so because the key characteristics of advantageous industries are shot through with non-free-market dynamics.

• Increasing returns industries are, though lucrative, protected from entry by the superior scale of incumbents. The market, on its own, will thus tend to keep new entrants out. As a result, nations can benefit from subsidizing entry into these industries. (And nations already hosting such industries must beware that potential rivals may be doing the same.)
• Pricing power exists when markets are not perfectly free, so getting it requires advancing into oligopolistic, increasing-returns industries, which in turn entails overcoming the incumbent scale advantages previously mentioned.
• Fundamental technological advances generally do not come from the private sector operating under free market conditions. They come from public sector research, from the private sector enjoying public sector help, or from government-sanctioned monopolies.
• Synergies do not generally result in profits for the parties creating them commensurate with the value they generate across the entire economy. As a result, the market doesn’t correctly “price” the industries that have these synergies, and therefore won’t create the optimal amount of them on its own.
• The private sector, on its own, often has short time horizons, not the multi-decade time horizons needed to lift a nation from poverty to prosperity or keep it prosperous if it already is.

For these reasons, markets are less effective for breaking into and retaining advantageous industries than the combination of markets plus sound industrial policy. And in a competitive international environment, where rival nations are already using effective, all-of-government industrial policies, relying on markets alone will result in the loss of existing traded advantageous industries and failure to establish leading positions in those of the future. As nations become more developed, markets get closer to being sufficient, which is why industrial policy matters more in developing nations, but even fully developed nations never reach a state where markets alone are sufficient.

Advantageousness Changes over Time

How advantageous particular industries are changes as technology’s leading edge moves forward and yesterday’s advanced technology becomes mundane and diffuses around the world. Any given industry’s advantageousness will thus generally decline with the technological status of its products and production processes, although barriers to entry can slow this process. As a result, most industries must constantly upgrade to hold their advantageousness. (Different activities within an industry can, of course, evolve at different rates, and modern communications and transportation systems allow these activities to be geographically dispersed.) Thus, in traded industries, nations must move forward just to stay in place. This is mostly a healthy process, because it forces developed nations to upgrade and allows developing nations to develop by entering industries advanced nations have left. However, it also means developed nations can lose the advantageous industries they already have.

Industries that have lost advantageousness in recent years include laptops, which has largely ceased innovating and entered a phase of price competition between similar models. Decades ago, at the dawn of consumer society, products such as refrigerators, washing machines, microwave ovens, and bread-making machines were also once highly advantageous, but then they, too, declined.

Conversely, some industries have seen their advantageousness revive, thanks to new waves of innovation. The most obvious example today is automobiles, where advances in battery technology enabled electric cars, and artificial intelligence is on the way to enabling self-driving vehicles.

Other products have held their position through incremental innovations: televisions now have Bluetooth connectivity, ultra-high definition, curved screens, and intelligent TV. Refrigerators have TV screens in their doors, see-through doors, separate cooling chambers, in-door ice and water dispensers, and Internet connections.

Other industries have held advantageousness because their internal structures create strong barriers to entry. These include large integrated systems like aircraft, other major aerospace systems, military systems, flight simulators, factory automation systems, Formula I race cars, and offshore drilling platforms. They are design-intensive, small-volume, high priced sectors. Their products are generally made of complex, often custom-tailored, components, which are themselves high-value and produced in relatively small volumes. Component suppliers to these industries tend to be located close by, so they can work closely together on the design and integration issues inevitable with complex and continually innovating products. These suppliers are often themselves operating at the technological cutting edge, such as the capital equipment for semiconductor production.

Other industries that have held onto their advantageousness center on product design and continuous processing, rather than unit manufacturing: non-generic pharmaceuticals, oil refining, chemicals, biotechnology, and advanced materials. In these industries, the physical manufacturing step is often a relatively small fraction of the cost of the product. For many, accumulated intellectual property, in the form of patents and trade secrets, creates barriers to entry.

Proximity-sensitive manufacturing, such as custom kitchen cabinets and architectural components, lacks some attributes of advantageous industries, but makes up for this by being sheltered from foreign, and sometimes even national, competition. Also sheltered from long-distance competition are industries like food processing that are tied to local supplies of agricultural inputs, especially those that are perishable, finicky to transport, or need to be consumed shortly after production. Similar factors apply to industries, like many construction materials, where transport costs are high relative to the price of the product.

Evolution of production technology is not, of course, the only reason industries migrate from developed nations. This migration has also occurred because of advances in transportation, communication, business software, and other things that make it easier for firms to take advantage of cheaper foreign labor. The invention of the container ship was a key factor. Others include the ability of foreign nations to artificially suppress the value of their currencies, features of private-sector markets that keep the dollar overvalued, and the subsidies and other mercantilist tactics foreign governments use in pursuit of advantageous industries. In recent decades, trade agreements have facilitated the migration of production abroad by guaranteeing access to the U.S. market and protecting investments in production facilities. The U.S. has also made deliberate choices, such as allowing imports of textiles from certain foreign nations and deliberately transferring technology to U.S. allies in service of non-economic foreign-policy objectives.

Industrial Policy Is Not Just about High Technology

“Advantageous” does not merely collapse in practice into “high tech.” Industrial policies singularly focused on pursuing more-advanced technology as an economic strategy have a poor track record all over the world. (Consider the technological triumph, but commercial failure, of the supersonic Anglo-French Concorde aircraft.)

From an employment point of view, everybody can’t work at Apple or its equivalents.  There aren’t enough jobs in these industries, and some people are too old or uneducable to be retrained for them, or live in places where there are none. There are also less advantageous industries that society needs simply in order to function.  Many “mid-range” industries have non-zero but modest amounts of increasing returns, pricing power, technological dynamism, and synergies: utilities, infrastructure, construction, transport, healthcare, energy production, and government. Together, these industries represent a large portion of GDP and employment. Many cannot be performed remotely, protecting them from foreign competition and making them viable sources of large numbers of at least medium-wage jobs. But precisely because these industries are so large in terms of GDP and employment, it is important to ensure that they make full use of available technology to become as advantageous as possible.

Productivity gains come not from inventing technologies per se, but from deploying them. As the consulting firm McKinsey has observed, most jobs created by technology are outside the technology-producing sector itself, estimating that the personal computer enabled the creation of 15.8 million net new jobs in the U.S. since 1980. [3] The number of people employed building PCs in the U.S. in 2019? A mere 156,000.[4] As a result, in addition to technology-creating industries, a nation also needs industries capable of absorbing technology. Some industries are thus advantageous, in part, because they serve as matrices for the deployment of technologies developed elsewhere. Without a thriving automobile industry in this country, for example, the productivity gains from newly emerging robotic technologies in auto manufacturing will accrue to other nations. Similarly, America loses many potentially high-productivity jobs when advanced products designed here are made elsewhere – and this tends to result in eventually losing the design work, too.

Advantageous Industries’ Benefit Works Generally

There are a limited number of big sectors where large, ongoing productivity gains are possible: manufacturing and a few others, such as information technology. These are where R&D pays off in profitable productivity gains, and thus why manufacturing accounts for 70% of U.S. R&D. Productivity growth in these sectors is the ultimate source of economy-wide income growth.

As previously noted, a restaurant today, and one from 1950, are not all that different.  In comparison, a steel mill, or a telephone switchboard, are unrecognizably different:  productivity at the mill, in  man-hours per ton, is about eight times higher, and the switchboard has almost disappeared, although the task is still performed out of sight electronically.[5] But it is because of productivity growth in industries like steel and telecommunications that more people can afford to eat in restaurants than in 1950.

Barbers earn over ten times as much in Germany as in the Philippines.[6] Do they use more capital or better technology in Germany? Not much. The main difference is that wages generally are higher in Germany, so barbers have to be paid more, or nobody would be one. But how did wages get to be higher there? Somebody’s productivity must have gone way up, because average wages must reflect an economy’s average productivity, and it wasn’t the productivity of barbers, which hasn’t changed much in millennia. Or the productivity of other local service jobs, like retail, dining, and local government. (In America, these make up two thirds of total jobs.)[7] Instead, rich nations are rich because they experienced wave after wave of productivity surges in the advantageous industries of the day over many decades. This allowed capital, skills, and technology to relentlessly accumulate, pulling up wages across the whole economy. As a result, everybody in the economy, not just workers in the most advantageous industries, has a stake in the health of such industries – though how much workers benefit also depends on other factors affecting labor’s bargaining power.

The Core Concepts of Industrial Policy Economics

The foregoing argument does not, of course, evaluate the effectiveness of the hundreds of specific policies, from currency manipulation to subsidies for scientific research, that governments use in the pursuit of more-advantageous economic activities and industries. Nor does it imply a specific set of such policies for the United States, a large and legitimate topic for debate. But it does explain why industrial policy can work:

• Economically advantageous activities and industries exist.
• They are the key to economic growth and prosperity.
• A laissez faire policy will not deliver the maximum possible amount of them.
• Industrial policy interventions can potentially deliver more of them.

These four points, together, are the foundation for any sound industrial policy. They imply that every country, including the U.S., can benefit from good industrial policy and provide, at a high level of generalization, the logic for evaluating specific proposals.

Notes

[1] Paul Krugman, “The Current Case for Industrial Policy,” Chapter 7 in Dominique Salvatore, ed., Protection and World Welfare, Cambridge University Press, 1993, p. 160.

[2] Innovation doesn’t only mean technology. Consider the mail-order catalog, or stock exchanges, or retail franchising: all these innovations in business technique unlocked new opportunities for growth. But technology is the main event.  And this is not to say that innovation itself is the only bottleneck of growth.

[3] “Jobs Lost, Jobs Gained: Workforce Transitions in an Time of Automation,” McKinsey Global Institute, December 2017, p. 5.

[4] Computer and peripheral equipment manufacturing, excluding digital camera manufacturing (NAICS 3341), 2018: Bureau of Labor Statistics, bls.gov/emp/tables/employment-by-major-industry-sector.htm, table 2.7, row 86, accessed January 5, 2020.

[5] Steel production man-hours per ton in the U.S.: 1950=15.1 (from Lee, K., and Ki, J. (2017). “Rise of latecomers and catch-up cycles in the world steel industry,” Research Policy, 46(2): 365-375 (p. 368)) 2017=1.9 (from American Iron and Steel Institute (2019). “2019 Profile of the American Iron and Steel Institute,” retrieved from steel.org/industry-data/reports, p. 9)

[6] According to the Economic Research Institute, German barbers make an annual salary of €33,991, or $37,419 USD (salaryexpert.com/salary/job/barber/germany). Barber salaries in the Philippines at ₱169,976 ($3,341 USD) per year. (salaryexpert.com/salary/job/barber/philippines).

[7] World KLEMS database, worldklems.org/data/basic/usa_wk_apr_2013.xlsx, tab DATA, rows 1043-1080, accessed February 1, 2020.