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Industrial Policy Comes Out of the Cold

WASHINGTON, DC – One of the best-kept economic secrets was strongly reconfirmed in 2010: most countries, intentionally or not, pursue an industrial policy in one form or other. This is true not only of China, Singapore, France, and Brazil – countries usually associated with such policies – but also for the United Kingdom, Germany, Chile, and the United States, whose industrial policies are often less explicit.

Given that industrial policy broadly refers to any government decision, regulation, or law that encourages ongoing activity or investment in an industry, this should come as no surprise. After all, economic development and sustained growth are the result of continual industrial and technological change, a process that requires collaboration between the public and private sectors.

Historical evidence shows that in countries that successfully transformed from an agrarian to a modern economy – including those in Western Europe, North America, and, more recently, in East Asia – governments coordinated key investments by private firms that helped to launch new industries, and often provided incentives to pioneering firms.

Even before the recent global financial crisis and subsequent recession, governments around the world provided support to the private sector through direct subsidies, tax credits, or loans from development banks in order to bolster growth and support job creation. Policy discussions at many high-level summits sought to strengthen other features of industrial policy, including public financing of airports, highways, ports, electricity grids, telecommunications, and other infrastructure, improvements in institutional effectiveness, an emphasis on education and skills, and a clearer legal framework.

The global crisis has led to a rethinking of governments’ economic role. The challenge for industrial policy is greater, because it should assist the design of efficient, government-sponsored programs in which the public and private sectors coordinate their efforts to develop new technologies and industries.

But history also tells us that while governments in almost all developing countries have attempted to play that facilitating role at some point, most have failed. The economic history of the former Soviet Union, Latin America, Africa, and Asia has been marked by inefficient public investment and misguided government interventions that have resulted in many “white elephants.”

These pervasive failures appear to be due mostly to governments’ inability to align their efforts with their country’s resource base and level of development. Indeed, governments’ propensity to target overly ambitious industries that were misaligned with available resources and skills helps to explain why their attempts to “pick winners” often resulted in “picking losers.” By contrast, governments in many successful developing countries have focused on strengthening industries that have done well in countries with comparable factor endowments.

Thus, the lesson from economic history and development is straightforward: government support aimed at upgrading and diversifying industry must be anchored in the requisite endowments. That way, once constraints on new industries are removed, private firms in those industries quickly become competitive domestically and internationally. The question then becomes how to identify competitive industries and how to formulate and implement policies to facilitate their development.

In developed countries, most industries are advanced, which suggests that upgrading requires innovation. Support for basic research, and patents to protect successful innovation, may help. For developing countries, Célestin Monga and I have recently developed an approach – called the growth identification and facilitation framework – that can help developing-country governments increase the probability of success in supporting new industries.

This framework suggests that policymakers identify tradable industriesthat have performed well ingrowing countrieswith similar resources and skills, and with a per capita income about double their own. If domesticprivate firms in these sectors are already present, policymakers should identify and remove constraints on those firms’ technological upgrading or on entry by other firms. In industries where no domestic firms are present, policymakers should aim to attract foreign direct investment from the countries being emulated or organize programs for incubating new firms.

The government should also pay attention to the development by private enterprises of new and competitive products, and support the scaling up of successful private-sector innovations in new industries. In countries with a poor business environment, special economic zones or industrial parks can facilitate firm entry, foreign direct investment, and the formation of industrial clusters. Finally, the government might help pioneering firms in the new industries by offering tax incentives for a limited period, co-financing investments, or providing access to land or foreign exchange.

Our approach provides policymakers in developing countries with a framework to tackle the daunting coordination challenges inherent in the creation of new, competitive industries. It also has the potential to nurture a business environment conducive to private-sector growth, job creation, and poverty reduction.

As economies around the world struggle to maintain or restore growth in 2011, industrial policy is likely to be under a brighter spotlight than ever before. Given the right framework, there is no reason for it to remain in the shadows.