A Few Good People

An underrated lesson from Industrial Policy

Recently, industrial policy has resurfaced as a significant topic in economic discussions. For a long time, mainstream economic advisors viewed industrial policy with skepticism and, at times, outright disdain. This perspective was primarily due to two factors: the empirical effectiveness of industrial policies remained uncertain, and these policies were often vulnerable to manipulation and corruption by vested interests. However, advocates of industrial policy point to the economic triumphs of East Asian nations like Japan, South Korea, Taiwan, and China as evidence of its viability. They argue that several affluent Western economies also historically employed industrial policy. On the other hand, detractors assert that the real catalysts behind these success stories were not industrial policies per se, but rather the liberalization of these economies and a transition towards market-driven policies. This debate continues in various forms. Yet, recent developments such as trade conflicts between the world's two largest economies, global supply chain disruptions caused by the pandemic, and escalating geopolitical tensions have propelled industrial policy back into the limelight of mainstream discourse. The prevailing question has shifted from whether industrial policies should be implemented to how they can be executed effectively.

In many low-income countries, particularly in Latin America and Africa, industrial policy and its advocates never lost favour or fervour - without having as much success as it supposedly did in East Asia. One key difference in East Asian developmental growth is that policy shifted towards promoting export industries, while policy in many Latin American and African states persisted with import substitution. This is where we get into the weeds of industrial policy and its varieties. Everything from tariffs and bans on foreign goods, to government-guaranteed credits, and regulatory protection for domestic firms has been called industrial policy. Some countries use a mixture of all these policies, which can create a muddle in figuring out what works.

However, economists have been making progress in research on industrial policies. For example, economists Dani Rodrik, Reka Juhasz, and Nathan Lane provide a handy definition of industrial policy:

We define industrial policies as those government policies that explicitly target the transformation of the structure of economic activity in pursuit of some public goal. Importantly, these policies are selective; they target some activities, but not others. Moreover, they are intentional in the sense that changing the structure of the economy is what they want to do. As such, industrial policy can be many things – our definition includes the targeted sectoral policies with which they are typically associated (e.g. support for steel, automobiles, shipbuilding, or semiconductors), but it also includes support for other targeted forms of intervention, such as R&D or exporting. Likewise, the goals of industrial policy may be broad. While historically, these policies were primarily aimed at facilitating structural transformation and industrialization in particular, today, goals include climate goals, the creation of ‘good jobs’, supply chain resiliency, national security, and more.

They also provide a useful rationale for industrial policy interventions by the government:

The economic rationale for industrial policy falls into three main categories: (1) market failures such as positive externalities which imply that the market will not provide enough of a positive activity (for example, modern manufacturing, green energy, good jobs); (2) coordination failures whereby a desirable activity may only be individually profitable if everyone else is also producing; and (3) the provision of activity-specific public inputs which are public goods (for example, the charging infrastructure needed for the uptake of electric vehicles).

The controversy surrounding industrial policy is often less about theoretical rationales – which are broad – and more about practicalities. Skeptics worry that the cure will be worse than the disease. There are two broad concerns: (1) information problems which prevent even a well-intentioned government from picking the correct activities to target; and (2) political capture, which implies that even if the government knows which activities to target, self-interested actors will divert the government away from those that create benefits to society at large. Both reasons create doubt about whether governments can ‘pick winners’.

But a third concern here is commonly ignored by industrial policy advocates, which I find personally frustrating. There is usually an assumption that the incentive and capability of governments to do industrial policy are the same everywhere. In essence, while industrial policy sees market failure everywhere, it ignores the more common problem of government failure. In many low-income countries, political capture ensues from vested interests pressuring governments into wasteful and inefficient industrial policy without any goal of industrialisation or structural transformation of the economy. This incentive problem also leads to a knowledge problem where bureaucrats responsible for implementation are not motivated to learn, adapt, and correct policies that are not working.

No country starts their development journey with great institutions. Often the challenge in developing countries is convincing diverse powerful interests to align to execute the right policies without formal rules, accountability, and even enforcement capabilities. In such a setting, successful policies are dependent on individual political leaders, technocrats, and bureaucrats who are motivated to put their country on the development path. This is also true of industrial policy. Doing it well is sometimes dependent on who is doing it. Despite the recent progress in industrial policy research, understanding the actors and agents of these policies is largely missing from the conversation - and I make bold to say that this is the most consequential element for real-life policies in low-income countries. So, I was glad to see economist Philip Barteska address this question in the context of one of the most successful experiments of industrial policy in South Korea.

The economic success of South Korea has been fitted to different theories and policies. However, what can be agreed is that in the early 1960s, under the leadership of Park Chung-Hee, South Korea reformed its policy, shifted toward export promotion, and embarked on a large-scale industrial policy to strategically industrialise its economy. Proponents of industrial policy think it suffices just to credit the policies and their execution. However, Barteska's research sheds light on a crucial aspect often overlooked in the discussion: the pivotal role of individual bureaucrats in the successful implementation of industrial policy:

In my Job Market Paper, we provide evidence that the effect of an industrial policy on economic development crucially depends on bureaucratic capacity. South Korea’s overseas export promotion provides an ideal laboratory to study how implementation capacity changes the effect of an industrial policy. Concretely, we find that individual bureaucrats – the directors of country offices – have large effects on exports to their country of appointment.

In South Korea, the remarkable transformation from a low-income country in the 1960s to an economic powerhouse today was not just the result of well-crafted policies on paper but also of the effective execution of these policies by competent and motivated bureaucrats. This revelation is particularly relevant for low and middle-income countries seeking to replicate South Korea's development success. It implies that the effectiveness of industrial policies is not solely determined by the policies themselves but significantly influenced by the individuals who implement them.

The broad lesson here for me is that you do not just need competent bureaucrats to implement policies. You also need competent bureaucrats to choose the right policies, especially for something like industrial policy as Ricardo Hausmann cautioned:

…a better metaphor for industrial policy may be the body’s immune system, which protects against various invaders by using a highly decentralized detection network to identify threats and determine when it needs to act. Leveraging its “memory” of previous infections, the immune system develops antibodies to address the issue at hand. Each exposure to disease thus strengthens the system’s capacity.

Such an analogy is apt because industrial policy involves close cooperation between a wide network of public entities – including area ministries, economic development boards, investment-promotion agencies, and special economic zones – and private-sector actors. Moreover, like the immune system, industrial policy can fail in one of two ways: its response can be too weak, or it can misfire, as with autoimmune disorders, attacking the body it is meant to protect. Policy capture, corruption, and bureaucratic inefficiencies can lead governments to exacerbate, instead of resolve market failures.

The fact that industrial policy can backfire does not imply that countries should eschew it. Learning how to deploy these interventions is as important for a well-functioning economy as developing sound education and health policy, and a failure to do so would likewise carry an unacceptable social cost.

I am quite convinced that Nigeria's woeful economic performance in the last decade is significantly due to the dearth of enough credible, motivated, and competent bureaucrats to manage important sectors like public finance, trade, agriculture, and monetary policy. And this is something that is not spoken about enough.