The Trouble with Industrial Policy

Since 2016, more and more Americans, from across the political spectrum, have called for local and national governments to expand the scale and depth of their industrial policies—that is, of targeted government interventions designed to foster, upgrade, reorient, or protect particular industries. Both Republican Senator Marco Rubio and former Democratic Senator Evan Bayh, for example, have argued that industrial policy is necessary for America; without it, they say, the country will neither maintain its technological edge nor reverse the declines in employment that particular regions and specific industries have experienced since the mid-1970s.

Recent arguments for industrial policy tend to be critical of the economic liberalization on which America embarked in the 1980s. But, as the economist Russ Roberts recently pointed out, the notion that America has made a fetish of free markets since 1981 doesn’t match the evidence. Americans live in an economy in which, for instance, government spending as a percentage of GDP, government spending on healthcare and welfare, and the number of pages in the Federal Code of Regulations have grown for decades. About the only thing to fall is tariffs. Moreover, whether they take the form of non-defense-related public investments, specific subsidies to businesses, or regulations that attempt to nurture new industries or bolster older sectors, industrial policies are alive and well in America.

Both now and in the past, people have defended industrial policy by claiming that it helps promote the common good. Today’s defenders also label critics of industrial policy “market fundamentalists,” as though the critics were unable to see beyond the world of supply and demand.

The prolific use of this particular f-word is a rhetorical device, designed to suggest that skeptics of industrial policy support free markets in ways that verge on fideism. But how is it “fundamentalist” to draw people’s attention to the failures of industrial policy?

Consider postwar Japan. For decades, Japan’s economy was held up as an example of the successful use of industrial policy. But Japan’s entry in the 1990s into 20 years of economic stagnation known as the “Lost Decades” forced a serious rethinking of this accepted wisdom, so much so that the Japanese Ministry of Finance’s Policy Research Institute conceded in 2002 that “the Japanese model was not the source of Japanese competitiveness but the cause of our failure.” Is it fideistic to highlight such a damning conclusion?

Market Failure or Government Failure?

Understanding the problems of industrial policy matters if America is going to have an economy that contributes to the common good, understood as the sum total of conditions that help people to flourish by their own free decisions. I would suggest that some of the very assumptions on which industrial policy rests are also its major weaknesses.

One such supposition is that, if the markets apparently fail to produce certain products, or to foster certain economic sectors that are deemed important for regional or national well-being, the government must intervene to rectify the problem. The theory claims that the ostensive inability of market forces in a given country, say, to create a large tech sector that produces sophisticated communications devices requires that the government act to help that sector grow. Such proactive measures can range from subsidies and tax incentives for companies that enter this field to tariffs that make it prohibitively expensive to import foreign products.

But what if the failure is not one of markets at all? What if the problem is pre-existing high taxes on tech profits? Or regulatory barriers to entry for tech entrepreneurs? Or weak protections for intellectual property rights? Or preexisting subsidies that incentivize businesses to invest in non-tech areas? Or some combination of these?

In short, what if the problem is primarily a government failure? I don’t just mean the obstacles and perverse incentives that these and other government interventions create: I also have in mind the fact that policymakers cannot know either the optimal allocation of capital and labor in any given economy or the respective comparative advantages of millions of individuals and companies at any moment in time. Put another way, not only do industrial policy advocates tend to ignore just how much preexisting government interventions already distort markets, but the additional interventions they propose require that the government possess a knowledge of the economy that no one can attain.

Some industrial policy advocates are willing to acknowledge this “knowledge challenge.” But they often respond by claiming that, despite this difficulty, the positive spillover effects of industrial policy will compensate in the long run for any inefficiencies generated by such interventions. Their argument goes like this: If, for example, the federal government subsidizes particular companies, or funds government laboratories to produce any number of innovations, these improvements will eventually be absorbed by other businesses. These innovations will then produce economic growth on a scale that is likely to compensate more than enough for any market inefficiencies that these interventions may also cause.

Such claims run into the problem of what are called opportunity costs. If the state chooses to subsidize a particular company, it gives up the opportunity to invest those resources elsewhere. Unfortunately, no government department—let alone a single technocrat—can know if the forgone alternatives might have been more profitable, or might have produced even more growth, innovation, or spillover effects for a greater number of businesses. This means that no legislator or expert can claim with any meaningful degree of certainty that a particular industrial policy will produce more such benefits than would have resulted if the state had not implemented the policy in the first place. For they simply do not know what might have otherwise occurred or come into existence.

This also makes it hard to identify any meaningful causality between industrial policy and economic growth. A 1993 World Bank analysis of the East Asian economic miracle (often touted as an industrial policy success story) made this very point: “It is very difficult,” its authors noted, “to establish statistical links between growth and a specific intervention and even more difficult to establish causality. Because we cannot know what would have happened in the absence of a specific [industrial] policy, it is very difficult to test whether interventions increased growth rates.”

At a minimum, this uncertainty should make industrial policy advocates very circumspect before they confidently predict that a given intervention will facilitate greater growth, ignite a new economic sector, produce thousands of manufacturing jobs in Western Pennsylvania, or restore prosperity to Detroit. They do not and cannot know such things. Nor can they rule out the possibility that a given industrial policy may undermine the economic well-being of a country, region, or industry. If all this is true, the burden of proof is surely on industrial policy advocates to demonstrate why a government should pursue an industrial policy in the first place.

And Then There Is Politics

Leaving aside these conceptual problems, industrial policy advocates, who often pride themselves on their realism, are oddly reluctant to acknowledge an important reality that plagues industrial policy from start to finish: politics.

Industrial policy often aims to promote economic sectors. But economic sectors do not engage in enterprise or economic exchange; nor do they create jobs. Individual enterprises do. Industrial policy thus always takes the form of financial support for particular businesses. Government officials may say that they want to promote American manufacturing generally, but such support always means bolstering or protecting specific companies.

This immediately raises important questions. Which businesses receive assistance? Which do not? And, perhaps above all, who makes these decisions? In many cases, officials at the Small Business Administration or the Department of Commerce are given that responsibility. Yet their decisions amount, at best, to “guesstimates,” not least because of the conceptual challenges that I mentioned above.

Note also that if a subsidized new enterprise fails, government officials suffer no penalty. They have no actual skin in the game, unlike private entrepreneurs, investors, and companies who take on significant and often personal risk every single day in the marketplace. By contrast, the cost of industrial policy failures is borne by American taxpayers, and thus it tends to pass unnoticed.

The other people who make decisions about industrial policy are legislators. Industrial policies are not designed and implemented in a politics-free setting. The moment there arises any prospect of subsidies or tariffs, you can be sure that corporations and businesses will relentlessly lobby legislators in pursuit of such assistance.

I am not a cynic. But does anyone doubt that narrow political considerations, like enhancing one’s reelection prospects, may well weigh heavier in a legislator’s decisions about such matters than the consideration of what is truly in the nation’s economic interest? Should we pretend that there is not a strong likelihood that a legislator’s hopes of a comfortable life after politics—with seats on company boards, or a position as a major corporation’s Washington-based government affairs director—may influence his choice about which company receives preferential treatment? The fact that industrial policy advocates consistently sidestep—or, in my experience, simply refuse to discuss—this cronyism problem, which is part and parcel of the reality of making decisions about industrial policy, only underscores the pointedness of the critique.

Humility Matters

The problems that characterize industrial policy are not the stuff of abstract speculation. They are real, and they should give any policymaker who cares about the common good significant pause before going down this path. Industrial policy provides many short-term satisfactions: most notably, the sense that one is “doing something” to fix real problems. In the long term, however, the economic and political dysfunction that industrial policy creates is, as countries from Japan to France and Argentina have discovered, difficult to eradicate.

Of course, governments do not and should not make policy choices—including economic policy decisions—solely on the basis of economic reasoning. Among the state’s core responsibilities vis-à-vis the common good is national security. Clear threats to national security may lead a government to decide that it must develop military technology domestically. In order to realize that goal within a specific time, governments often fund private ventures or establish government-directed defense initiatives, such as the Manhattan Project.

I have no difficulty in principle with genuine concerns for national security trumping economic growth and efficiency. Adam Smith himself recognized that defense “is of much more importance than opulence” and is “the first duty of government.”

That said, industrial policy, even if it is employed to realize legitimate national security goals, is just as vulnerable as any other industrial policy to being co-opted by the supported industries for their own private ends. Government-subsidized industries and their political allies have always tended to stretch appeals to national security to the point of justifying policies that have nothing to do with the nation’s defense, and everything to do with giving businesses government handouts or protecting them from competitors.

These problems are not easy to address. But policymakers must have a firm grasp of how they result from both the assumptions behind industrial policy and the perverse incentives that such policies create. Even more importantly, governments and those who advise them must humbly recognize the limitations of their own capacities and foresight.

Humility is not low self-regard. Rather, it is freedom from pride and hubris. I don’t doubt that industrial policy advocates love their country and want to contribute to its flourishing. I do think, however, that they are often cavalier in the face of the knowledge problem and the associated issue of opportunity costs. They also overestimate what can be achieved by selective interventions into the economy, downplay the dysfunction that such measures create, and ignore considerable evidence that industrial policies fail to achieve their stated goals. Neither these attitudes nor the policies that they inspire help build up the common good. On the contrary, they all too frequently achieve the opposite.