South can re-deploy effective industrial policy, says Prof Rodrik

Geneva, 22 Dec (Chakravarthi Raghavan) - Unlike what is commonly believed, the last two decades have not witnessed the twilight of industrial policy and, while some old models have been hit by the WTO agreements, developing countries could still redeploy a right model of industrial policy for economic self-discovery and development of countries.

This view is advanced by well-known US academic Dani Rodrik (professor of economics at the Harvard Kennedy School of Government), in a paper prepared for the UN Industrial Development Organization (UNIDO). The paper is available at Rodrik’s home page at the Harvard Kennedy School of Government website and has also been published as a discussion paper (No. 4767) by the UK-based Centre for Economic Policy Research.

Governments everywhere, in industrialised and developing economies, have been engaged in using industrial policy - providing incentives and subsidies to exports and foreign direct investment (FDI) in the belief that they are the source of significant positive spillovers.

Rodrik points that there is no empirical evidence of ‘significant positive spillovers’ either in providing incentives for exports or attracting FDI - to back these two interventions by the state in the market. Instead he suggests industrial policy needs to be redeployed in a more effective manner.

In presenting a new agenda of industrial policy, and for developing country governments to choose such policies, with an institutional framework, and redeploy them, Rodrik says that while such an agenda may sound overly ambitious and too big a departure from today’s accepted policy practice, and though industrial policies have supposedly been confined to the trashbins of history, the reality is very different.

Industrial policy has run rampant over the last decades - nowhere more than in those economies that have steadfastly adopted the agenda of orthodox reforms.  These policies, Rodrik says, have privileged exports and foreign investments - “the two fetishes of the Washington Consensus era” - because their advocates call them strategies of ‘outward orientation’ or other similar sounding names, Rodrik says.

The Export Promotion Zones are the most visible forms of discrimination in their favour, with favoured treatment given to firms locating in the EPZs: unlimited duty-free access on all imports provided the output is exported; tax holidays on corporate, property and income taxes; shelter from bureaucratic regulations; provision of superior infrastructure and communication services; and often exempt from labour laws applying to other firms.

The incentives offered to FDI are even more common, Rodrik points out.

The driving force behind these incentives favouring exports and foreign investment has been the belief that they are particularly prone to positive externalities and spillovers.

However, “economic research provides little support for such presumption.”

Exporting firms tend to be more productive and technologically more dynamic, but not because of any benefits accruing from such activities, but simply with selection efforts. Subsidizing exports can do little to enhance overall productive or technological capacity.

Similarly careful studies have been able to find little systematic evidence of technological or other externalities from FDI - some even finding negative spillovers.

“In these circumstances, subsidizing foreign investors is a pretty silly policy, as it serves to transfer income from poor-country tax-payers to the pockets of shareholders in rich countries, with no compensating benefit.”

Is industrial policy feasible in today’s global environment?

There is a hierarchy of rules of the WTO, which are far-reaching and more intrusive than under the old GATT. Under the WTO there are several restraints: export subsidies are WTO-illegal for all but the least-developed, as are domestic content requirements and other performance requirements. And countries not yet members of the WTO often are hit with more restrictive demands as part of their accession negotiations.

Regional and bilateral agreements expand the range of these disciplines beyond those found in WTO.

Among existing WTO rules, those relating to subsidies and intellectual property have some bite.

In the light of these, Rodrik finds it encouraging that multilateral trade regimes are paying attention to ‘policy space’ for developing countries. He views that even the Uruguay Round ‘single undertaking’ concept is all but dead.  Developing countries, he suggests should push hard for ‘policy space’ in future trade negotiations.

Rodrik notes that economists once believed that the developing world was full of market failures and poor countries could escape the poverty trap only through extensive government interventions. Then there came a time when economists believed that government failure was the biggest evil, and governments should give up the pretence of steering the economy.

“Reality has not been kind to either set of expectations,” says Rodrik.

While few now believe that state planning and public investment can act as the driving force of economic development, and even economists of the left share a healthy respect for power of market forces, it is also increasingly recognized that developing societies need to enlist private initiative in a framework of public action to encourage restructuring, diversification and technological dynamism beyond what market forces on their own would generate.

This recognition is now particularly evident in those parts of the world, notably Latin America, where market forces were taken the farthest and the disappointment about the outcomes is correspondingly the greatest.

This softening of convictions on both sides presents an opening to fashion an agenda for economic policies that takes an intelligent intermediate stand between these two extremes. “Market forces and private entrepreneurship would be in the driving seat of this agenda, but governments would also perform a strategic and coordinating role in the productive sphere beyond simply ensuring property rights, contract enforcement and macro-economic stability.

Policies for economic restructuring were known in the past as ‘industrial policies’. Rodrik uses the same term (as he puts it for lack of a better one) to restructuring of policies favcouring dynamic activities generally - regardless of whether they are within industry or manufacturing per se. His specific examples and illustrations in the paper include activities in agriculture and services.

There is no evidence that the type of market failures calling for industrial policy are located predominantly in industry, Rodrik says.

The nature of industrial policies, he notes, is that they complement market forces - reinforcing or counteracting the allocative effects that existing markets would otherwise produce.

By thinking of industrial policy in a somewhat different light, Rodrik’s paper develops a framework for industrial policy that would maximize its potential to contribute to economic growth, while minimising the risks of generating waste and rent-seeking.

The conventional approach to industrial policy is to enumerate technological and other externalities and target policy interventions on these market failures.

In proposing industrial policy in a different framework, Rodrik’s paper starts from the premise of generic market failures, but whose location and magnitude is highly uncertain, and argues that the task of industrial policy is as much about eliciting information from the private sector on significant externalities and their remedies as about implementing appropriate policies.

The right model of industrial policy is not of an autonomous government applying Pigovian taxes or subsidies but of strategic collaboration between the private sector and government to uncover where the most significant obstacles to restructuring lie and what type of interventions are most likely to remove them.

The analysis of industrial policy hence must not be on policy outcomes - inherently unknowable ex ante - but on getting the policy process right: how to design a setting in which private and public sectors come together to solve problems in the productive sphere, with each side learning about opportunities and constraints faced by the other - and not whether the right tool is directed credit, or R&D subsidies or whether the steel industry is to promote or software industry.

Industrial policy ought to be looked at as a discovery process, and in this light the traditional arguments against it lose much of their force - and typical ripostes about governments inability to pick winners becomes irrelevant.  Governments have imperfect information, but so does the private sector. The information externalities generate by ignorance in the private sector creates a useful public role - even where the public sector has worse information than the private sector.

Government needs to maintain its autonomy from private interests, but can still elicit useful information from the private sector only when it is engaged in an ongoing relationship with it - what sociologist Peter Evans calls ‘embedded autonomy’.

It is innovation that enables restructuring and productivity growth. Innovation in the developing world is constrained not on the supply side, but on the demand side - not the lack of trained scientists and engineers, absence of R&D labs or inadequate protection of intellectual property that restricts innovations.  Rather, innovation is undercut by lack of demand from potential users in the real economy - the entrepreneurs, who perceive new activities to have low profitability.

Citing findings in some existing literature, Rodrik argues that whatever it is that serves as the driving force of economic development, it is not the forces of comparative advantage as understood conventionally. The trick is to acquire mastery over a broader range of activities, instead of concentrating on what one does best.

Rodrik argues that the two key ‘externalities’ that blunt incentives for productive diversification are information externalities and coordination externalities. And both are reasons to believe diversification is unlikely to take place without directed government action.

Diversification of productive structures require ‘discovery’ of an economy’s cost structure, of which new structures can be produced at low enough cost to be profitable. This ‘self-discovery’ is an activity of great social value, yet very poorly remunerated. If an entrepreneur fails in his venture, he bears the full cost of his failure. If successful he has to share value of discovery with other producers who can follow his example into the new activity.

The kind of discovery that matters differs from innovation and R&D as commonly understood. It is not one of coming up with products or processes, but ‘discovering’ that a certain good, already well-established in world markets, can be produced at home at low cost - involving some technological tinkering to adapt foreign technology to domestic conditions, but one that rarely amounts to something actually patentable and hence monpolizable. Policy regimes in developing countries have no analogues to the patent system protecting innovation in advanced economies. These features are endemic to the process of economic development.

The first-best policy response to informational externalities restricting self-discovery is to subsidize investments in new, non-traditional industries.  However, it is difficult in practice to implement such a subsidy. There has to be a carrot-and-stick approach. Since self-discovery requires rent to be provided to entrepreneurs, the carrot side of the policy could be a subsidy of some kind, trade protection or provision of some venture capital. These rents have to be subject to some performance requirements - the stick for the policy.

Even under optimal incentive programs, some investments could be failures. If there are no or few failures, it could be interpreted as a sign that the program is not aggressive or generous enough. The trick for the government is not to pick winners, but to know when it has a loser.

As for coordination externalities, many projects require simultaneous, large-scale investments to be made to become profitable. Some of the services to be provided have high fixed costs (for example an assured supply from an electrical grid, irrigation, logistics and transport networks, quarantine and other public health measures against pests etc). All these services have high fixed costs and are unlikely to be provided by private entities without the assurance of enough demand. This is a classic coordination problem, and only upstrream and downstream investments coaxed simultaneously can produce results.  Government investments upstream are aimed at producing such results.

Coordination failures can arise whenever new industries exhibit scale economies and some of the inputs are non-tradable. Big push development models are based on the idea that such features are predominant in low-income environments.  Whether it be in tourism, pharmaceuticals or bio-tech, there is a premium for coordinating investment and production decisions of different entrepreneurs. An often neglected aspect of coordination failures is that they do not necessitate subsidization, and overcoming them need not be costly for the government budget.  None of the investments need to be subsidized, but investments need to be made in the first place - and this can be achieved only through true coordination.

Viewed from these perspectives, argues Rodrik, industrial restructuring rarely takes place without significant government assistance. Beneath the surface of any non-traditional export success story from anywhere in the world can be found industrial policies, public R&D, sectoral support, export subsidies, preferential tariff arrangements and similar interventions.

Comparing the experiences of East Asia and Latin America in this regard, Rodrik says that the difference between the two is not that industrial transformation was state driven in the first and market driven in the latter, but rather than industrial policy in Latin America has not been as concerted and coherent as in East Asia.

Dealing with institutional arrangements for industrial policy, Rodrik argues that the public sector is not omniscient and typically government has even less information than the private sector. Governments may not even know what they don’t know. Hence, the policy setting has to be one in which public officials are able to elicit information from the business sector in an ongoing basis about constraints that exist and opportunities available. “It cannot be one where the private sector is kept at arms’ length and autonomous bureaucrats issue directives.”

However, industrial policy is open to corruption and rent-seeking. And the natural response is to insulate policy-making and implementation from private interests - and shield public officials from close interaction with businessmen.

The critical institutional challenge is to find an intermediate position between full autonomy and full embeddedness. It should be a process that is democratically accountable and carry public legitimacy.

Getting this balance right, says Rodrik, overshadows all other elements of policy design. Once the institutional setting is right, we need to worry less about appropriate policy choice. A first-best policy in a wrong institutional setting will do considerably less good than a second-best policy in an appropriate institutional setting.

In terms of an institutional architecture, the success of industrial policy often depends on the presence of high-level political support. Just as fiscal prudence has a champion in the finance minister and sound money in a central bank governor, economic restructuring needs a political advocate who has the ear of the president or prime minister and can stand as equals with other members of an economic cabinet, Rodrik says.

While institutional choices can differ from setting to setting, depending on initial conditions, there is a need for coordination or deliberation councils with which information exchange and social learning can take place. These are private-public bodies with relevant groups or their representatives. And to avoid biases of incumbents and insiders, they need to go beyond typical ‘peak’ organizations of only well-organized groups and business associations. They would be the setting in which private sector interests would communicate their requests for assistance to government, and the latter could goad the private sector into new investment efforts.

Such councils can be created at national and subnational or sectoral levels - with the larger councils having their staff of technocrats. To ensure that society at large view these as strategies to expand opportunities for all, and not only privileged sections, the operations of these councils need to be transparent in an accountable way, and their decisions published. There should be full accounting of public resources spent in support of new activities.

In terms of design principles for industrial policy, Prof Rodrik sets out some ten principles:

·        incentives should be provided only to ‘new’ activities - new in the sense of both products new to the local economy and new technologies for producing an existing product. Many countries provide tax incentives, but without sufficiently discriminating between investments expanding the range of capabilities of the home economy and those that do not. This focus also differs from the tendency to provide incentives to subsidize small and medium enterprises (SMEs).

·        there should be clear benchmark criteria for success and failure.

·        there should be a built-in sunset clause - to ensure that financial and human resources do not remain tied up for a long time in activities not paying off.  Every publicly supported project needs to have a clear ex ante statement to judge success or failure.

·        public support must target activities, and not sectors - and cross-cutting programs such as subsidized bilingual training, feasibility reports for non-traditional agriculture, infrastructure investment, adaptation of foreign technology for local conditions, risk and venture capital etc are better than providing investment incentives for tourism or call-centres.

·        subsidized activities must have the clear potential of providing spillovers and demonstration effects. There is no reason to provide public support for an activity unless it has the potential to crowd in other complementary investments or generate informational or technological spillovers. And activities must be so structure as to maximise spillovers to subsequent entrants and rivals.

·        authority to carry out industrial policies must be vested in agencies with demonstrated competence.

·        implementing agencies must be monitored by a principal with a clear stake in the outcomes and has political authority at the highest level.

·        agencies carrying out promotion must maintain channels of communication with private sector.

·        optimally, mistakes resulting in ‘picking the losers’ will occur. While safeguards must be built-in to avoid this, some promoted activities will fail.  The objective should not be to minimize the chances of mistakes occurring, which would result in no self-discovery at all, but minimising the costs of mistakes when they occur.

“If governments make no mistakes, it only means they are not trying hard enough.”

·        promotion activities need to have the capacity to renew themselves, so that the cycle of discovery becomes an ongoing one.

Industrial policy should not be thought of as a generic range of incentive programs, but as a process designed to elicit areas where policy actions are most likely to make a difference. The output of such a process will depend critical on a country’s own circumstances. Outlining some illustrative programs, Rodrik suggests:

·        subsidizing costs of ‘self-discovery’ - with a government facility to defray costs of early stages of cost discovery process. The financing of such studies should be for substantially new activities, with potential to providing learning spillovers to others in the economy and the private sector entities being willing to submit themselves to oversight and performance audits.

·        mechanisms for higher risk finance such as through development banks, publicly funded (but professionally managed) venture funds, public guarantees for longer term commercial bank lending or special vehicles to direct a share of public pension fund assets to a portfolio of higher risk investments.

·        multiple level mechanisms for internalizing the coordination externalities; the government’s relationship with various private sector entities need to be socially legitimised through mechanisms of accountability and transparency - with proposals made public, formally analysed and evaluated by technocrats and their fiscal impact costed out.

·        public R&D - technology cannot be acquired from advanced economies in an off-the-shelf manner - and publicly funded R&D efforts are need to identify, adapt and transfer technology from abroad.

·        general technical training needs to be subsidized - since new activities will eventually meet with a shortage of adequately trained personnel.

·        advantage could be taken of national abroad -by governments actively courting them, encouraging their return and using them to spawn new domestic activities.

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