Rethinking Industrial Policy

I have been reading a lot of Dani Rodrik lately and found his writings very insightful. His ideas are strongly persuasive but somewhat orthogonal to conventional mainstream economists thinking; I get a strong suspicion that this is because he is merely ahead of the curve. He principally favours ‘eclectic solutions that mix government and the private sector in pragmatic ways’ and is critical on the repercussions of globalisation, particularly on the danger (and folly) of rapid liberalisations of capital and trade flows. He was one of the first to write favourably on Malaysia’s capital controls during the financial crisis in 1997/98 (and my undergraduate dissertation was basically an extension of his paper with Kaplan).

Recently he has been writing much on industrial policy for developing economies, often using China’s as the centre stage for discussion. Again, his ideas are mostly unconventional to contemporary thinking, but my intuition tells me that we should listen closely.

Doomed to Choose: Industrial Policy as Predicament
(with Ricardo Hausmann), September 2006.

…As in these 17th century books, the fundamental arguments are two: information and incentives. First, governments cannot substitute for the decentralized information processing that markets can achieve. Second, even if they could, it is not clear what incentives would make them use this capacity to advance the public interest. In short, governments don’t have the requisite information to pick winners but even if they did, they may not have the incentives to do so and if they tried, they would set off powerful rent-seeking behavior that will distort the achievement of the good intentions that motivated them in the first place. The proverbial road to hell is paved with well meaning industrial development plans.

…

But, as we have seen, this is a rather poor description of reality. …It is not an issue of state vs. market. If the government does not provide the inputs, market efficiency will be low. In this world, laissez-faire is a dead-end street. Instead, the ideal alternative is for the government to provide all the complementary inputs to all potential activities. There are two major problems with this solution. First, it is unaffordable. The government cannot address all potential infrastructure needs or fix all the standards and rules affecting all existing and potential economic activities. It would overwhelm its financial, managerial and political resources. It is just not in the feasible set. Second, the list of interventions is unknowable ex-ante. Institutions and markets co-evolve and this implies that transaction costs and problems will be revealed as new transactions appear and new markets develop. Solutions have to fit the specifics of the context. This may be the reason why there is such an enormous variability of institutional arrangements across industrial countries.

The fact that providing the complementary inputs is costly implies that choices need to be made. It is in this sense that, as Isaiah Berlin pointed out, “we are doomed to choose”. It is not that choosing is desirable. It is regrettably inevitable.

…

Industrial policy is hard, but that is no argument against its use. Fiscal policy, say, or education policy is hard too, but few people would argue that governments should just give up on them. Theory and evidence have convinced us that governments need well designed tax and expenditure programs and that they must invest in human resources. And so it is with industrial policy. Governments need well articulated strategies to provide the specific inputs that markets need in order to foster the structural transformation that drives economic development.

Industrial Development: Stylized Facts and Policies
Revised, November 2006

…Let me end with one word on industrial policy, since there is much opposition to (and confusion on) this kind of policy intervention. What I understand by “industrial policy” is not an effort by the government to select particular sectors and subsidize them through a range of instruments (directed credit, subsidies, tax incentives, and so on). The critics of industrial policy are correct when they argue that governments do not have adequate knowledge to pick “winners.” As discussed in Rodrik (2004), industrial policy is more appropriately conceived as a process whereby the state and the private sector jointly arrive at diagnoses about the sources of blockage in new economic activities and propose solutions to them. Industrial policy requires the government to take an ex-ante stand neither on the activities to be promoted nor on the instruments to be deployed. It simply requires it to build the public-private institutional arrangements whereby information on profitable activities and useful instruments of intervention can be elicited.

Elanor

(Emphases added)

PS: And this 'product forest' chart, from the first paper quoted above, might just be the first step that would revolutionise the way we think about economic development and industrial policy…