Industrial Policy: A Brief Comment

Most recently, I have debated the blogger Cynicus Economicus on Keynesianism and industrial policy in a very thoughtful debate from both sides here:

http://cynicuseconomicus.blogspot.com/2010/06/post-keynesian-solutions-reply-to.html#comment-form

I have argued, in response to comments that seem to doubt not just the success of industrial policy but its very existence, that Cynicus’ blog has repeatedly described China’s industrial policy. He refers to it as “mercantilism.”

I asked him whether he denied the existence – and effectiveness – of this mercantilist industrial policy. Although I may be incorrect, and he has not said so directly in any of his comments, he seems to suggest that industrial policy can never work or has never been successfully done anywhere. I then posed the question: doesn’t China’s success with its particular type of industrial policy show such policy exists and can work?

In response, Cynicus states:

So what we are coming to is a belief that mercantilism might work for the developed world? Do I understand this correctly?

The anwser is “no”. I was simply asking whether Cynicus was willing to concede what he so frequently seems to say in other posts: that China’s mercantilism is an obvious example of the success of one kind of industrial policy. There are many kinds, of course.

Having one obvious example of the success of a type of industrial policy in China, one wonders why in other comments Cynicus seems to suggest that he knows of no example of industrial policy and thinks that the idea is “vaguely defined” or has never been implemented anywhere in real countries.

Yet the literature on economic history is filled with works on industrial policy in real countries, for example, post-WWII France, South Korea, Taiwan and Japan.

As I have said in other posts on the Cynicus Economicus blog, in the 19th century there was an early type of industrial policy that was called “infant industry protectionism” (usually involving tariffs) in countries like Germany or the US.

Note that this policy was not simply the adoption of tariffs on all imports or an endorsement of endless protectionism through tariffs, but selected tariffs on imports of high value added manufactured goods when domestic manufacturing was in its early stages of development, particularly where the creation of these industries gave increasing returns to scale, rather than dead-end “diminishing returns to scale.” Once these sectors became internationally competitive, it was possible to reduce or eliminate tariffs. Note also that this policy is perfectly compatible with the fact the other types of tariffs or poorly targeted tariffs can be harmful to economic development.

It should be noted that many apologists for free trade cannot – or refuse to – even properly understand the “infant industry” argument. Instead they present a caricature of it. Henry Hazlitt’s criticisms of protectionism in his book Economics in One Lesson are a good example of this.

I give a very brief sample of some specialist work on 19th-century infant industry protectionism below:

(1) Mark Bils, “Tariff Protection and Production in the Early U.S. Cotton Textile Industry,” Journal of Economic History 44 (December 1984): 1033–1045.

Mark Bils concludes:

Cotton textiles constituted nearly two-thirds of value added in large-scale manufacturing in New England in the 1830s. The removal of the tariff, according to my results, would have reduced value added in textiles by, at a minimum, three-quarters. The implication is that about half of the industrial sector of New England would have been bankrupted.

(2) Paul Bairoch, Economics and World History: Myths and Paradoxes, University of Chicago Press, Chicago, 1993, ch. 4.

(3) Antonio Tena, “Tariff Structure and Institutions in the Late 19th Century. New Perspectives on the Tariff Growth Paradox,”
Paper presented to the Seventh Conference of the European Historical Economics Society Lund, 29 June - 1 July 2007
http://www.ekh.lu.se/ehes/paper/Antonio%20Tena%202%202%20(EHS%20Lund)%20(2).pdf

Tena concludes:

We assume that high tariffs only have a positive relation with growth if they protect those sectors which generate positive externalities in the economy in general. So, in the relation between trade policy and growth what is significant is not just average tariffs, but the structure of tariffs. The causal mechanism between tariffs and growth is better explained by the structure of tariffs.

(4) Ha-Joon Chang, Kicking Away the Ladder: Development Strategy in Historical Perspective, London, 2002.
Ha-Joon Chang, Bad Samaritans: Rich Nations, Poor Policies, and the Threat to the Developing World, London, 2007.

Ha-Joon Chang demonstrates that many Western nations industrialized through infant industry protectionism. It is a complete myth that industrial development occurred through free trade and free markets in many Western countries.

In the era after WWII, infant-industry protectionism was replaced with a new, more radical form of industrial policy called import-substitution industrialization (ISI), which was now given a theoretical basis in development economics.

The east Asian states of Japan, South Korea, and Taiwan used a radical type of ISI to become economic giants. Access to the US market, a fundamental element of these countries export-led economic growth, is also a feature of China’s new model of industrial policy.

The classic policies of ISI were:

(1) policies to subsidize and create industries producing manufactured goods
(2) protective barriers to trade (e.g. tariffs or non-tariff barriers)
(3) an overvalued currency assisting manufacturers to import capital goods (heavy machinery), at least initially in industrial development.

In South Korea, Taiwan and Japan, there were also these additional elements of ISI:

(4) Export led growth = outward-oriented ISI
(5) direction of subsidies and investment to industries producing goods for export
(6) some use of an undervalued local currency to stimulate exports.

One can note that China certainly practises (1), (4), (5), and (6). (2) is also achieved by the undervalued currency. China is an exception to (3).

The conclusion is clear: China uses a similar type of industrial policy to that pursued earlier in Japan, South Korea and Taiwan.

I hope to address the issue of industrial policy soon on this blog and in more detail.