How to tell good industrial policy from bad

Gillian Tett in The FT

 
Five years ago Reda Cherif and Fuad Hasanov, two economists at the IMF, wrote a paper with the (slightly) sarcastic title: “The Return of the Policy That Shall Not Be Named: Principles of Industrial Policy”. 

This pointed out that while strategic policy intervention was widely viewed as a key reason for the east Asian economic miracle, it had a “bad reputation among policymakers and academics” — so much so that, from the 1970s onwards, the phrase was rarely mentioned in polite company, or by the IMF. 

No longer. Last month the fund reported that it had observed no less than 2,500 industrial policy actions around the world in the last year alone, of which “more than two-thirds were trade-distorting as they likely discriminated against foreign commercial interests”. 

More striking still, industrial policies used to be far “more prevalent in emerging economies” than developed ones; between 2009 and 2022, there were cumulatively 7,000 subsidies tracked in developing countries, and fewer than 6,000 in developed ones. But last year’s surge was “driven by large economies, with China, the EU and the US accounting for almost half of all new [industrial policy] measures”. 

That shift can be seen not just in data, but rhetoric too. Last month, Mario Draghi, former head of the European Central Bank, lamented that Europe “lack[s] a strategy for how to shield our traditional industries from an unlevel global playing field caused by asymmetries in regulations, subsidies and trade policies”. He called for the EU to fight back with industrial policy. 

In the UK, the opposition Labour party is echoing these themes, calling for a “New Deal” and touting what it calls “securonomics”. In the US, Donald Trump wants huge trade tariffs, while Joe Biden has called for tariffs in sectors such as steel. The president’s Inflation Reduction Act is yet more industrial policy. 

But anyone pondering that striking number in the IMF report should remember a crucial point that ought to be obvious but is often overlooked: “industrial policy” can mean many different things. As Cherif and Hasanov told a seminar at Cambridge’s Bennett Institute this week, there is an important difference between policies that try to create growth by shielding domestic companies from foreign competition and those which help those companies compete more effectively on the world stage.  

The former “import substitution” strategy was pursued by many developing countries in recent years, including India. It is also the variant favoured by Trump and the one being considered by some European politicians, for instance in the case of Chinese solar panels. 

But it is this latter approach that has given industrial policy a bad name. On the basis of copious data, Cherif and Hasanov argue that import substitution models undermine growth in the long term since they create excessively coddled, inefficient industries. 

By contrast, the second variant of industrial policy aims instead to make industries more competitive externally in an export-oriented model, while worrying less about imports. This approach is what drove the east Asian miracle, and is what creates sustained growth, the data suggests. 

The difference in approach is embodied by the contrasting fortunes of Malaysian automaker Proton car and South Korea’s Hyundai. The former was developed amid import substitution policies, and never soared; the latter flourished on the back of an export-oriented strategy.  

A cynic might retort that policy is rarely so clear cut as these contrasting car tales might suggest. It is hard for any company to fly on the world stage if its key competitors are excessively subsidised in closed markets — as evidenced by the woes of EU solar-panel makers trying to compete with their Chinese rivals. It is also tough to tell countries to aim for export-driven growth in a world where trade is fragmenting and protectionism rising. 

In any case, while export-oriented strategies work for small or medium-sized countries such as South Korea, they may seem less relevant for a giant such as America. 

Then there is a more fundamental question around economic change. As a thoughtful paper published last year by the economists Réka Juhász, Nathan Lane and Dani Rodrik notes, while “industrial policy has traditionally focused on manufacturing”, it is the service sector that now dominates. Thus “governments are likely to look beyond manufacturing as they consider productivity-enhancing ‘industrial’ policies in the future”. 

Cherif and Hasanov think institutions such as America’s Darpa give one clue to innovation-boosting measures in this space; Juhász, Lane and Rodrik cite worker training and export credit. But this needs holistic policy, which America, say, lacks. 

Either way, the key point is that insofar as western politicians are now increasingly happy to utter the once forbidden words “industrial policy”, they need to define what they mean. Is the goal to exclude competitors from the domestic stage, via tariffs? Or to make domestic producers more competitive and innovative in a global sense and better able to compete? Or is it something else? Investors and markets need clear answers. So, more importantly, do voters.

The Milk Sector in India Explained

 

A Level Economics 96: International Trade

Theory of Comparative Advantage:

The theory of comparative advantage, proposed by economist David Ricardo, explains how countries can benefit from specializing in the production of goods or services in which they have a lower opportunity cost compared to other countries. The principle suggests that even if one country can produce all goods more efficiently than another country (absolute advantage), both countries can still benefit from trading with each other based on their comparative advantage.

Example of Comparative Advantage:

Let's consider two countries, Country A and Country B, and two goods, Cars and Computers. The table below shows the number of hours each country requires to produce one unit of each good:

Country	Cars (Hours per unit)	Computers (Hours per unit)
A	10	5
B	8	2

In this example, Country A is more efficient in producing both cars and computers because it requires fewer hours for each unit. However, to determine comparative advantage, we need to compare the opportunity costs between the two goods within each country.

Opportunity Cost: The opportunity cost represents the value of the next best alternative that is given up when choosing one option over another.

• Opportunity Cost of Producing Cars (Country A): For Country A, the opportunity cost of producing one car is 10 hours (the time required to produce one car) divided by 5 (the time required to produce one computer) equals 2 computers.

• Opportunity Cost of Producing Computers (Country A): For Country A, the opportunity cost of producing one computer is 5 hours (the time required to produce one computer) divided by 10 (the time required to produce one car) equals 0.5 cars.

• Opportunity Cost of Producing Cars (Country B): For Country B, the opportunity cost of producing one car is 8 hours (the time required to produce one car) divided by 2 (the time required to produce one computer) equals 4 computers.

• Opportunity Cost of Producing Computers (Country B): For Country B, the opportunity cost of producing one computer is 2 hours (the time required to produce one computer) divided by 8 (the time required to produce one car) equals 0.25 cars.

Comparative Advantage Determination:

• Country A has a comparative advantage in producing computers because it has a lower opportunity cost (0.5 cars) compared to Country B (0.25 cars).

• Country B has a comparative advantage in producing cars because it has a lower opportunity cost (4 computers) compared to Country A (2 computers).

Benefits of Trade based on Comparative Advantage:

• Country A can specialize in producing computers and export them to Country B while importing cars from Country B. Both countries benefit from the trade as they obtain goods at a lower opportunity cost than if they produced them domestically.

• By specializing in their respective comparative advantages, both countries can increase overall production and enjoy a higher standard of living through trade.

Theory of Absolute Advantage:

The theory of absolute advantage, also introduced by David Ricardo, suggests that a country should specialize in producing goods or services in which it can produce more efficiently (using fewer resources) than other countries.

Example of Absolute Advantage:

Continuing with the example of Cars and Computers for Country A and Country B:

• Country A has an absolute advantage in both cars and computers because it requires fewer hours to produce one unit of each good compared to Country B.

• Country B does not have an absolute advantage in either cars or computers because it requires more hours to produce one unit of each good compared to Country A.

Comparing Comparative Advantage and Absolute Advantage:

The key difference between comparative advantage and absolute advantage lies in the concept of opportunity cost. While comparative advantage considers the opportunity cost of producing one good in terms of the forgone production of another good, absolute advantage focuses solely on the efficiency of production without considering opportunity costs.

Conclusion:

Both comparative advantage and absolute advantage play crucial roles in shaping international trade patterns. Comparative advantage enables countries to specialize in the production of goods in which they have a lower opportunity cost, fostering mutually beneficial trade relationships. Absolute advantage highlights a country's superior efficiency in producing specific goods, emphasizing its ability to compete in global markets. Together, these theories explain the underlying rationale for international trade and its potential benefits for countries involved.

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Advantages of International Trade:

1. Increased Efficiency: International trade allows countries to specialize in producing goods and services in which they have a comparative advantage. This specialization leads to higher productivity and efficiency, as resources are allocated to areas where they are most productive.

2. Economic Growth: Trade enables countries to access larger markets, promoting economic growth. Increased export opportunities can stimulate domestic industries, leading to higher output and job creation.

3. Diversification of Resources: International trade allows countries to access resources and raw materials that may be scarce or unavailable domestically. This diversification reduces dependency on a limited set of resources and enhances economic resilience.

4. Consumer Benefits: Consumers benefit from access to a wider variety of goods and services at competitive prices. Imports often provide consumers with more choices and better quality products.

5. Technology Transfer: Trade facilitates the exchange of knowledge and technology between countries. Developing countries can gain access to advanced technologies through trade, accelerating their economic development.

6. Foreign Investment: International trade attracts foreign investment as companies seek to tap into new markets. Foreign direct investment (FDI) can lead to technology transfers, job creation, and infrastructure development.

Disadvantages of International Trade:

1. Trade Deficits: If a country imports more than it exports, it may lead to trade deficits, which can put pressure on domestic industries and lead to job losses.

2. Dependency on Foreign Suppliers: Relying heavily on imports for critical goods can create vulnerabilities, especially during times of geopolitical tensions or supply disruptions.

3. Job Displacement: Some domestic industries may struggle to compete with cheaper imports, leading to job displacement and unemployment in those sectors.

4. Environmental Concerns: Increased international trade can lead to higher carbon emissions and environmental degradation due to longer transportation routes and increased production.

5. Income Inequality: The benefits of trade may not be equally distributed among all segments of society. Certain industries and regions may benefit more than others, contributing to income inequality.

Advantages and Disadvantages for Developed and Developing Countries:

Developed Countries:

• Advantages: Developed countries typically have advanced technologies, expertise, and established industries. They can export high-value-added goods and services, leading to increased export earnings and economic growth.

• Disadvantages: Developed countries may face challenges in protecting domestic industries from competition and dealing with job displacement. Additionally, they may encounter pressure to reduce trade barriers from developing countries seeking access to their markets.

Developing Countries:

• Advantages: Developing countries can benefit from international trade by exporting their abundant natural resources and low-cost labor. Trade can provide opportunities for economic diversification and technology transfer.

• Disadvantages: Developing countries may face competition from more established industries in developed countries, hindering the growth of their domestic industries. They might also become vulnerable to price fluctuations in global commodity markets.

Conclusion:

International trade offers various advantages, such as increased efficiency, economic growth, and consumer benefits. However, it can also bring challenges like trade deficits, job displacement, and environmental concerns. The impact of international trade varies for developed and developing countries, with each facing unique advantages and disadvantages based on their economic structure and competitive strengths. Governments need to strike a balance between promoting the benefits of trade and addressing its challenges to ensure sustainable and inclusive economic growth for their countries.

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Protectionist Policies:

Definition: Protectionist policies are government measures implemented to shield domestic industries and businesses from foreign competition. These policies are designed to promote the interests of domestic producers and can take various forms, such as tariffs, quotas, subsidies, and other trade barriers.

Arguments For Protectionist Policies:

1. Protect Domestic Industries: One of the primary reasons for implementing protectionist policies is to protect domestic industries from foreign competition. By imposing tariffs or quotas on imports, the government can make foreign goods more expensive, making it more attractive for consumers to buy domestically-produced goods. This protects domestic industries from being undercut by cheaper imports and prevents potential job losses in those industries.

2. Infant Industry Argument: The infant industry argument is based on the idea that some industries need protection in their early stages of development until they become competitive in the global market. By protecting these infant industries from foreign competition, governments can give them a chance to grow and become self-sustaining. Once these industries have achieved economies of scale and become globally competitive, the protectionist measures can be removed.

3. National Security: Protectionism can be justified on national security grounds, especially for industries that are critical for a country's defense or technological advancement. By protecting these industries from foreign competition, the government ensures that the country is self-sufficient in strategic sectors and not dependent on other nations for essential goods and services.

4. Reducing Trade Deficits: Trade deficits occur when a country imports more than it exports, leading to an imbalance in international trade. Protectionist measures, such as tariffs and quotas, can be used to reduce imports and promote domestic production, thus reducing the trade deficit and improving the country's balance of payments.

5. Retaliation: Sometimes, countries use protectionist measures as a bargaining tool in international trade negotiations. By imposing tariffs or other trade barriers on imports from specific countries, a government can encourage those countries to open their markets to the first country's exports in return. This tactic is often used in trade disputes to gain concessions from trading partners.

Arguments Against Protectionist Policies:

1. Higher Consumer Prices: One of the main disadvantages of protectionism is that it leads to higher prices for imported goods. When tariffs or quotas are imposed on foreign products, their prices increase, and consumers may have to pay more for those goods. This reduces consumer choices and can result in a decrease in overall purchasing power for households.

2. Reduced Global Trade: Protectionist measures restrict international trade and limit access to global markets for domestic businesses. This can hinder economic growth and development, as countries miss out on the benefits of international specialization and trade.

3. Inefficient Resource Allocation: Protectionism can lead to the misallocation of resources. When industries are protected from foreign competition, they may lack incentives to improve efficiency and productivity. As a result, resources may be used less efficiently, leading to lower overall economic performance.

4. Trade Retaliation: When one country implements protectionist measures, other countries may respond with their own trade restrictions in retaliation. This can lead to a trade war, where countries impose tariffs and quotas on each other's goods, causing harm to global trade and economic growth.

5. Loss of Comparative Advantage: Protectionism may prevent countries from benefiting from their comparative advantage. Comparative advantage refers to the ability of a country to produce goods or services at a lower opportunity cost than other countries. By restricting trade, countries may miss out on the gains from specialization and trade based on their comparative advantage.

Methods of Protectionism:

1. Tariffs: Tariffs are taxes imposed on imported goods at the border. When foreign products enter the domestic market, the government charges a tax based on the value of the goods. This increases the price of imported goods and makes them less competitive compared to domestically-produced goods.

2. Quotas: Quotas limit the quantity of specific products that can be imported into a country. The government sets a maximum limit on the quantity of a particular product that can enter the country during a specific period. This restricts the supply of the product in the domestic market, giving an advantage to domestic producers.

3. Subsidies: Subsidies are financial support provided by the government to domestic industries. These subsidies lower the production costs for domestic producers, making their goods more competitive in both domestic and international markets.

4. Exchange Rate Manipulation: Countries may manipulate their exchange rates to make their exports cheaper and imports more expensive. A weaker domestic currency makes exports more attractive to foreign buyers, while making imports costlier for domestic consumers.

5. Administrative/Regulatory Policies: Administrative or regulatory policies involve imposing various regulations and bureaucratic procedures to create barriers to trade. These can include licensing requirements, product standards, and safety regulations that make it difficult for foreign products to enter the domestic market.

Examples of Protectionist Policies:

• In 2018, the United States implemented protectionist measures, including tariffs on Chinese goods, to address its trade deficit with China and protect domestic industries.

• India has imposed import quotas on certain agricultural products like sugar and rice to protect its domestic farmers and maintain food security.

• Many countries provide subsidies to their domestic industries, such as the aerospace or renewable energy sectors, to support their growth and competitiveness in the global market.

• Exchange rate manipulation has been used by some countries to boost their export competitiveness. For example, China has been accused of keeping its currency undervalued to support its exports.

• The European Union has strict regulations on the import of genetically modified organisms (GMOs) to protect its agricultural sector and maintain consumer confidence.

Conclusion:

Protectionist policies have been a subject of debate for decades, with proponents and critics arguing about their effectiveness and implications. While some countries have implemented protectionist measures to safeguard domestic industries, others emphasize the benefits of free trade and globalization. Policymakers need to carefully consider the economic consequences and potential risks of implementing protectionist policies, taking into account the overall welfare of the economy, businesses, households, and global trade relationships. Evaluating the success of protectionist policies requires a comprehensive analysis of their impact on macroeconomic indicators, including economic growth, employment, inflation, and trade balances. Ultimately, finding the right balance between protecting domestic industries and promoting global economic cooperation remains a complex challenge for policymakers around the world.

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The debate over whether developing countries should adopt unrestricted free trade policies or protectionist policies for development is a complex and contentious issue. Both approaches have their advantages and disadvantages, and the effectiveness of each strategy depends on various factors specific to the country's economic, political, and social context. Below, we evaluate both approaches using examples:

Unrestricted Free Trade Policies:

Advantages:

1. Access to Global Markets: By embracing free trade, developing countries can gain access to larger and more diverse global markets. This can provide opportunities for their industries to export goods and services, leading to potential economic growth and job creation.

2. Efficiency and Specialization: Free trade encourages countries to focus on producing goods and services in which they have a comparative advantage. Specialization allows countries to be more efficient and productive, leading to increased economic output.

3. Foreign Direct Investment (FDI): Free trade policies can attract foreign direct investment, which can bring in capital, technology, and expertise, contributing to the development of local industries and infrastructure.

Examples:

• China's economic transformation and rapid growth over the past few decades have been attributed, in part, to its embrace of free trade policies and integration into the global economy. China has become one of the world's major trading nations and a significant destination for foreign direct investment.

• South Korea is another example of a developing country that experienced significant economic development through free trade policies. By promoting export-oriented industries and engaging in global trade, South Korea has achieved impressive growth rates and improved living standards.

Disadvantages:

1. Dependency on External Factors: Developing countries that rely heavily on unrestricted free trade can become vulnerable to fluctuations in global markets. External shocks, such as changes in commodity prices or economic downturns in major trading partners, can adversely impact their economies.

2. Unequal Bargaining Power: Developing countries may face challenges negotiating fair trade agreements with more developed and economically powerful countries. Unequal bargaining power can lead to unfavorable trade terms that disproportionately benefit developed countries.

3. Displacement of Local Industries: In some cases, unrestricted free trade can lead to the displacement of domestic industries unable to compete with cheaper imports, resulting in job losses and economic instability.

Protectionist Policies:

Advantages:

1. Domestic Industry Protection: Protectionist policies can shield domestic industries from unfair competition and give them time to develop and become more competitive. This approach is particularly relevant for infant industries that need support to establish themselves.

2. Revenue Generation: Some protectionist measures, such as tariffs and import quotas, can generate revenue for the government, which can be used to fund development projects and public services.

3. Economic Stability: Protectionist policies can provide a level of stability to developing countries, as they are less susceptible to external market fluctuations.

Examples:

• India has implemented various protectionist measures, including tariffs and quotas, to protect its domestic industries, particularly in the agricultural and manufacturing sectors.

• Brazil has used protectionist policies to support its automotive industry and encourage local production of vehicles.

Disadvantages:

1. Inefficiency and Rent-Seeking: Protectionist policies can lead to inefficiencies in domestic industries, as they may not face the same level of competition and incentive to improve productivity. Additionally, protectionism can foster rent-seeking behavior, where companies seek favors and protection from the government rather than focusing on innovation and efficiency.

2. Higher Consumer Prices: Protectionist measures can result in higher prices for imported goods, reducing consumer choice and purchasing power.

3. Trade Retaliation: Implementing protectionist policies can trigger trade disputes and retaliatory measures from other countries, potentially harming overall global trade relationships.

Conclusion:

There is no one-size-fits-all approach when it comes to trade policies for developing countries. The choice between unrestricted free trade and protectionist policies should be based on a careful assessment of the country's specific circumstances and objectives.

While unrestricted free trade can offer opportunities for growth and access to global markets, it also poses risks of economic vulnerability to external shocks and unequal bargaining power. On the other hand, protectionist policies can offer support to domestic industries and provide a degree of economic stability but may lead to inefficiencies and trade disputes.

The key to successful economic development lies in finding a balanced and sustainable approach. Developing countries can benefit from selectively adopting elements of both free trade and protectionism. For instance, focusing on export-oriented sectors while protecting essential domestic industries during their early stages of development. Moreover, enhancing competitiveness through domestic reforms, investment in education and infrastructure, and addressing structural issues can complement trade policies and foster sustainable development.

Ultimately, a well-designed and strategic trade policy, taking into account the country's specific needs and objectives, can be instrumental in promoting economic growth and development for a developing nation.

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The economic policies of various countries, including the USA and the UK, have evolved over time, and different approaches to trade and protectionism have been employed during different periods of their development. Let's take a closer look at the historical context of trade policies in these countries:

United States:

• In the early years of its development, the United States implemented protectionist policies to shield its infant industries from foreign competition. Tariffs were imposed on imported goods to protect domestic production and promote economic self-sufficiency.
• During the 19th and early 20th centuries, the U.S. followed a policy of protectionism, which was in line with the prevailing economic thinking of the time, known as the "infant industry argument." This approach was aimed at nurturing domestic industries until they could become competitive on the global stage.
• However, as the U.S. economy grew and its industries matured, it gradually shifted towards a more open trade policy, especially after World War II. The establishment of the General Agreement on Tariffs and Trade (GATT) and the subsequent World Trade Organization (WTO) helped foster greater international trade cooperation, leading to a more liberal trade regime.

United Kingdom:

• The United Kingdom also adopted protectionist policies during its early industrialization phase to shield its industries from foreign competition and support domestic manufacturing.
• In the 19th century, the UK was a major advocate of free trade with the adoption of policies such as the repeal of the Corn Laws in 1846. This move aimed to lower tariffs on grain imports and promote free trade, leading to lower food prices and increased access to raw materials for British industries.
• While the UK has historically been a strong supporter of free trade, it has also employed protectionist measures in certain circumstances, particularly during periods of economic uncertainty or strategic considerations.

It is essential to recognize that economic policies are influenced by various factors, including the prevailing economic conditions, geopolitical considerations, and the ideologies of the ruling governments. Over time, the economic priorities and circumstances of a country may change, leading to shifts in trade policies.

Today, both the USA and the UK generally support free trade and are active participants in the global trading system. They have been strong advocates of multilateral trade agreements and have generally embraced open markets. However, it is also true that trade policies can be subject to political debates and may experience changes based on shifting economic or political dynamics.

In conclusion, the USA, the UK, and many other countries have experienced shifts in their trade policies over time, reflecting the changing economic and political landscapes. While protectionist policies were historically employed during their early stages of development, they eventually moved towards supporting free trade as their economies matured and global economic integration increased. However, trade policies can remain a subject of ongoing discussions and debates, and countries may adjust their stances based on current economic conditions and policy objectives.