Watch out, industrial strategy could leave us with a herd of white elephants

Invoking the success of the US moon mission in the 1960s, the new evangelists of industrial policy, with even grander ambitions in mind, have rebranded it as ‘industrial strategy.’ To its credit, as a way to manage government in the areas where government works best, industrial strategy brings sensible ideas to bear.

Starting with a pressing challenge such as halving a country’s emissions by 2035, the task is broken down into specific ‘missions’ with broad but measurable goals, and the country’s relevant players are brought on board.

Also read: Industrial policy is back with a vengeance everywhere

Less compelling is the vision of a large new bureaucracy, with a central board advised by experts (academics always find a place for themselves) coordinating all missions (each with its own board).

By putting so much trust in top-down coordination across ministries, the private sector, unions and civil society, the evangelists sometimes seem naively optimistic about bureaucratic capacity or the absence of turf battles. And in articulating their neo-statist dream, they are giving a licence to all governments’ innate instinct to intervene and expand.

Nevertheless, as long as this new industrial strategy is offering ideas for better public governance, it is useful on balance. But it becomes positively dangerous when it advocates intervening in the private sector. With support provided by subsidies, loans, tax breaks, tariffs, government procurement and so forth, select market participants will be enlisted to pursue not just economic but also social and environmental outcomes.

Like the industrial policy of old, this approach undermines competition, disrupts price signals and insists that corporate performance be judged according to criteria other than profitability, including parochial national interests.

For these reasons, industrial strategy—even if launched with the best intentions—always saps the vitality of private economic efforts. Add all the lobbying, cronyism and corruption that surrounds any government initiative where billions of dollars are on offer, and it is hard to believe that this approach could ever be the ideal solution to the world’s biggest challenges.

Since industrial policy (sorry, industrial strategy) is implemented by a government, it reflects perceived national interests, not global or individual needs. To see why this is a problem, just look at chip manufacturing. Every country of reasonable economic size now wants a domestic fabrication plant to protect against global shortages, and to sustain military production in case of war.

But the self-insurance benefits are invariably overstated. Since no country can make all the chips its industry needs, a domestic manufacturer does not assure protection from all shortages. Moreover, if a shortage is global, there must be some global reason for it, such as a pandemic. Why would the domestic chip manufacturer be immune?

When there is free trade in chips—driven by market prices and the profit motive—supply will be allocated where there is the greatest need. But if governments control output because they have subsidized domestic chip manufacturers, everyone can end up worse off. I write ‘can’ because the profit motive is hard to suppress entirely.

Each country can direct the use of the chips it makes only if there is no smuggling. But if there are multiple user countries with severe shortages (and therefore high prices), what is to prevent chips from being smuggled out of countries that have plenty to those that don’t? We get near-market outcomes but with higher costs.

The national-security rationale suffers the same problem. Even though Russia is heavily sanctioned by much of the chip-producing world, it has been able to conduct a full-scale war with modern armaments containing many chips—and without a significant chip-maker of its own.

Also read: The return of industrial policy is welcome but it needs far more

In any case, having a chip fab in one’s country does not assure resilience, since the chip supply chain runs through other countries. For example, the machines that make the most advanced chips are produced by ASML in the Netherlands, which can shut them down remotely with ‘kill’ switches.

If designs, wafers, machines and key chemicals all need to be produced within the same country to achieve true security, only a vast continental economy like the US—and maybe China and the EU—can obtain significant manufacturing independence, and only at tremendous cost.

Part of the cost is the subsidy needed to move uncompetitive domestic manufacturers closer to the technological frontier. Through its CHIPS and Science Act, the US is pouring enormous subsidies into Intel, which gave up global leadership in chip fabrication a while back.

As part of an industrial strategy, this money has strings attached, including restrictions on the use of foreign talent and procurement, and requirements to promote various social and ethical goals—such as creating skilled technical jobs that do not require a graduate degree.

With so many additional burdens imposed on an already-flailing manufacturer, and a fundamental shortage in the US of the kind of personnel that sophisticated chip plants need, it is no wonder that Intel and even industry leader TSMC’s new plants in the US have fallen far behind schedule.

Nor are these one-time costs. When every large country is willing to subsidize an industry, it will become dependent on state support. Investments will be driven not by profits and competition, but by subsidies, national-security policies and bureaucrats, leading to periodic gluts and losses.

Innovation also may suffer, despite research subsidies, because subsidized laggards will drive down profits industry-wide, leaving leaders with smaller surpluses to invest in R&D.

It would make sense for mid-size economies to sit this frenzy out. But industrial strategy, especially when it has the imprimatur of leading economies, is all too tempting for political leaders who want to get credit for creating shiny new industries.

Thus, after promising $10 billion in chip subsidies and securing only the promise of a few jobs and facilities producing older-generation chips, India is doubling down with another $15 billion in subsidies it can ill afford. Would this money not be better spent opening tens of thousands of high-quality primary schools, thousands of high-quality high schools and hundreds of top-notch universities?

With China’s industrial strategy prompting reciprocal moves by developed democracies, the same trends have swept up electric vehicles, solar cells and batteries.

Instead of allowing competitive markets to drive green-tech innovation and cheap production for the global good, we are balkanizing and weakening these critical sectors with tariffs, subsidies and government-supported zombies. We will have won the battle for domestic production while losing ground in the war against climate change.

Also read: Adopt clear evaluation criteria for industrial policies

We need a global dialogue on the proper place for industrial strategy in a country’s policy, or else we can expect many more ruinously expensive pale pachyderms. ©2024/Project Syndicate

The author is professor of finance at the University of Chicago Booth School of Business, a former governor of the Reserve Bank of India and co-author (with Rohit Lamba) of ‘Breaking the Mold: India’s Untraveled Path to Prosperity’.