MEMORIA Y ESTUDIOS COMPLEMENTARIOS

The concept of industrial policy can be traced back to the infant industry argument, first proposed by a Founding Father and the first Secretary of the Treasury of the United States, Alexander Hamilton (1755-1804).²³ The core of his argument was that backward economies, which the US was in the late 18^th century, need to protect and nurture their industries in their infancy through various policy measures until they attain international competitiveness. In his Report on Manufactures submitted to the US congress in 1791, Hamilton stressed the importance of government ‘patronage’ to new productive ‘pursuits’ (specifically manufacturing industry), as this can’t be attained spontaneously.

23 Chang (2002, p.25) shows that were thinkers before Alexander Hamilton who had elements of the infant industry argument in their writings, but that Hamilton was the first to systematically set it out.

The spontaneous transition to new pursuits, in a community long habituated to different ones, may be expected to be attended with proportionally greater difficulty…To produce the desirable changes as early as may be expedient may therefore require the incitement and patronage of government…To this it is of importance that the confidence of cautious, sagacious capitalists should be excited. And to inspire this description of persons with confidence, it is essential that they should be made to see in any project which is new, the prospect of such a degree of countenance and support from governments, as may be capable of overcoming obstacles inseparable from first experiments (Hamilton, 1934[1791], p.204).

Hamilton also highlighted the difficulty of competing with more advanced industrial nations. Observing that manufacturing industry in these nations had governments that provided

‘bounties, premiums and other aids’ (government support) to their national firms in order to achieve a competitive edge, he explicitly advocated an emulation strategy.

But the greatest obstacle of all to the successful prosecution of a new branch of industry in a country in which it was before unknown, consists, as far as the instances apply, in the bounties, premiums, and other aids which are granted, in a variety of cases, by the nations in which the establishments to be imitated are previously introduced. It is well known (and particular examples, in the course of this report, will be cited) that certain nations grant bounties on the exportation of particular commodities, to enable their own workmen to undersell and supplant all competitors in the countries to which those commodities are sent. Hence the undertakers of a new manufacture have to contend, not only with the natural disadvantages of a new undertaking, but with the gratuities and remunerations which other governments bestow. To be enabled to contend with success, it is evident that the interference and aid of their own governments are indispensable (Hamilton, 1934[1791], p.205).

Whereas Hamilton didn’t properly theorise the infant industry argument, his ideas were developed by Friedrich List (1789-1846), who presented a theoretical framework in his National System of Political Economy (List, 2005 [1841]). List, like Hamilton, believed that infant industries could not be developed without a strong, supportive government. He argued that the government not only had the right, but also the duty, to promote economic activities that could increase the wealth and power of a nation, and that the promotion of such activities necessitated the protection of infant industries and jumping ahead of current comparative advantage.

The infant industry argument has met resistance. The Classical economist David Ricardo (1772-1823) outlined a theory in The Principles of Political Economy and Taxation, first published in 1817, in support of free trade and against protectionism. The theory of comparative advantage, as it is called, postulates that countries will benefit from free

international trade, with each country specialising in the production and export of goods with the least relative cost of production, i.e. its comparative advantage (Ricardo, 2004 [1817]).²⁴

2.5.2.1.1 Contemporary controversies

The debate between the supporters of free trade versus the supporters of the infant industry argument has held sway for centuries. In today’s discussions, plenty of guns are aimed at the proponents of industrial policy, although not always in a convincing manner. Wade (2015) quotes an interview with ex-World Bank economist William Easterly, during which he was pressed by the interviewer as to why the typical developing country had better economic performance in the 1960s and 1970s, when governments intervened more heavily than in any later period. Easterly responded, “It is a bit of a mystery why they did well…the growth had a lot of mystery for me…it is mysterious to those who advocate hands-off markets” (Wade, 2015, p.67).

But the theory of comparative advantage still seems to hold a convincing case for many.

It has become immensely popular, so much so that the WTO makes the case for its mandate—

which is lowering trade barriers worldwide—based on it:

Simply put, the principle of ‘comparative advantage’ says that countries prosper first by taking advantage of their assets in order to concentrate on what they can produce best, and then by trading these products for products that other countries produce best.

In other words, liberal trade policies—policies that allow the unrestricted flow of goods and services—sharpen competition, motivate innovation and breed success (WTO, 2016).²⁵

The debate is highly relevant in today’s African context, where one of the most pressing challenges policy makers face is whether to conform or defy comparative advantage when formulating their industrialisation strategies. After the rapid growth and industrialisation spurts of the Asian tigers in the post-WW2 era, a strong case has been made for industrial policy—

the basis for success in these countries was the guiding hand and interventionist policies of the state (see for example Amsden (1989), Chang (1994) and Wade (1990)).

24 David Ricardo did not aim to refute Alexander Hamilton (and he didn’t have the chance to refute List, as he wrote before him). Ricardo was more concerned about the benefits of free trade and international division of labour whereas Hamilton talked more about the importance of the development of national productive capabilities.

But clearly, they held opposing views: one argued for protectionism, the other against it.

25 The case for free trade also has a strong support base outside ‘policy circles’, some prominent examples being Bhagwati (2004), Irwin (2002), Lal (1983) and Wolf (2005).

But others have been drawing on the same East Asian experiences to make a case for export-oriented, market-friendly policies with low price distortions and reliance on comparative advantage (see for example World Bank (1993) and Lin (2010)). However, neither World Bank (1993) nor Lin (2010) neglects the importance of government intervention.For example, with reference to the East Asian countries, World Bank (1993, p.6) writes:

In each of these economies the government also intervened to foster development, often systematically and through multiple channels. Policy interventions took many forms:

targeted and subsidized credit to selected industries, low deposit rates and ceilings on borrowing rates to increase profits and retained earnings, protection of domestic import substitutes, subsidies to declining industries, the establishment and financial support of government banks, public investment in applied research, firm – and industry specific export targets, development of export marketing institutions, and wide sharing of information between public and private sectors.

It is clear that the debate is not a black-and-white one. The differences of the sides in the debate as it is currently carried out come out well in Lin and Chang (2009), an article entitled Should Industrial Policy in Developing Countries Conform to Comparative Advantage or Defy it? A Debate Between Justin Lin and Ha-Joon Chang. Both Lin and Chang agree on the end goal—which is the development of productive capabilities, primarily through industrialisation —and that the state should play a role in this process. Yet, there are clear differences in opinion.

Lin argues for a facilitating state that helps the private sector exploit comparative advantage. He claims that successful development experiences show that industrialisation is a process of climbing the ladder, not jumping the rungs. According to Lin, technological upgrading happens in line with nations’ current factor endowments. So, for example, if a country were well endowed with labour and short on capital, that country would be wise to specialise in labour-intensive activities. He goes on to argue that when surplus earned from a country’s current endowment structure is reinvested, this allows both human and physical capital to be accumulated, transforming both the endowment and industrial structure towards more capital-intensive intensive activities. Lin’s notion does not build directly on Ricardo’s version of comparative advantage, but more on the Neoclassical version—the Hekscher-Ohlin-Samuelson (HOS) model. The difference between the two is that, while Ricardo’s version assumes that nations’ sources of comparative advantage lies in differences in technology, the HOS model defines comparative advantage based on factor endowments—land, labour and capital. All countries are assumed to have the same level of technology in the HOS model.

Chang argues that there is no guarantee that a country with the ‘correct’ ratio of certain factor endowments for an industry will enter that industry, or put in different terms, move physical and human capital accumulated from one activity to another. “Blast furnaces from a bankrupt steel mill cannot be remoulded into a machine making computers. Steel workers do not have the right skills for the computer industry” (Chang’s words in Lin and Chang, 2009, p.489). There is nothing natural about entering any sort of industry, whether it is capital-intensive or labour-capital-intensive. Because the HOS model assumes away international differences in technological capabilities, it fails to take this into account. Even in manufacturing industries where they are supposed to have comparative advantages, like the apparel industry or the footwear industry, African countries have failed to establish themselves internationally because they lack the necessary technological capabilities to produce and export their products at a sufficient scale and of good enough quality. The main challenge is for developing countries to change their productive capabilities, which is why industrial policy is so important.

However, there is no denying that developing countries can more easily break into industries that have lower technological barriers. Chang argues, in line with Lin, that deviating too much from one’s current comparative advantage, whether you use the Classical version (differences in technology) or the Neoclassical version (differences in factor endowments) can have risks. That is why most countries that have successfully industrialised have put investments into industries that conform more closely to their comparative advantages at early stages of development, to quickly provide jobs and export earnings.

But what Lin fails to recognise is that many of these countries at the same time worked to defy their comparative advantage. Chang points out that Japan had to protect its automobile industry with tariffs for nearly four decades before it became internationally competitive, Nokia (the Finnish cell phone company) had to be cross-subsidised by its sister company for 17 years before it made any profit, and South Korea launched programmes to advance its shipbuilding and automotive sectors when it was still a poor country (Lin and Chang, 2009).

2.5.2.1.2 Common tools to nurture infant industries: tariffs and (direct and indirect) subsidies The main tenet of the infant industry argument is rather simple: in order to advance towards the global technological frontier in one or several industries, backward economies cannot simply rely on the market mechanism. Government support and interventions, often against market signals (i.e. industrial policy) is necessary. The list of various instruments that can be deployed to this end is possibly endless, but two commonly used tools are tariffs and subsidies.

A tariff is a tax on imports or exports (although export tax is a more commonly used term for a tariff on exports) and is perhaps the one tool most closely associated with the infant industry argument. The rationale behind an import tariff is to protect industries in their infancies against international competition, so that they have the domestic market to serve to begin with. It is the most explicit protectionist tool, and is highly controversial in international trade debates, as it works against the exports of other countries.

Protectionist policies, like tariffs, are closely associated with import-substituting-industrialisation (ISI) strategies, most prominently deployed in Latin American countries between the 1950s and 1980s. But the really ardent users of tariffs have been the rich countries of today, in particular Austria, France, Germany, Italy, Spain and the US, when trying to catch up with the industrial powerhouse of the 19^th century, Great Britain. The US in particular, which the economic historian Paul Bairoch called “the mother country and bastion of modern protectionism” (Bairoch, 1993, p.30), applied high tariffs. Between 1816 and the end of WW2, the country had the world’s highest average tariff rate on imported manufactures (Chang, 2002).

A subsidy is a form of financial support provided to an economic activity with the aim of promoting that activity. Whereas tariffs are explicit trade policy measures, this does not have to be the case for a subsidy (e.g. subsidies for infrastructure investments, R&D and/or for worker training programmes). The Asian tigers, whose industrialisation spurts are by some attributed to market friendly policies, as already mentioned, were heavy users of direct and indirect subsidies during the 1960s and 1970s (even more so if we include non-fiscal subsidies, such as targeted loans from state-owned or state-directed banks, which will be discussed later in this chapter). For example, many people forget that the government of Hong Kong, the poster boy of market-led growth in the post-WW2 period, owned and controlled all land, which they used to subsidise housing construction heavily: worker’s housing typically received a 50 per cent subsidy (Amsden, 2001). For another example, in Taiwan, export subsidies on manufactured goods were among the highest in the world in the late 1960s (Wade, 1990).

One could also make a case for the importance of tariffs among some of the Asian tigers. Yet, Latin American and African countries have also applied tariffs and subsidies without being as successful. This indicates that there is more to successful industrial policy than just these tools. Wade (2012) suggests that we stop using “misleading policy dichotomies like ‘import substitution’ vs ‘export orientation’” (Wade, 2012, p.266), on which the vices and virtues of tariffs and subsidies are often loaded. He argues that we have to get down to the nitty-gritty operations of the state.

What Wade means by this is that successful industrial policy is not only about specific tools (like tariffs and subsidies) per se, but about the intricate ways the state operates with its array of incentives designed to improve the production capacity of firms or industries. In East Asia, according to Wade, this was done in two ways: ‘leading the market’—when the government makes an investment decision that private firms are hesitant to make—and

‘following the market’—when the government supports some of the bets of private firms.

POSCO, the South Korean steel-making company that is currently one of the world’s largest, is a classic example of the ‘leading’ kind. In the early mid-1960s, no private firm in South Korea wanted to undertake investments in steel (according to the World Bank, steel was not aligned with the comparative advantage of South Korea at the time), so the government took on the initial risk.

A good example of the ‘following’ kind would be some of Taiwan’s industrial policy measures. Across various industries, the Taiwanese government designed a fiscal incentive scheme to encourage firms’ bets to make products close to the global technological frontier.

The government made a list of product specifications that signified eligibility for fiscal support.

They constantly changed the specification of products, but at any given time, those firms who met the specifications were eligible for tax holidays and accelerated depreciation (Wade, 2012).

For Amsden (2001), Taiwan is a great example of effectively using reciprocal control mechanisms (RCM), whereby the government would give special favours and assistance to firms, often in the form of direct or indirect subsidies, in exchange for meeting certain performance targets—such as exporting, local content, or product specifications. In addition to Taiwan, Amsden argues that this device was key to many of the successful growth experiences in the post-WW2 era, such as Brazil, South Korea and China.

A common RCM would be to grant protection and the privilege of a certain industry to sell in the domestic market on the condition that the firms in that industry had to match imports with an equivalent value of exports (or to comply with some sort of trade balancing arrangement). The RCM has taken other forms as well. In Brazil, a condition for receiving soft loans from development banks was to employ non-familial professionals in positions of responsibility, such as chief financial officer and quality control engineer. In South Korea, the license to establish a general trading company depended on exports meeting criteria related to value, geographical diversity and product complexity. In Taiwan, cherry-picked firms would be granted facilities in science parks on the condition of spending a certain percentage of their sales on R&D and employ advanced production techniques. In China, science and technology enterprises were granted special legal status in exchange for performance standards with

respect to technically trained employment and the development of new and more advanced products (Amsden, 2001).