The Corner


More Evidence That Industrial Policy Isn’t All It’s Cracked up to Be

Chinese President Xi Jinping attends an extended-format meeting of heads of the Shanghai Cooperation Organization member states at a summit in Samarkand, Uzbekistan, September 16, 2022. (Sputnik/Sergey Bobylev/Pool via Reuters)

The economic rise of China is often used to justify the U.S. embracing industrial policy. The theory is that China’s growth can be directly linked to its enormous public spending at all levels of government and that we Americans will lose ground if our government fails to respond in kind to China’s massive subsidies of Chinese industries. Proponents of industrial policy also like to point to what they see as success stories — such as South Korea.

This reasoning rests on a mountain of mistaken assumptions. The most fundamental of these errors is the assumption that a country’s sustained economic growth is promoted by subsidies. But government-dispensed subsidies by their nature direct resources from uses determined by market forces into uses determined by political forces. In practice, subsidies direct resources away from their most productive uses into less-productive uses. It’s therefore absurd for Washington to damage the American economy to match the damage that Beijing is inflicting on the Chinese economy.

Another error arises from the failure to ask, “Compared to what?” or “At what cost?” Of course subsidies result in expanded outputs from subsidized industries. But these extra outputs come at too high a cost in the form of outputs that are not produced because of subsidized industries getting resources from unsubsidized industries. Markets excel at supplying genuinely valuable and cost-justified outputs — government economic intervention excels only at causing some industries to wastefully produce too much and other industries to produce too little.

Yet another error comes from assuming that because a country throws a lots of money at an industry, and this industry happens to become globally competitive, the success should be credited to the subsidies. But the industry is often successful in spite of the government handouts, generally because it was already doing what it is now being subsidized to do.

It is easy to point to a successful company and say that because it received some subsidies, its success must be attributable to those subsidies. But it is much harder to measure how the original success of the subsidized industry can fade away when hindered by the many strings that come with government help, or how a company can be made more fragile because of the handouts.

Scott Lincicome has a great article illustrating all these points in the context of South Korea’s industrial policy. He writes:

When pressed to suggest a country that the United States should emulate, industrial policy fans often point to South Korea. It has a relatively large and advanced manufacturing sector (in terms of both output and employment), a persistent trade surplus, and a government that hasn’t been shy about thumbing the economic scale to support favored industries. Thus, so the theory goes, the Korean government has been successful in using industrial policy not only to generate more “good jobs” and “strategic industries” than the United States, but also to be less “dependent” on foreigners for essential goods in times of crisis (war, pandemic, etc.).

Indeed, South Korea has done very well. Its government has spent lots of money on R&D and other subsidies, enjoyed trade surpluses, and has a large manufacturing sector — electronics and semiconductors in particular.

That was then, however, and there is now. If the global demand for South Korea’s industrial output was high, the country’s intense focus on these “strategic industries” may have been a good idea. Bad times and a shift in demand brings a new perspective. Lincicome quotes economist Joey Politano explaining the following:

The kind of large, high-tech manufacturing goods that the nation excels at exporting — cars, computers, semiconductors, cargo ships, consumer electronics, and the like — have seen demand wane from their COVID-era highs amidst a global economic slowdown and the rebalancing of consumer demand toward service consumption. Meanwhile, prices for the food and energy that the nation must import have surged to new highs — all the while China, its largest trading partner, deals with the aftershocks of COVID, and Korean property prices continue falling amidst higher interest rates. Finance Minister Choo Kyung-ho warned the country will face “a complex crisis for a considerable period” as he pledged support for the nation’s struggling industries. Meanwhile, GDP contracted by 0.4% in the last quarter of 2022.

Exports, industrial output, and GDP in South Korea are also declining fast. As Lincicome notes:

Not all of these troubles can be laid at the feet of Korean industrial policy, but to the extent it actually was “successful” in shaping Korea’s economy and boosting certain companies above others — it now deserves some of the blame for today’s problems. As Politano notes, Korea’s economic contraction and future troubles are owed to the fact that it is “overexposed to the manufacturing and fixed investment slowdowns that are now hitting most high-income nations.”

But it’s not just South Korea that is seeing its so-called dominance from subsidies fade. Because of its strong exports and manufacturing, Germany — another country praised by those advocating for industrial policy — is facing some headwinds, too. Lincicome writes:

As the Wall Street Journal reported a couple years ago, moreover, Germany’s economic struggles weren’t just a COVID-19 problem, either (emphasis mine): “German industrial output and exports began stagnating in 2017, posing a problem for an economy where some 30% of jobs and output are tied to overseas demand, roughly four times the share in the U.S.

The alternative to overexposure looks something like the U.S.:

consider the more diversified—and, up until very recently, less industrial policy-inclined—United States. We might have looked like an economic laggard last decade but sure look better (and more “resilient”) these days, with world-class production of suddenly important goods like vaccines and petroleum products (which, by the way, have been exported to Korea), new innovations like generative artificial intelligence (e.g., ChatGPT), and a still-growing services-based economy. The collapse of one important sector or industry will still hurt (see, e.g., banking today), but—barring some sort of major contagion—probably won’t collapse the economy because lots of other sectors will keep humming along. And as long as overall productive capacity is high (spoiler: it is) and the economy remains open, market actors—consumers, producers, investors, etc.—will adjust to whatever comes our way.

Read the rest here.

And, by the way, here are two paragraphs worth highlighting from a New York Times piece:

Just a few years ago, China was on track to challenge United States dominance in artificial intelligence. The balance of power was tilting in China’s direction because it had abundant data, hungry entrepreneurs, skilled scientists and supportive policies. The country led the world in patent filings related to artificial intelligence.

Today, much has changed. Microsoft — an icon of American technology — helped the start-up OpenAI usher its experimental chatbot, ChatGPT, into the world. And China’s tech entrepreneurs are shocked and demoralized. It has dawned on many of them that despite the hype, China lags far behind in artificial intelligence and tech innovation.

Here is my prediction: The argument that China is going to eat our lunch with its industrial policy and big spending will be hard to make in the coming years.

Veronique de Rugy is a senior research fellow at the Mercatus Center at George Mason University.
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