FINDING AND PROMOTING WINNERS

The Truth About Industrial Policy

Attend any Washington think tank gathering and mention the words “industrial policy” , or do it in any interview with the elite press or at any sophisticated economics meeting at an Ivy League school or a prestigious West Coast university and the response is completely predictable. You will be accused of wishing to have the government “pick winners and losers.”

At best you will be the target of laughter and you might even be spat upon. Obviously you have not imbibed the conventional wisdom of the “Washington Consensus” of think tanks and leading economists like Larry Summers and Paul Krugman who insist that government cannot effectively identify industrial and technology winners for special support let alone identify losers to be left to die on the vine.

THE TALE OF HISTORY

Yet, the tale of history completely belies this latter day interpretation. It is generally agreed that the Industrial Revolution that began in the mid 18th century marked a major shift in world history based on discovery of a new way to create wealth as opposed to the ancient ways of discovering and exploiting wealth that already existed. The new way was called manufacturing and its decisive moment came when England forbad the export of its very large annual wool supply in favor of the wool being used by domestic weavers and producers to make finished textiles with significantly more value added than the raw wool itself. In this way, England captured more value and thus created equipment and techniques that speeded up textile production, thereby obtaining what came to be known as “economies of scale” as the cost of producing each new wool based item continuously fell as more of it more items were produced.

As a way of maximizing the returns to the King/Queen, to the state of the UK, and to the citizens of the UK, the British government imposed laws that required not only that raw wool not be sold abroad, but also that all items shipped abroad or imported into the UK (tea being an important example) must be carried in British bottoms, and that all raw materials imported from the American, Caribbean, and other colonies must be shipped first to the UK for processing and manufacture there before any onward sale abroad.

This was full fledged mercantilism with high barriers to the import of finished products from abroad, and with the aim of further reducing costs by dint of economies of increasing scale in domestic finishing factories from which higher priced finished products could be carried in British bottoms to buyers in foreign countries or in the British colonies.

It WORKED. Great Britain became the pioneer and driver of the historic Industrial Revolution and dominated global production as the “workshop of the world” from 1750 to 1870. During that period it was by far the world’s richest country and undisputed hegemon.

AMERICA: FARM OR FACTORY?

In the fledgling United States, a great debate raged over twenty odd years between between 1790 and 1812 between Thomas Jefferson and Alexander Hamilton with Jefferson arguing for a nation of free trading yeoman farmers and Hamilton calling for imitation of Great Britain’s manufacturing oriented mercantilism. The debate was decided by the War of 1812 which the U.S. came close to losing for lack of capacity to produce the implements of war. In the wake of this close call, Jefferson amended his views and remarked that “manufacturing is as necessary for our defense as for our convenience.” Thus from 1816- 1948, the United States followed the British example of industrial policies that promoted manufacturing and of mercantilist trade policies that protected and promoted domestic producers.

For example, the U.S. Congress funded Eli Whitney to develop the production of a variety of guns using the same interchangeable parts upon being shown how much more productive and high quality this system would be compared to the traditional gunsmithing of making each new gun separately. This greatly reduced the costs of gun-making and established the basis for what has come to be known as the manufacturing production line. This was not “picking winners and losers”. It was funding new ways of creating wealth. Similarly, Congress allocated funds to enable Samuel Morse to create the first U.S. telegraph line over which in 1844 he sent the immortal message from Washington DC to Baltimore: “What hath God wrought?” This was supporting the advance of technology and industry in the United States.

In the midst of the Civil War, Abraham Lincoln raised the tariff on imports of British steel which, at the time, was lower priced than domestically made steel. When criticized, Lincoln responded as follows: “ I don’t know much about steel or tariffs but I do know that if we buy the steel from Britain, they get the money and we get the steel, whereas if we buy in America we get the steel and also keep the money.” In fact, what Lincoln’s tariff did was to create a larger market for U.S. steel producers. Keep in mind that steel, like virtually all manufacturing, is characterized by “economies of scale” which means that the cost of production of per unit declines as the number of units produced rises. In the wake of Lincoln’s tariff, the U.S. steel industry became bigger than the British industry and the cost and price of American made steel soon undercut those of Britain making the United States the world’s leading and low cost steel producer while avoiding a trade deficit and keeping the money, as Lincoln said, “in America.” Nor was the cost of the tariff in terms of higher steel prices very long lasting because the extra volume shifted to the domestic makers cut their costs and led to prices lower than those of imports. Lincoln’s move was effectively an investment in making America the low cost and dominant producer.

Nor were America and Lincoln the only players in this industrial revolution game. Germany also adopted tariffs on steel imports and those of other manufactures and soon became a lower cost producer than Great Britain in a number of industries. France, Sweden, and others followed suit and also grew rich by dint of the industrial revolution. Countries that did not industrialize gradually fell behind in technology and productivity and, alas, also in wealth creation. In order to succeed, a country had to have a period of protection during which it could encourage investment and achieve sufficient scale in production to enable competitiveness.

NATIONAL SECURITY

Before WWI, it was argued that the countries of Europe could not and would not go to war with each other because of their trade interdependence with Germany, France, and Britain being each others’ biggest trade partners. Norman Angell’s famous book The Great Illusion predicting that war in Europe would never happen because the countries were too interdependent to afford such a catastrophe was translated into fifteen languages and sold over two million copies. Alas, Angell turned out to be spectacularly wrong.

War did break out and with it came a great need for industrial policy among all the players. On the one hand, the economies needed to be reorganized around the war effort and on the other they desperately needed to find new technologies and production techniques in the struggle to obtain supremacy. All the governments poured money into aviation, the search for new and better ships or submarines, and into entirely new materials. The United States focused on developing aviation, merchant marine, and new weapons capability. This was not picking winners and losers. It was all aimed at the enormous task of maintaining some level of economic stability while also overcoming a powerful enemies. National economies had to be put on a war footing and that inevitably meant the use of industrial policy

In the wake of WWI, a step was taken in the course of the peace negotiations that demonstrated the varied causes and purposes of industrial policy. At the Versailles peace negotiations, President Woodrow Wilson discovered that his mail was being read by British Marconi, the UK’s dominant telegraph company that gave the UK government a back door into the international telegraph traffic that it dominated at the time. In a moment of rage and retribution, Wilson directed his Secretary of the Navy, a man named Franklin Delano Roosevelt, to call in the CEOs of United Fruit, Westinghouse, General Electric, and AT&T to become partners of the U.S. Navy in the creation of a new international telegraph company to be named Radio Corporation of America (RCA). This was not a matter of picking winners and losers so much as a caprice of the President of the United States to protect his mail and a retaliation against the British government which had been reading his mail. Of course, it turned out to be a major global corporation, but it was not a matter of picking winners and losers.

WORLD WAR II, KOREA, and COLD WAR

With the outbreak of WWII, industrial policy became the major tool for running the war time economy. Auto companies were directed to build tanks. Steel companies had to produce steel for the tanks, and so forth. The War Production Board was created to this activity as well as to stimulate and direct efforts at production of new products with new materials and at development of better airplanes, better tanks, better machine guns, and so on. It was an immense undertaking that represented an enormous industrial policy. It was not about picking winners and losers among companies or countries. It was about getting the production, technology, and supply necessary to win the war. Whole new industries were created while obsolete ones were torn down. The aircraft industry in particular became highly developed and advanced rapidly in technological terms. These technologies later became valuable for commercial aircraft but they were not initially developed for that purpose. This is a dual aspect of industrial policy that is typically ignored.

In the wake of WWII, we fairly quickly slipped into the Cold War which meant a continuing contest with the Soviet Union for technological leadership across the board. The U.S. armed forces continued to drive technology and new industry development with the creation of the Defense Advanced Research Projects Agency (DARPA) and later DARPANET to pioneer development of what has become the Internet. And let us not forget President John F. Kennedy’s declaration that the United States would put a man on the moon by the end of the decade of the 1960s. None of these efforts were aimed specifically at picking a winning corporation over a losing corporation or specifically even at assuring American corporate leadership. But technology typically has dual uses and these policies and institutions inevitably led to American leadership and domination in a wide variety of related industries. If, for example, GE could build a superior jet engine for U.S. bombers and fighters, it could also use the same engine for commercial airliners. This was not picking winners and losers specifically. But it worked out to put U.S. industry in the technological lead in a wide variety of industries from aviation to semiconductors to advanced materials to the Internet and more.

Now we are engaged in an economic and ideological competition with China which has long been conducting industrial policies aimed at overcoming U.S. leadership in a wide variety of industries and technologies. The recent passage of the Chips Act which provides some subsidy to semiconductor companies who make semiconductors in the United States is a reaction to China’s policy of Made in China 2025 and 2035. Again, it is not a policy aimed at picking a specific corporate winner or declaring a specific loser. Rather, it is a general industrial policy aimed at maintaining U.S. based leadership in key, strategic technologies. Non-American corporations with operations in the U.S. are included under this policy, and sometimes they are included even if they have no operations in the U.S.

REST OF THE WORLD

If we look at how other countries like Japan, South Korea, Ireland, Finland, Switzerland, Germany, Taiwan, Singapore, and now China, we find that all have vigorously pursued industrial policy that included subsidizing what have been identified as key industries, protection of domestic markets in a variety of ways, and subsidization of exports particularly to the U.S. market. Look, for example, at the auto markets of Japan and South Korea. Even today in the wake of a variety of free trade agreements, virtually no foreign autos drive on Japanese and South Korean roads.

Or, look at a product like semiconductors for which several countries are striving to achieve or maintain leadership in production. In all cases, the governments are pursuing industrial policies aimed at enhancing their production of cutting edge chips. The same countries all swear that they are dedicated to free trade, but each of them has an industrial policy aimed at catching up or maintaining leadership in the technology. This illustrates a major weakness of free trade theory and doctrine with regard to manufactured goods characterized by economies of scale. Free trade models attempt to prove that certain trade patterns based on various endowments of land, labor, and capital are inevitably optimal. But the existence of economies of scale in manufacturing belies the models and the theory. For instance, a few years back, Germany was the low cost international producer of solar panels and dominated global markets. Then China decided that it wished to dominate those markets. It copied the German product, subsidized production in China, and imposed high tariffs on imports from Germany. After a while, the volume of the production in China was so high that it drove Chinese costs below those of Germany. Today, Germany produces almost no solar panels and the global markets are dominated by Chinese panels. That is a classic example of industrial policy at work. Of course, it required that the Germans not retaliate in some way against the Chinese, and that China have a large enough domestic market to attain a sufficient level of economies of scale. In fact, in this case, both conditions were present and China took the business away from Germany despite all the free trade rules and calculations. In truth, the free trade models are substantially mere nonsense. Of course, Germany could have complained to the WTO or to the Chinese, but German auto makers still maintain a large share of the Chinese auto market. In view of this, Germany kept quiet as it was shoved out of the global solar panel market by China. This is the real politik of globalization.

In this case, industrial policy was about picking and backing a number of winning solar panel producers while keeping German panels out of the Chinese market and also while making clear to the Germans that it might be painful for them to complain or try to retaliate in some way.

For the United States today, there is no option not to have an industrial policy. China’s dominance of high tech dual use products and technologies would be potentially dangerous to national security as well as to the future prosperity of the country. It must be understood that industrial policy is not about picking commercial winners and losers. It is never about picking losers and the option to provide special support to some industries or corporations is rooted in preserving national security not in benefiting a particular corporation or organization at the expense of another and never a wild guess by inexperienced people about the potential of one potential investment versus another.

The Internet, global air traffic, artificial intelligence, the semiconductor industry, the aviation industry, advanced drugs and medical devices, and much, much more owe their existence to industrial policies. All of the rich countries like the U.S., the EU, Japan, South Korea, Taiwan, Singapore, and now increasingly China owe their wealth to industrial policies.

Far from avoiding industrial policy, the United States and other advanced countries should be embracing it more comprehensively.

Clyde Prestowitz is President of the Economic Strategy Institute and Chief Economist for Cardinal Wealth Management of Bethesda, Md.