Competitiveness and Industrial Policy

Speaker's Corner - Issue 2

When it comes to technological leadership, nations have always tried to catch up, gain an advantage, or stifle competition by whatever means necessary. Recently, competitive anxiety in some countries has been further exacerbated by anger from the perception that others play by different rules or none at all. Trade restrictions and subsidies that are seen as necessary by some, are viewed as unfair by others. Theft of intellectual property is believed to be widespread by all.

The post-World War II economic order was largely built – with leadership from the U.S. – to counter such protectionism, so that the whole world could benefit from freer trade. The World Trade Organization was intended to discourage trade barriers except for narrowly defined reasons such as national security. But today, the U.S. is expanding its definition of national security and rejecting WTO oversight, in fear that the country is losing its competitiveness in key industries.

Which industries are “key”? It depends on your perspective – and perhaps on who is lobbying you. The Trump administration erected trade barriers to steel. The Obama and Biden administrations protected green technologies. The Information Technology and Innovation Foundation (ITIF) laments that “U.S. performance is weak and declining” in seven advanced technologies (ranging from motor vehicles to pharmaceuticals to IT), and calls for Congress to provide $25B/year of incentives, to be matched by state and local governments, to support American R&D and production in these sectors.  

The active embrace of industrial policy in the U.S. is a major shift in both spending and ideology. Last year, President Biden signed the CHIPS and Science Act, and then the Inflation Reduction Act: together, they offer over $500B of incentives and subsidies to boost domestic production of semiconductors, EVs, batteries and their materials, and biofuels, and to promulgate advanced mobile networks and other technologies.

These acts represent a comprehensive (and, in the case of CHIPS and Science, bipartisan) rejection of Ricardo’s theory of comparative advantage – one of the few theories on which virtually all economists agree. This states that markets should determine which industries thrive, and where, with all countries benefiting as a result of specialization in what they are relatively good at. It’s always been hard to sell this theory to politicians and other laypeople, and even economists acknowledge exceptions and carve-outs:

• Spillover or long-term benefits: Local production may generate innovations or growth in related industries, and create valuable human capital. In Ricardo’s day, England grew rich by selling textiles due to the spillover benefits of industrialization, while Portugal arguably fell behind in its economic development by specializing in the low-tech production of wine. In more modern times, Detroit and Silicon Valley have offered evidence of this effect.

• Supporting infant industries: This concept is usually limited to developing countries trying to create a viable industrial base; but it can be argued that, for example, the U.S. lithium-ion battery industry could use support to climb the learning curve.

• Security: National security mandates the domestic production of weapons, equipment and other war materiel. But economic security can be threatened too, by overdependence on potential adversaries for the supply of certain goods. Europe’s dependence on Russia for gas gave Russia leverage and caused economic hardship as gas was restricted after the invasion of Ukraine.

• Non-economic values: Production of some goods by some countries or companies may violate ethical or other values. Supporting local production may preserve traditional lifestyles or cultures.

So has the U.S. been losing its technological leadership and economic competitiveness? The ITIF compared selected countries’ advanced-technology output to their share of global GDP. On this measure, the U.S. scores lower than Germany and the major Asian economies. It remains a leader in pharmaceuticals, aircraft and IT, but its global position in motor vehicles, machinery and other high-tech equipment has fallen over the last two decades, as China’s has grown.

The ITIF argues that policies like the CHIPs and Science Act are urgently needed to shore up the US share of production in these sectors. This is the latest salvo in a 40-year-old argument that other countries (Japan and Germany were cited back then) would outstrip the U.S. by supporting industrial champions – yet since that time, the U.S. has grown much faster than either. Today’s bogeyman is, of course, China, but there is no evidence that subsidies can spur U.S. growth in advanced technologies. Some countries owe their market share to low wages, and even China’s industrial policies may no longer reap much reward now that its companies are competitive with those in developed countries.

Another issue with industrial policy is that it is likely to provoke retaliation from other countries. Europe is preparing its own Chips Act to counter the US legislation. This risks an expensive battle to attract chipmakers’ investment, inflating the value of subsidies and ultimately the cost to taxpayers; trade disputes; and even export controls on technology. Dueling industrial policies could become a “prisoner’s dilemma” game.

The final argument against government subsidies is the well-grounded fear that they are inefficient. For example, the credits to be “earned” by an electric vehicle under the Inflation Reduction Act depend on where it is assembled, its selling price, the buyer’s income, and the sources of the battery’s materials and components. This is a recipe for red tape, backroom deals and waste. A smart industrial policy should have “embedded autonomy” (policies neutral to method or company), with no scope for lobbying or political pork. Alas, it’s hard to imagine this on Capitol Hill.

The U.S. may be embracing industrial policy; but smart industrial policy must be designed for efficiency, autonomy, and the provision of real spillover or security benefits. Game theory to predict and help manage the actions of companies, governments, legislators, and bureaucrats would also help!

Sources

Atkinson RD, “The Hamilton Index: assessing national performance in the competition for advanced industries”, Information Technology & Innovation Foundation, June 2022.

Baruzzi S, “China tightens control over management of rare earths”, Dezan Shira & Associates China Briefing, February 2021.

von Thun M, “The EU and US Chips Acts: Mutually beneficial or zero-sum game?”, Global Counsel Insights, September 2022.