About Nick: i am an economist based in malaysia. I write about development economics, while sneaking in a pop culture reference or two.

The Logic of Industrial Policy

Published in The Edge Malaysia, 16 June – 22 June 2014.

I am currently undertaking a two month internship in Tirana, Albania, where, as part of a 14- member crew consisting of my classmates from the Kennedy School, I help support the Albanian government in their (very familiar) objective of leading Albania on a path of rapid and sustainable development. The initiative is spearheaded by Professor Ricardo Hausmann as part of Harvard’s Center for International Development’s Growth Lab program. Essentially, the team helps the Albanian government in ideation, implementation and analysis of policy across a wide range of sectors including but not limited to tourism, manufacturing, agriculture, and power.

What the Albanian government is trying to do is somewhat similar to what the Malaysian government tried to do and is currently doing, via its Economic Transformation Program (ETP), is essentially industrial policy. Roughly defined, industrial policy is a set of policies for economic restructuring, where governments attempt to change the status quo of their economic structure, perhaps by moving from an agriculture-intensive economy to one that is focused on low-cost manufacturing or on high-skilled services.

Just over a year ago, my response to the industrial policy concept would be one of utter opposition. The logic goes, leave market forces to determine the structure of the economy; que sera sera, whatever the market spits out will be optimal for the economy. Sure, there may be market failures, coordination failures, information externalities and the like, but surely the government can do no better. This is not to say that I thought the government had no role; rather, the government’s role would be to ensure that the market could operate as smoothly as possible, thereby enabling the smoothest market mechanisms possible.

This idea is best illustrated using forests. Let’s suppose you wanted to grow a forest. Industrial policy would posit that the government chooses what trees to grow in the forest and plants them – according to some method (or madness) – accordingly and thus, constructs a forest. The way I saw it, the government should ensure, for instance, that the earth is fertile, that there were no problems in accessing water and sunlight, and that no set of oak trees colluded to steal all the nutrients and grains from the smaller trees. Given that, the trees that were most conducive to the current climate in which the forest was located and to the natural soil available to the forest would be the ones to grow and make up that forest. There was no need for governments to plant trees.

For the sake of posterity, I still largely believe in that method of growing forests. The government should ensure that all trees that grow in the forest are able to grow in the optimal environment. Where I depart from my prior belief is the idea that the government should not plant trees. I think the government, despite not being in the general business of planting trees, has a role, at times, to plant trees. However, the types of trees that it plants is what really matters for industrial policy. If a given tree (or industry) is going to grow and thrive naturally or is already growing and thriving as it is, then the government should not further focus on those trees or further promote those industries. Those industries are already thriving; there is little economic rationale, if any, for the government to intervene in those industries (unless, of course, it was trying to engage in crony capitalism but, for all intents and purposes, let’s assume we have a benevolent government for now).

Thus, while I argue that the government has very little direct role to play in industries that are already thriving – in the case of Malaysia, these include Electronics, Palm Oil, Tourism, Oil and Gas (funnily enough, these are also National Key Economic Areas (NKEAs) under the ETP) – the government should instead focus its efforts on new industries, particularly industries which are not ‘natural’ to the economic environment and endowments of the country. These would include industries which require a massive “big push” capital investment before it can get off the ground – the types of investments which private sector firms would be entirely unwilling to make in a new territory – or industries which employ technology that hitherto was underdeveloped or even unused in the country. Consider, for example, the case of cars in Japan (why should a country made up of a bunch of islands be conducive to cars) or the case of coffee in Brazil or salmon in Chile. These were industries which were not native to their respective countries and yet have thrived in those countries because they were given the opportunity to blossom.

The standard counterargument, in the Malaysian context, is, “Well, look at Proton.” In principle, there is nothing inherently wrong per se with the introduction of an automobile industry in Malaysia. In fact, I think it could have been the right move at the time for a host of economic reasons such as the opportunity to mechanize, to introduce frontier technology and to be a regional exporter. Yes, we do know what happened after, but the point of industrial policy, as eloquently put by Dani Rodrik, an economist at Princeton’s Institute for Advanced Study, is “not to minimize the chances that mistakes will occur, which would result in no self-discovery at all, but to minimize the costs of the mistakes when they do occur.” He adds, in a separate paper, that, “The appropriate questions therefore is not whether a government can always pick winners – it shouldn’t even try – but whether it has the capacity to let the losers go.” The problem with Proton is not that it was started, it is that it was continued after it had failed to compete globally.

Thus, a government should give its economy the chance for self-discovery, hoping that a particular “discovery” may pay off enough such that it more than pays for the inevitable other failures that necessarily arise from “trying.” Industrial policy must therefore not be about promoting industries that are already prevalent and thriving, but rather promoting industries that afford economies the chance for self-discovery and the chance to increase their complexity – in the Ricardo Hausmann sense – while simultaneously having the capacity to let the losers go when failures inevitably occur.

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