Industrial Policy for National Champions

2. Some Thoughts on Industrial Policy and Growth

2 Some Thoughts on Industrial Policy and Growth Philippe Aghion 2.1 Introduction In the aftermath of WWII, many developing countries have opted for policies aimed at promoting new infant industries or at protecting local traditional activities from competition by products from more advanced countries. Thus several Latin American countries advocated import substitution policies, whereby local industries would more fully benefit from domestic demand. East Asian countries like Korea or Japan, rather than advocating import substitution policies, would favor export promotion, which in turn would be achieved partly through tariffs and nontariff barriers and partly through maintaining undervalued exchange rates. For at least two or three decades after WWII, these policies, which belong to what is commonly referred to as “industrial policy,” remained fairly noncontroversial as both groups of countries were growing at fast rates. However, the slowdown in Latin America as of the 1970s and in Japan as of the late 1990s contributed to the growing skepticism about the role of industrial policy in the process of development. Increasingly since the early 1980s industrial policy has been raising serious doubts among academics and policy advisers in international financial institutions . In particular, it was criticized for allowing governments to pick winners and losers in a discretionary fashion and consequently for increasing the scope for capture of governments by local vested interests . Instead, policy makers and growth/development economists would advocate general policies aimed at improving the “investment climate”: the liberalization of product and labor markets, a legal and enforcement framework that protects (private) property rights, and This chapter draws unrestrainedly from joint work with Peter Howitt. 14 Philippe Aghion macroeconomic stabilization. This new set of growth recommendations came to be known as the “Washington consensus,” as it was primarily advocated by the IMF, the World Bank, and the US Treasury, all based in Washington, DC. The Washington consensus advocates did have a case: for example, recent empirical work by Frankel and Romer (1999) and Wacziarg (2001) would point to a positive effect of trade liberalization on growth. Thus Wacziarg (2001) showed that increasing trade restrictions by one standard deviation would reduce productivity growth by 0.264 percent annually. Similarly Keller (2002, 2004) showed that 70 percent of international R&D spillovers are due to cross-country trade flows, and more recently, Aghion et al. (2008) pointed to large growth-enhancing effects of the trade liberalization and delicensing reforms introduced in India in the early 1990s, particularly in more advanced sectors or in Indian states with more flexible labor market regulations. The main goal of this chapter is to see whether a case can still be made for policies aimed at supporting or protecting some local sectors, or whether the proponents of a full and unconditional liberalization have definitely won the debate. 2.2 The Traditional Infant Industry Argument 2.2.1 The Argument in a Nutshell The infant industry argument, as formalized, for example, by Greenwald and Stiglitz (2006),1 can be summarized as follows. Consider a local economy that comprises a traditional (agricultural) sector and a nascent (industrial) sector. The industrial sector’s new activities involve high costs initially. However, production and the resulting learningby -doing reduce these costs over time. Suppose that there are knowledge externalities between these new industrial activities and the traditional sector. Two conclusions are immediately obtained in this setting. First, full trade liberalization will make it very costly for domestic industrial sectors to invest in learning-by-doing; so it involves producing but not selling in the short run, since domestic costs are initially higher than foreign costs. Second, the social benefits from learning-by-doing are not fully internalized by industrial sectors since they do not internalize the knowledge externalities they have on the agricultural sector. It is the combination of these two considerations that justifies domestic policies aimed at (temporarily) protecting nascent industries. Some Thoughts on Industrial Policy and Growth 15 Such policies may take the form of targeted subsidies or import restrictions, or they may involve nontargeted policies, for example, maintaining undervalued exchange rates, that will benefit the local industry as a whole as long as it does not import too many inputs from abroad itself. 2.2.2 Criticisms The main objections to the infant industry argument have been empirical . Thus Krueger and Tuncer (1982) saw no systematic tendency for unprotected firms or industries in Turkey over the 1960s to display higher productivity growth than...