A good industrial policy is about making and not picking winners

The argument for letting markets decide export ‘winners’ through the principle of comparative advantage is flawed.
The argument for letting markets decide export ‘winners’ through the principle of comparative advantage is flawed.


The idea is not to replace the invisible hand of free markets but to use the guiding hand of the state to make up for its failures.

My previous article (bit.ly/3GQ8aqn) argued that Industrial Policy has been instrumental in the development of now-advanced economies and arguments against its use by less developed countries like India are unconvincing. Having said that, outcomes from using Industrial Policy tools have ranged from moderate success (Mexico, Brazil, Malaysia and Thailand) to superlative economic performance (Japan, South Korea and Taiwan). This has led many to question its utility by arguing that the government and bureaucrats running Industrial Policy cannot pick winning industries and firms better than free markets and thus not only does it fail, it leads to misallocation of public resources to industrialists (often monopolists) in the form of freebies.

The basic problem with this argument is that the objective of a successful Industrial Policy is not to pick but to make winners. A good policy does not seek to replace the ‘invisible hand’ of markets, but to introduce the guiding hand of the state in places where the former has failed. Industrial Policy seeks to address market failure. Admittedly, bureaucrats do not have perfect information, but neither do businessmen and entrepreneurs. The objective of Industrial Policy is to pool information, share risk and coordinate actions between the state and private entrepreneurs to meet development goals.

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The argument made in favour of letting markets decide export ‘winners’ through the principle of comparative advantage is flawed because it assumes that entrepreneurs are perfectly informed of all opportunities, which is far from true. Under this assumption, barring fortuitous discovery, like India’s discovery of labour arbitrage in IT-enabled services, a country will forever be stuck in a rut waiting for a comparative-advantage sector to emerge. The objective of true Industrial Policy is to fix this information failure and expand the sphere of an economy’s relative advantages.

Research has shown that the principle of natural comparative advantage driving exports exists only in the imagination of free-trade fundamentalists. Imbs and Wacziarg (‘Stages of Diversification’) show that as a country becomes richer, its sectoral concentration of production and employment falls. If the principle of comparative advantage worked, this wouldn’t be observed, as countries would specialize and see increased sectoral concentration. Klinger and Lederman (‘Discovery and Development’) show that new export products increase as countries become richer. Again, this serves as evidence against comparative advantage. The key to success for rich countries has been their ability to expand into newer export areas instead of focusing on areas of comparative advantage. This is a resounding rebuttal to those who would have India focus on “services led growth" rather than manufacturing.

A valuable lesson for India is that the ability to expand into new export areas is what differentiates moderate success from overwhelming victory. Dani Rodrik and many others have highlighted this in their comparisons between Latin America, East Asia (Thailand and Malaysia) and the famously successful ‘Gang of Four’ (Japan, South Korea, Taiwan and Singapore).

Latin American countries like Chile, Brazil and Mexico have largely focused their Industrial Policy on areas of some comparative advantage (agriculture, pisciculture and natural resources). As a result, they have grown and have successes like Embraer (aircraft manufacturing), but have remained stagnant from a productivity viewpoint for many years. This is in contrast with countries like Malaysia and Thailand which have leapfrogged to middle income status but remain stuck there, unable to attain a trajectory that would help them match advanced countries. They focused on areas beyond their comparative advantage and have seen productivity growth and improved export sophistication, but still lag the Gang of Four. This is where the most important Industrial Policy lessons for India lie.

Japan, South Korea, Taiwan and Singapore have become advanced countries within two generations because not only did their Industrial Policy focus on areas of comparative advantage (like Chile), and on expanding these (like Malaysia), but, importantly, they took moonshots at new technology and harnessed innovation to dominate export markets. This is the magic ingredient missing from the Industrial Policy of, say, Malaysia or Thailand, which have little innovation and have focused on becoming efficient assemblers of products developed by multinational companies, which deprives them of a large chunk of the value addition.

The Gang of Four, on the other hand, took several moonshots and focused on owning technology. Japan focused on becoming a major exporter of automobiles and ships with its own technology in the 1950s, when its per capita gross domestic product (GDP) was only 19% of the US. South Korea entered heavy industries and chemicals in the 1960s with a per capita GDP of 6% of America’s; in 1972, it created the world’s largest shipyard. In 1983, with a per capita GDP of only 14% of the US, South Korea entered chip manufacturing.

So far, India’s government has taken baby steps towards a coherent Industrial Policy. Its recent effort began with production-linked incentives (PLIs) for industries where India has some comparative advantage, and has graduated to mild support for an expansion of India’s comparative advantage (semiconductor subsidies). What we need for our exports to flourish, however, is an Industrial policy that not only builds on our comparative advantage and expands it, but also takes moonshots at technology (like green hydrogen) that we can own and export. To be sure, some initiatives will fail, as they do in all spheres of economic activity, but this should not dissuade us. We should pay heed to Georges Jacques Danton’s revolutionary call for “de l’audace, encore de l’audace, et toujours de l’audace" (audacity, more audacity and ever more audacity). Only with audacity will India be able to expand the Gang of Four into a Pack of Five.

Diva Jain is a director at Arrjavv, a real estate firm.

This is the concluding part of a two-part series.

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