Letter from America: When industry means hard work

Daron Acemoglu writes about the return of industrial policy in the United States


Industrial policy is back. But in a very different form than before.

The term refers to the suite of policies used by governments to encourage sales, investment, and technology adoption by certain industries. It was popular among lawmakers and economists in developing countries, for example, with the import substitution system, which sought to encourage domestic industry by limiting imports of manufactured products, while at the same time allowing import of advanced inputs. Some experts, such as the late Alice Amsden and Robert Wade, saw it as the secret sauce for East Asia’s rapid industrialization. The same perspective has also been applied to China’s breakneck growth experience over the last thirty years.

Industrial policy has always been controversial. There are some well-documented success stories. Nathan Lane’s research shows how the drive to support heavy and chemical industries in South Korea, under General Park’s presidency between 1973 and 1979, increased productivity and investment in these sectors. These positive effects persisted long after General Park was assassinated in 1979. Related research by Matti Mitrunen finds support for effective industrial policy closer to home, in Finland. After the country, unexpectedly and heroically, resisted the Russian invasion during World War II, it had to agree to war reparations. Though largely agrarian at the time, Finland had to promise to make payments in terms of various industrial products, equivalent to about 5% of its GDP. These sectors expanded and provided employment opportunities and higher wages in manufacturing.

Nevertheless, for every South Korea and Finland, there are several examples of abject failure from Latin America and Africa. Corruption was a major issue when governments were tasked with supporting industries or even specific firms, though problems went beyond graft. Subsidized firms became inefficient, resources got directed to the wrong sectors, and strategic industrial policy often meant firm-specific subsidies creating monopolies for a few politically-connected companies.

Today, the new push for industrial policy is coming not from emerging economies, but from the United States. Even as industrial policy in developing economies was criticized, many European governments supported specific industries, especially in strategic areas. But now the United States is also all in.

Three separate but related considerations are pushing in this direction: the green transition, technological competition with China, and global supply chains.

The United States finally adopted a set of ambitious measures to promote a green transition in the strangely-called Inflation Reduction Act (IRA). The IRA departs from the recommendations of some economic models that the main policy tool to deal with fossil fuel emissions should be a carbon tax. In the simplest public finance model, if the economy is competitive and does not feature other distortions, and fossil fuel emissions create negative externalities, then the government should just impose a large enough carbon tax, and let the market do the rest.

The IRA does the opposite, mostly because of political necessity, as a carbon tax did not appear feasible in the current political climate. It includes a whole host of subsidies to green technologies. Hence, the United States opted for a form of industrial policy, rather than the more minimally-intrusive and market-friendly option of carbon taxes.

My own work in this area shows that, in realistic settings with endogenous and directed technological change, the optimal policy mix should be carbon taxes and direct subsidies to green technologies. Hence neither the simplest public finance benchmark nor the IRA solution are optimal by themselves. Nevertheless, our results suggest that sufficiently ambitious subsidies to renewables and other clean technologies may be quite effective in ensuring a green transition.

An even more ambitious industrial policy is embedded within the other major piece of legislation that the Biden administration passed, the Chips and Science Act, which promises more than $50 billion of government investment in semiconductors and other advanced chip manufacturing. The act includes $39 billion of investment in the form of chipmaking grants, and $11 billion to build a national semiconductor technology centre and hubs of federally-funded innovation centres. The act, motivated by worsening competition with China, also bans the export of certain advanced technologies to Chinese companies.

The fact that it looks very different from the import substitution programmes developing nations used to adopt in the past shouldn’t obscure the fact that this is a bold experiment in industrial policy, involving direct support for specific industries and technologies.

The final big push for industrial policy comes from concerns about global supply chains. Economists and policymakers viewed the global proliferation of supply chains as a source of efficiency gains, perhaps the most essential part of modern globalization. Yet disruptions of the supply chain during and in the aftermath of the Covid-19 pandemic brought the global economy to a standstill and may have propped up inflation.

Strengthening the American supply chain was one of the first priorities of the Biden administration, as exemplified by Executive Order 14017, issued shortly after the president took office in January 2021. A major and ambitious reform, Building Resilient Supply Chains, followed thereafter. Although dealing with technical issues related to supply chains, the 250-page report was also a call to arms for industrial policy. At its centre was the idea of investing in domestic strategic industries, partly for the defence implications of excessive reliance on other nations’ suppliers for inputs.

But the perspective of the report was more radical than just the defence industries and strategic considerations. It declared, for example: “Our private sector and public policy approach to domestic production, which for years, prioritized efficiency and low costs over security, sustainability and resilience, has resulted in supply chain risks identified in this report” (p. 7).

Put differently, the market may under-invest in some industries in its efforts to minimize short-run costs, but this creates long-term risks. The market failure results from the fact that cost-minimization by firms often ignores systemic effects on others, especially via risks for the entire economy. If so, the government should step in and bolster critical domestic industries in order to reduce long-term risks and dependencies.

Is this resurgence good news or bad? On the whole, probably good news, but with caveats.

The Green New Deal, as initially formulated, did not just aim to support a green transition, but almost completely supersede market allocations. Some pundits have argued that government can be a better judge on which specific technologies to choose, so civil servants can do the job of the market and entrepreneurs. My reading of the evidence does not support such claims. Recent work, for example, shows that Chinese industrial policy led to lower productivity among affected firms, and if the new enthusiasm for industrial policy leads to a wide swing of the pendulum to the other side, this would be potentially very costly.

On the other hand, the idea that the market would get the composition of investment and innovation across sectors right was probably a conceit. In fact, it is not only the green transition, competition with China, and global supply chains that may create sectoral distortions. My own research has argued that pecuniary externalities — distorted prices — can do that amply as well. Two examples are automation technologies and health care. When wages are above the social opportunity cost of labour — for example, due to market imperfections or rent sharing — automation can be excessive. When markups differ between different technologies, for instance, between those that cure diseases or their symptoms after onset vs. preventative ones, the market will also get the composition of health care investment and innovation wrong.

However, there are also important lessons to learn from failures of traditional industrial policy. The successful examples such as those in South Korea and Finland mentioned above did not involve the government picking winners, but support for broad sectors. Moreover, any industrial policy should be justified by well-documented market failures or systemic distortions. It should be based on careful economic research and its reasoning must be communicated clearly to the public. Industrial policy, if it is going to be more successful in its second reincarnation, must find a way of being much more broad-based and pro-competitive, rather than getting mired in attempts to pick winners and falling prey to mission creep.

Daron Acemoglu, 25 February 2023


References and further reading

Acemoglu, D., Aghion, P., Bursztyn, L. and Hemous, D. (2012). The environment and directed technical change. American Economic Review, 102(1), 131-66.

Acemoglu, D., Akcigit, U., Hanley, D. and Kerr, W. (2016). Transition to clean technology. Journal of Political Economy, 124(1), 52-104.

Acemoglu, D., Ozdaglar, A. E. and Tahbaz-Salehi, A. (2015). Systemic risk in endogenous financial networks. Columbia Business School Research Paper No. 15-17.

Acemoglu, D. and Restrepo, P. (2018). The race between Man and Machine: Implications of technology for growth, factor shares, and employment. American Economic Review, 108(6), 1488-1542.

Branstetter, L. G., Li. G. and Ren, M. (2022). Picking winners? Government subsidies and firm productivity in China. NBER working paper no. 30699.

Bruton, Henry J. (1998). A reconsideration of import substitution. Journal of Economic Literature, 36(2), 903-36.

Juhász, R., Lane, N., Oehlsen, E. and Pérez, V. C. (2022). The who, what, when, and how of industrial policy: A text-based approach. Manuscript, University of British Columbia.

Lane, N. (2021). A flight plan that fails. Boston Review, September 15, 2021.

Lane, N. (2022). Manufacturing revolutions: Industrial policy and industrialization in South Korea. Manuscript, University of Oxford.

Mitrunen, M. (2021). Industrial policy, structural change, and intergenerational mobility: Evidence from the Finnish war reparations. Manuscript, University of Helsinki.

Rodrik, D. (2004). Industrial policy for the twenty-first century. Manuscript, Harvard.