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Making the case for industrial policy

Nobel Prize winning economist Joseph Stiglitz's latest book, "Creating a Learning Society: A New Approach to Growth, Development, and Social Progress," co-written with Bruce C. Greenwald, takes on one of the most sacred ideas in economics, the benefits of free trade between nations. Ever since Adam Smith and David Ricardo pointed out the benefits of absolute and comparative advantage, economists have promoted the advantages of specialization and trade among nations: Protectionism of markets or industries within a country is to be avoided, and open markets are the key to prosperity for all.

There may be winners and losers within a country, with an example of the latter being workers who become unemployed as production moves to countries with an advantage in a particular industry. Still, it's generally possible to compensate the losers and still have enough left over to make everyone in a country better off.

But is this true always and everywhere? If not, what are the exceptions to the argument that free trade has the potential to make everyone better off? And when is protectionism in one form or another justified?

Stiglitz argues that protectionism in the form of industrial policy can sometimes make a country better off, particularly for developing economies. Taking off from Robert Solow's work on economic growth and Kenneth Arrow's research on "learning by doing," Stiglitz argues that knowledge is the most important determinant of economic growth. Thus, learning and the acquisition of knowledge ought to be at the forefront of economic development strategies.

Unfortunately, when markets are left to their own devices, they don't produce enough learning. In particular, learning produces spillover effects within an economy, what economists call externalities, and the spillovers prevent firms from capturing the full value of their investment in learning.

For example, other companies can mimic the firm that invests in learning, and that reduces the advantage of the investment and removes the incentive to invest in learning. Thus, an important market failure is associated with investment in learning, and that leads to underinvestment in new knowledge.

From the perspective of the economy as a whole rather than the individual firm, the spillovers from learning are a positive outcome. The more firms that have the needed know-how for production, marketing, etc., the more growth the economy will have.

Thus, government has a role to subsidize learning and to protect companies that are "learning by doing." If the knowledge needed to compete in particular industrial sectors isn't present, how can the country have a presence in these markets? A country might have everything it needs to be strong in a particular area if only it had the necessary knowledge, and government can use industrial policy to promote the needed learning.

But which industry should a developing country's government protect and promote? Isn't the marketplace much better at picking winners than governments?

Stiglitz makes a strong argument that the evidence for that argument "is not as compelling as free-market advocates claim. America's private sector was notoriously bad in allocating capital and managing risk in the years before the global financial crisis, while studies show that average returns to the economy from government research projects are actually higher than those from private-sector projects -- especially because the government invests more heavily in important basic research. One only needs to think of the social benefits traceable to the research that led to the development of the Internet or the discovery of DNA.

But, putting such successes aside, the point of industrial policy isn't to pick winners at all. Rather, successful industrial policies identify sources of positive externalities, that is, sectors where learning might generate benefits elsewhere in the economy."

As this discussion from The World Bank states, "the question Stiglitz challenges us to ask is not, 'What can an economy produce today?' but 'What can it learn to produce?' and 'What production processes can catalyze learning in other sectors?'"

Stiglitz and Greenwald make a strong case for protecting infant industries while they "learn by doing" and also for protecting other areas. For example, "financial-market liberalization may undermine countries' ability to learn another set of skills that are essential for development: how to allocate resources and manage risk."

The economists' bottom line is that while free trade is still generally desirable, in some circumstances "industrial protection and exchange rate interventions may bring benefits -- not just to the industrial sector, but to the entire economy."

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