Getting Industrial Policy Right | Foreign Affairs

For two decades, the free movement of goods, services, and capital was the world’s guiding principle, crystallized in the so-called Washington consensus. Although countries didn’t always live up to these ideals or implement laissez-faire policies, most aspired to do so. They had to explain, justify, and limit their deviations from this consensus, at least in theory. The vast majority of the world’s countries signed on to multilateral institutions that promoted and enforced this view—such as the International Monetary Fund (IMF) and the World Trade Organization (WTO). 

Yet the era of the Washington consensus is now over—and despite what some commentators have argued, the COVID-19 pandemic is not the cause of its demise. Developing countries started pushing back against the consensus in the early years of this century. Mature economies began to sour on its tenets after the 2008 global financial crisis. Today, advanced countries and developing ones alike are embracing “industrial policy,” a catchall term for government interventions in certain industries and in the broader economy. This shift is apparent even in the United States. The Trump administration ignored and attacked the liberal world order that the United States has led for decades. But its approach partly reflected a new conventional wisdom in Washington in favor of an economic path that relies much more on active government involvement.

The policies of the Washington consensus spurred growth and development all over the world. But they had clear downsides, as well. Free trade disadvantaged workers in many developed countries, including the United States, and market-based approaches proved inadequate in tackling global crises such as climate change. Redressing the faults of the Washington consensus, however, does not mean the United States should embrace protectionism, which would spell economic disaster. Global supply chains are here to stay, and U.S. workers will be left behind if American companies can’t take advantage of them. A U.S. industrial policy built on more global cooperation and competition, better U.S. access to international markets, and public investments at home can mitigate the shortcomings of the Washington consensus and avoid the pitfalls of protectionism.

THE END OF AN ERA

The Washington consensus grew out of the volatility of the 1970s and 1980s. Mainstream economic thinking shifted as traditional, Keynesian economists fumbled through recessions and stagflation and more market-friendly, neoliberal thinkers gained currency in academic departments. Their intellectual godfather, Milton Friedman, won the 1976 Nobel Prize in Economics. By the 1980s, his acolytes were populating finance ministries and multilateral institutions around the world, ready to put his teachings into practice. As they did, debt crises were spreading throughout emerging markets, spurring a backlash against fiscal deficits and populist spending. Meanwhile, central economic planning lost its luster with the collapse of the Soviet Union. 

Under the Washington consensus, trade agreements brought down tariffs, eliminated quotas and government licenses for imported goods, and protected intellectual and other property rights. International money flows surged as capital markets opened up. Governments deregulated industries and privatized state-owned enterprises. At the same time, multilateral institutions enforced the rules; the WTO, for example, adjudicated disputes and punished rule breakers. The IMF encouraged countries to open up to foreign investment and prescribed spending cuts and other austerity measures to get debtor countries back on track. 

In retrospect, this faith in the consensus was misplaced. Emerging markets that followed the prescribed path often didn’t thrive. Despite bursts in trade and investment, many economies didn’t expand or diversify. Meanwhile, places that bent (or even broke) the rules, such as China, Taiwan, and Vietnam, made much more progress. Opening up to global capital proved not to be the blessing that was promised. Money came in, but it also flowed out quickly, intensifying boom-and-bust cycles. In Asia, many countries blamed the IMF and its austerity measures for deepening and extending the economic and social losses from the 1997 financial crisis. 

The era of the Washington consensus is now over.

The consensus eventually wore thin in wealthier countries, as well, where neoliberal policies offered little to address the harm done to workers by falling or stagnating wages, the loss of manufacturing jobs, and the decline of labor unions. Meanwhile, after the 2008 financial crisis, social safety nets began to fray, owing to the prolonged economic downturn and austerity measures—implemented even at a time when servicing public debt cost very little, with interest rates falling close to zero. 

Economists tried to save the model by supplementing its basic menu with reforms such as anticorruption regulations and targeted antipoverty measures, for example, conditional cash transfers to the needy. But it was too late; the sheen had faded. In finance ministries, at central banks, and even in conversations among elites in snowy Davos, the site of the annual conference of the World Economic Forum, critiques of the Washington consensus spread. As global policy attitudes shifted, so did the actions of the consensus’s institutional enforcers. Starting in 2015, the WTO relinquished its role as a promoter of freer trade when, after years of stalemate, negotiators finally gave up on the Doha Round of international trade negotiations, which would have further lowered trade barriers on agricultural goods and other products. In 2019, the WTO lost its ability to referee disputes when the United States refused to approve new judges to its appellate court. Meanwhile, the IMF has done an about-face: after years of preaching austerity, the fund has determined that fiscal restraint is out and spending is in. This past fall, IMF economists officially blessed more government largess, designating it a necessary catalyst in spurring private-sector investment. 

Of course, even in the heyday of the consensus, industrial policy had not disappeared. Governments continued to intervene in markets, using a mix of trade rules, tax incentives, low interest rates, and public contracts to protect domestic businesses, create jobs, and attract and direct investment. States built critical infrastructure, funded research labs, trained workers, and enticed immigrants—or tried to woo back their own citizens who had emigrated elsewhere and acquired new skills. 

Opening up to global capital proved not to be the blessing that was promised.

Asian countries, in particular, took this more hands-on approach. Although China professed a belief in market-based reforms at crucial moments, such as when it was applying for WTO membership, it never played by the laissez-faire rules. Instead, Beijing expanded public financing and subsidies, strengthened protections for domestic industries, and forced foreign companies that wanted to do business in China to share their proprietary technology with Chinese partners. Japan also protected and supported certain sectors, keeping out rice imports through quotas and tariffs and barring foreign-made autos through strict environmental and safety standards.

In Europe, the European Economic Community and its successor, the European Union, played an important role in national economies, as well, most notably by stitching together over two dozen countries into one market. EU regulations covered everything from labor laws to environmental standards, and Brussels spent tens of billions of dollars to build roads and rails, deepen ports, and connect rivers. It provided public funding for research and development and temporary loans to many companies. More recently, the EU has stepped up subsidies for local industries and allowed national governments to intervene in order to keep major European firms from coming under the control of foreign investors. 

Support for more active state intervention in the economy has grown in the United States, too. States already routinely offer carrots, such as tax breaks, worker training, and cheap electricity, to attract new plants or corporate headquarters. The federal government also mandates that U.S. highways and airports be built with steel and iron made in the United States, that publicly funded school lunch programs use only American-grown foods, and that many defense contracts include “Buy American” clauses. More recently, the Trump administration raised and expanded tariffs, and President Donald Trump used his bully pulpit to name and shame U.S. companies operating abroad. 

THE NEED TO INTERVENE

Even governments that oversee market-based economies sometimes must intervene to overcome market failures and deal with problems that individual companies or whole industrial sectors choose to ignore. And when it comes to research and development, governments are the only actors that can invest in ways that ignite innovation again and again, as they have far more resources and a longer time frame than any private enterprise. In the United States, federal funding spurred the science behind the Internet, global positioning systems, touch screens, solar panels, LED lights, fracking, artificial intelligence, quantum computing, and the sequencing of the human genome. The federal government has backed hundreds of university research labs, private contractors, and businesses, and those investments have paid off many times over by seeding new industries, boosting tax revenues, improving public health, and securing U.S. technological dominance. The case for an active role for government has only grown stronger in recent years as the effects of climate change—perhaps the clearest example of a market failure—have become more apparent. In the United States, even professed libertarians have warmed to state activism to ward off the threat.

More traditional national security issues present additional reasons to expand the public sector’s role in the economy. Some of the newfound enthusiasm for industrial policy stems from a growing realization about the vulnerabilities that come with global supply chains. International manufacturing enhances efficiency by allowing companies to shave costs, but it also exposes production to faraway natural disasters, targeted attacks, or aggression by other states. In 2011, for example, floods in Thailand submerged factories that made auto components for days, halting work on Honda and Toyota assembly lines all over the world. The COVID-19 pandemic has revealed the risks posed by the global concentration of production sites for even relatively mundane goods such as ventilators, personal protective equipment, and pharmaceutical ingredients; last March, the United Kingdom had just a few weeks’ worth of aspirin left within its borders.

Countries increasingly worry that international supply chains could be weaponized for geopolitical gain—for example, if China denied adversaries access to the rare-earth minerals that power everyday electronics. The United States has already taken steps in this direction, using its central role in global finance to force European companies to divest from Iran and Indian refiners to turn away Venezuelan oil. The United States has also banned semiconductor companies that use U.S. equipment or software, no matter where they are based, from selling their products in China. In 2019, Japan stopped exporting essential chemicals for semiconductor manufacturing to South Korea because of ongoing tensions between the two countries over reparations for war crimes committed during World War II. 

As technology becomes ever more embedded in people’s lives, policymakers worry that foreign hardware and software could expose citizens and governments to surveillance and espionage. Technological backdoors into phones could reveal sensitive information; car computers could be hacked and vehicles remotely hijacked; and malware could bring down power plants, electricity grids, or banking systems. One way states can address these national security vulnerabilities is to entice companies to move back home—or convince them not to leave in the first place.

THE PITFALLS OF PROTECTIONISM

History, however, provides many examples of industrial policy gone wrong. Supposedly temporary protections for infant industries or struggling economic sectors often become permanent, encouraging the development of monopolies or oligopolies. Over time, such measures impede national competitiveness, as protected corporations and sectors are less inclined to innovate. Governments are rarely wise or nimble enough to figure out the right amount of protection.

Latin America’s experience in the postwar period highlights these potential downsides. Several countries introduced a mix of tariffs, quotas, licenses, industrial subsidies, and credits to spur domestic manufacturing. There were initial economic gains: GDP surged ahead in many countries, as did local manufacturing of steel, chemicals, cars, and all sorts of consumer goods. In Brazil, the aerospace corporation Embraer made inroads into the international jet market, and the mining company Vale became one of the world’s biggest miners of iron ore. In Mexico, lucrative government contracts and control of the domestic retail cement market helped fund the building materials company Cemex’s successful global expansion. But more often, governments weren’t particularly good at choosing winners and were even worse at weeding out unproductive but politically connected companies. Indigenous innovation stalled, as monopolies and oligopolies captured the benefits of government protections and created a bevy of multimillionaires and billionaires. Consumers paid higher prices for inferior goods, and taxpayers shouldered the burden as country after country faced public debt crises and economic stagnation. 

The COVID-19 crisis has laid bare the importance of striking the right balance. The United States has long maintained stockpiles of crude oil, essential medical supplies, copper, zinc, and a number of other essential commodities. Now, Washington is broadening the list to include personal protective gear, ventilators, and pharmaceutical ingredients. Owing to geopolitical concerns, another nearly three dozen commodities are likely to be put on the list, including rare-earth minerals. 

Floods in Bangkok, Thailand, October 2011

Damir Sagolj / TPX Images of the Day / Reuters

Filling shelves with supplies or paying to make sure they are available if and when the country needs them can create an important buffer during catastrophes. But reserves should be selective. It isn’t cheap to maintain backup supplies indefinitely. And it is hard to guess what will be needed the next time a catastrophe strikes: the U.S. government has had medical stockpiles for years, but they either weren’t replenished or weren’t relevant for taking on COVID-19. Moreover, for many products, privately managed international supply chains have proved to be resilient, surviving the shock of lockdowns and huge swings in demand, as the market for suits and dresses collapsed, for example, and customers clamored instead for hand sanitizer and toilet paper. Within a few months, most goods were again widely available. 

The pandemic and recent natural disasters have also demonstrated the limits of “reshoring” production—that is, abandoning overseas manufacturing facilities in favor of domestic ones. Put simply, moving production from Wuhan to Wichita does not reduce a company’s vulnerability to the risks of geographic concentration. A case in point: in the months after Hurricane Maria hit Puerto Rico in 2017, hospitals across the United States ran low on IV bags, surgical scalpels, and a number of common drugs as dozens of factories on the island struggled to reopen. It made no difference that these facilities were on U.S. soil and not in another country. The lesson was clear: it’s best when production isn’t dominated by any single company or country. Indeed, Washington may find that strengthening access to critical goods means more, rather than less, international collaboration. Industrial policy works even less well when its goals are explicitly protectionist, aiming to punish others or “bring jobs home.” These interventions tend to make the United States less productive and secure. They hurt local industry by raising costs and incentivizing other countries to retaliate. Take the case of Trump’s tariffs. According to the U.S. Bureau of Labor Statistics, the tariffs his administration placed on foreign steel and aluminum in March 2018 created some 4,500 jobs in U.S. foundries and mills, but at the cost to the United States of nearly $900,000 per job created—a cost that took the form of higher prices for U.S. consumers. Those higher prices also increased expenses for the many domestic industries that use these metals and that employ 80 workers for every one worker employed by the steel industry. That dynamic explains why a study published by the U.S. Federal Reserve in 2019 estimated that, on balance, the tariffs led to the loss of 75,000 U.S. manufacturing jobs.

GETTING BACK IN THE GAME

A smarter U.S. industrial policy would eschew narrow, protectionist measures and would instead open global markets to U.S. goods and services and strengthen the ability of U.S.-based companies and their workers to take advantage of these opportunities. Rather than too much free trade, the United States has too little: U.S. companies have preferential access to less than ten percent of the world’s consumers. Mexico and Canada, in contrast, maintain such access to over 50 percent of global markets. To make the United States more competitive, Washington’s industrial policy should incorporate free-trade agreements, lowering the barriers U.S. enterprises still face when selling abroad. That means rejoining finished deals such as the Comprehensive and Progressive Agreement for Trans-Pacific Partnership and reviving dormant trade negotiations with Europe. Together, these agreements would give U.S. companies better access to markets with some one billion people. Recent trade negotiations have also gone beyond tariffs: they have opened up bidding for lucrative foreign government contracts, strengthened labor and environmental standards, protected intellectual property, and taken on state subsidies (often called “behind the border” protections). These measures, too, can help U.S.-based businesses compete.

The United States must stop taking a back seat when it comes to shaping global standards. In the past, U.S. leadership and participation often meant that American ways of doing things became the global standard. This happened when it came to criteria for automobile fuel efficiency, Internet protocols, and international payment systems, for example. Yet in recent years, U.S. influence has diminished. China, Germany, Russia, and over a dozen other countries now send more representatives to international meetings on technical standards than the United States does. In its fiscal year 2021 budget proposal, the Trump administration cut federal funding for the labs that produce studies and expert analyses for the discussions around setting international standards. And U.S. rules against interacting with the Chinese technology company Huawei have barred many U.S. companies from meetings where international telecommunications standards are discussed and decided. Rather than scoffing at such forms of cooperation, the U.S. government should step up its efforts to set the rules. This will benefit U.S. companies and make sure U.S. technologies and processes are more broadly accepted.

Climate change is another area in which the United States should rejoin the global conversation and actively take part in setting rules. Europe is already leaning hard into green industrial policy. It is implementing carbon taxes, funding regional supply chains for clean technologies, and investing in renewable energy and emission-free transportation. The United States should create incentives for American companies to shift away from dirtier energy sources and catalyze the arrival of cleaner ones. This would mean undoing tax policies that subsidize fossil fuel production and tariffs that raise the costs of solar panels, subsidizing renewable energy sources, funding the research and development of clean energy technology, creating environmentally friendly urban planning and building codes, and setting a price on carbon emissions. 

TEACH YOUR CHILDREN WELL

The U.S. government should also invest more in its citizens. To date, the United States has addressed the costs of globalization on the cheap. Today’s unemployment benefits are temporary and modest, and they mostly leave out tens of millions of independent contractors and workers in the so-called gig economy. What is more, health insurance, retirement plans, paid parental leave, and life insurance are linked to a job market of the past, in which more workers received such benefits from their employers. And when tens of millions of Americans lost their jobs at the start of the pandemic, it was a brutal reminder of just how vulnerable even those with employer-provided protections remain: without their jobs, their safety nets vanished. The United States needs to catch up with other developed countries and build a true support system that shields workers and their families from the shocks produced by globalization. 

Educational curricula also need to shift in order to better prepare Americans for the kinds of work the future is likely to offer. This means more science, technology, engineering, and mathematics programs. But tomorrow’s workforce will also have to move beyond such fields as intelligent machines increasingly take over calculations and coding. In the future, the most valuable and highly compensated workers will be those who can think creatively, solve problems, communicate across cultural divides, and define new ethical frameworks. That means that the federal and local governments need to not only expand education in the sciences but also invest in the liberal arts. And Washington should get back in the business of funding basic science. The United States still outspends the world on research and development, but the private sector invests much more than the government. Since companies focus on their bottom lines, they tend to avoid the kinds of ambitious, long-term development projects that have historically led to the biggest breakthroughs. For the United States to retain its technological dominance, the government needs to get back to funding invention. 

THE PATH AHEAD

To fully reap the rewards of a smart industrial policy, Washington will have to get over its new habit of going it alone by reengaging with the world, reaching out to others, and leveraging differences in skills, labor costs, natural resources, patents, and access to capital. The United States should start with its neighbors, Canada and Mexico. In July 2020, the U.S.-Mexico-Canada Agreement replaced the quarter-century-old North American Free Trade Agreement, protecting deep-rooted regional supply chains and potentially signaling the dawn of a more united economic front among the three countries. Washington should complement the new agreement with better coordination around border infrastructure, customs procedures, and other regulations. Such efforts would expand opportunities for companies and employees in all three places, tie together a continental market of nearly 500 million consumers, and make North American products and services more globally competitive.

Blocking or slowing the advancement of other countries will never be as effective as outpacing them. An industrial policy that tries to preserve the past through protectionism and isolation will only weigh down the United States. Americans would be better served by a government that opens up more of the world to their goods and services, makes U.S. companies and workers more competitive, and reaches out to the United States’ neighbors. That is the only approach to industrial policy that holds the promise of a more prosperous future for the country.

Loading…