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Speaking of providing innovators with government support to unlock whole new levels of attainment, though, another important part of this whole dynamic is that it’s not just individual researchers whose productivity can be significantly boosted in this way. Under certain circumstances, government may be able to achieve similar results on an even larger scale by throwing its support behind entire industries. I talked a lot in my last post about how trying to have the government “steer” what the economy produces is usually a massive mistake, and how it’s almost always better to let private markets organically determine which goods and services get produced. But I also mentioned that one possible exception to this rule might be if a developing country is trying to transition from producing (say) nothing but basic foodstuffs and other primary goods – which puts a natural ceiling on how high its productivity levels can be – to producing more sophisticated goods and services for which there’s more room for increases in demand as societal wealth increases (see Wendover Productions’ video on the subject here.) This is known as the “infant industries” argument, because the basic idea is that nascent industries in a particular country might theoretically be capable of operating efficiently enough to compete freely on the international market, but can’t actually do so until they’ve grown large enough to take advantage of economies of scale – so in order to help them get there, the government can provide them with some measure of short-term support (e.g. direct subsidies, temporary tariff protection from foreign competition, etc.) until they’ve grown efficient enough to compete. It’s admittedly a fairly contentious idea among economists, with strong arguments both for and against it – and in all honesty, I’m not entirely sure how fully I buy into it myself – but it does seem compelling enough to be worth mentioning, at least – because if it really is a legitimate strategy for development, it might well be one of the most important things a government of a developing country can do for its citizens. I’ll just repeat here the relevant parts from the last post where all this is discussed; so if you’ve already read that post, you can just skip this bit, but if not, here’s the first quotation, from Stiglitz:

Real development requires exploring all possible linkages: training local workers, developing small and medium-size enterprises to provide inputs for mining operations and oil and gas companies, domestic processing, and integrating the natural resources into the country’s economic structure. Of course, today, [poorer] countries may not have a comparative advantage in many of these activities, and some will argue that countries should stick to their strengths. From this perspective, these countries’ comparative advantage is having other countries exploit their resources.

That is wrong. What matters is dynamic comparative advantage, or comparative advantage in the long run, which can be shaped. Forty years ago, South Korea had a comparative advantage in growing rice. Had it stuck to that strength, it would not be the industrial giant that it is today. It might be the world’s most efficient rice grower, but it would still be poor.

And Heath elaborates:

Naturally, [David] Ricardo [with his idea of comparative advantage] is not the last word on the subject of international trade. It is important, however, that he be given the first word. His analysis of comparative advantage is the bedrock of modern international trade theory. It is simply not possible to have a proper conversation on the subject unless everyone fully understands this theory, along with all the constraints that it imposes upon our thinking about the subject.

That having been said, there are all sorts of interactions in which the harmonious logic of comparative advantage does not prevail. For example, countries compete against one another fairly directly for foreign direct investment. When Toyota needs to decide whether to build a new manufacturing facility in Ontario, Kentucky, or Baja California, it is not misleading to describe the issue in terms of international competitiveness. It is also important to note that comparative advantage is a trickier concept than it sometimes appears to be. When Ricardo presented his original argument, he used the example of England buying wine from Portugal in exchange for cloth. In this case, the fact that it took less effort to grow grapes in Portugal would seem to be a natural consequence of a more favorable climate. This in turn led to the suggestion that comparative advantage arose from conditions that were largely outside of anyone’s control, such as natural resource endowment. While this is sometimes true, often it is not. Knowledge, productive technology, and even organizational forms are not nearly as portable across national borders as they are often made out to be. Portugal remains a major exporter of port wine to this day, not because of climatic advantages, but because of advantages stemming from the knowledge, experience, and tradition that have arisen through centuries of producing this product. There are also significant economies of scale in winemaking that confer an advantage upon the “first mover,” as well as firms that have a large domestic market for their products.

Many of the most important sources of comparative advantage are completely overlooked in public policy discussions. For example, the presence of a large number of native (or highly competent) English speakers is a source of enormous advantage in particular sectors, not just in media and publishing, but also in law, financial services, scientific research, software development, and so on. Local and national culture can create advantages in ways that are very poorly understood. (Silicon Valley, as people are fond of pointing out, does not contain any significant silicon deposits, but it does contain a lot of Californians.) Network effects are important—the presence and success of one industry can generate advantages in related fields, often in very indirect ways. The legal system also confers advantages upon particular industries. The production of so-called intellectual property, for example, thrives only in jurisdictions with a legal environment that offers reasonable protection of patents and copyrights.

As a result, comparative advantage is not just something that countries happen to possess; it is also something that they can actively cultivate. In particular, subsidies to a given industry may create an advantage that is purely artificial, but over time they can lead to the creation of genuine comparative advantage, as the appropriate support networks, training systems, and reservoir of local knowledge needed for the industry are formed. This is, for example, what the government of Brazil is counting on with its support for Embraer (backed by the desire to get a slice of the international market for commercial aircraft), and the United Kingdom with its subsidization of the video game industry. Of course, this sort of political interference is unwise in many respects, but it does not rest upon any sort of misunderstanding or fallacy. It is possible for a country to do very well for itself through a well-planned and well-executed industrial strategy (particularly in “winner-take-all markets,” where the world only needs one or two suppliers). In this respect, the vocabulary of international competitiveness is again not misleading. If a nation has a particular reason for wanting to be an exporter in a particular sector, it may find itself competing with other nations to build up the right sort of advantages for itself.

Of course, just because it’s possible for a government to provide the necessary “scaffolding,” so to speak, for an industry to successfully build up its economies of scale and become internationally competitive, doesn’t mean that such efforts will always be successful; there’s a long list of examples of countries attempting to build up particular industries and failing badly. So how can a country ensure that it’s tackling the task in the right way, and building up industries that actually are ultimately able to compete, instead of just pouring endless funds into infant industries that never grow up and just turn out to be massive wastes? Alexander summarizes Joe Studwell’s take on the whole issue:

East Asian countries got rich by manufacturing. First it was “Made in Japan”, then “Made in Taiwan”, then “Made in China”. At first each label was synonymous with low-quality knockoffs. Gradually they improved, until now “Made in Japan” has the same kind of prestige as Germany or Switzerland, and even China is losing some of its stigma.

Not every rich country gets rich by manufacturing. Studwell divides successful countries into three groups. First, small financial hubs, like Singapore, Dubai, or Switzerland. This is good work if you can get it, but it really only works for one small country per region; you can’t have all of China be “a financial hub”. In the 1980s, everyone was so impressed with Singapore and Hong Kong that they became the go-to models for development, and people incorrectly recommended liberal free market policies as the solution to everything. But the Singapore/Hong Kong model doesn’t necessarily work for bigger countries, and most of the good financial hub niches are already filled by now.

Second, “high-value agricultural producers”. Studwell gives Denmark and New Zealand as examples. Again, these countries are very nice. But they also tend to be small and sparsely populated, and they also don’t scale. New Zealand’s biggest export category is “dairy, eggs, and honey”. Imagine how much honey you would have to eat to lift China out of poverty that way. It would be absolutely delicious for a few years, and then we would all die of diabetes.

Third, manufacturing, eg everyone else. Every big developed country went through its manufacturing phase. Britain, Germany, and America all passed through an era of sweatshops, smokestacks, and steel. Most developed countries gradually leave that phase, switch to a services-based economy, and offshore some of the worse jobs to places with cheaper labor. But they can’t skip it entirely.

And every big developed country that passed through a manufacturing phase used tariffs (except Britain, which industrialized first and didn’t need to defend itself against anybody). Economic planners like Friedrich List in Germany and Alexander Hamilton in the United States realized early on that British competition would stifle the development of native industry without government protection. Once their industries were as good as Britain’s, they removed their tariffs, which was the right move – but they never would have been able to reach that level without protectionism.

Imagine having to start your own car company in Zimbabwe. Your past experience is “peasant farmer”. You have no idea how to make cars. The local financial system can muster up only a few million dollars in seed funding, and the local manufacturing expertise is limited to a handful of engineers who have just returned from foreign universities. Maybe if you’re very lucky you can eventually succeed at making cars that run at all. But there’s no way you’ll be able to outcompete Ford, Toyota, and Tesla. All these companies have billions of dollars and some of the smartest people in the world working for them, plus decades of practice and lots of proprietary technology. Your cars will inevitably be worse and more expensive than theirs. Every country that’s solved this problem and started a local car industry has done so by putting high tariffs on foreign cars. Locals will have to buy your cars, so even if you’re not exactly making a profit after a few years, at least you’re not completely useless either.

This will become a problem if it shelters companies from competition; they’ll have no incentive to improve. Successful East Asian countries avoided this outcome by having many local car companies. The most successful ones went a bit overboard with this:

In the Korea of 1973 – which at the time boasted a car market of just 30,000 vehicles per annum – government had offered protection and subsidies to not one but three putative makers of ‘citizens’ cars: HMC, Shinjin, and Kia. Inasmuch as the market was too small for one producer, the licensing of three companies was ridiculous. HMC posted losses every year from 1972 to 1978, despite very high domestic car prices. However, the government sanctioned multiple car makers not to make shot-term profits – which would have come much sooner to a monopoly manufacturer – but rather to force the pace of technological learning through competition.

In addition to domestic competition, these governments enforced “export discipline”. In order to keep their government perks (and sometimes in order to keep existing at all), companies needed to sell a certain amount of units abroad each year. At the beginning, they might have to sell for way below-cost to other equally poor countries. That was fine. The point wasn’t that any of this was a short-term economically reasonable thing to do. The point was to force companies to be constantly thinking about how to succeed in the “real world” outside the tariff wall. And the secondary point was to let the government know which companies were at least a little promising, vs. which ones were totally unable to survive except in a captive marketplace. If a company couldn’t export at least a few units, the government usually culled it off and gave its assets to other companies that could.

Aren’t there good free-market arguments against tariffs and government intervention in the economy? The key counterargument is that developing country industries aren’t just about profit. They’re about learning. The benefits of a developing-country industry go partly to the owners/investors, but mostly to the country itself, in the sense of gaining technology / expertise / capacity. It’s almost always more profitable in the short run for developing-world capitalists to start another banana plantation, or speculate on real estate, or open a casino. But a country that invests mostly in banana plantations will still be a banana republic fifty years later, whereas a country that invests mostly in car companies will become South Korea. The car company produces a big positive externality – in the sense of raising the country’s level of development – which isn’t naturally captured by the owners/investors. So development is a collective action problem. The country as a whole would be better off if everyone started car companies, but each individual capitalist would rather start banana plantations.

So the job of a developing country government is to try to get everyone to ignore profits in favor of the industrial learning process. “Ignore profits” doesn’t actually mean the companies shouldn’t be profitable. All else being equal, higher profits are a sign that the company is learning its industry better. But it means that there are many short-term profit opportunities that shouldn’t be taken because nobody will learn anything from them. And lots of things that will spend decades unprofitable should be done anyway, for educational value.

[…]

I think there are [strong] counterarguments to Studwell scattered throughout journals that I haven’t quite figured out how to navigate and collect. The infant industry argument seems to be a going controversy within economics and not at all settled science. The picture is complicated by studies showing that countries with lower tariffs have had higher GDP growth since 1945. Studwell could respond that tariffs only work as part of a coherent and well-designed industrial policy; if you just tariff random things to protect special interests, it will go badly in exactly the way free marketeers expect.

To be sure, there are good reasons why economists tend to be so adamant in their insistence that this kind of planned industrial policy shouldn’t be tried under ordinary circumstances. If history has shown anything, it’s that trying to steer the course of an entire economy via government policy is a very hard thing to get right, to say the least. Still, it does seem like one thing that can make it easier is if the countries in question aren’t trying to chart a whole new path to prosperity, but are simply aiming for known benchmarks in order to catch up to other countries who’ve already become rich successfully. Here’s Alexander again, citing the work of Robert Allen this time:

By the early 20th century, a clear gap had emerged between Europe, North America, and Japan (on one side), and everyone else (on the other). After World War II, the former colonies declared independence from Europe, hoping to try the Standard Development Model at long last and get the same easy successes the West had. But this no longer worked; they had missed the boat entirely. [Allen] invokes the increasing gap between developed and less developed countries; when the gap was still small, the Standard Model prongs were enough to overcome it. By the 20th century, developed countries were so far ahead that the model made less sense. If you’re 1820s France trying to catch up to Britain, you can probably find some craftsmen somewhere in your economy who can make something like a textile mill, train them a bit, get them to make textile mills, use some clever investment policy to create whatever prerequisites to textile mills you don’t already have, and eventually end up with textile mills without too much trouble. If you’re 2000s Bangladesh trying to catch up to the West, you want semiconductor factories. Scrounging around a mostly-agrarian economy and eventually cobbling together enough expertise and capital to make a textile mill is one thing. Making a semiconductor factory is a lot harder. And if you decide to just make the textile mill instead, what if First World textile mills are some sort of amazing robotic wonderland now and nobody wants your crappy 1800s-technology textiles? Development needs a lot more slack now before it can become profitable.

Is it still possible to succeed? Allen points to South Korea, the USSR, and China as examples that it might be. He describes their strategy as “the Big Push” – a strong central government producing lots of (not immediately useful or profitable) industry, in the hopes that it will pay off later:

This is Big Push industrialization. It raises difficult problems since everything is built ahead of supply and demand. The steel mills are built before the auto factories that will use their rolled sheets. The auto plants are built before the steel they will fabricate is available, and indeed before there is effective demand for their product. Every investment depends on faith that the complementary investments will materialize. The success of the grand design requires a planning authority to coordinate the activities and ensure that they are carried out. The large economies that have broken out of poverty in the 20th century have managed to do this, although they varied considerably in their planning apparatus.

There follows some discussion of the Soviet Union and China. Both [took this approach], but the Soviet economy stagnated anyway in the 1970s. Allen seems kind of unsure about why this happened, and is willing to entertain both the possibility it was random and contingent (maybe the planners made a mistake in trying to pour so much investment into parts of Siberia that weren’t really habitable), and the possibility that planned economies are fundamentally better at catch-up growth than at the technological frontier (central planners can force people to make steel mills if you know steel mills are next up on your tech tree, but if you don’t know what’s next on the tech tree it’s hard to plan for it). […] The author is [more] impressed with China, which seems to have gotten this part right (maybe by accident): they communismed until they reached the technological frontier, then uncommunismed in time to get on the path to being a normal developed country. [Allen’s book] isn’t very big on prescriptions, but I think it would probably suggest having a pretty heavily planned economy while you’re playing catch-up, and then unwinding it once you’re close to where you want to be.

Like I said, I don’t personally claim to know how valid this idea is; even the professional economists, it seems, aren’t exactly unanimous on the matter. And at any rate, it’s something of a moot point for those of us living in the US, since so few of our industries are in their infancy compared to the rest of the world anyway; we tend to be at the forefront of most fields, so there aren’t really any industries that would theoretically need to be protected until they “caught up” at all. Having said that, though, for less developed countries the question isn’t such a moot point; in fact, getting it right might be the key to pulling themselves out of their economic rut and becoming prosperous – or, if they get it wrong, digging themselves even more deeply into it. Either way, it’s definitely an idea that merits attention – because if there’s really something to it, it’s yet another example of an area where government intervention in the market can mean the difference between fantastic wealth and abject poverty for entire populations of people.

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