Panel Discussion on Industrial Policy Ann Harrison Trade and International Integration Development Economics Research Group September 14, 2009

Introduction My discussion today is based on a forthcoming article co-authored with Andres Rodriguez- Clare for the next Handbook of Development Economics We were asked by Dani Rodrik and Mark Rosenzweig to answer the following question:

When Does Industrial Policy Work? ….Growth was not a passive, trickle-down strategy for helping the poor. It was an active, pull-up strategy instead. It required a government that would energetically take steps to accelerate growth, through a variety of policies including building infrastructure such as roads and ports and attracting foreign funds…. Jagdish Bhagwati, In Defense of Globalization (2004)

Outline What do we mean by industrial policy (IP)? Theoretical justification for IP in trade The evidence on infant-industry protection Cross-country evidence on tariffs, trade, and growth IP and Foreign Direct Investment Policy Recommendations: “soft” versus “hard” IP

What do we mean by Industrial Policy ? Working definition: any intervention which shifts incentives away from policy neutrality A broad conception of IP, which spans a range of policies – Tariffs – Tax breaks – Trade promotion

Distinguishing between Hard and Soft IP “Hard” Industrial Policy: – Tariffs – Subsidies to specific sectors – Tax breaks for foreign investors – Domestic content requirements Soft” Industrial Policy: – Special Economic Zones offering lower cost infrastructure – Roads and ports designed to increase trade – Special Credit for exporters (Trade Credit) – Promoting clusters in order to export

When does IP make sense in theory? Whenever there are industry-level (Marshallian) externalities, and a sector has a latent comparative advantage or there are excess profits Sector receiving support must eventually be able to compete on international markets When the (discounted future) benefits from intervention exceed the costs of the distortion – Not enough to show that favored sector grew faster – Need to be able to show that welfare is higher (but no one does the welfare calculations in general)

What do we mean by a latent comparative advantage?

How to resolve this debate? Answer lies in the facts Evidence on infant industry protection Cross-country evidence on Tariffs, Trade Shares, and Growth Foreign investment and IP Biggest limitation of existing research: no evidence that intervention in trade for IP reasons even exists

Empirical Evidence on infant- industry protection Evidence is mixed: suggests that getting interventions “right” is difficult Industry-specific case studies – Yes, welfare increased due to intervention Aircraft in Europe (Baldwin and Krugman (1989)) Steel rail industry in the USA (Head (1994)) Production of electricity from wind power (Hansen et al (2003)) – No, welfare fell as a consequence of intervention Semi-conductors in Japan (Baldwin and Krugman (1986)) Tinplate in the United States ( Irwin (2000)) Computers in Brazil (Luzio and Greenstein (1995)) Cross-industry studies – Removal of protection often generates within-firm and within-industry productivity gains – But studies typically fail to measure the impact of policies, focusing instead on outcomes (like trade shares).

Cross-country studies Strong positive relationship between trade shares and growth Weak, generally insignificant relationship between tariffs and growth on average: – If IP works, expect a positive relationship – If IP doesn’t work, expect a negative, significant effect – So evidence in aggregate is not conclusive for tariffs However, the PATTERN of protection matters: – tariffs on investment goods negatively and significantly affect growth WHAT you export matters

Taken from Easterly, Reshef, and Schwenkenberg (2009)

So what to conclude from this mixed evidence? We know externalities exist (Rosenthal (2004)) but exploiting them through “hard” IP is not easy If agglomeration economies are important, then IP in small domestic markets is likely to fail Any interventions associated with increasing the share of trade in GDP are more likely to succeed In practice, this means that: – Intervention should be oriented towards Sectors with a latent comparative advantage (Lin (2009)) Sectors with large externalities or coordination failures – IP should be in the form of export promotion (Trade Facilitation, Aid for Trade, Trade Credit) instead of import protection

Policy Implications for IP and Trade Who is doing IP matters (need strong institutions to prevent capture) What is being promoted makes a big difference: – Sectors with strong externalities (learning by doing; spillovers to other sectors) – Sectors with a “latent” comparative advantage When to promote: emerging not declining sectors How to promote: “soft”, not “hard” IP: Instead of tariffs, we propose programs and grants to help particular clusters by increasing the supply of skilled workers, encouraging technology adoption, and improving regulation and infrastructure. Warning: Agglomeration may be necessary but not sufficient for increased productivity. Subsidizing the software sector may not generate a Silicon Valley.

Foreign Investment and Industrial Policy All countries promote incoming foreign investment, but this is rarely referred to as IP. In 1998, 103 countries offered tax concessions to foreign companies setting up facilities within their borders. Countries frequently offer other benefits, such as free or subsidized infrastructure. Foreign investment policies as examples of successful IP (back to what, when, and how)

Many countries promote FDI selectively (From Alfaro and Charlton): IndustriesTargeted by number of countries Agriculture and Fishing4 Mining of metals2 Extraction of petrochemicals5 Food products5 Textile and wood activities5 Petroleum, chemical, rubber, plastic products9 Metal and mechanical products3 Machinery, computers, communication10 Vehicles and other transport equipment11 Electricity, gas and water3 Construction0 Trade and repairs1 Hotels and restaurants5 Land, sea, and air transport1 Telecommunications12

Specific Suggestions for “Soft” IP (1) Regulations to enforce higher quality standards Public investment in specific infrastructure projects when there are large investment complementarities Attracting FDI through provision of infrastructure Scholarships for studies abroad in areas important for diversifying clusters but with thin markets Technical assistance, prizes, grants for projects proposed by organized producers and performed by local research centers

Specific Suggestions for “Soft” IP (2) Don’t expect governments to identify coordination failures, but invite sector and cluster organizations to come forward If such organizations are weak, provide support to sectors that want to initiate or improve their organizations In general, avoid “price interventions” to reallocate resources but use existing clusters to identify effective interventions. Public-private collaboration is crucial

Conclusions Broader vision of IP Interventions must be consistent with growing trade Economists generally favor IP for foreign investors; some evidence that such IP may work because it targets new or export oriented, growing sectors with externalities Support for “soft” IP rather than “hard” IP All countries engage in IP: question is not whether to do IP, but how