Industrial policy resurgence: Balancing aid and market risks
The popularity of industrial policy is growing worldwide, which means increased government support for selected sectors or companies. Such interventionism can be justified when market competition fails and its outcomes need correction. However, industrial policy is often costly and ineffective, especially in developing countries.
The percentage of goods and services exports supported by governments as part of industrial policy is rapidly increasing. In 26 out of nearly 40 countries where the European Bank for Reconstruction and Development operates, industrial policy accounts for an average of 45% of exports compared to just 10% in 2010. In the USA and Germany, this percentage has reached 90%.
This is the conclusion of this year's flagship report by the EBRD ("Transition Report 2024"), published on Tuesday. The publication is dedicated to the causes and effects of the rising tide of interventionism.
The government will help when the market fails
The report's authors explain that industrial policy includes state actions to influence the economy's structure, whether by supporting or protecting a selected sector from competition. Such policy instruments include tariffs, subsidies, tax reliefs, and regulatory actions, such as requirements for manufacturers to use local components. Conversely, instruments that aim to support the entire economy rather than a selected sector, such as VAT, income tax reductions, or reforms to facilitate business running are not examples of industrial policy.
"Such solutions can be effective and justified when they address evident and urgent market failures, such as climate change or environmental degradation. But the current effects of industrial policy are ambiguous when considering the benefits, costs, and consequences of mistakes," wrote Prof. Beata Javorcik, Chief Economist of the EBRD, in the foreword to the report.
Javorcik points out that with every market failure to which state intervention responds, there is an accompanying risk of government failure. "80 to 90% of industrial policy actions involve discrimination against foreign entities, which can distort the playing field and lead to tensions in international cooperation," explains Javorcik. However, the worst consequence of such a policy is that it often replaces real reforms needed to maintain economic competitiveness.
The pandemic was a turning point
Economic interventionism's previous peak in popularity occurred after World War II. At that time, it was meant to aid in rebuilding economies. Industrial policy fell out of favour with governments in the 1970s and 1980s. However, in recent years, a renaissance has been observed. Why?
The authors of the report highlight several causes. Firstly, there is growing public support for interventionism and a greater role for the state in the economy, which can be linked to a series of crises in the global economy. One of the previous EBRD reports already indicated this.
Secondly, problems have emerged worldwide that the market does not seem to cope with effectively. This includes, first and foremost, the need to halt climate change without compromising energy and food security and increasing economic innovation.
Thirdly, there is a trend towards concentration in many markets, meaning an increase in the share of the largest firms. Such enterprises find it easier to persuade governments to support them, especially since politicians may feel that helping the largest domestic companies is in the interest of the whole economy.
Fourthly, the largest economies, including the USA and China, have more willingly started using industrial policy instruments, convincing other countries' governments that they, too, cannot remain passive. The most notable examples of industrial policy in the USA in recent years are the CHIPS and IRA acts, which provide financial support for semiconductor manufacturers and reduce inflation by supporting domestic production in the so-called green economy. Other developed economies, such as Canada and the EU, reacted to such protectionist policies from Washington.
Poland is a regional leader in industrial policy
Economists from the EBRD highlight that since 2010, China and the USA have introduced the most industrial policy instruments, followed by Germany, Brazil, India, Italy, Japan, Russia, Canada, Spain, France, and the United Kingdom. Among the countries where the EBRD operates, the leaders are Turkey and Poland, followed by Greece, Hungary, and Romania.
Expenditures related to industrial policy surged during the Covid-19 pandemic. The authors of the report calculate that in the EU countries where the EBRD operates, state aid for companies jumped from 0.8% of GDP to 1.5% of GDP. Later, it did not decrease and amounted to 1.6% of GDP in 2023. This amount does not include the costs of tax reliefs, only subsidies and preferential financing.
Effective industrial policy requires competence
When can industrial policy be effective? Economists from the EBRD explain that such actions should have a clearly defined goal. Without this, or if there are several goals, it is impossible to assess whether the industrial policy instruments have achieved the expected outcomes. Without such evaluation, it is difficult to determine when they should be phased out.
Unfortunately, the EBRD report shows that industrial policy increasingly rarely has one well-defined goal. More and more often, there are several, sometimes conflicting, goals. For example, a government may want to accelerate the green transformation of economies, support employment, and ensure supply chain security simultaneously.
Negative consequences of industrial policy are more likely to appear in less developed countries with problems with the rule of law and the quality of the public sector. These are places where there is a greater temptation to reach for the simplest and cheapest tools to implement but, at the same time, the most disruptive to the market, such as direct export or import bans, discretionary licensing requirements for exporters or importers, and subsidies. Their consequence may be suboptimal allocation of labour and capital resources, leading to higher costs and prices and corruption.
Economists from the EBRD recommend that industrial policy – when necessary – should have a well-defined goal and timeframe. It should also, as far as possible, enforce competition among entities that benefit from it rather than supporting pre-selected firms.
