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Industrial Policy Instruments The industrial policy literature usually distinguishes between functional (horizontal) and selective (vertical) policies (Lall, 1997; Pack & Westphal, 1986). The former denotes policies that are not directed toward specific activities, and are, rather, geared toward improving the economic environment more generally. The latter denotes more targeted policies, such as industry tariffs, subsidies or tax breaks. Economists usually favour functional policies over selective ones, as the risk of introducing market distortions grows with the selectivity of a policy. Functional policies are more “market friendly” in that they leave it up to market forces to allocate productive activity among actors. While theoretically attractive, this distinction is very difficult to make in practice, and even the broadest functional policy will favour certain sectors and discriminate against others.

Rodrik (2009) illustrates this problem with the example of exchange rate policy: while an undervalued exchange rate can help stimulate exports in the broadest sense, it necessarily discriminates against the non-tradable sector. Therefore, a more informative classification of policy instruments could be based on the degree of government intervention. With a multitude of possible policy instruments at a government’s disposal, we reproduce an aggregate classification as adopted by Altenburg (2009) in Figure 2.

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Adapted with permission from Altenburg (2009).

IISD REPORT JUNE 2013 2013 The International Institute for Sustainable Development © Industrial Policy for a Green Economy Comparative History Industrial policy has a long tradition in economic history and has been employed by countries in various stages of development. Targeted government intervention in trade and industry has been widely adopted during the catch-up phase of some currently developed countries (Chang, 2002; Landes, 2003; Reinert, 1994).

Early Industrialization The earliest systematic overview is widely believed to have been written by List (1885), who is also one of the earliest proponents of the infant-industry argument for industrial development. List’s book reviews a plethora of industrial policies in the Western world, tracing them up to his time of writing and assessing their importance for industrialization in the 19th century. List (1885) argues that the development and survival of the manufacturing sector in Britain, which is conventionally depicted as the laissez-faire nation par excellence, has fundamentally relied on “a system of restrictions, privileges and encouragements” to shield it from competition from relatively more advanced industries in countries such as Belgium, Switzerland or the Netherlands. There is also evidence for the existence of industry clusters à la Marshall (Chapter 3), for example the 19th-century gun-making cluster in Birmingham described by Stigler (1951).

List believed that free trade would be beneficial once modern sectors were established and able to compete, or for trade between nations at similar stages of development. Chang (2002) makes this point more generally, illustrating how both Britain in the mid-19th century and the United States in the mid-20th century owed their industrial supremacy to nationalistic use of heavy protectionism but became the most ardent defenders of free trade once their industrial bases had sufficiently matured.1

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Conventional accounts converge on the mid−19th century as the beginning of British-led trade liberalization and the end of the Second World War in 1945 as the beginning of US-led trade liberalization.

IISD REPORT JUNE 2013 2013 The International Institute for Sustainable Development © Industrial Policy for a Green Economy Figures 3 and 4 illustrate how Britain moved toward greater liberalization only in the second half of the 19th century, while the same period also witnessed a substantial increase of protection levels in the United States with the outbreak of the Civil War. The United States did not make a substantial shift toward more liberal policies until the mid-20th century. The aggressive use of infant-industry policies to achieve rapid industrialization in the United States led the eminent economic historian Paul Bairoch to call the nation the “mother country and bastion of modern protectionism” (Bairoch, 1993, p. 30).


Reprinted with permission from Akyüz (2009).

Smaller countries such as Belgium, the Netherlands or Switzerland had lower levels of protection, arguably because they were already closer to the technology frontier and thus did not need to protect their already mature and competitive industries from foreign competition (Chang, 2002).

Indeed, trade relations during the first half of the 19th century were marked by heavy use of tariffs and other trade restrictions as tools of industrial policy (Clemens & Williamson, 2001; O’Rourke, 2000). While they were not the only tools used, it must be recognized that governments were generally subject to much greater restrictions in choosing their policy instruments, as compared with modern standards. Tools of government intervention were quite limited up to the 20th century, as many modern government institutions did not yet exist. Government budgets were small by modern standards, because tax bases were generally narrow.2 Central banking did not develop fully until the early 20th century. Banks were little regulated by the state, which made directed credit programs similar to those undertaken by Asian countries later in the 20th century impossible to maintain on a similarly large scale. Of course, resorting to tariffs is an obvious option for governments seeking to support their domestic industries. One notable exception from this trend is Japan, which did not gain autonomy over its tariffs until 1911, due to a series of unequal treaties signed with Western powers. But even here the government took an active lead in modernization, for example using targeted subsidized lending through state-controlled banks or setting up pilot plants in certain industrial sectors, generating demonstration effects much in the same sense of promoting self-discovery described in the previous chapter.

Small government budgets and narrow tax bases are still a feature of many developing countries, a point to which we will return later.

IISD REPORT JUNE 2013 2013 The International Institute for Sustainable Development © Industrial Policy for a Green Economy More generally, state institutions, including laws and regulations in the 19th century, were substantially different from those we know in modern times. While it is still instructive to look at how Western countries industrialized in the 19th century, we must bear in mind that it was a time in which modern national states were still in the making.3 The first passports were issued later that century, suffrage was far from universal and male if anything, limited liability was a privilege rather than a right, and labour markets relied extensively on child labour (Chang, 2002). But the bottom line remains that states were indeed actively involved in the development and modernization of their industries, notably manufacturing.

Industrial Policy After World War II: State-Led Industrialization Perhaps the best opportunity to study industrial policies in a more modern context is provided by the success and failure of certain states to achieve high growth and rapid industrialization after World War II, and notably after political independence for many of them. The immediate years after the Second World War were characterized by immense government efforts to restore technological capacity, especially in the context of the Marshall Plan in Europe, but also in Japan. Economic reconstruction was achieved with a considerable degree of direct state resource allocation, multiple exchange rates, quantitative import and foreign exchange controls, foreign direct investment, and royalties for technology licensing (Noland & Pack, 2002). These interventions were largely defensive in nature and were designed to rebuild what had been functioning before. But as the technology gap with the United States widened over the years, governments more actively pursued development in high-technology sectors. Using a variety of tools that included subsidies for R&D, preferential procurement by public agencies, and the promotion of mergers, the United Kingdom and France were the most active proponents of such activist government roles in Europe (Owen, 2012). Japan displayed effective rates of protection of over 10 per cent in almost all manufacturing sectors until 1975, while maintaining strict regulation of inward foreign investment and technology transfer, preferential tax treatment, and access to capital, as well as various subsidies, in an effort to promote growth in high-technology sectors (Noland & Pack, 2002).

From a development perspective, however, it is probably most telling to analyze the various policies that were employed by latecomers to industrialization, notably in Asia and Latin America.4 A striking first observation is that policies in all countries have been very similar. All countries have used similar policy instruments, such as tariffs, quotas, import licensing, foreign exchange rationing and various forms of subsidies to substitute imports with domestic production, a strategy that came to be known as import substitution industrialization (Shapiro, 2007). Meanwhile, governments took the role of identifying and targeting the development of priority sectors. Again, these sectors have generally been the same across countries with activist governments.

We will now briefly review those policies before turning to a detailed assessment.

Protection and Trade Policy Standard economic theory views the use of trade policy to support domestic industry very critically. We have seen how the principle of comparative advantage requires free trade among nations to determine efficient global production patterns. We have also seen how this efficient outcome rests on the assumption of perfectly functioning competitive A more extensive overview of industrial policies before the Second World War is provided in Cimoli et al. (2009).

The countries whose policies have served as the object of most research on the topic have been Argentina, Brazil, Chile, China, India, Indonesia, South Korea, Malaysia, Mexico, Taiwan, Thailand and Turkey. However, most of the policies described have also been employed in various other countries, including in Africa.

IISD REPORT JUNE 2013 2013 The International Institute for Sustainable Development © Industrial Policy for a Green Economy markets. In the presence of market distortions as described in the previous chapter, the theory of targeting implies that policies need to be aimed at the source of the distortion that is to be addressed, and hence direct production subsidies, for example, would be usually more efficient to tackle issues pertaining to stimulating domestic production in a given industry (Bhagwati & Ramaswami, 1963).5 Tariffs drive a wedge between domestic and international prices and therefore alter the incentive structure that import-competing domestic firms face, effectively shielding them from international competition. On the one hand, welfare losses arise due to the fact that consumers will face higher prices on protected goods, reducing their purchasing power. On the other hand, domestic firms operating under such protective environments lack incentives to increase productivity as long as tariff protection is not linked to some performance indicator. Disproportionally high rents accrue to protected domestic firms, as their domestically sold products fetch higher tariff-induced prices than would prevail under a free trade scenario.

Nevertheless, trade protection for purposes of import substitution industrialization, in the form of tariffs and quantitative restrictions such as quotas, was widespread in the early decades after the Second World War. Trade protection in the framework of import substitution industrialization strategies was an important tool all over Latin America, designed to alter the prevailing specialization structure toward more technology-intensive activities (Peres & Primi, 2009).

Average nominal tariffs typically exceeded 100 per cent until the late 1970s. Industrial policies in Latin America were generally inward-looking, promoting the substitution of imports through domestic production, but often lacked an explicit effort aimed at increasing exports or firm productivity. The failure to improve export performance led to a gradual deterioration of countries’ trade balances and contributed to balance-of-payment imbalances, and many Latin American countries began accumulating foreign debt in the mid-1960s (Di Maio, 2008), resulting in the debt crisis and “lost decade” of the 1980s.

Rapidly industrializing Asian countries also employed trade policies to foster industrial development. Taiwan and China maintained high levels of protection, with more than 40 per cent of imports receiving nominal protection in excess of 30 per cent by 1980. Indonesia, Malaysia and Thailand also had unusually high rates of protection until the 1980s (World Bank, 1993). Korea maintained protection through a mix of tariff and non-tariff barriers, even when it became clear that protected sectors were successful as measured by export performance. In general, an explicit outward orientation in the design of industrial policies was a major feature of all East Asian Tiger states—a feature completely lacking in Latin American states (except, to a lesser extent, in Brazil).

This outward orientation manifested itself in various provisions to promote exports. Domestic support and protection in Asia was generally conditioned on the fulfillment of certain export targets, defined at sectoral, product and firm level.

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