A few months back, Justin Lin, the World Bank's chief economist, and Bill Easterly had a friendly debate about the merits of industrial policy. Lin has been promoting a concept he terms New Structuralist Economics, or what might more plainly be called Industrial Policy 2.0. I was reminded of the debate while reading How Markets Fail, a book that applies some basic lessons about market failures to the financial crisis. John Cassidy, the author of the book and a journalist at The New Yorker, makes the following observation:
Two of the biggest success stories in the U.S. economy are commercial aircraft production and the rise of online commerce. At first glance, the two industries don't seem to have much in common, but they share a common heritage: the technologies they are based on—the jet engine and the Internet—were both developed by the government...
...These stories aren't untypical. The list of commerical products that originated in research financed by the Pentagon or NASA includes satellite television, titanium golf clubs, GPS navigation systems, water filters, cordless power tools, smoke detectors, ear thermometers, and scratch-resistant spectacles. It can even be argued that the Department of Defense, through its finance of research into integrated circuits during the 1950s and '60s, was primarily responsible for the rise of the personal computer industry...one of [the Pentagon's] main contributions to the strength and well-being of the United States has been in providing it with a surrogate industrial policy. Freed from the threat of free riders and imperatives of short-term profit maximization, scientists and companies working for the U.S. military have created many of the technologies on which the country's prosperity is now based.
Why bring up the U.S. in a debate about industrial policy in the developing world? Because it flips on its head the argument that Lin presented during his debate with Easterly. Lin argued that in advanced economies, industrial policy is not a very good idea since these economies are at the forefront of technological innovation. Thus, government planners are unable to predict where the next blockbuster innovation will come from. But in developing countries, the next stage of production is relatively clear since other countries have already climbed that ladder, or so the argument goes.
Yet the U.S., the bastion of the free market, has benefitted significantly from large investments in basic research, both through the military and through universities and the National Institutes of Health. The problem of free riding on others' research—even taking into account the partial remedy provided by patent rights—provides a strong argument in support of certain kinds of government-sponsored research. Developing countries in turn get to free ride off of research carried out in advanced economies, reducing their incentives to engage in this type of industrial policy.
This still leaves some room for industrial policy in developing countries, though. If transferring new knowledge between countries is costly for a potential entrepreneur, but the knowledge (be it a new production process, new product, etc.) is freely accessible to all potential entrepreneurs once transferred, then a developing country might well be justified in subsidizing this process. The example of FDI into China strikes me as a good example.
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