The Faulty Logic of Industrial Policy

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The Faulty Logic of Industrial Policy

October 26, 1983 20 min read Download Report
Dwight R.
Senior Visiting Fellow

(Archived document, may contain errors)

299 October. 26 1983 THE FA .UL T Y LOG IC OF INDUSTRIAL POLICY INTRODUCTION Intellectual support for the notion of an industrial policy is unraveling. Several decades of increasing political control over the economy have left a record that only the most doctrinaire interventionists attempt to d efend economics known as public choice has developed a formidable'set of models indicating that the failure of intervention is not an aberration, but a logical consequence of political decision-making next time we will do it right-is a triumph of hope ove r experience and over logic as well. Those whose political careers, business interests, and academic efforts are served by active government involvement in the economy have cause for concern over the falter ing of scholarly support respectability, their ar guments become transparent and vulnerable It is not surprising that an anxious market is demanding fresh arguments for big government from academically respected sources and recommendations calling for a national industrial policy.

But recognizing that a d irect call for more government is not likely to be a successful approach, the advocates of an industrial policy are predictably vague about the specifics of their recommen dations. Generally, they draw attention to a host of problems that currently plague the U.S. economy, with the clear suggestion that the source of these problems is excessive reliance on the private market.

Recommendations for action typically take the form of vague platitudes, such as creating a "productive partnershipi1 between governm ent and business, or using government intervention not to supplant market forces but rather to "make them more effective And the growing field in The response by proponents of a national industrial policy Without the cover of intellectual This demand is n ow being met with a supply of rhetoric 2 And the justification for specific measures inevitably includes the assumption that government operates in an impartial, far sighted way and will always achieve its supposedly wise goals.

At a different level, the justification for an industrial policy rests on the argument that the approach has worked economic wonders in other countries, most notably Japan, and so presumably will work here as well.

Such arguments seem to have their maximum impact when they are packaged in scholarly prose emanating from academically renowned institutions.

There is no shortage of books and articles fitting this des And while the industrial policy advocates do present cription similar recommendations, it is possible to discern a numbe r of schools of thought-=or at least different degrees of emphasis on policies. Lester Thurow of MIT, for instance, strongly recommends federal government involvement in basic investment decisions in order to facilitate the transition from sunset to sunri s e indus tries Thurow's advocacy of public investment banking puts him in step with New York investment banker Felix Rohatyn, who urges a new Reconstruction Finance Corporation, a key part of the New Deal. The purpose of the new RFC would be to allocate ca p ital in accordance with the dictates of a council of labor, business and government leaders. Professors Barry Bluestone of Boston College and Bennett Harrison of MIT, on the other hand, see government bailouts, nationalization of selected industries, and more politi cal control over the hiring and promotion decisions of private firms as the central features of a national industrial policy These and other academics play varied, and sometimes even conflicting roles in the industrial policy campaign.

Harvard's Robert Reich, however, who has attracted most attention.

Reich's book, The Next American Fr~ntier,~ has received an enthusi astic reception in liberal quarters, because of the intellectual horsepower it seems to provide to the case for a strong and acti ve government Bob Reich is brilliant I1 gushed New York Magazine lone of the most important works of the decade," said Walter Mondale The historical sweep of the analysis and the intellectual rigor of the diagnosis are truly remarkable." And Senator Gary H art believes strongly in "Mr. Reich's admonition that we must adapt and his penetrating insights on how to adapt should be heeded at stake It is Nothing less than America's economic future is Lester C. Thurow, The Zero Sum Society for Economic Change (New York: Penguin Books, 1981), pp. 203-204.

Barry Bluestone and Bennett Harrison, The Deindustrialization of America Plant Closings, Community Abandonment, and the Dismantling of Basic Industries (New York: Basic Books, 1982).

Robert B. Reich, The Next American Frontier (New York: Times .Book 1983).

Lee, "Robert Reich's Industrial Fantasies," Journal of Contemporary Studies Summer 1983 Distribution and the Possibilities The following two sections of this paper are based on Dwight R 3 Such lavish praise has little to do, of course, with the merit of the analysis trust in government solutions have latched onto Reich with such zeal indicates just how desperate they are for intellectual support and how weak this support really is. Reich's book is almost devoid o f new arguments in support of political guidance of economy and completely devoid of arguments that make sense That those who continue to put their THE ALLEGED INFLEXIBILITY OF AMJIRICAN BUSINESS The U.S. economy is obviously suffering from problems, and R eich lays them out clearly over the last two decades, for instance, and basic industries such as steel, automobile, and rubber are being battered by foreign competition. In describing such factors, Reich attempts to maintain credibility by acknowledging, although cautiously that government has been responsible for some of industry's difficulties policies that have been widely blamed for recent economic problems.

We are "informed," for example, that government regulations have not retarded productivity and that budget deficits cannot be blamed for discouraging capital formation. The root of the problem, apparently, is an inflexible business community that refuses to adapt to the reality of "global change The rate of productivity has declined But he quickly e xonerates many of the government Paper Entrepreneurialism economy is falling behind the rest of the world because business is still relying on outmoded management techniques motion approach to assembly line production, he says, was well suited to the stan d ardized high-volume production processes upon which an industrially based economy depends trade has expanded, and the world has become one big market, the U.S. is being overtaken in basic industrial production by less developed countries with easy access to high-volume production techniques and cheap labor. America's comparative advantage, he believes now lies in precision products, custom products, and those products that depend on rapidly changing technologies.

Their production is not suited to standardized high-volume tech niques, says Reich, but instead requires what he calls 'Iflexible system" prod~ction Unfortunately, American businessmen are tied At the heart of Reich's thesis is the idea that the U.S.

The time and But as international Reich provides page after page of detailed description and history of the standardized, high volume production management technique, but when he comes to the flexible-system approach, the approach upon which our economic f uture supposedly depends, he is distressingly vague the flexible-system approach is a highly integrated system that merges traditionally separate business functions into a team that can respond quickly to new opportunities nothing that resembles operation a l information here flexible-system production approach is simply too flexible to hold still for easy description We are told that This certainly sounds good, but there is Apparently the 4 i I to an old management approach and are unwilling to adapt to the flexible-system technique. Rather than adapt U.S. businessmen have resorted to nonproductive, short-sighted measures that allow them to maintain their traditional ways.

Reich refers to this short-sighted activity as "paper entre preneurialism.Il The essen ce of this phenomenon is the use of potentially productive resources, not to create new wealth, but to realize short-term profits by capturing the existing wealth of others. The increased use of conglomerate mergers, creative accounting, litigation, corpo r ate takeovers, management shifting and tax avoidance schemes are given as examples of paper entrepre neurialism.' And the IIatmosDhere of insecuritv and imDermanenceI resulting from all this unpkoductive predatory activiiy, in Reich's words, "bred a selfi s h attitude among directors, managers, and employees II 5 Employee Training Reich is also concerned that American workers are not being properly trained for the new economic realities. He sees a need for public policies that will assist workers to develop the skills required in a flexible-system production environment.

Existing policies are retarding the development of these skills and, according to Reich, America's workers are headed for "dead end labor.Il the same as that for other economic problems: infa tuation with standardized, high-volume production techniques. The effective ness of government services, which Reich sees as an important vehicle for training, is limited by standardized procedures that fail to recognize the circumstances of individual re cipients.

Yet business training is oriented toward the narrow labor skills appropriate to mass production techniques, and the results are inadequate, if not counterproductive. Even the problems of the public schools are traced back to the fixation with mas s pro duction. The schools are interested in processing large numbers of students, says Reich, and standardized procedures and programs facilitate this objective. An educational environment that resem bles the assembly line unfortunately fails to develop a nd nourish the creativity and adaptability that workers will need in an en vironment of flexible-system production Reich's underlying explanation for dead-end labor is THF, WEAKNESS OF REICH'S ANALYSIS What does Reich recommend for overcoming these proble m s does not recommend more government directly. Rather, 'Ithe govern ment's role in industry [should] become not so much more extensive as more open, more explicit, and more strategic.Il6 For government He Reich, op. cit p. 166 Ibid 9 P. 14 5 to properly a s sume this role, he notes, will require a reassessment of the distinction between the private and public sectors. In reality, Reich argues, a useful distinction between the two no longer exists. There is, in fact, a partnership between government and busin ess, and for this partnership to be effective, it is necessary to accept government's ineluctable role in the economy.

One searches Reich's book in vain, however, for specifics on how political incentives are to be restructured to motivate appropriate resp onses from politicians and bureaucrats to the economic challenges he delineates. There are calls for a new consensus for political action, but no plausible operational details. Apparently, once business embraces government as an equal partner and develops a social consensus, the foundation will be in place for the economic renaissance. This approach has worked wonders, the reader is told, for Japan, West Germany and to a lesser extent, France.

It is interesting to note that, although Reich is praised for l aying the groundwork for a new industrial policy, he actually is reluctant to make an outright call for more government economic planning and intervention. Indeed, he says explicitly that the answer to U.S. problems is not national planning, with bureaucr a ts channeling capital to those industries identified as winners and away from others designated as losers. Instead, Reich proposes a government that "seeks to promote market forces rather than supplant them Throughout his book, nonetheless, the call for m ore government responsibility is clear. And it is this call sounded in the guise of scholarly analysis, that appeals so strongly to politicians seeking a rationale for variations on outdated interventionist policies.

Innovation After penetrating Reich's generalities and platitudes, one finds little of substance, little that can stand up to critical examination, and much that borders on the preposterous.

The argument that U.S. economic problems are rooted in the reluctance of businessmen to adapt because they are hopelessly wedded to outmoded techniques seems to be original with Reich.

It is also blatantly wrong. Consider Reich's statement: IIAmerican industry has a tradition of marginal, incremental change-like the annual alterations in automobile styling- -that maintains high-volume production of essentially the same goods. American managers and investors have generally found wholly new products or processes simply too risky.817 Obviously most changes are incremental. But to claim that fearful avoidance of significant change best characterizes U.S. business is to completely ignore American .economic history. The light bulb, the cotton gin refined petroleum products, the Polaroid camera, supermarkets Ibid p. 137. 6 fast food franchises, Xerox, the telephone, transistors and electronic chips, and fast freezing are but a few revolutionary innovations that were developed and marketed by American entre preneurs force for radical economic change and adaptation. Indeed, one of the most common complaints against the market economy has been that it subjects people to too much change. Yet Reich asserts that "America [has] lacked any mechanism to accelerate economic change I8 of market forces--certainly does not have a very good track record. Reich seems to understand t h e reasons for this when he points out that, "America's old industries and their workers carry far more political power than emerging industries."9 matter how noble the objectives, an increase in the responsibility of government for economic decisions will result in an increase in the political power of the groups organized around the dominant interests (the owners and workers in existing industries) relative to those who are less organized (the innovators and potential employees of emerging businesses and t he consuming public It is clear from the historical record that political power of this nature has been used to stifle competition and retard economic change. government became more involved in economic decision making are not likely to improve the standa r d of living, even by the standards defined roughly by Reich.1 or allow the U.S. to outperform other countries in highly visible ways--yet which private investors are reluctant to finance--are very appealing to a political agency charged with improving eco n omic performance and Ilaccelerating economic change Nuclear power plants, which became commercially viable only because of generous government backing, and the supersonic jet transport which almost became another black hole for U.S. taxpayers' money are t y pical of the projects likely under an industrial policy.ll Industries that innovate and utilize the latest technology to respond to market competition, on the other hand, grow rapidly without political assistance would prop up socially wasteful business v e ntures, not save socially desirable ones Throughout U.S. history, the free market has been an enormous The mechanism Reich advocates--government llpromotionll No The innovations and economic change that would be favored if Projects that utilize high techn o logy Political direction of the economy Reich is correct in much of his criticism of paper entrepre neurialism. Increasingly, American businessmen have devoted Ibid 9 P- 11 Ibid p. 194 lo Ibid p. 271 l1 Bruce Bartlett cites the examples of nuclear power a n d the SST in his perceptive article The Old Politics of a New Industrial Policy in The Wall Street Journal, April 19, 1983, p. 34 7 their talents and resources to activities designed to plunder or protect existing wealth, rather than produce new sources. But it is preposterous to blame this wasteful activity, as Reich does on the inability of businessmen to adapt to new economic realities.

They have adapted quite well. The problem is that the new economic reality most relevant to the bottom line of major i ndustries today has less to do with competition in the market arena than it does with competition in the political arena. The taxing, spend ing, and regulating activities of the federal government present U.S. business with major threats and opportunities . The ability to understand the intricacies of government actions and rules can do more to enhance the firm's profitability than most far-sighted research programs. The political influence to obtain subsidies or protection can be much more important than m eeting foreign competition.

Reich is also on the mark when he charges that it is bekoming increasingly hard to distinguish between government and market activity. Rather than using this fact as a justification for blurring the distinction even further, how ever, Reich should have recognized that the paper entrepreneurialism he finds indefensible is the direct result of government intervention in the economy It will only be further encouraged by more government involvement.

Obviously this is not a position t hat Reich and his supporters can embrace. But in dismissing the obvious, Reich is left with the absurd argument that the creativity behind paper entrepreneur ialism is explained by the inability of American businessmen to adapt.

Education and Training It is easy to sympathize with Reich's concern over education and training. But it is not so easy to understand how improvements will emerge from Reich's vague generalities. The poor quality of public education needs no elaboration--except to say that standar ds have declined as federal involvement has increased. Reich is correct that the bureaucratic uniformity characterizing the welfare system has failed to motivate the poor to develop the attitudes and skills necessary for genuine economic progress.

This bureaucratic uniformity has been a function of the increased centralization of welfare programs in the federal government.

Yet Reich faults the fragmented administration of welfare result ing from the local control that still exists.

Reich acknowled ges that U.S. business spends large sums on employee training 30 billion in 1981, or about one half the total cost of higher education in the U.S but he feels that this funding is inadequate It is motivated by profits, and thus is tainted and results in t raining that is focused too narrowly.

The vague and unhelpful suggestion from Reich is merely that the goal of employee training should be to prepare workers for flexible system production 8 Minimum Wage While reluctant to advance specific proposals for re medying problems when discussing "inadequatell industry support for employee training, Reich does express concern over what he sees as continu ing Ilpolitical pressure to reduce the minimum wage.lll* Reich goes so far as to suggest that increasing the min i mum wage might motivate employers to spend more on training their employees, in order to justify the higher wage. Yet both evidence and common sense strongly suggest that the minimum wage has motivated em ployers to place the unskilled, when hired at all, in jobs where they have an immediate impact on output but little opportunity to develop skills.

Federal Deficits and Investment productivity during the 1970s, Reich argues that government deficits have not been large enough to significantly discourage pri vate investment and retard economic growth. How does Reich know this? Because Japan and West Germany have a larger public debt as a proportion of their national economies than does the U.S. This is true. What Reich conveniently leaves unsaid however, is t h at the savings rate, as a percentage of national income, is nearly four times larger in Japan, and three times larger in West Germany, than it is in the U.S. This means that resources for investment are comparatively smaller in the U.S and therefore feder a l borrowing has a correspondingly greater negative impact on business investment In dismissing the standard explanations for lagging U.S Reich tries to buttress his case that economic growth in the U.S. cannot be blamed on declining private investment by citing figures that indicate little change in U.S. investment, as a percentage of GNP, over the last two decades. Once again Reich is misleading because he fails to include relevant information.

The numbers he cites refer to gross investment. But it is net investment (investment over and above depreciation) that adds to the stock of capital and is therefore pertinent to increased productivity to GNP remained about the same from the late 1960s through the late 1970s, the ratio of net business investment to GNP declined by nearly 40 percent over the same inter~a1.l obviously has had a negative impact on U.S. economic productivity And while the ratio of gross business investment This decline l2 l3 Reich, op. cit, p. 225.

See Martin Feldstein, "Has the Rate of Investment Fallen The Review of Economics Statistics (February 1983), pp. 144-1

49. This decline in net investment in the absence of a decline in gross investment reflects an increase in the rate of capital depreciation during the 70s reason for the incre ased depreciation was the rapid increase in the price of energy which reduced the value of energy intensive capital better suited to the era of cheap energy A major 9 The Reich Prescription When Reich at last gets around to offering specific sugges tions- o nly about.12 pages of his 325 page book--the reader finds a rather standard rendition of the conventional interventionist approach: the use of taxation, spending and the regulatory authority of the federal government to accomplish politically inspired obj e ctives. For instance, "tax incentives could be used to encourage companies to invest in upgrading their work forces and communities,1114 and !'the tax code also might reward companies for remaining in their communities by giving them deductions proportion a l to their length of stay.1115 The latter suggestion one should remember, comes from a man who has just spent over 200 pages arguing that hope for America's future lies in flexi bility and adaptation. Or consider Reich's suggestion for the federal governm ent to llestablish regional banks to provide low interest long-term loans to industries that agree to restructure themselves to become more competitive.lIl6 In other words, moti vate firms to stand on their own feet by giving them a crutch.

Reich is fully aware of the past and present abuses of government subsidies and tax breaks, many of which he criticizes.

And he is aware that political pressure and expediency, rather than economic productivity and efficiency, typically have been the dominant considerations when government assistance is provided.

But apparently all this will change if political decisions are made more openly and explicitly. To achieve this fundamental reform:, a public board to monitor public programs, Itperhaps located in the White Hou se's Office of Management and Budget."17 The mountain brings forth a mouse.


But have not the industrial policies of such countries as Japan and West Germany shown that economic miracles can be orche strated by detailed government involvement in economic decisions?

There is no denying that these countries have been successful though there has been a recent tendency to exaggerate their success. But most of it can be explained for reasons other than government policy and, indeed, has often occurred in spite of government policy.18 Consider, for example, the widely held view that Japanese employers give their workers a high degree of job security. In l4 l5 Ibid p. 241.

Reich, op. cit, p. 240. l5 Ibid p. 242 l7 Ibid p. 245. l8 Katsuro Sakoh, "Industrial Policy Heritage Foundation Asian Studies Center Backgrounder, July 13, 1983.

Super Myth of Japan's Super Success ,I1 10 fact, this is quite misleading. It is true that employees o f major Japanese corporations are not as likely to be laid off as readily as their American counterparts as much as 35 percent of the Japanese worker's annual salary comes in the form of a year-end bonus, a bonus that is not paid unless the employer has h a d a profitable year. In other words rather than lay off their employees, market-clearing wages are allowed to prevail, and Japanese corporations can reduce salaries up to 35 percent But it is also true that If U.S. corporations had this much wage flexibil i ty, they also would be willing to retain their full labor forces, except under the most extreme circumstances. But U.S. labor unions historically have been much more anxious to protect wages than to protect jobs a willingness to be more flexible in their w age demands. Interest ingly, Reich speaks disapprovingly of this wage flexibility Only in the last years have American unions shown It should also be remembered that only a minority of Japanese workers in key industries is directly employed by the major c o rpo rations for these corporations, being employed by small firms that operate a contract basis. When demand declines, the major corporations contract out less work, reducing employment in the smaller firms rather than laying off their own workers A large percentage of the labor force works indirectly This is not to deny that Japan maintains a lower unemployment rate than the U.S. Nor should it be overlooked that much of the unemployment currently experienced in the U.S. is explained by the restrictive mon etary policy that has significantly reduced the inflation rate. When inflation becomes a persistent feature of the economic landscape, there is no way to bring it under control without precipitating a temporary increase in unemployment.

This unfortunate co st has to be paid to correct the inflationary consequences of previously irresponsible monetary policy. In the mid-l970s, Japan suffered higher than normal unemployment when it reduced its inflation rate from over 25 percent to less than 5 percent.

Reich never even mentions the connection between the rate of monetary growth and the inflation rate and the importance of this connection for the unemployment rate. This is hardly a surprising omission it would be hard indeed for him to reconcile the poor recor d of government control over the money supply with his view that government can be relied upon to behave in a responsible way.

The industrial success of Japan cannot be credited to govern ment policy to assist private companies with research and develop me nt R&D The Japanese government has devoted only about 5 percent of its R&D expenditures to private industrial research In West Germany the figure is nearly 27 percent. In the U.S., by i I 11 contrast, approximately 50 percent of government expenditures fo r R&D are directed to private industrial research.lg has been the result of government ability to allocate capital to those industries with the greatest promise. Japan's Ministry of International Trade and Industry MITI) does target particular industries f o r investment funds from the Japanese Development Bank JDB However, these funds are relatively modest--less than 10 billion dollars in a trillion dollar economy important, many of those industries commonly believed to be successful because of government as sistance actually have received little help. The iron and steel industry, for example, received less than 1 percent of the loans made with JDB funds from 1951-1972.

The hotel industry received about twice as much over the same period.20 The computer and au tomobile industries have received surprisingly little special government assistance investment made in the machine and information industry (including computers) from 1976 through 1979, only 0.8 percent came from special government loans.21 Neither can it be persuasively argued that Japan's success But more Of the total If anything, government may have harmed more than it helped the successful Japanese industries. When the Japanese automobile industry was in its infancy the government attempted to consolid a te it by encouraging mergers, the thought being that the number of firms was excessive and fewer firms would be more efficient.22 When Honda was contemplating its move into automobile production it was discouraged from doing so by MITI.23 The founder of t h e Sony corporation, Masaru Ibuka, remembers government policies that would have retarded Japan's electronic industry First tried to stop us from bringing the transistor to Japan, and later they tried to limit the ways we could use it.1124 Fortunately for the Japanese economy, these government efforts to restrict entre preneurial responses to market opportunities were largely thwarted.

While it cannot be claimed that Japan has an unfettered free market economy, the evidence suggests that Japan's economic su ccess owes market incentives and government restraint than it does to political direction of economic decisions there is a lesson to be learned from Japan it is clearly a lesson in supply-side economics burden on investment income, for example, an d personal income is also taxed substantially less than in the U.S.--with perhaps 30 If Japan imposes a relatively low tax l9 Ibid p. 4 21 2o -9 Ibid P. 5 Ibid. D. 10 22 Japanese Economic Miracle: An Interview with Hugh Patrick Manhattan Report on Economic Policy, October 1982, pp. 3-4. 23 George Gilder The Entrepreneur ,It Manhattan Report on Economic Policy October 1982, pp 12-15. 24 Newsweek, May 30, 1983, p. 28 12 percent of the population paying no income tax cent saving rate is explained in part by th e fact that interest income on up to 15,000 in savings is tax-free Japan's 20 per Advocates of a national industrial policy are on weak ground when they point to Japan's experience as evidence that increased reliance on government initiatives is the best w ay to promote economic progress. The facts indicate the opposite conclusion.

CONCLUSION The strongest support for a national industrial policy comes from special interests in and out of government, who try to justify government involvement in economic deci sion making actual case for an explicit national industrial policy, both theoretically and empirically, is extremely weak. It is not surprising, therefore, that supporters of such a policy resort to platitudes about productive partnerships between governm e nt and business, and cite highly selective and misleading examples of government economic planning in such countries as Japan and West Germany The For the most part, the arguments favoring a national indus trial policy are either vacuous or wrong. And the r e is no better evidence of the weakness of the arguments for an industrial policy than the enthusiastic reception of The Next American Frontier--a book by Robert Reich that supposedly lays the ground work for the national strategy. The success of Reich's b ook is a case of the triumph of rhetoric over substance. Unless they are completely immune to intellectual embarrassment, supporters of a national industrial policy will find Reich's book, and others like it, of little comfort when they are confronted wit h substan tive arguments in favor of reducing, rather than increasing government's role in the economy.

Prepared for The Heritage Foundation by Dwight R. Lee, Ph.D.

Center for the Study of Public Choice George Mason University


Dwight R.

Senior Visiting Fellow

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