In a social market economy, the state is needed. Economists agree on that. However, industrial policy does not belong to the tasks of the state – private companies in competition can identify sustainable sectors much more efficiently.
The question of the usefulness of industrial policy is about something very fundamental, namely the role of the state in a social market economy. The question is not whether the state should play any role at all in such a system. The fact that it should do this is completely undisputed among economists. Rather, it is about which role that should be exactly. And here, established economics recommends a crystal-clear division of labor between the state and the private sector, which ensures that scarce resources are used as efficiently as possible.
The state is responsible for setting the regulatory framework for economic activity: guaranteeing property rights or mitigating clearly defined market failures, for example with the help of environmental policy or competition policy. In addition, in a social market economy, the state ensures that there is a certain redistribution in favor of the disadvantaged. The private sector, in turn, is responsible for the use of resources within this framework. The competition ensures that there is as little waste as possible. This use of resources is ultimately controlled by the price, which indicates the scarcity. It is one of the most fundamental insights of classical economics that such a setting maximizes wealth.
Swarm intelligence beats central planning
The alternative to this is the planned economy. Here the state and not the private sector is responsible for the allocation of scarce resources. Not price signals, but official decisions then determine in which technologies or sectors should be invested. It is no coincidence that this is also the description of industrial policy. It is based on the idea that government agencies should assess which industries will be promising for a country in the future. And these sectors are then promoted with instruments such as subsidies, tax breaks or protectionism.
The development of the post-war period – think of the economic collapse of the Soviet Union – teaches us impressively that the market economy is far superior to the planned economy in terms of resource efficiency. There is no reason to assume that a government agency is in a better position than private companies to judge which activities should be invested in. In the case of the state, a single body decides in a monopoly situation, while in the case of companies, there are many who are in competition with one another. There is no question that private individuals use significantly more information and therefore have a much greater chance of making the right decisions than with the state.
Precisely because we do not know what will ultimately prevail when it comes to innovations, it is so important to involve as many people as possible in this discovery process and give them an incentive to react to new information as quickly as possible. The key here is that private individuals use their own money and therefore bear the costs of a wrong strategy themselves. This is less the case when using taxpayer money. A misdirected subsidy hardly has any direct personal consequences for the state employee. So even if one assumes that the state is pursuing the goal of greater efficiency to the best of its knowledge and belief, state control is inferior to private-sector use of resources.
Lobbying adds to inefficiency
In addition, there is the whole political-economic dimension, which again greatly worsens the balance sheet of state control. If the state determines the use of resources, there is a strong incentive for interest groups to influence the decision to their advantage. And then, understandably, it is no longer about overall economic goals, but about the well-being of their own clientele. Industrial policy decisions are therefore usually overlaid by political interests and then serve more to arbitrary redistribution in favor of politically influential groups than to efficiency.
It is precisely for these reasons that a strict separation of state and private sector activity is so important for a functioning market economy. Industrial policy blurs this separation and with it accountability. Or, to put it in extreme terms: If one believes that public authorities are superior to private ones when it comes to resource allocation, why not nationalize all the “important” or ideally all companies at once? And then you would be in the pure planned economy.
The empirical economic literature on the subject also clearly expresses the fact that the greatest skepticism about industrial policy is appropriate. Especially in the case of success stories like the Southeast Asian tiger states, studies show that their rapid growth has to do with opening up to the outside world, political stability and investment in education and not with their industrial policy. This general assessment is also confirmed by more recent studies.
Skepticism about free markets
Why is industrial policy still so popular, and why has it recently experienced another renaissance? Ultimately, it is probably the idea that (certain) economic decisions should better be carefully planned centrally, since they are too important to be left to decentralized decisions in little controlled markets. The current topic here is climate policy, the implementation of which is accompanied by strong skepticism about decentralized market decisions. Since the climate problem is largely due to market failure (externalities of environmental pollution not priced in), government interventions are legitimate here. But here, too, it would be much more efficient from an economic point of view to use free market instruments to ensure that market prices are not distorted (e.g. via incentive taxes) than to act in industrial policy with subsidies and controlled innovation.
The current popularity of state interventions certainly has something to do with the fact that it is obviously tempting for politicians to present themselves as doers who, inspired by a vision of the country’s economic future, actively support sectors or – even worse – individual companies . How much more boring is it to do the only right thing from an efficiency point of view, namely to set competitive, undistorted framework conditions and leave it to the private sector to decide in which sectors they want to invest.
Industrial policy also for services
And on current occasion: industrial policy is by no means limited to industry in the narrower sense, but can also be observed in services. Since the takeover of Credit Suisse by UBS, it has often been emphasized how important it is that Switzerland has a major global bank and that one should therefore be careful with the regulation of the new UBS. This assessment has a strong industrial-political aftertaste. What kind of financial institutions Switzerland “needs” in the future cannot and should not be decided by the state, but by the market. And so that this plays efficiently, big banks should not be protected by a de facto state guarantee, which consists in the fact that they are “too big to fail” and therefore – unlike all other companies – have to be rescued by the state in the event of a crisis.
To date, Switzerland has fared very well economically by leaving the allocation of resources largely to the private sector and forgoing an industrial policy. Neither in climate policy nor in financial market policy is there any reason to deviate from this renunciation of planned economy approaches due to current developments.
Irwin, Douglas (2023). The Return of Industrial PolicyFinance and Development, IMF, Washington DC.
Noland, Marcus und Howard Pack (2003). Industrial Policy in an Era of Globalization: Lessons from Asia. Institute for International Economics, Washington, DC.
Taylor, Timothy (2023). Qualms about Industrial PolicyBlog «Conversable Economist».
A notice: The article first appeared in: The national economyJuly 18.