One of the most significant economic achievements of the past fifty years has been the radical diminishment of extreme poverty. Between 1990 and 2018 alone, those in extreme poverty (defined as someone living on less than 1.90 international dollars a day) fell from 1.9 billion (36% of the world’s population) to 650 million (about 7%). The pace and scale of this decline is unparalleled in human history. Granted, there are outliers to this trend—most notably, sub-Saharan Africa—but the reduction goes beyond China’s borders. Significant players like Indonesia and India have also realized major successes.
These changes were not achieved through massive wealth transfers from developed nations to the developing world of the type advocated by many development economists after 1945. Nor did it have much to do with foreign aid or industrial policy, likewise promoted by the same experts. It was accomplished through economic growth. And that growth was primarily driven by nations shifting their economies from the late-1960s onwards towards competition and trade openness. They did so by liberalizing imports and foreign investment rules, steadily removing export controls, and broadening the scope for individuals and businesses to pursue their comparative advantage in domestic and foreign markets.
Such policies were the precise opposite of those recommended by Latin American dependency theory economists like Argentine Raúl Prebisch in the 1950s. They insisted that developing nations should reduce their reliance on raw minerals and agricultural exports and make aggressive use of industrial policy to stimulate the emergence of new domestic economic sectors.
Markets, it turned out, were far more effective at reducing poverty than any of these measures. Beginning in the early-1990s, however, many development economists changed their tune. While acknowledging economic freedom’s role in driving the growth that reduces poverty, they maintained that insufficient attention was given to how growth was impacting inequality and unemployment levels. The effects of growth, they held, had been very uneven, with some groups benefiting more than others. Phrases like “inclusive growth” and “broad-based growth” consequently entered the development economics lexicon to describe growth that, to use the World Bank’s definition, is “broad-based across sectors, and inclusive of the large part of the country’s labor force.” Sectoral outcomes were now to be considered as important as overall poverty reduction.
These emphases have made their way into contemporary discussions about America’s economy. Growth, we are informed, must be more inclusive. That translates into trying to ensure that specific regions enjoy more of the benefits of growth than they presently do or seeking to steer growth so it particularly impacts the living standards and employment opportunities of people from specific economic (blue-collar) and racial (non-white) backgrounds. This, the argument goes, requires a broad-based economy in which new industries and businesses emerge in different parts of the country.
Realizing this goal is invariably presented as necessitating more targeted government interventions into the economy. The calls for more state intervention to deliver inclusive growth and more sectoral diversity have only accelerated in Covid-19’s wake. When policymakers on the left and right invoke the “Build Back Better” refrain, this is what many of them have in mind.
I and others would dispute some of the assumptions driving arguments for more broad-based growth. Concerns for greater equity, for instance, can’t be reduced to questions of need. Criteria like merit and readiness to assume risk are also relevant. People willing to take more risks, whether by choosing to start a business or to invest capital in an enterprise, are generally entitled to more of a share of profit than those who don’t take such risks.
That said, the idea of a broad-based economy is not problematic in itself. Not everyone can or should work on Wall Street or in Silicon Valley. The substantial economic and political challenges associated with a country (like Saudi Arabia) being highly dependent on one or two industries (like oil) are well-documented. Two reference points, however, need to be factored into any discussion about how the U.S. economy might experience more sectoral diversification as well the emergence of new types of enterprises and employment. The first is that industrial policy has a poor track record at realizing such ends; greater entrepreneurship and competition are more likely to generate the desired outcomes. The second is that particular economic dynamics associated with growth (without which entire economies stagnate, with the poor and marginalized suffering the most) put parameters around how such broadening might occur.
Growth and the Dynamics of Sectoral Change
Sectoral economic change has characterized the history of America’s development since the 1790s. In 1800, the U.S. economy was dominated by agriculture and mineral production, with an estimated 85 percent of the workforce engaged in farming. On the eve of the Civil War, America had the world’s second-largest GDP and second-largest industrial base. In 1900, just under 40 percent of the total US population lived on farms, and 60 percent lived in non-metropolitan areas. By 2016, the respective figures were about 1 percent and 20 percent. Beginning in the late-1960s, the move from factories to service-provision started accelerating across the United States, as it did in all the world’s developed economies. In 2015, approximately 80 percent of the American workforce was located in the entire service sector.
These transitions reflect what it means to live in an economy orientated towards the generation of growth. If an economy is to continue growing and competing with the rest of the world, then people and material resources must continuously shift to higher value-added sectors, and, within specific sectors, to the more efficient firms.
That, however, doesn’t mean that entire economic sectors disappear or become less productive. While the percentage of Americans who work in agriculture today is far smaller than what it was 100 years ago, U.S. agricultural productivity has never been higher. Technological developments ranging from tractors in the early twentieth century to high-tech vertical farming in more recent years may have reduced agricultural employment as a percentage of America’s workforce, but they also have magnified agriculture’s output many times over. The same technological transformations have changed the profile of agricultural employment. Agronomists and agricultural scientists, for example, are more needed today than unskilled labor.
A similar story may be told about American manufacturing. Although the number of Americans employed in manufacturing has dropped since the 1970s, real manufacturing production grew by 180 percent between 1972 and 2007. By 2019, it had rebounded to pre-Great Recession levels. Today, America continues to rank high among the world’s manufacturing nations and is a major global locus for manufacturing investment.
Thus, while American manufacturing constitutes a smaller slice of the U.S. economy than the services sector, it is more sophisticated and productive than it was 50 years ago. The oft-repeated mantra of economic nationalists that America is de-industrializing is simply false. The service sector may have grown faster and bigger, but that doesn’t imply that the manufacturing sector’s output has shrunk. It simply means that manufacturing’s overall share of the U.S. economy was many times bigger 50 years ago.
These sectoral shifts in the American economy also owe a great deal to the discipline exerted by pursuing comparative advantage. If you permit entrepreneurs and businesses in an economy to pursue and capitalize upon their comparative advantage, some sectors of that economy will be more domestically and internationally competitive than others. This is one reason why so many Americans work in the service sector. Whether the business is finance, insurance, telecommunications, education, or health, this is where America’s comparative advantage presently lies. It follows that people and capital gravitate to such industries. The more competitive an industry, the more likely it will outshine other economic sectors in its productivity and its ability to generate the higher average wages that go along with higher degrees of average labor productivity.
These facts surrounding how and why the U.S. economy’s sectoral composition has changed, and their implications for the levels and types of employment provided by different sectors, cannot be ignored in any discussion about building a broad-based economy. It’s one thing to desire sectoral diversification, but quite another to think that you can do so while ignoring the impact of comparative advantage, technological developments, or the need to continually shift more and more investment and people into the economy’s value-added and competitive sectors. If you want sustained growth, these constraints are real.
The False Promise of Industrial Policy
Some policymakers nonetheless remain convinced that state intervention can break through these limitations on sectoral and employment diversification in growth-orientated economies. They believe that the emergence of an American economy better than the one which existed before March 2020 must involve a wider distribution of economic activity across sectors. They also want more economic activity occurring between the two coasts, especially in economically depressed areas. If government doesn’t proactively try to alter the American economy’s sectoral and employment makeup, they fear that particular regions (“rust-belt” towns and states) and demographic groups (blue-collar male workers) are doomed to obsolescence and relative poverty while the financial and high-tech hubs on the coasts boom.
This is where industrial policy comes into play. Industrial policy seeks after all to alter the allocation of resources and incentives in particular economic sectors that would otherwise transpire if entrepreneurs and businesses were left to themselves to innovate and compete. It involves the government engaging in targeted economic interventions in order to: 1) produce particular outcomes in terms of capital investments, provision of goods and services, type of jobs, and employment levels; and 2) encourage the advent of economic sectors that, it is argued, would struggle to materialize without state-intervention. The forms taken by industrial policy range from subsidies to preferential tax treatment, loans at below-market interest rates, outright grants of capital, joint public-private enterprises, and special regulatory treatment.
Alas, there are good reasons to doubt industrial policy’s effectiveness in producing a more broad-based economy. East Asian miracles like South Korea and Taiwan are often touted as examples of industrial policy achieving this goal. The ground-breaking study of these cases undertaken by the distinguished Indian-American economist Arvind Panagariya, however, indicates that industrial policy played at best a marginal role, and often produced dysfunctional effects. Even the instance of Taiwan’s development of its world-class semiconductor industry turns out—contra the economic nationalist refrain—to have had relatively little to do with industrial policy. As I’ve previously illustrated in these pages and others have corroborated, industrial policy (if one can even call it that in this case) had a fringe and very temporary role in the emergence of Taiwan Semiconductor Manufacturing Company (TSMC) as the world’s biggest semiconductor player.
Looking at the U.S. economy, some have argued that industrial policy played a major part in the high-tech sector’s emergence and expansion. They point to the Internet’s development, so crucial for the high-tech sector’s success, as an instance of successful industrial policy. That claim, however, is highly questionable. Harvard economist Shane Greenstein’s comprehensive study of the Internet’s emergence, for instance, demonstrates that the Internet as it exists today emerged largely from below through innovation by private actors. Greenstein particularly underscores the “absence of any large, coordinating government planner” driving the Internet’s development and notes that there was no government department overseeing its design, construction, or operation.
Then there is another factor requiring consideration: industrial policy has a poor track record at reversing decline in communities once especially reliant upon particular forms of manufacturing. In their study of this question, Scott Lincicome and Huan Zhu found that such efforts have overwhelmingly failed, whether in Massachusetts textile towns like Lawrence and Lowell or similar communities in the Midwest such as the steel-town of Youngstown, Ohio. That alone, I’d suggest, indicates that we should question industrial policy’s capacity to realize a broader-based economy.
Of course, if a government decides to put enough money and resources behind a given industrial policy, it will likely produce some results. Yet the same is true of the gambler. If she stays in the casino long enough and spends enough money, she will win a few hands of cards. But the odds are that she will also lose a great deal of money, especially if she is as inept a gambler as the government is maladroit at identifying industry trends or entrepreneurial opportunities. Moreover, just as a compulsive gambler’s behavior will have numerous negative effects on her family’s well-being, so too does industrial policy risk inflicting wider damage upon a nation’s economy and political system. The harms range from gross misallocations of resources to the rampant cronyism and rent-seeking that seems inseparable from industrial policy (which, I again note, its advocates studiously avoid discussing), to name just a few. In this sense, Adam Thierer’s description of industrial policy as “casino economics” is spot-on.
Try Entrepreneurship and Competition Instead
Given these solid grounds for skepticism concerning industrial policy’s capacity to spur the emergence of new industries or diversification within existing sectors, how might one realize such ends? I would suggest that entrepreneurship and competition are part of the way forward.
At the core of entrepreneurship are creativity, imagination, insight, and the ability to transform new ideas and potentialities into economic realities. Entrepreneurship’s very nature involves going beyond the bounds of existing knowledge, and therefore undermining the status quo prevailing in any economy. The discoveries and initiatives undertaken by entrepreneurs cannot help but challenge the existing allocation of resources across an economy and open up new possibilities for the more efficient and ongoing redeployments of skills and capital within and between economic sectors. In many cases, their work unintentionally spurs the creation of industries and forms of employment that has not hitherto existed, often in surprising places.
The capacity of bottom-up entrepreneurship to facilitate widespread change and diversification throughout the economy and between and within different sectors and regions is, however, dependent on several factors. These include strong rule of law and security of property rights. These give entrepreneurs confidence that neither their enterprise nor the fruits of their initiative will arbitrarily be taken from them.
Competition is also vital for stimulating individuals and groups to be more entrepreneurial and efficient and thereby potentially serving as a catalyst for broadening the economy’s sectoral and employment makeup. In highly competitive economies, every business—small, medium, or large—knows that their viability is perpetually open to challenge from existing and potential rivals. Competition forces companies to assess continually what they are doing and why they are doing it by subjecting them to unending pressures to control costs, find less expensive inputs, reorganize their distribution networks, take their products into new markets, and lower their prices. This creates an ongoing tug-of-war between thousands of businesses throughout an economy, and a degree of insecurity that incentivizes people to work harder and innovate. While there is no respite from this remorseless discipline, it does create new or refined products which businesses hope—but do not know—will generate revenue that covers costs and produces a profit.
Competition also makes it harder for any one business to maintain its dominance in a sector or an industry to keep its premier place in an economy. Even big seemingly-dominant firms find themselves tending to innovate when exposed to competitive pressures. No matter how large their capitalization or market share of a given economic sector, all such companies are under some degree of constant challenge in a competitive economy. Big businesses can certainly respond by buying out actual or potential competitors, or through purchasing someone else’s innovations and then integrating them into their own products and operations. But these are manifestations of a large company’s need to react to competitive pressures if it wants to maintain (let alone grow) its market position.
Above all, companies know that there is a greater likelihood in a competitive economy that there is an entrepreneur or business emerging “out there” who, as the economist of innovation Joseph Schumpeter wrote, “commands a decisive cost or quality advantage and which strikes not at the margins of the profits and the outputs of existing firms but at their foundations and their very lives.” There is thus always the possibility that someone will come up with a new idea or product that will decisively shift consumer sentiment away from an Amazon or Blackrock, add such seemingly omnipotent companies and industries to the list of once great but now minor league players, or even lead to a hitherto poorer part of the country experiencing an economic take-off.
Excessive regulation, however, remains a major obstacle to the capacity of entrepreneurship and competition to challenge an existing status quo and potentially broaden an economy’s sectoral and employment composition. The burden created by regulatory compliance can become a major distraction for start-ups trying to focus on innovation. Over-regulation also makes entry barriers into the marketplace for new entrepreneurs higher than they should be. Such individuals find themselves having to expend capital on hiring experts to help them work their way through the endless rules. Some regulations may even force entrepreneurs to pay wages and benefits that, at least at an early phase, they cannot really afford. Large existing businesses can more easily absorb such costs than startups. To that extent, regulation helps solidify the control of existing businesses over a given economic sector. Lastly, regulation can influence the directions in which people’s entrepreneurial instincts are directed. In heavily-regulated economies, many innovative individuals will gravitate towards seeking new ways to engage in regulatory capture, thereby engaging their talents in effecting wealth transfers rather than wealth creation. Industrial policy only exacerbates this problem insofar as it creates considerable incentives for people to invest their creativity in rent-seeking.
The literature illustrating how diminished competition results from rent-seeking by businesses that establish barriers to entry is overwhelming. Economists Thomas Philippon and Germán Gutiérrez show how industry concentration increases with regulation as dominant firms continue “to erect barriers to entry and increase market power.” In their study of regulation’s effects on competition, James Baily and Diana Thomas found that more-regulated industries experienced fewer new firm births and slower employment growth. The same regulatory environment inhibits employment growth in small firms more than in large firms, not least because big companies possess the resources lacked by smaller firms to navigate heavily regulated markets.
The more numerous the regulations and the more costly the compliance, the harder it is for new firms to break into the market and alter the status quo within sectors and across the wider economy. Here it is telling that the heads of Big Tech firms like Facebook’s Mark Zuckerberg have asked legislators on numerous occasions for more regulation of their industry. These individuals are not stupid. They know that the resources which they can devote to lobbying, combined with their present high level of access to legislators, give them the ability to craft regulations to stave off entrepreneurs and competitors from encroaching on their market share. While such large firms will also incur the costs associated with increased regulation, they know that they can better diffuse the costs over the greater amount of things that they produce than smaller companies can.
Know Thy Trade-Offs
Diminishing regulation is thus essential if one wants to open up the possibilities for a broad-based economy via competition and entrepreneurship. There are, however, several caveats that warrant mentioning.
First, if you choose to try and realize a broad-based economy through entrepreneurship and competition, it means accepting that any broadening which occurs—whether of an economy’s sectoral composition or the type and availability of employment across a country—will happen in unpredictable ways. There is no guarantee that a particular change will happen in a specific part of the country, or in one sector rather than any other sector. Such things are largely unknowable in advance. It also means accepting that letting a thousand flowers bloom has consequences for established companies and industries. While some will adapt and prosper, others will shrink and retrench. Some will disappear altogether. In short, the creative destruction associated with entrepreneurship and competition may well broaden the type of enterprises and jobs within an economy, but it will likely result in some businesses and forms of employment dwindling or going on the endangered and extinct species list.
Second, the same processes mean that it is very difficult to plan for the distribution of wealth, overall employment, or types of employment to assume a certain pattern—whether by region or economic sector, let alone promise that any specific demographic group will benefit more than others. Nor can you plan to shift jobs away from the financial sector to retail, or from manufacturing to agriculture—let alone recreate a mythical 1950s-America. Such ambitions must be put aside if you believe that the path of entrepreneurship and competition is the optimal means for broadening an economy. Likewise, it’s important to recognize that the new industries and businesses won’t necessarily emerge in, say, a rust-belt town. This means that some people may have to make the hard choice to move if they want to take advantage of the new employment opportunities. Americans have, however, been doing this since the Republic’s beginning.
In that sense, the entrepreneurship-plus-competition path to a broader-based American economy in a post-Covid world is one that requires humility about what governments can reasonably do if the goal is to promote diversification across and within the different sectors of the U.S. economy and/or spread the benefits of growth among demographic groups and regions. That’s unlikely to enthuse those elected officials and their technocrat advisors fond of promising that their intervention of preference will guarantee 1,000,000 new manufacturing jobs across the country in four years’ time, or 10,000 new high-tech start-ups in their region or state by the end of their term of office. It does, however, go some way to ensuring that aspirations to a broad-based economy remain grounded in reality and don’t succumb to the mindset that now dominates not just most of the American left but also significant sections of the American right: i.e., the hubris of wishful economic-thinking.
Reprinted from Law & Liberty
This article, Industrial Policy? Try Competition and Entrepreneurship Instead, was originally published by the American Institute for Economic Research and appears here with permission. Please support their efforts.