Miracle, or marginal gain?

From 1960 to 1989, South Korea experienced a famous economic boom, with real GDP per capita growing by an annual average of 6.82 percent. Many observers have attributed this to industrial policy, the practice of giving government support to specific industrial sectors. In this case, industrial policy is often thought to have powered a generation of growth.

Did it, though? An innovative study by four scholars, including two MIT economists, suggests that overall GDP growth attributable to industrial policy is relatively limited. Using global trade data to evaluate changes in industrial capacity within countries, the research finds that industrial policy raises long-run GDP by only 1.08 percent in generally favorable circumstances, and up to 4.06 percent if additional factors are aligned — a distinctly smaller gain than an annually compounding rate of 6.82 percent.

The study is meaningful not just because of the bottom-line numbers, but for the reasons behind them. The research indicates, for instance, that local consumer demand can curb the impact of industrial policy. Even when a country alters its output, demand for those goods may not shift as extensively, putting a ceiling on directed growth.

“In most cases, the gains are not going to be enormous,” says MIT economist Arnaud Costinot, co-author of a new paper detailing the research. “They are there, but in terms of magnitude, the gains are nowhere near the full scope of the South Korean experience, which is the poster child for an industrial policy success story.”

The research combines empirical data and economic theory, using data to assess “textbook” conditions where industrial policy would seem most merited.

“Many think that, for countries like China, Japan, and other East Asian giants, and perhaps even the U.S., some form of industrial policy played a big role in their success stories,” says Dave Donaldson, an MIT economist and another co-author of the paper. “The question is whether the textbook argument for industrial policy fully explains those successes, and our punchline would be, no, we don’t think it can.”

The paper, “The Textbook Case for Industrial Policy: Theory Meets Data,” appears in the Journal of Political Economy. The authors are Dominick Bartelme, an independent researcher; Costinot, the Ford Professor of Economics in MIT’s Department of Economics; Donaldson, the Class of 1949 Professor of Economics in MIT’s Department of Economics; and Andres Rodriguez-Clare, the Edward G. and Nancy S. Jordan Professor of Economics at the University of California at Berkeley.

Reverse-engineering new insights

Opponents of industrial policy have long advocated for a more market-centered approach to economics. And yet, over the last several decades globally, even where political leaders publicly back a laissez-faire approach, many governments have still found reasons to support particular industries. Beyond that, people have long cited East Asia’s economic rise as a point in favor of industrial policy.

The scholars say the “textbook case” for industrial policy is a scenario where some economic sectors are subject to external economies of scale but others are not.

That means firms within an industry have an external effect on the productivity of other firms in that same industry, which could happen via the spread of knowledge.

If an industry becomes both bigger and more productive, it may make cheaper goods that can be exported more competitively. The study is based on the insight that global trade statistics can tell us something important about the changes in industry-specific capacities within countries. That — combined with other metrics about national economies — allows the economists to scrutinize the overall gains deriving from those changes and to assess the possible scope of industrial policies.

As Donaldson explains, “An empirical lever here is to ask: If something makes a country’s sectors bigger, do they look more productive? If so, they would start exporting more to other countries. We reverse-engineer that.”

Costinot adds: “We are using that idea that if productivity is going up, that should be reflected in export patterns. The smoking gun for the existence of scale effects is that larger domestic markets go hand in hand with more exports.”

Ultimately, the scholars analyzed data for 61 countries at different points in time over the last few decades, with exports for 15 manufacturing sectors included. The figure of 1.08 percent long-run GDP gains is an average, with countries realizing gains ranging from 0.59 percent to 2.06 percent annually under favorable conditions. Smaller countries that are open to trade may realize larger proportional effects as well.

“We’re doing this global analysis and trying to be right on average,” Donaldson says. “It’s possible there are larger gains from industrial policy in particular settings.”

The study also suggests countries have greater room to redirect economic activity, based on varying levels of productivity among industries, than they can realistically enact due to relatively fixed demand. The paper estimates that if countries could fully reallocate workers to the industry with the largest room to grow, long-run welfare gains would be as high as 12.4 percent.

But that never happens. Suppose a country’s industrial policy helped one sector double in size while becoming 20 percent more productive. In theory, the government should continue to back that industry. In reality, growth would slow as markets became saturated.

“That would be a pretty big scale effect,” Donaldson says. “But notice that in doubling the size of an industry, many forces would push back. Maybe consumers don’t want to consume twice as many manufactured goods. Just because there are large spillovers in productivity doesn’t mean optimally designed industrial policy has huge effects. It has to be in a world where people want those goods.”

Place-based policy

Costinot and Donaldson both emphasize that this study does not address all the possible factors that can be weighed either in favor of industrial policy or against it. Some governments might favor industrial policy as a way of evening out wage distributions and wealth inequality, fixing other market failures such as environmental damages or furthering strategic geopolitical goals. In the U.S., industrial policy has sometimes been viewed as a way of revitalizing recently deindustrialized areas while reskilling workers.

In charting the limits on industrial policy stemming from fairly fixed demand, the study touches on still bigger issues concerning global demand and restrictions on growth of any kind. Without increasing demand, enterprise of all kinds encounters size limits.

The outcome of the paper, in any case, is not necessarily a final conclusion about industrial policy, but deeper insight into its dynamics. As the authors note, the findings leave open the possibility that targeted interventions in specific sectors and specific regions could be very beneficial, when policy and trade conditions are right. Policymakers should grasp the amount of growth likely to result, however.

As Costinot notes, “The conclusion is not that there is no potential gain from industrial policy, but just that the textbook case doesn’t seem to be there.” At least, not to the extent some have assumed.

The research was supported, in part, by the U.S. National Science Foundation.

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