Competing to shoot ourselves in the foot

We should resist the revival of protectionist industrial policy

Since the so-called CHIPS and Science Act was enacted in the United States, the European Union has also became interested in ways to influence industrial production in European countries. Right now the United States, Europe and China are participants in a competition aimed at (re-)industrialization, and in particular, regarding the production of semiconductors and other important intermediate products. In a market economy, price signals and competition, dubbed as “the invisible hand” are usually responsible for directing economic activity into different industries. When demand for a final or intermediate good increases, prices are bid up which increases profits in that industry, which then draws more capital and labour into the industry which then starts driving down prices. This process works wonders especially if there are no substantial positive or negative externalities associated with the process. Faith in the power of competitive markets is, however, on the fade. As I mentioned above, political leaders around the world grew sceptical of the invisible hand, and more trusting of their own hands in directing economic activity. This is a dangeorus development for several reasons. First, there is no way Joe Biden, Ursula von der Leyen, any of their advisers (however smart they may be) or members of congress or the European Parliament, in fact, any particular individual knows how to best allocate resources across different sectors (we know this since at least Hayek’s famous 1945 AER paper, “The Use of Knowledge in Society”). Why should we, for instance, pour government money into producing semiconductors? One answer is that governments do this in order to “create more jobs”. Yet, from an economic point of view, which is, after all, about economizing, more jobs are a cost, not a benefit! Labor-saving technologies are good as labour then can be reallocated into more productive uses. Another answer is that we should promote “green investments”. But a revenue-neutral carbon tax combined with subsidies to basic R&D is a much more potent and efficient way of decarbonization. Another answer is that we need to produce more semiconductors so that they are not produced in China. This argument tacitly accepts that many Western economies do not in general have a comparative advantage in producing these goods, as otherwise they would need not to be subsidized. Without putting money into our semiconductor industries, after which capital and labour would flow into them, and over time, more workers would be trained for these favoured industries, these resources would not remain idle but instead would flow elsewhere where they could earn more. As I said at the beginning, the price system and competition are generally good enough ways to find out which sectors to employ one’s human or physical capital. Politicians, experts and intellectuals, unless private business, do not have much “skin in the game”; they do not risk their own money when they decide or advise on the industries that are to be subsidized. I see, therefore, no compelling economic reason for anything like the original CHIPS Act or its European copycat. If there are no good economic reasons, then there must be other, most likely political, ones. One reason not to “outsource” the production of semiconductors to China may be that we just don’t want China to grow any stronger economically and politically. Yet, an economically stronger China can also serve as a large market for all kinds of (higher added value) products produced by American and European firms and workers. Of course, China presents a geopolitical challenge to us. Yet as I argued in a previous post, decoupling from China is not necessarily a good way of decreasing China’s global clout and may even backfire. A China well-integrated in the world economy may be much easier to deal with than a China increasingly shunned and isolated. A more sophisticated argument holds that while decoupling would be a bad strategy, “derisking” is necessary as geopolitical and other political risks around China abound. Yet I do not see why private business decision makers would not internalize these political risks. For if they do, there is little need for governments to nudge companies and investors in safer directions. Having said that, I am open to contrary arguments. Yet too many commentators seem to accept at face value that now there is a growing need to leave behind the “Washington Consensus” and for governments to be active in supporting particular industries. As I see it, basic economic facts, such as the relative advantage of market competition to decide where and how much to invest, did not change in the past few years, and hence there is little need to opt for a more active industrial policy. I will say one more thing: one can see that as the US started down this current path, the EU followed soon; just as in the case of trade wars, there seems to be a “beggar thy neighbour” strategy developing, a wasteful competition between large economic blocks over the semiconductor industry. As this competition intensifies, there will be (and already are) calls for ever more intrusive industrial policy, and we don’t know where this whole thing will stop. Over time, it will be more likely to be a competiton over who can best shoot itself in the foot. Meanwhile, industrial interest groups will compete over influencing politicians in order to get their hands on funds, an activity known in the economic literature as “rent-seeking”. We should also remind ourselves that there is actually little evidence that Asia’s “tigers” grew rich due to industrial policy. More likely, they grew rich because they promoted exports in general by being open to trade, and investing heavily in education and other human capital. A better way than active industrial policy to improve our industrial fortunes would be to allocate more public funds to basic research, for that is not patentable and hence private actors have too weak an incentive to produce it. Furthermore, Western Europe’s unflexible labor markets and high taxes are a bigger drain on its economic capacity than anything China or other emerging economy does.