Industrial policy is back in vogue. After decades of eschewing the use of market-shaping policy tools like tariffs and subsidies, many Western governments have embraced them, spurred by the COVID-19 pandemic, which exposed vulnerabilities in global supply chains, and by broader fears about Chinese technological and commercial dominance, which could cost the West countless well-paying jobs. If these efforts are to succeed, however, an emphasis on knowledge is crucial.
Industrial policy has a poor track record in the West. When postwar governments tried it, they usually failed to achieve their goals, because they supported industries with no viable path to profitability. By the 1970s and 1980s, they abandoned industrial policy altogether. But if we view industrial policy as knowledge policy, its comeback can succeed.
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An effective knowledge policy would focus less on creation of knowledge than on its diffusion. While innovation is clearly valuable, it is also expensive and challenging, requiring a particular combination of conditions that is often difficult to ensure. Not every country can realistically aspire to be a technological frontier. But a country does not have to produce cutting-edge innovations of its own to be able to reap the benefits (including higher productive capacity, greater wealth, and stronger military capabilities) of new processes, methods, and ideas produced elsewhere.
Knowledge diffusion – which depends on both access to knowledge and the ability to absorb it – is the key to a prosperous society. The German and Japanese economies recovered rapidly after World War II largely because, while their physical infrastructure was in ruins, their stock of knowledge was intact. Both countries had a cohort of engineers, doctors, scientists, and managers capable of absorbing, spreading, applying, and building upon the advanced knowledge brought by occupying American forces.
Recognising the value of such knowledge transfers, one might ask why the state needs to get involved. The answer is that knowledge diffusion is the quintessential externality. When an individual or a firm invests in knowledge, it typically captures only a fraction of the returns: knowledge acquisition often brings far higher social returns than private gains. This explains why the state has long supported and incentivised knowledge production, such as by creating a patent system and strengthening education.
An effective knowledge policy must include both domestic and international components. On the domestic front, it requires a targeted education policy, subsidies encouraging local actors to import knowledge, and a flexible intellectual property (IP) framework, which strikes the right balance between motivating innovation and encouraging its diffusion. Countries that are far from the technological frontier are better off with lax IP regimes, such as the one that enabled India to build a thriving pharmaceutical industry. (Membership in the World Trade Organization has since driven India to adhere to stricter rules.)
In a geopolitically fragmented world, such domestic measures must be complemented by free-trade zones to facilitate knowledge-sharing among partner countries. These zones would allow for specialisation in some areas, but not in all. Economists’ obsession with comparative advantage notwithstanding, this is not necessarily a bad thing. After all, a country at the technological frontier – or close enough that it can continue to absorb new knowledge – is likely to be a more productive and prosperous economic partner.
When it comes to importing technology, countries should erect barriers only in sectors where catch-up is both achievable and desirable (the same sectors where direct subsidies might also be justified). In this sense, the United States and the European Union have much better reason to invest in strengthening their domestic semiconductor industries than India, which is so far behind in this area that any resources spent on catching up are probably wasted. But even the US risks failing to achieve its semiconductor ambitions, unless it also implements an education policy that encourages the study of engineering. Taiwan leads the world in semiconductor production thanks not only to its vast knowhow, but also to its appropriately educated workforce.
But even for an economy with the right capabilities, if too many of its peers are trying to catch up in the same area, the costs of the strategy will rise, and the probability of success will drop. This brings us to another reason why free-trade zones are useful: they can facilitate policy coordination, at least among allies. India would be far more willing to abandon its semiconductor ambitions if it knew it could rely on a steady supply from a trusted partner.
To be sure, that partner might make demands of its own – say, for India to strengthen its IP enforcement, which would be very costly. But, in today’s tense and divided world, such trade-offs are practically inevitable. A sensible knowledge policy must recognise the constraints under which allies operate.
Western governments are bringing back industrial policy at a particularly fraught moment. Strategic considerations cannot be ignored, as they were during the decades when globalisation was progressing rapidly, and Pax Americana remained firmly in place. Instead, leaders must rise to the challenge and devise sophisticated industrial-military strategies – including knowledge policies – that account for a wide range of risks, objectives, and pressures.
— Tano Santos is Professor of Finance at Columbia Business School. Luigi Zingales is Professor of Finance at the University of Chicago. ©Project Syndicate
