July 12th 2024.
The concept of industrial policy is gaining popularity once again. After years of avoiding the use of market-manipulating tools like tariffs and subsidies, many Western governments have turned to them in response to the COVID-19 pandemic. The pandemic has exposed the vulnerability of global supply chains, while concerns about China's dominant position in technology and commerce have raised fears of job losses in the West. But for these efforts to be successful, a focus on knowledge is essential.
In the Western world, industrial policy has not had a great track record. Previous attempts by postwar governments have often fallen short of their goals, as they have supported industries that were not sustainable and lacked a clear path to profitability. As a result, by the 1970s and 1980s, industrial policy was largely abandoned. However, if we shift our perspective and view industrial policy as a means of promoting knowledge, its resurgence could be a game-changer.
A successful knowledge policy would place less emphasis on the creation of knowledge and more on its diffusion. While innovation is undoubtedly valuable, it is also costly and demanding, requiring a unique set of conditions that are not easily attainable. Not every country can realistically expect to be at the forefront of technology. However, a country does not necessarily need to produce cutting-edge innovations to reap the benefits of new ideas, processes, and methods developed elsewhere.
The key to a prosperous society lies in the diffusion of knowledge, which depends on both access to knowledge and the ability to absorb it. After World War II, the economies of Germany and Japan recovered rapidly, despite their physical infrastructure being in ruins, because their existing stock of knowledge remained intact. Both countries had a pool of engineers, doctors, scientists, and managers who were capable of absorbing, spreading, applying, and building upon the advanced knowledge brought in by American occupying forces.
One might ask why the state needs to intervene in knowledge diffusion, given the value of such transfers. The answer lies in the fact that knowledge diffusion is a classic example of an externality. When an individual or a firm invests in knowledge, they typically only capture a fraction of the returns, as the acquisition of knowledge often brings about much higher social returns than private gains. This explains why the state has historically supported and incentivized knowledge production by establishing a patent system and strengthening education.
A successful knowledge policy must encompass both domestic and international elements. On the domestic front, it requires targeted education policies, subsidies to encourage the import of knowledge, and a flexible intellectual property framework that strikes the right balance between fostering innovation and promoting its diffusion. Countries that are far from the technological frontier are better off with loose IP regimes, such as the one that enabled India to build a thriving pharmaceutical industry.
In a world that is geopolitically fragmented, these domestic measures must be complemented by free-trade zones that facilitate the sharing of knowledge among partner countries. These zones would allow for specialization in certain areas, but not all. Despite economists' fixation on comparative advantage, this may not be a bad thing. After all, a country that is at the forefront of technology or is close enough to continue absorbing new knowledge is likely to be a more productive and prosperous economic partner.
When it comes to importing technology, countries should only erect barriers in sectors where catching up is both feasible and desirable. In this sense, the United States and the European Union have a stronger case for investing in their domestic semiconductor industries than India, which is significantly behind in this field. However, even the US may struggle to achieve its semiconductor ambitions without an education policy that encourages the study of engineering. Taiwan leads the world in semiconductor production thanks to its vast knowledge and a workforce that is appropriately educated.
But even for an economy with the right capabilities, if too many of its peers are attempting to catch up in the same area, the costs of the strategy will rise, and the likelihood of success will diminish. This brings us to another reason why free-trade zones are beneficial – they can facilitate policy coordination, especially among allies. India would be more willing to abandon its semiconductor ambitions if it knew it could rely on a steady supply from a trusted partner.
Of course, that partner may have its own demands, such as India strengthening its IP enforcement, which could prove to be costly. But in today's tense and divided world, trade-offs like these are inevitable. A sensible knowledge policy must take into account the limitations and constraints under which allies operate.
Western governments are reintroducing industrial policy at a critical moment. Strategic considerations cannot be overlooked, as they were during the decades of rapid globalization and a stable Pax Americana. Instead, leaders must rise to the challenge and develop sophisticated industrial-military strategies, including knowledge policies, that take into account a wide range of risks, objectives, and pressures.
Tano Santos, Professor of Finance at Columbia Business School, and Luigi Zingales, Professor of Finance at the University of Chicago, are the authors of this article. It was originally published by Project Syndicate.
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