How to successfully solve one of our most pressing challenges: Sustainable development

• Eike Hirschberg
• 10. June 2020

We need a re-orientation of economic policy for the developing world because there are still 734 million people who live in extreme poverty, i.e. on less than $2 per day. One of the most important strategies to do so is industrial policy: This term, which has re-entered discussions in academia and among policy makers in the last 10 years, describes a coordinated effort by governments to ignite the growth in the manufacturing sector in order to eliminate poverty.
The biggest danger to successful industrial policy is rent-seeking which describes efforts by actors from the private sector, such as entrepreneurs, as well as from the public sector, such as politicians or bureaucrats, to profit personally from the state’s resources. One of the major reasons is lacking control over these actors: Examples include corruption, as well as more subtle forms such as the abuse of permits allowing certain businesses to operate. Sometimes, they are only awarded to certain businessmen close to the decision-makers which ensures that these businessmen are not threatening the regime while ensuring high income for these businessmen due to lacking competition.
Another major reason why rent-seeking might occur is that businesses face lacking demand for their products: In many developing countries, high unemployment means that people can barely buy the necessities they need to survive. Under these conditions, it is very hard for many entrepreneurs to sell their products, pay their bills and continue to operate. Thus, they turn to the government for support in order to continue their operation. This implies that, certain privileged businesses are able to sell their products thus enabling them to stay in operation, while all the others cannot continue to operate anymore.
This system only benefits a few people and has a very severe consequences for the whole economy, especially on its productivity: It reduces the incentives to innovate and encourages the waste of resources to secure these privileges, instead of investing them in productivity advances. As industrial policy is by definition a government intervention, it is highly prone to this kind of behaviour. If policy makers do not take it into account, industrial policy will not have any positive effect; quite the contrary: it will strengthen rent-seeking behaviour and thus block economic and social development.
To achieve this, the State can use “sticks”, i.e. institutions to discipline political and economic actors, as well as “carrots” to reduce the danger of lacking demand.

Enhancing oversight over economic and political actors
The “sticks” are measures that improve the oversight over political and economic actors. They are necessary because of closed circles of power between the government and private sector which are one of the main reasons for rent-seeking.
The integration of lower segments of the society has historically been key to improve the oversight over the government, as shown by Rueschemeyer et al. One instructive case is the farmer’s protests against the collectivisation of the Vietnamese agriculture in the 80s shown by Pingali and Xuan: During the land reform, the Communist party integrated peasants into the party who consequently formed their power basis. When the government began to collectivise the agriculture, they organised major protests, and the party leadership understood that their policies were not satisfying a majority of the people, which was, importantly, threatening their power base. Thus, they not only partially reversed on collectivisation, but also introduced the first steps towards economic liberalisation which formed the basis of Vietnamese success.
To improve oversight over economic actors, Altenburg and Lütkenhorst propose to design industrial policy making in a sequential way. That means industrial policy making should include regular checks on the effectiveness of the realised policies in order to withdraw state support when deemed appropriate. Once again, Vietnam provides an instructive example for the successful realisation of this (details on this case can be read in this publication by Page, Tarp, and the World Institute for Development Economics Research): It set up a council of retired government officials without their own businesses who were responsible for industrial policy. This ensured that they had a high degree of independence as they had neither career aspirations, nor business interests on their own. Thus, they could regularly check the policies and change them independently which ensured a sequential and gradualist industrial policy making. They were responsible for important steps for Vietnam’s economic success, such as the introduction of the Enterprise Law, which allowed the free operation of businesses and thus laid the foundation of the introduction of a market economy.
Another important part of controlling economic actors is that governments have to establish criteria to decide which enterprises they support. In the past, many governments have used export targets as such a criterion. The Chinese evaluation system for local officials provides a compelling example, described by Page, Tarp, and the World Institute for Development Economics Research: Embedded in a taxation reform, the central government based their evaluation on local economic performance. Thus, in order to minimise the risk to get a bad evaluation, local officials decided to support the enterprises that were already performing well which they found in the light-manufacturing export-oriented sector.
Export performance is a clear criterion which allows the state to control the private sector and it has been used successfully in other cases of late-comer industrialisation as well. As evidenced by Wolf, however, a high degree of competition on export markets due to Chinese dominance, as well as the high number of countries using this strategy to industrialise simultaneously means that export markets in general cannot be the main basis for industrialization today. Thus, export performance criteria have to be complemented by others. One criterion might be sales on the domestic market, but the discussion has to continue on this topic.

Fighting poverty is essential for successful industrial policy
The “carrots” are necessary, because enterprises have to sell their products on markets in order to stay profitable. As just mentioned, using the export market for this becomes increasingly difficult. This implies that rising wages for everybody is important because industrial development is built on mechanisation, as shown by Elsenhans. Mechanisation means that enterprises invest in buying machines which produce a large number of relatively simple products. In order to pay for this investment, these products have to be sold. Thus, ensuring that the people living in the respective country have enough money to actually buy these products crucially supports industrialisation. In addition, ensuring rising wages incentivise entrepreneurs to invest in more machinery because they can sell their products in the future, too. Thus, rising wages also provide an important incentive for enterprises to invest resources in productivity increases instead of rent-seeking.
Consequently, policy makers should consider how the state can promote domestic demand in order to allow enterprises to make profits because there the free market does not automatically ensure increasing wages. This is because in many developing economies, high levels of unemployment lead to a power imbalance between employers and employees: Every time employees demand a wage increase, the employer can just fire them and hire new employees from the big pool of unemployed. This means that employees cannot enforce higher wages although their productivity rises because of rising educational levels or more experience. Thus, State interventions in order to reduce poverty, to increase wages and consequently increase domestic demand are crucial to the success of industrial policies.
How can we achieve this? Although many government interventions to support domestic demand are not allowed today by the World Trade Organisation (WTO), the following measures are still realisable for policy makers in this regard:

(1) The support and reform of the agricultural sector,
(2) setting up a universal social security system,
(3) promoting employment and education at the same time.

Increasing agricultural yields is important for a number of reasons: Firstly, food security is not a given in all developing countries. Thus, by promoting the agricultural sector, governments ensure that all their citizens have enough food to eat. In addition, they become independent from imports from the world market which ensures that they are independent from food speculation increasing the stability of food supply. Furthermore, this enables them to devaluate their currency in order to make their products cheaper on the world market: If their food supply remained dependent on imports, they could not do this, as it would increase prices.
Land reforms are an important step towards food security. Page, Tarp, and the World Institute for Development Economics Research show that land reforms were most successful when they redistributed land to the peasants. This is evidenced by the East Asian experience in comparison to Latin America: The successful industrialisers in Asia undertook land reforms, enabling peasants to profit directly from their harvests and giving them direct access to food which considerably increased incentives to work harder on the fields. Whereas in Latin America, the feudal systems stayed more or less intact and industrialisation did not take off. The experience of Communist countries shows that agricultural yields went up after the breakdown of the feudal system but decreased when land was collectivised because it led to lacking incentives to increase the yields. Thus, land reforms without collectivisation seem to be the key to success. In addition, Ghosh shows that agricultural yields have been increased by investments in higher productivity in the successful cases of industrialisation.
We can learn from comparing Latin America and East Asia that a universal social security system is superior than a targeted one. This is because a more targeted system was used in many cases to ensure support from certain social groups, such as urban workers in the case of Latin America, as shown by Haggard and Kaufman. Although this at least improves the lives of some people, it perpetuates dependency from the government and thus decreases oversight over political actors which is detrimental to industrial policy and industrial development. In the East Asian countries, which achieved food security via land reforms and secured political support via economic growth, the States only provided a backbone social security system. It provided for the most basic needs, like old age pensions or education, but it was more universal than in Latin America. However, there is no reason to not expand it in later phases of industrialisation: As described by Tang, many East Asian countries enlarged their social security systems during the short periods of democratisation in the 1980s.
In order to increase the workers’ wages, it is important to increase their productivity so that the enterprises can afford to pay them higher wages. Productivity can be increased by incentivising enterprises from industrialised countries to invest in the country so that they bring their advanced technology which can be adopted by the domestic firms. This makes it immediately clear that this kind of investment should be connected to the domestic economy, e.g. by forming joint-ventures between domestic and foreign firms, as was the case in successful industrialisers described by Chang, Hauge, and Irfan. Governments should not rely on foreign investment too much, however, as its rates are declining globally, according to Cimoli, Dosi and Stiglitz.
Another way is to promote education: Formal education has played an important role for the success of all the East Asian economies, especially concerning the education of engineers. This can be accompanied by efforts to promote informal learning, such as promoting exposure of entrepreneurs to the newest trends, consumer demands, technologies and business ideas.
It is important to create employment at the same time because well-educated workers for whom there is not enough work are not able to profit from their education. And even if they are employed but there are not enough jobs, they cannot claim higher wages as already explained. Suitable sectors are those which match the countries’ needs for development as well as the educational endowment of the population. In the past, this was the export-oriented light manufacturing industry. This is not feasible anymore, however, so that new sectors have to be found. Wolf shows that Angola promoted the agro-alimentary industry, the construction materials industry, the iron and steel industry, wood processing, and chemical industry in the framework of an industrial policy using the domestic market which led to high growth rates of the manufacturing sector. Furthermore, as shown by the Chinese experience, it is important to open up the economy gradually in order to avoid job losses in the manufacturing sector due to foreign competition.

Making industrial policy work means to go beyond the confrontation between “the state” and “the market”
In order to make industrial policy work, it is necessary to go beyond the “Unproductive Confrontation” criticised by one of the godfathers of industrial policy, namely Ha-Joon Chang. But it is a different confrontation than the one he refers to, namely between “the state” and “the market” which can be seen to be very inter-related. By introducing the concept of rent, we can see that State interventions to support domestic demand (which I called “carrots”) do not stop enterprises from trying to get money from the state. Without ensuring that enterprises can become profitable by using these interventions, however, the institutions to improve control over political and economic actors (which I called “sticks”) will also not be enough to stop the enterprises from rent-seeking. Or, in other words, setting up the basic institutions of a market economy without underpinning it by ensuring that people can actually buy the products that are made by the enterprises operating on these markets will lead to a failure of industrial policy.