Industrial policy: Do your homework

By James Manyika

Instead of engaging in doctrinal debates between believers in the market and those who advocate public-policy intervention, governments will boost their odds of success if they take a sector view and draw on experience to learn what approaches to industrial policy have been effective—and which have not—in different sectors and situations, MGI director James Manyika writes as a featured guest in an Economist.com debate on industrial policy.

Industrial policy has a mixed track record at best, and governments have made costly mistakes. But industrial policy does not always fail. Indeed, government activity in markets is often the critical difference between sectors' growth and competitiveness. In this era of heightened activism as governments seek to restore economic growth, what matters is understanding what approaches are likely to work best, when and where. The worst outcome for governments is failing to do their homework and spending scarce public resources on ineffectual forays into the market.

The McKinsey Global Institute (MGI), McKinsey's economics and business research arm, has studied the performance of sectors and their contributions to economic growth and jobs. A key finding has been the distinctions between service sectors and manufacturing, tradable sectors and non-tradable sectors, and the unique characteristics of new sectors. Our work on American multinational companies (MNCs), which tend to be concentrated in globally tradable sectors, finds that a different kind of policymaking may also need to develop in a new era of global competition for the location of MNCs and their investment. High-income economies—the United States in particular—have traditionally dominated as the favoured location for MNCs, but other countries are making huge strides in competing for such investment by providing companies with more consistent and more business-friendly environments in which to operate. Non-G7 economies are now home to 33% of Fortune 500 companies compared with 16% in 2000.

Policymakers must take into account these new realities, tailor their approaches to the particular sector, and think carefully about their priorities. For example, is generating jobs in the short term the major aim; or should the focus be on achieving long-term improvements in productivity and value added? Consider cutting-edge new sectors such as green technologies. These are too small to deliver large-scale job creation in the short term, but they can make a huge difference in the long term if their innovations are widely adopted by large end-using sectors, as happened with semiconductors. In the short term, policymakers primarily interested in jobs should not ignore services, which generated all net jobs growth in high-income economies and 85% of net new jobs in middle-income countries between 1995 and 2005.

So what lessons does the past offer today's policymakers? In the case of globally competing, capital- and R&D-intensive sectors, experience shows that laissez-faire may indeed not be feasible for any country determined to grow a local industry. For instance, no successful semiconductor cluster has ever developed without substantial and sustained government support whether in the form of early defence contracts in America or the provision of public capital in South Korea. But—and it is a big but—trying to build local industries in these sectors is highly risky. Even committed government support cannot guarantee success in this sector, as we have witnessed in the cases of Germany and Singapore. Yet it is precisely this kind of sector with low odds of industrial policy success on which today's policymakers have their sights trained, often with unreasonable expectations for near-term contributions to jobs growth.

Depending on the sector, governments can step out of the way and let companies get on with their business. For largely domestic service sectors, governments can—and arguably should—limit policy to setting the regulatory environment and setting broad national priorities and roadmaps. In retail, good industrial policy looks very much like the Washington Consensus. Reducing barriers to entry, deregulation, flexible labour laws and encouraging creative destruction has been shown time and again to boost productivity (from the United States to Mexico and Russia) with benefits passed on to consumers in the form of lower costs and better products.

A light touch but a more active "enabling" role works for many other sectors. Without interfering with the market mechanism, governments can support the private sector by expanding infrastructure; educating and training a skilled workforce; and supporting R&D. In software, where access to talent is the key, government education policies are critical factors. India, Ireland and Israel, all countries with exceptionally rapid IT services export growth, had a pool of skilled engineers available at a globally competitive cost.

Further along the intervention spectrum, governments can opt to tilt the playing field in favour of domestic producers through trade protection and financial incentives, and shape local demand growth through public purchasing or regulation. At the extreme end of the spectrum, government is the lead actor, establishing state-owned or subsidised companies, funding businesses to ensure their survival and imposing restructuring on certain industries.

The most effective potential approach to myriad manufacturing sectors varies enormously. If there is one common theme, it is that these tend to be globally competing sectors and the odds of success depend on whether governments focus on activities that have an inherent competitive advantage in the location, the sector's role in a global value chain and the execution of policy.

Instead of engaging in doctrinal debates between believers in the market and those who advocate public-policy intervention, governments will boost their odds of success if they take a sector view and draw on experience to learn what approaches to industrial policy have been effective—and which have not—in different sectors and situations.

For MGI's full analysis, see:

This commentary was published on Economist.com as a guest contribution in a debate on industrial policy. The full debate can be viewed at economist.com.

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