Industrial Policy vs. Free Trade: Does Federal Industrial Policy Make the US Economy better off

Term Paper 2014 7 Pages

Business economics - Economic and Social History


I. Introduction

The world we live in today has changed drastically from the world that my parents and grandparents lived in. With increasing globalization, the world has become more and more interconnected in various aspects. The phrase “What happens in Vegas, stays in Vegas” might still apply in a social context, although social media has made it more difficult for secrets to be kept. However, from an economic point of view, events that happen in one country will have an impact on other countries. Since the General Agreement on Tariffs and Trade (GATT) was first introduced in 1948, trade barriers have been decreased and the trade between nations has increased rapidly. What started as a mere agreement between nations eventually turned into the World Trade Organization with a total of 159 member nations. (World Trade Organization, n.d.) Economies all over the world are interdependent because the world has become a global marketplace. The recent financial crisis that started with the collapse of the U.S. real estate bubble has shown everyone how economic conditions in one country can lead to an economic recession worldwide.

Despite the World Trade Organization’s great success in promoting free trade across the world, this success has not been without a lot of criticism. Many people argue that free trade does not make every economy better off and that it takes jobs away from domestic economies. Some economists believe that federal economic policy, a policy by which the government fosters growth in specific industries, would make the US economy better off. The question whether the United States should apply this model is not a new idea. Many democratic presidential candidates in the 1980s were pushing for a federal industrial policy in order to aid the U.S. manufacturing industry which was on the brinks of destruction because of increased competition from European Nations and Japan. Even today, under the Obama Administration, it is still a hot topic in the field of economics and international business. But what exactly is Federal Industrial Policy and would it make the U.S. a winner?

I. Industrial Policy

National Industrial policy is a set of economic reforms to change the industrial structure of a nation's economy. Proponents of National Industrial policy are opponents of an unfettered market and think that the government has to foster economic growth by more than just fiscal and monetary policies. One of the most famous proponents of industrial policy was Harvard Professor Robert Reich. He claimed in the 1980s that the U.S. Economy “had been unraveling since the sixties.” (McKenzie, n.d.). He argued that it was in a phase of deindustrialization. The core industries steel, textiles, rubber, shoes, and automobiles were declining and becoming increasingly uncompetitive in the global market. Reich believed that foreign nations that used industrial policy like Europe or Japan were more successful because their policies provide for economic adaptation, the U.S. did not. Therefore he argues the government should be directly involved in establishing national industrial goals and assuring that the goals are achieved.

Federal industrial policy involves letting the federal government decide the industrial structure, redistribute resources and output, and reallocate income from one region of the country to another and from one income class to another (McKenzie, n.d.). The government's task is to identify the industries that are perceived to be competitive in the future and give specific aid to them. The aid consists of government subsidies and a variety of protectionist policies such as trade barriers and tariffs on foreign competitor products. Industrial Policy also supports federal and state expenditures for basic education and worker training to improve competitiveness, plant-closing restrictions to slow down the outflow of capital, and federal expenditures on day-care facilities to get more human capital into the labor market. By focusing on specific industries, the government hopes to create internationally competitive industries that have a competitive advantage over all foreign competitors. Proponents of this theory argue that the government has superior information on which industries in their country are the most competitive. By targeting and using resources to aid these specific industries, the whole nation will be better off because the country is specializing in industries for which it has a competitive advantage.

An example of industrial policy in effect is Japan's postwar economy. Japan experienced a tremendous growth in industrial production after the war. Its highest peak was in 1975. Between 1962 and 1975, Japan's economy grew by 66% and is described as the Japanese “miracle” (Nakamura, 2011). This booming growth is merely attributed to Japan's industrial policy in the 1950s and 1960s. The objective of Japan's government was to shift resources to specific competitive industries in order to gain a competitive advantage for those industries in the international market. Specifically, Japan has used industrial policy with its auto and computing technology industries in the 1970s. Japan’s auto industry has seen huge growth and has been regarded as one of the most efficient in the world. Its policies in the chip industry were also regarded as very successful and have almost caused US chipmaker Intel to go out of business in the 1980s. (Lohr, 2009)

In the late 1980s, Japan’s government stopped industrial policy and intervened less in the market. Trade and foreign investments were liberalized and tariff barriers were lowered to allow for global free trade and an unfettered market. Japan fell into a long recession at the beginning of the 21st century and is still fighting its way out of economic stagnation.

Whether or not industrial policy was the key to Japan's economic boom in the 1960s and 70s is still being discussed by many economists. Although in the 1970s, a majority of economists would have answered this question with a clear yes and that it strongly contributed to the economic boom, today many economists believe that “free play of market forces driven by dynamic entrepreneurs” was the actor of the post-war growth. This theory is supported by the fact that Japanese’ industrial policy also had a negative effect on some companies that are actually very successful today. For example, the automaker Honda was prohibited from expanding into the car making industry by the Japanese Ministry of International Trade and Industry, or better known as mighty MITI. Honda, who was merely a motorbike manufacturer wanted to build cars, but the MITI was opposed to this plan because it did not want another player in this industry. The more globally competitive and open an industry is, the harder it is for governments to promote companies effectively. (Picking winners, saving losers, 2010)

II. Economic Freedom

This idea of “free play of market forces” is called economic freedom. For economic freedom to work there needs to be economic liberty. A free market and the protection of property rights are inevitable for economic freedom. One has the right to produce, trade, and consume any goods and service. These rights are embodied in the rule of law, property rights, and freedom of contract. Economic freedom means the least amount of government interference and regulation enforced upon the market. Low tariffs, no minimum wage, and least environmental restrictions for the private industry are signs of economic freedom. It is essential that markets are completely open to foreign investment. Economic freedom can be measured in many different ways. There are two main indices that measure or attempt to measure it. The “Index of Economic Freedom” by the Heritage Foundation and the annual survey “Economic Freedom of the World” by the Fraser Institute (IEF, 2014). Both use criteria such as government expenditures; taxes on enterprises; legal structure and property rights; access to money; freedom to trade internationally; regulations of credit, labor, and business; inflation rates; costs of importing, and regulated prices. According to many economists, these indices show a strong correlation between economic freedom and economic and social well-being. A high ranking in one of these indices correlates with higher average income, higher life expectancy, higher literacy rate, lower infant mortality rate, higher access to water sources and lower corruption in government and private companies.



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Title: Industrial Policy vs. Free Trade: Does Federal Industrial Policy Make the US Economy better off