Growth policy for dummies

A recent working paper by Nicholas Crafts - Creating Competitive Advantage: Policy Lessons from History - should be compulsory reading for any South African politician, bureaucrat, journalist, student, trade unionist or anyone vaguely affiliated with policy-making in South Africa. Let me rephrase that: at least the first four pages of this paper should be compulsory reading for anyone working for South Africa's Department of Trade and Industry, Treasury and the Department of Economic Development. Why? Because it gets to the heart of what a government can do to help grow an economy (and, consequently, improve the lives of its citizens). And also why - even if we know what to do and how to do it - it probably won't happen. I'll quote liberally.

The main lesson, as I've mentioned before, is that long-run growth happens on the supply-side, i.e. by improving productivity:

Economic growth, and especially productivity growth, is at the heart of the matter. In turn, longrun productivity performance depends upon decisions to invest, innovate, and adopt new technology which in a market economy will be sensitive to incentive structures. This means that a wide range of government actions which comprise ‘supply-side policy’ can potentially have an impact on productivity growth.

So what can governments do?

The main thrust is that growth depends on investment in tangible and intangible capital, in education and training, and on innovation. Decisions to invest and innovate respond to economic incentives such that well-designed policy which addresses market failures can raise the growth rate a bit. This implies governments need to pay attention to making investments that complement private sector capital accumulation, for example in infrastructure, to supporting activities like R & D where social returns exceed private returns, to avoiding the imposition of high marginal direct tax rates and to fostering competitive pressure on management to develop and adopt cost-effective innovations.

Technology - foreign and domestic - is important:

In the long-run, the key to sustained growth in labour productivity (and growth in living standards) is technological progress. In this context, however, it is important to recognize that better technology can be the result of domestic invention or technology transfer from abroad which is implemented by means of appropriate investments in physical and organizational capital. In fact, most new technology comes from abroad and TFP growth depends much more on foreign than domestic R & D. Nevertheless, the contribution of new technology to growth comes from its use. The key to good growth performance is prompt and effective diffusion of foreign technology rather than domestic invention.

I like that last point. It's not about flashy, new technologies being developed in the domestic industry (think: Rooivalk, or the Joule?), but about adopting technologies that will permeate several, large industries (think: mobile technology). Crafts, for example, finds the distribution industry to have made the largest contribution to the gains in labour productivity between 1995 and 2007. What explains this?

First, a sector’s contribution depends not only on its productivity growth rate but its weight in the economy. (Distribution is large.) Second, distribution is a sector which does (virtually) no R & D but is big and has benefited greatly from the opportunity to improve productivity using ICT. In sum, policymakers should be aware of the basic arithmetic of growth and realize that diffusion matters much more than invention and that productivity improvement in big service sectors is central.

But growth is neither smooth, nor linear:

Economic growth is an unbalanced process – over time, some sectors expand and others contract. This reflects relative productivity growth, differences in income elasticities of demand, and, in an open economy, comparative advantage which reflects relative production costs between (South Africa) and the rest of the world based on differences in productivity and payments to factors of production. Comparative advantage evolves reflecting developments both in (South Africa) and our trading partners in terms of relative wage rates, technological capabilities, labour force skills, agglomeration benefits and this implies the need for sectoral and spatial adjustment as workers are redeployed, especially away from activities which have become importables in the face of competition from emerging Asia. A key requirement fully to realize the benefits from increased trade in a globalizing world is flexibility of labour and product markets.

Of course, this isn't easy to achieve because politicians have different goals than a benevolent dictator - they need to win votes:

Although higher productivity may seem attractive, the politics of achieving it may be quite challenging. A central aspect of technological progress is ‘creative destruction’, i.e., the exit of the old replaced by entry of the new. The pursuit of higher productivity through policies such as trade liberalization creates losers as well as gainers; realizing the potential productivity gains from privatization involves job losses. The common theme here is that, while there are gains for the economy as a whole, these do not translate into votes whereas the losses of the downsized producer groups are highly visible, matter a lot to the individuals involved, and have adverse implications for vote-seeking politicians.

So is there no way government can help? Well, there is industrial policy, a tricky topic. But what is industrial policy really?

Industrial policy encompasses public sector intervention aimed at changing the distribution of resources across economic sectors and activities. Thus, it includes both 'horizontal' policies which focus on activities such as innovation, provision of infrastructure and so on, while 'selective' policies aim to increase the size of particular sectors.

Why do we need industrial policy?

The classic justification for industrial policy is that it remedies market failures, for example, by providing public goods, solving coordination problems, or subsidizing activities with positive externalities. More generally, the development of endogenous-growth theory suggests that horizontal policies which raise the appropriable rate of return to innovation and/or investment can have positive effects on the rate of growth. Quite a wide range of government policies might be relevant here including the structure of taxation, extent and type of regulation, quality of state education and supply of infrastructure capital which raises private sector profitability.

So it seems like horizontal industrial policy, where no industry benefits absolutely, is beneficial. What about selective industrial policy?

The case for selective industrial policies has always been more controversial. However, the modern literature highlights three arguments in their favour, namely: infant-industry related capital market failures, agglomeration externalities, and rent-switching under imperfect competition. It should also be acknowledged that there are important potential downsides to the use of selective industrial policy. In particular, it has been widely remarked that, in practice, support is disproportionately given to sunset rather than sunrise industries and some economists argue that this 'government failure' is an inherent aspect of the political economy of industrial policy.

(Consider the South African clothing and textiles industry.)

An important issue is whether industrial policy reduces competition. Ideally, industrial policy should be used in a competition-friendly way and not through aiming to create ‘national champions’.

There is much more to read in the paper, including a discussion of UK industrial policies and their failure to deliver the desired results. I guess the take-away is that governments should tread lightly whenever support for a certain industry weights more heavily than another. The focus should be on improving the productivity of the large sectors and industries (in South Africa, as in most middle-income countries, services and manufacturing). How to do this? Investment in infrastructure and education that will allow firms in these industries to become more productive by adopting more efficient technologies and hiring more efficient workers. That is, building a fast and reliable telecommunications and transport network, and delivering graduate students that are able to work in these industries. This is not only difficult, it's also unsexy. Which means dummies politicians will continue their search for national champions that do more harm than good.

*Photo by Ales Nesetril on Unsplash.