The Myth of National Industrial Policy
AUGUST 01, 1985 by DENNIS BECHARA
Mr. Bechara is an attorney in Washington, D.C.
Calls have come in recent years for a new industrial policy as a certain cure for economic stagnation. Between 1969 and 1976, the Northeast and Midwest sections of the country lost about a million manufacturing jobs. It was common to refer to some of the more blighted areas as the “rustbelt” of America, foreshadowing ominous things to come. Although the recent economic rebound has in some ways muted the urgency, the call for government planning is still very much with us.
Demands for a new industrial policy no longer originate solely from academic circles. Prominent business leaders are espousing such a solution to our economic evils. Lee Iacocca, for instance, asks for the implementation of a “rational” industrial policy. In fact, he has stated that, “Any debate over whether the [United States] should have an industrial policy is outdated and way off course. We already have one but it’s all messed up. The real issue is, should we have a rational industrial policy.” In a sense, he is right. We have a hodgepodge of Federal policies that affect investment decisions in a significant fashion. Whether these policies could ever be “rational” is, of course, a debatable point.
Two Variations of a Theme
Two names are commonly associated with the proposal for a national industrial policy—Felix Rohatyn and Robert Reich. Rohatyn acquired national prominence when he became the chairman of the Municipal Assistance Corporation (MAC), an off budget enterprise created by the State of New York, which issued $10 billion in bonds. MAC was credited with saving New York City from bankruptcy, and Rohatyn, as its chairman, basked in the so-called success of the rescue operation. He became affectionately known as “Mr. Fixit.”
New York City by 1975 had borrowed $724 million to cover current expenses. Its short-term debt amounted to $4.5 billion. MAC was devised as a way of financing the short-term debt and averting outright default. MAC was able to function only with the backing of the federal government. This was achieved by measures that guaranteed to the capital markets that even if the City of New York defaulted, the taxpayers would cover the bonds. New York City was saved from bankruptcy by the spreading of its risks to the national level.
Rohatyn’s proposed national industrial policy is to revive a scrapped agency called the Reconstruction Finance Corporation (RFC) which would target decaying industries and regions and inject them with much-needed capital. Rohatyn also calls for easy credit by the Federal Reserve System to encourage the expansion of the housing and construction industry. The new RFC would not be vulnerable to public pressure, according to Rohatyn, because it would make its investment decisions behind closed doors, after consultation with appropriate business, labor and government representatives. As part of the conditions for granting financial assistance, the RFC would require certain policy and management changes, and it would obtain a share of equity in the enterprise. Thus, dying industries, such as steel, textiles, rubber and automobiles would be favored and strengthened by the RFC.
Robert Reich, a Harvard Professor, proposes to favor industries with potential future technology. In contrast to Rohatyn, Reich’s version of the RFC would conduct its deliberations in public and would welcome the participation of all segments of society.
Interestingly enough, Reich and Rohatyn criticize each other’s proposals. Reich feels that Rohatyn’s closed-door RFC represents a dangerous concentration of power and a threat to our democratic institutions. Rohatyn’s criticism is that an open-door RFC would only lead to politicized decisions. Both criticisms are valid arguments against the creation of an RFC.
Credit Is Earned
The unfettered market extends credit according to the profitability of an enterprise. If a business venture seems headed for failure, the credit markets either charge higher borrowing costs or simply do not grant any further financial assistance. On the other hand, if an enterprise has a probability of success, credit is allocated to it. This is a healthy phenomenon, because profitable enterprises are rewarded by the credit markets and unprofitable industries are penalized. A profitable enterprise is one that has correctly judged desires of consumers and thus is allocating resources in the most efficient way. An unprofitable enterprise, on the other hand, is one that has failed to adjust to consumer demand and misallocates resources.
By granting financial assistance to dying industries, the proposed RFC would, in effect, lower the rate of economic growth because resources would be allocated to inefficient uses. In addition, the RFC would be the lender of last resort. Industries whose prospects are so bleak that they cannot obtain further financing from the private markets, would flock to the RFC seeking assistance.
The funds granted to these poorer risks would crowd out more deserving users of funds. This may happen either because interest rates go up as a result of government operations, or, because one borrower obtains actual physical capital goods—let’s say tractors on farms—at the expense of others. So we would be allocating resources to those poorer risks, who would either fail, or produce inefficiently. Therefore, it is not just a mere re-allocation of capital that is involved in an industrial policy. Also involved is the reduction in the country’s wealth.
There is no guarantee that government is any better equipped than the credit markets to judge what will be the technology of the future. A few years back, France and England joined in a common government enterprise to develop a new airplane that would be the fastest in the world. The result was the Concorde, a massive white elephant that is no longer in production. The test of profit and loss is the crucial one to determine what industries have potential for growth, and the credit markets are better equipped to judge this.
The incentive to be careful in allocating credit would be removed if credit were socialized, because government is not under the constraint of having to turn a profit. Other considerations, such as “the public interest,” are prone to political manipulation. On July 25, 1983, Senator Proxmire, when discussing the desirability of instituting a national industrial policy, wondered how resources would be allocated, and he answered the question in this fashion:
Money will go where the political power is . . . It will go where the union power is mobilized. It will go where the campaign contributors want it to go. It will go where the mayors and governors as well as Congressmen and Senators have the power to push it. Anyone who thinks government funds will be allocated to firms according to merit has not lived or served in Washington very long.
In addition, it is easy to envisage dying industries, with their lobbyists, Congressmen and labor unions influencing an RFC and persuading it to grant further economic assistance. The so-called “new” or “promising” industries that Reich would like to aid would simply not have the political clout that the established industries already have. An RFC would provide a further incentive for groups to engage in rent-seeking behavior. Political considerations will enter into play in the allocation of capital, and those firms that are economically efficient but politically unpopular, will suffer the consequences.
Government Allocation Distorts the Economic Message
To the extent that the proposed RFC channels resources to industries less favored by consumers, we distort the economic information which is essential to entrepreneurs. Where the relative profitability of industries is forcibly altered by the government, the wrong signals are sent to entrepreneurs, and further malinvestments take place. An RFC could only perpetuate inefficient firms at the expense of the efficient ones.
In fact, this is happening right now. If we look at the activities of the federal government, we observe that there are over $30 billion in direct loans and over 150 agencies that guarantee loans to different groups in the country. All of this activity amounts to approximately $100 billion a year. Economist Herbert M. Kaufman of the University of Arizona studied the effect of Federal loan guarantees and his conclusion should not surprise us. For every $1 billion in Federal loan guarantees, between $736 million and $1.2 billion in private investments that otherwise would have taken place is crowded out.
In addition, the current tax code provides a series of incentives and deductions that skew production and the allocation of resources away from where the market would have put them. For example, by fiscal 1986, the combined tax breaks provided to people and businesses will be in the neighborhood of $400 billion. It has been estimated that in 1983 alone, the wealthy legally avoided paying taxes on more than $35 billion of income by placing investments in such qualifying ventures as oil drilling, avocados, dairy farms, real estate and other tax-sheltered enterprises. This is one of the reasons Lee Iacocca is correct when he states that we already have an industrial policy. There is no question that a substantial segment of our economy is directly influenced by considerations that are outside the free market.
History of the RFC
Perhaps a better way of understanding the proposals for a national industrial policy is to study the actual record of the much-trumpeted Reconstruction Finance Corporation.
The RFC was established on January 22, 1932, as part of Herbert Hoover’s programs to combat the Depression. Its purpose was to provide financial assistance to a number of institutions, public and private, in order to promote economic recovery. During the first few months of its existence, the RFC refused to divulge to the public the names of the institutions that were being considered for or which were granted financial relief. It was feared that the public would lose confidence in any corporation that received funds from the RFC, perceived as the lender of last resort. Congress, however, revised this policy and mandated that the RFC’s activities become publicly known. It soon became evident that loans were granted on the basis of political considerations, as shown by the following:
(a) $90 million to the Central Republic Bank of Chicago, whose “honorary chairman,” Charles G. Dawes, was the past president of the RFC.
(b) $14 million to Union Trust Company of Cleveland. Its chairman was the treasurer of the Republican National Committee.
(c) $12.3 million to the Guardian Trust Company also of Cleveland. Atlee Pomerone, president of the RFC, was a director of this company.
(d) $7.4 million to the Baltimore Trust Company, whose vice chairman was a Republican Senator.
(e) $13 million to the Union Guardian Trust Company of Detroit, a director of which was Roy D. Chapin, Secretary of Commerce.
Aside from banks and trust companies, over the years the RFC provided financial assistance to insurance companies, mortgage companies, credit unions, agricultural credit corporations, railroads, and eventually even to topless bars and massage parlors! Over 13 years, the RFC distributed more than $35 billion. Although some apologists of the RFC claim that when it ceased operations it left a surplus of $500,000,000, a closer analysis reveals an $11.5 billion loss due to loans that defaulted and were otherwise written off.
Did the RFC achieve its goals? If we consider unemployment as a reliable indicator, we have to conclude that the RFC failed. In 1931 unemployment stood at 8 million. By 1939 there were 9 million people unemployed. Unemployment declined only after Pearl Harbor. All the RFC achieved was to misallocate resources. Capital was diverted from more efficient uses to less efficient, but politically more savvy uses. No one will ever know how much investment was crowded out by the RFC, but if the study by economist Kaufman is an indication, the effects were substantial.
One of the shining examples utilized by many proponents of a national industrial policy is Japan. According to this version, .Japan’s economic miracle is due to the guidance provided by the Ministry of International Trade and Industry (MITI). Therefore, all we have to do is set up our own MITI and permanent economic recovery will be with us. Before we do that, it would be instructive to analyze just what MITI has done in Japan. Is the Japanese miracle due to MITI’s omniscience? Or is it due to a policy of limited government and laissez-faire?
At the end of World War II, Japan was devastated militarily and economically. Two of its cities, Hiroshima and Nagasaki, were obliterated by atomic bombs. Food was scarce, and only 16 per cent of Japan’s land is arable. In 1947 more than half the Japanese population was engaged in farming. Although lacking capital and technology, Japan had a vast amount of cheap labor. So labor-intensive industries began to prosper and produced such items as foodstuffs, textiles, ceramics, and beverages. These export industries in turn brought foreign currency into the country, enabling Japan to acquire foreign technology, managerial expertise and raw materials.
As the evolution continued in the 1960s, capital intensive industries began to emerge, producing such items as automobiles, motorcycles, television sets, radios and cameras. Japan’s success in exporting its goods was the result of thousands of private companies which imported cheap raw materials, acquired foreign technology and exported goods. What was the role of the Japanese government and of MITI in particular during this time?
During the 1950s, MITI was convinced that there were no commercial possibilities for the transistor. After all, a change to transistors was simply too revolutionary an idea. So for two years, MITI attempted to prevent Sony from acquiring manufacturing rights from Western Electric. Similarly, MITI felt that Japan’s automobile manufacturers could not compete in the world markets. So they attempted to dissuade the manufacturers from getting into the export market. In addition, MITI felt that there were just too many automobile plants in Japan, so it at tempted to force all ten firms into merging into two—Nissan and Toyota.
Needless to say, MITI failed to persuade the Japanese business community of the wisdom of its advice. Robert Reich points at the Japanese semiconductor industry as the one example where the government successfully targeted an industry. But, if we take a closer look at the statistics, the U.S. government has been spending 10 times as much money as the Japanese government spends on the semiconductor industry. Therefore, government spending is not the answer to the success of the semiconductor industry. In fact, the Japanese government’s share of all research and development (including defense) is amazingly low. In the U.S. it is 48 per cent, whereas in Japan it is 28 per cent.
Not surprisingly, during the 1950s and 1960s, the Japanese government was concerned with rebuilding the nation’s infrastructure. Roads, harbors and airports were built. The government balanced its budget during this time, and taxes were kept low. The tax system did not penalize savings, and the share of national income taken by taxes was and still is the lowest among the de veloped nations. In addition, the devastation of the Second World War took away the power enjoyed by the old bureaucratic elite, the Zaibatsu, and this in turn has spurred competition.
Perhaps the most astonishing fact is that contrary to what the proponents of a national industrial policy contend, most loans recently issued to business in Japan have come from the private sector. There has been, in other words, no massive financial targeting of industries by the government. In fact, the industries that have received government financial assistance have been politically powerful, but economically weak.
Farmers receive a substantial amount of protection in the form of outright subsidies and import restrictions. Coal mining has benefited from low interest loans. Yet output has decreased from 54 million metric tons in 1962 to 19 million tons in 1978. The shipbuilding industry also received low interest loans. Yet it is operating at 35 per cent capacity and, after 1977, 46,000 workers had to be laid off. Petroleum refining, petrochemicals and aluminum have also received government aid. None of these industries, however, is responsible for the outstanding rate of growth experienced in Japan. Rather, the “secret” of Japan’s success may be reasonably attributed to the government’s policy of keeping spending under control, and of providing a favorable business climate.
Is it true that in spite of having a general policy of favoring free enterprise, we are nevertheless experiencing a de-industrialization of our economy? A brief review of some of the statistics will be revealing.
The Changing Pattern of The American Economy
A common observation among the proponents of a national industrial policy is that the economy has shifted away from manufacturing. Non-agricultural employment has increased from 60.6 million in 1965 to 90.8 million in 1980. The manufacturing sector has, during this same period of time, fluctuated between 18.5 and 21 million jobs. Between 1969 and 1975, about a million manufacturing jobs were lost. Yet, 3 million manufacturing jobs were created between 1975 and 1979. Some of the manufacturing industries contracted as a result of the recent recession, but manufacturing employment has subsequently stabilized. Fears that our manufactur ing sector was on the verge of extinction were unfounded.
The importance of the manufacturing sector, however, has declined during this same period of time. In 1965, 30 per cent of all non-agricultural employment was in manufacturing, whereas in 1980, it was 22 per cent. The growth in jobs has occurred in the service and the governmental sectors. But this does not mean that we are fast becoming a nation of janitors. The share of man ufacturing jobs in Japan, Germany and England has fallen even more sharply than in this country.
Although the reasons for the contraction of the relative share of manufacturing jobs are varied, they do not defy logical analysis. One reason is that some industries, like the steel industry, paid exorbitantly high wages to its unionized labor force at a time when their productivity was declining. The average wage rate for a Japanese automobile’ worker is half what his American counterpart earns.
Paradoxically, many employees have voluntarily left the manufacturing sector and joined better-paying jobs in the service sector. The service sector created 9 million jobs in the decade of the 1970s. Of these, about 8 million were in the professional and business service area. In addition, the growth of the service sector has been made possible by the entry in the market of many part-timers, such as teenagers and the elderly, who seek temporary assignments that demand few skills. Clearly, there is a need for these jobs. However, there is no danger that the manufacturing sector is about to disappear. Even if the manufacturing sector were in the decline, that in and of itself is insufficient to justify an industrial policy.
As we have seen, the proposals for a national industrial policy are founded upon a misunderstanding of basic economic issues. The role of the price system; the allocation of re sources; supply and demand—these are all crucially important issues that we must understand if we are to prevent one economic folly from being implemented on top of another. As Friedrich Hayek once said, the fundamental problem in economics is that knowledge of all the relevant circumstances “never exists in concentrated or integrated form but solely as the dispersed bits of incomplete and frequently contradictory knowledge which all the separate individuals possess.”
This is the fundamental reason all central planners, from the 5-year plan in the Soviet Union to national industrial policy, are bound to fail. Understanding why this is so is an important step. This is why it is so crucial that groups, such as the Foundation for Economic Education, exist. As each one of us strives to improve his understanding of the market order and its moral underpin nings, we shall approach a more just and freer society.