Web Version of Institutional Framework for Industrial Policy

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INSTITUTIONAL FRAMEWORKFOR

INDUSTRIAL POLICY

Designing a modern institutional framework using best practice design principles forthe evaluation, formulation, and deployment of industrial policies.

Prepared by

Dr. Ohan Balian

DubaiUnited Arab Emirates

January 22, 2010


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Table of Contents

1. Introduction.......................................................................................................... 32. Rationale for industrial policy............................................................................. 4

2.1 Informational failures........................................................................................ 42.2 Coordination failures ........................................................................................ 4

3. Design elements .................................................................................................. 53.1 Embedded autonomy ....................................................................................... 53.2 Generic design elements.................................................................................. 53.3 Top 10 design principles ..................................................................................6

4. Proposed structure of framework ...................................................................... 8

4.1 Brief description of existing structures.............................................................. 84.2 Generic components ........................................................................................ 8

4.2.1 Ownership.................................................................................................. 84.2.2 Coordination Councils................................................................................ 84.2.3 Carrots-and-Sticks ..................................................................................... 9

4.3 Other components............................................................................................ 94.3.1 Formulation................................................................................................ 94.3.2 Monitoring and Evaluation ....................................................................... 104.3.3 Deployment..............................................................................................10

5. Concluding remarks .......................................................................................... 11

References .............................................................................................................12


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1. Introduction

Diversification strategies in many countries have been driven primarily bywhat is known as industrial policydefined as government intervention in the form ofsupport programs to the private sector. This broad definition encompasses almost alltypes of economic policies exceptmonetary and fiscal policies which are known asstabilizationpolicies. Industrial policy thus includes policies to enhance competitive-ness, develop clusters, build free zone areas, support SMEs, encourage public-private partnerships, attract FDI, and a host of other economic policies1. Even withthe proliferation of government support programs in recent years, the empirical evi-dence on the effectiveness of industrial policy has been inconclusive2. Some ob-servers have even suggested that the lost-decade of economic stagnation in EastAsian countries in the 90s may have been caused by inappropriate industrial poli-

cies in the 70s.

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The argument against industrial policy is that it is impossible for the govern-ment to consistently pick winners because of the existence of market failures. A cen-tral question in industrial policy is therefore howto take into account these marketfailures such that industrial policy maximizes the likelihood to contribute to economicgrowth. In other words, what is the best institutional frameworkor process throughwhich the effectiveness of industrial policy is maximized? This modern institutionalframework is known as embedded autonomy(Evans 1995) a discovery process inwhich the government and the private sector come together to learn and discoverunderlying challenges and opportunities, and engage in strategic cooperation.

Once industrial policy is conceptualized in terms of this discovery process, thetraditional argument against industrial policy is considerably weakened because thegovernments ability to target specific sectors and activities(in response to marketfailures) is substantially improved. The efficacy of this discovery process is condi-tional upon the incorporation of best practice principles in designing a modern insti-tutional framework for industrial policy. This short paper outlines the main designelements of a modern institutional framework using best practice design prin-ciples for the evaluation, formulation, and deployment of existing and new in-dustrial policies. This will be achieved by linking 13 best practice design elements(3 generic and 10 principle) to the structure of the existing institutional framework.Hence, the purpose is not to design a completely new framework. It is to upgradethe existing traditional principal-agent model to the modern embedded autonomyone.

1Industrial here is a generic term and includes services and other non-manufacturing weightless

products such as high-tech, tourism, banking, and many others.2

Most notably in Japan and Taiwan, but not in Singapore, South Korea, and China. See Beason andWeinstein (1996), Nehru and Dhareshwar (1993), and Smith (2000).3

See Noland and Pack (2003).


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2. Rationale for industrial policy

The rationale for industrial policy can be explained by two types of marketfailures: informationalfailures, and coordinationfailures.

2.1 Informational failures

Government support to investors is necessary because when entrepreneursexplore new business opportunities, they incur high discovery costs with no guaran-tees of success. When the economy is going through a diversification process, en-trepreneurs need to self-discover the economys cost structure i.e. what are thenew4 products that can be produced at a sufficiently low cost to be profitable? Entre-preneurs must experiment with new technologies, new processes, and other newinnovative ways of producing this product (self-discovery) which might have a large

social benefit but is poorly rewarded for the individual entrepreneur. If the entrepre-neur fails in these experiments, he will bear the full cost of the investment. If shesucceeds, she has to share the benefits with entrants into this new product whichwill reduce its profitability. The governments response aims at reducing the entre-preneurs self-discovery costs.

2.2 Coordination failures

Governments also intervene because for some industries to succeed, otherindustries must also be established simultaneously. This is the general idea behindclustering where an entrepreneur contemplating whether to invest in a specific in-

dustry needs to know that there is an electricity supply he can access readily, thelogistics and transport networks are in place, the country has been marketed abroadas a dependable supplier of that particular newproduct, and so on. This businessenabling environment, a term freely used by economic commentators, is very costlyto supply and can only be provided by the government.

Because of these two market failures, it is not surprising that entrepreneursrequire considerable government support. Scratch the surface of export success sto-ries all over the world and you will find industrial policies such as public R&D, exportsubsidies, preferential tariffs, and various types of tax incentives all lurking beneaththe surface. The main reason as to why East Asian economies are more successful

than in Latin America (and to some extent in the expanded European Union) is thatindustrial policies in East Asia are evaluated, formulated, and deployed using care-fully crafted modern institutional frameworks.

4New does not necessarily imply new in the traditional sense. It can be an already existing good or

service but is not yet produced domestically.


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3. Design elements

3.1 Embedded autonomy

The main consideration in designing a modern institutional framework is thatthe government, however efficient it might be, does not have complete market infor-mation. Even if it has some information, it is less than the information that the privatesector has about the location and nature of market failures discussed above. Gov-ernments may not even know whatit is that they need to know. For this reason, theinstitutional framework for conducting industrial policy must be one in which the gov-ernment is able to elicit information from businesses on an ongoing basis about theexisting challenges and the available opportunities. In the traditional institutionalframework, industrial policy making is a top-down approach (principal-agent model)where the private sector is kept at a distance and autonomous policy makers issue

directives. In the modern approach, industrial policy making is embedded within anetwork of linkages with the private sector without any loss of autonomy hence theterm embeddedautonomy. This is a much more flexible form of strategic collabora-tion between the government and the private sector that is specifically designed toelicit information about objectives, formulate policies for solutions, and evaluate pol-icy outcomes as they appear.

3.2 Generic design elements

The first design element of a modern institutional framework is that it shouldhave high-level government support. Just like monetary policy has a champion ad-

vocate in the form of a Central Bank Governor (or the Federal Reserve Chairman inthe US), industrial policy should have such an advocate who has the ear of thePrime Minister or the President, or both. This advocate should also coordinate, over-see, and monitor the agencies and government officials entrusted with carrying outindustrial policy. If these agencies are to have autonomy in industrial policy making,it is critical that their performance be closely monitored by such a high-ranking offi-cial.

The second design element of the modern institutional framework is that itshould have Coordination and Deliberation Councils within which information ex-change takes place. These are public-private bodies that include representatives of

relevant groups. This would be the setting in which entrepreneurs would communi-cate their requests for assistance to the government, and the government would inturn direct them into new investment opportunities. The roles and responsibilities ofthese Councils would be to gather information on investment ideas, coordinateamong different implementing agencies, propose changes in regulations to reducered-tape, generate subsidies and financial backing for new activities, and groupthese various support programs along with appropriate conditionalities.

This leads to the third key design element which is the requirement that in-dustrial policies should have both an incentive and a conditionality structure - what isknown as a carrot-and-stickpolicy where the carrot represents the incentive and the


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stick is the conditionality, say, the discontinuation of the incentive if targets are notmet. This is to ensure that mistakes are not repeated and bad projects are automati-cally phased out5. However, even if an optimal support program is adopted, someinvestments will inevitably fail. In reality, if there are no failures, it might be an indica-tion that the support program was not aggressive or generous enough.

3.3 Top 10 design principles

1. Provide support only to new activities: New refers to products and services thatare new to the domesticeconomy, or existing products and services produced bynew technologies. Industrial policy should target investments that expand the rangeof capabilities in the domestic economy. This type of targeting differs substantiallyfrom targeting, say, SMEs. SME support programs are based on the criterion of size

not on whether the SME in question has the potential to create new areas of spe-

cialization. It is thispotential that drives economic growth.

2. Prepare criteria/benchmarks for success and failure:These are necessary to pre-vent support recipients to game the government. The criteria for success shoulddepend on productivity both its absolute level and its rate of increase and not onemployment or output6. Also adopt benchmarking by looking at the experiences ofsimilar industries in other countries, especially at the experiences of countries withsimilar cost structures and macroeconomic characteristics. Another indicator wouldbe performance in international markets (export levels) which would provide a quick-and-dirty way of measuring how well an industry is doing relative to its global com-petitors.

3. Use built-in sunset clauses: Support programs should have built-in terminationclauses (sunset clauses) which are triggered automatically after an appropriate pe-riod of time has passed. This is necessary to ensure that scarce resources are nottied-up in activities that are unprofitable. Should there be a need for continuing thesupport, the program should be reviewed before its automatic termination triggermechanism is activated.

4. Target activities, not sectors: It is common for industrial policy in the traditionalprincipal-agent model to specify support programs in terms of sectors tourism,manufacturing, biotech, high-tech, aerospace, etc. This type of targeting provides

across the board generic support to this or that sector. But when a support programis targeted at an activity, it directs the support to fix a specific market failure. For ex-ample, instead of providing support in the form of a subsidy to the tourism sector, theprogram should subsidize bilingual training for receptionists, for taxi drivers, for touroperators, and the like. Similarly in other sectors, support programs should subsidizefeasibility studies, adaptation of new technologies from abroad to make them more

5East Asian industrial policies have typically used both carrots and sticks with the right balance

while Latin American policies have used too much of the carrot and too little of the stick which ex-plains their relative industrial inefficiencies compared to East Asian economies.6

While productivity can be notoriously difficult to measure, project audits by technical consultants canprovide useful indications.


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key tasks of industrial policy programs need to be phased out while new programsare adopted.

4. Proposed structure of framework

4.1 Brief description of existing structures

Industrial policy making has traditionally followed the principal-agent modelwhere the principal (the government) has issued directives to the agent (the privatesector) in its provision of various types of support programs. These programs havebeen channeled mostly through various implementing agencies such as Chambersof Commerce and Industries, Municipalities, Departments of Economic Develop-ment, Councils of Economic Development, and the like. To a large extent, theseprograms (such as support to free zone areas, clustering, SME support, and manyothers) have addressed both the informational and coordination market failures dis-cussed at the beginning of this paper by creating a business enabling environment.

The questions that need to be asked at this juncture basically determine theparameters of the institutional framework, namely, are these support programs de-signed such that they provide support to new activities? Do they have built-in termi-nation clauses? Do they generate spillover and demonstration effects? Are they im-plemented by competent agencies? Are they monitored closely? All of these ques-tions ultimately determine the parameters of an institutional framework for industrialpolicy. In short, it is safe to say that existing institutional frameworks for conductingindustrial policy is closer to the traditional principal-agent model, albeit with someperformance indicators and monitoring mechanisms.

4.2 Generic components

4.2.1 Ownership

Even though there might be some desirable characteristics in the institutionalframeworks of various regions within the same country, there exists no such frame-work at the National level. This is partly due to the high degree of industrial policyindependence at the local level, and partly because of the absence of a principal ad-vocate for industrial policy. One of the key design elements of a modern institutionalframework for industrial policy is that it should have government support at the high-est level, just like a Minister of Finance for fiscal policy, or a Governor of a CentralBank for monetary policy. This advocate should also coordinate, oversee, and moni-tor the agencies and officials entrusted with carrying out industrial policies at the Na-tional level. If these agencies are to have autonomy in industrial policy making, it iscrucial that their performance be closely monitored by a high-ranking official.

4.2.2 Coordination Councils

The second component of a modern institutional framework is that it shouldhave National Coordination or Deliberation Councils for information exchange.


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port program to changing conditions in the self-discovery process of the entrepre-neur.

5. Concluding remarks

The recent turmoil in the global economy has reinforced the role of the gov-ernment as an indispensable provider of support the private sector. For over a cen-tury, different economic schools have been grappling with various ideologies formore or less government intervention in the economy. Although the argument formore government intervention has been gaining the upper hand in recent years,government intervention must be done the right way such that it provides an incen-tive to entrepreneurs in their self-discovery experimentations with newproducts and

technologies. The effectiveness of industrial policy on economic growth is notat dis-pute here - we all agree that most governments provide a so-called business ena-bling environment to their citizens and foreign investors. However, the institutionalframework for conducting industrial policy is seldom in place and is more of an after-thought as evidenced by the poor performance of many industrialized countries inrecent years. The main benefit of designing a system of industrial policy perform-ance management is to enable governments to formulate, evaluate, and deploy eco-nomic policies based on best practices gleaned from the experiences of many suc-cessful economies, especially in East Asia.

Economics has many shortcomings as demonstrated in its failure to predict

financial catastrophes. But it also provides many solutions to existing problems bytaking a closer look at the incentive structure of markets - a central theme of supportprograms in industrial policy. Moreover, institutional economics has demonstratedthat institutions matter, which can annul the unrealistic assumptions of traditionaleconomics. No wonder this years Nobel Prize in economics was granted to two in-stitutional economists - Oliver Williamson and Elinor Ostrum - with truly formidablepolicy implications if, and only if, they were more successful in conveying their poli-cies on-the-books to policy makers on-the-ground. This short paper is an honest andgenuine attempt in that direction.


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References

Beason, R. and R. Weinstein (1996). Growth, economies of scale, and targeting inJapan. Review of Economics and Statistics78, No.2: 286 - 95.

Evans. P. (1995). Embedded Autonomy: States and Industrial Transformation. Princ-eton, N J: Princeton University Press.

Government of Abu Dhabi (2008). The Abu Dhabi Economic Vision 2030. AbuDhabi, United Arab Emirates.

Nehru, V. and A. Dhareshwar (1994). New estimates of total factor productivitygrowth for developing and industrial countries. Policy Research Working Pa-perNo. 1313, Washington D.C., The World Bank.

Noland, M. and H. Pack (2003). Industrial policy in an era of globalization: Lessonsfrom Asia. Institute for International Economics, Washington D.C.

Rodrik, D. (2004). Industrial Policy for the Twenty-First Century. Paper prepared forUNIDO. Kennedy School of Government, Harvard University, Cambridge.

Smith, H. (2000). Industrial policy in Taiwan and Korea in the 1980s. Cheltenham,Edward Elgar.

The Executive Office (2006). Highlights: Dubai Strategic Plan(2015) Dubai, UnitedArab Emirates.

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Web Version of Institutional Framework for Industrial Policy