Principles for good industrial policy

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A year after the US Inflation Reduction Act was passed, the British government is developing an “advanced manufacturing plan”. The details are sketchy, but it is just the latest in a new wave of industrial policies following America’s multibillion-dollar package of incentives affecting sectors from electric vehicles to green hydrogen production.

New factories are already sprouting across the US. But the scale of government intervention combined with provisions that favour domestic production leaves most economists sceptical about its long-term impact. Trying to replicate global green, tech and battery supply-chains at home is a tall order. Pulling production away from where it can be done most efficiently is wasteful and raises costs. It also invites retaliation.

Developing an industrial policy, particularly in a time of geopolitical fragmentation, is fraught with complexity. But as more governments seek to emulate and respond to the IRA, there are some principles worth heeding.

First, any economic strategy should place emphasis on creating a welcoming business environment that fosters competition. This enables existing strengths to flourish. Investing in modern infrastructure, developing an effective training system and designing an immigration policy that attracts global talent is important. Meanwhile, an openness to trade, a stable long-term policy environment and minimal red tape will support investment decisions and help industries achieve scale. As it is, the IRA is facing shortages of skilled workers and lengthy planning delays.

Beyond this, targeted support should be considered in a few cases. First, to build capabilities that are integral to national security, such as defence, and for securing supplies of critical materials. And second, to tackle market failures. For instance, renewable infrastructure may need a jump-start when the private sector is unclear about future demand but long lead times mean preparation needs to happen in the present.

Targeted interventions should not aim to recreate entire global supply chains at home, but rather develop a foothold in these clearly and narrowly defined strategic sectors. This helps to limit wasteful spending and accusations of unfair trading practices. Time-limited support is important too. Indeed, the latest forecasts show the IRA’s open-ended tax credits could exceed $1tn.

The type of policy tool used should match the issue it is trying to tackle. For instance, green energy projects obtain certainty from a guaranteed market price and public-private partnerships help de-risk otherwise unviable projects for battery or semiconductor plants where no foothold exists. Financial incentives, such as tax credits, can play an important role meanwhile in encouraging the shift of resources from low to higher productivity industries. Indeed, they are most cost effective and less distortionary when applied across sectors to encourage investment in training, R&D, and machinery, as well as the adoption of existing technologies.

Above all, industrial policy should not exclude competition. For decades, globalisation based on international supply chains connected by national specialisms has driven productivity growth. But protectionist measures, including local content rules in the IRA, undermine this by coddling domestic manufacturing and sparking tit-for-tat measures. Friendshoring, or free trade between allies, offers an alternative to trading with malign states.

Rising to the challenges of the climate transition, technological change and unstable geopolitics requires targeted and well-designed interventions from national governments. But if leaders decide increasingly to override free markets and open trade, they will find it even harder to reach their goals.