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. Last Updated: 07/27/2016

Catching Up Comes First

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Discussions about industrial policy and the need to strengthen state interference in the economy invariably call up a plethora of black-and-white images from the past: the glorious days of industrialization, giant factories, five-year plans and the conquest of virgin lands.

The reality is not so simple, of course. Debates about the role of the state in the economy are not simply about the choice between unlimited market freedom and heavy state paternalism in all spheres of life. There is no consensus today in global academic circles on priorities for growth policy, but some reliable pointers can be found.

A body of theoretical work by a group of influential economists including Daron Asemoglu of MIT, Harvard's Philippe Aghion and Fabrizio Zilibotti of the London School of Economics has determined the optimal level of state involvement in the economy in association with how far it is behind the current cutting edge of technology. Another pointer is a book coming out in the near future by economist Barry Eichengreen of the University of California, Berkeley, entitled "Coordinated Capitalism and Beyond," which examines Europe's post-war economic history. These works should be required reading for those determining economic strategy in Russia.

Long-term growth policy can be divided into two separate but equally important parts. The first -- "chasing the leader" -- is when a country achieves world levels of technological development by adopting and copying global best economic practice and know-how. Many Asian countries are applying this strategy. The second part – "joining the leaders" – involves breaking through current technological boundaries. It involves the drafting of a longer-term policy to stimulate innovation and research. Here we'll focus on first part of the strategy.

In many respects, Russia is running into the same problems as 1950s Europe -- technological backwardness, underdeveloped market institutions and obstacles to the free functioning of markets.

To close the technological gap with the global leader of the time -- the United States – in the 1950s-70s, Europe made a basic choice in favor of state intervention, using tools varying from direct subsidies and cheap loans to individual elements of state planning. In France, for example, Jean Monnet created the General Commissariat for the Plan, which was chiefly charged with stimulating investment. Italy's Institute for Industrial Reconstruction maintained direct control over industrial enterprises. By any standards, growth in the 1950s-1970s was outstanding, averaging 4 percent per year across the 12 leading countries in Western Europe.

Years of experience, backed up by neo-classical theory, have shown that state interference is successful only in very rare cases. What is Brazil's chief export to the United States? Aircraft. The aircraft industry in Brazil is one of the most successful products of industrial policy in economic history. The main lessons of Brazil's success are blindingly obvious -- formulate a goal and stick to it. In this case, the goal was to create an airplane with certain characteristics at a certain price. Compare this, for example, with the goal of developing a soft drink market. It is unlikely that the state would be able to formulate and support the development of a new Coke or other soda using a goal-oriented policy, as there are millions of different recipes. The result of such a policy would be store shelves full of the Buratino brand and a couple of other similar drinks.

The second condition for successful state intervention is "market failure," i.e., cases when the market has failed to coordinate entrepreneurial efforts. Often, and particularly in less-developed market economies, the coordination and development of a number of sectors is essential to fuel growth. Consider a case of successful state intervention, described by Dani Rodrik of the Kennedy School of Government at Harvard: salmon farming in Chile. Salmon is Chile's third most-important export product, behind only copper and grapes. Raising the fish required simultaneous development of technical knowledge to adapt them to local conditions as well as the construction of the fish farms themselves. In a developed economy a private company could take on both tasks at once. But in Chile, given significant fixed expenses to carry out both tasks and the need to coordinate efforts between them, state intervention was effective.

Here's why. In these examples, the country's main aim was to reduce the technological lag behind the leader. At this stage, the role of innovation and the free market is small, as a rule. In conditions in which firms are busy imitating the leader's technologies, the simplest way to achieve rapid economic growth is to reduce barriers to investment. This can be achieved either by coordinating the efforts of individual firms, or by reducing the expenses associated with weak financial markets and institutions. At this stage of development, picking the right managers, fine-tuning the investment climate and stimulating growth of production and innovation -- basically those areas in which the market is usually more effective – play a less significant role. So the most important principle in reducing a technology gap is to find those sectors where the market is working poorly.

The second basic principle is that state support should only be provided for a defined period at a fixed level. Export subsidies, for example, should be limited to five years. This condition is crucial, as state policy often leads to the redistribution of profits in favor of individual market participants, which gives them an incentive to lobby for longer periods of state support when it is no longer economically justified. This can lead to a growth trap, in which industrial protectionism leads to slower economic growth. A good example of this is European trade unions. In the 1950s-1970s, by allowing companies to make use of a significant part of their profits for further investment in a coordinated fashion, rather than to increase workers' salaries as would likely have happened in free-market conditions, powerful trade unions were essential to rapid economic growth. Today, however, growth based on innovation, lowering costs and raising productivity is much more difficult because of the activities of those same unions.

Rodrik offers a more comprehensive approach to forming industrial policy. He suggests that industrial policy has played a key role in the successful development of almost every export sector in developing countries. He also suggests a principle that seems the most appropriate for Russia: the centralization of industrial policy. Success here depends on one person being made responsible for the implementation and management of the policy. Too many cooks will clearly spoil the broth.

Finally, it is essential to remember that industrial policy is only a temporary solution in beating technological backwardness. The strategy of targeted state programs that allowed economies in postwar Europe and some Latin American countries to develop quickly ran into serious problems as soon as the focus shifted to stimulating long-term economic growth based on technology and innovation. At this point a strategy to stimulate technological developments has to come to the fore if Russia is to achieve the living standards of developed countries. But closing the present gap has to come first.

Aleh Tsyvinski is assistant professor of economics at Harvard University and faculty research fellow at the National Bureau of Economic Research in Cambridge, Massachusetts. This comment was published in Vedomosti.