The Industrial Policy Debate of 2016: Justin Yifu Lin vs. Zhang Weiying (Part 1)

"I have still not seen an example of a developing country that did not employ industrial policy and yet caught up with developed countries." - Lin Yifu

In 81 B.C., the foremost scholars of the Western Han assembled in Chang’an to debate the statesman Sang Hongyang on the government’s salt and iron monopolies. These exchanges were later recorded as the famous Discourses on Salt and Iron (《盐铁论》).While Sang argued in favour of state-led development of these industries and the system of “equitable supply” (均输) as a means to restrain magnates and distribute goods across the realm, the scholars criticised these measures for “competing with the people for profit” (与民争利) and producing tools unsuited to the needs of people in different regions.

Ideologies shift, and few economists today would share the basic suspicion both sides held towards private capital accumulation. Yet some of the fundamental questions—how to ensure the provision of public goods and how government intervention shapes incentives—remain central to modern economic debates. The “Industrial Policy Debate” (《产业政策之争》) of 2016, between Peking University economists Justin Yifu Lin and Zhang Weiying, carries comparable significance in the modern context. Given the stature of both figures, it has exercised a definitive influence over subsequent discussions of this central issue in China’s policy direction.

Lin advocates industrial policy on the grounds that government intervention is necessary to address negative externalities in the market and provide the right incentives for entrepreneurs to invest in productive industries. At the same time, he emphasises that his framework does not call for government control but instead relies on an effective market in which individuals are free to innovate, compete and make choices. Lin’s own life illustrates the unpredictability of individual agency; growing up in Taiwan, in 1979 he famously swam to Xiamen and defected while posted as a soldier on Kinmen, subsequently building a career in China and international organisations. He maintains that entrepreneurship is not confined to businessmen; academics, politicians and others too can possess an “entrepreneurial spirit” in their own right.

Lin’s formula for identifying areas that the government should support rests on his idea of “latent comparative advantage”; less developed countries enjoy an advantage in labour, while developed countries do so in capital. Accordingly, unlike his colleague and fellow industrial policy advocate Lu Feng, Lin does not advocate maintaining a “complete industrial system” as China moves up the value chain and loses its labour advantage; rather government should help the country’s old industries transition. Furthermore, whereas others scholars view India as a potential threat in this regard, Lin looks upon India’s supply of young workers as complementary to China’s different set of comparative advantages. Even as industrial policy has become the dominant trend in China’s policymaking—and to a growing extent globally—there remain significant divergences among its supporters over its application.

—James Farquharson

Key Points

1. Industrial policy refers to any measure designed to promote the development of a particular industry; this extends to “soft institutional arrangements” such as intellectual property protection and environmental regulation.

2. An “active government” [有为政府] is necessary to resolve problems of economic coordination and address market failures, particularly in basic research and in infrastructure where market incentives are weak.

3. Entrepreneurial officials are motivated to pursue effective state intervention—rather than succumb to corruption—by rational incentives to secure a continued mandate and to “make their mark on history”.

4. An active government may identify priority areas by assessing the nation’s “latent comparative advantage” [潜在比较优势], shaped by its endowments of labour, capital and natural resources.

5. As a country develops, its endowments shift from labour to capital abundance; accordingly, the government needs to “guide action according to circumstances” [因势利导] and facilitate industrial transition.

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6. China once held an advantage in labour-intensive industries such as industrial processing, but this has been lost; it should not continue subsidising them merely for political reasons.

7. However, in industries critical to national security and defence, government investment remains essential even when it contradicts the country’s comparative advantage.

8. Though China [in 2016] lacks the physical capital of developed countries, its comparative advantage in human capital was almost on a par; innovation in sectors with short research cycles is therefore most suitable for overtaking them.

9. Foreign investment has been valuable for bringing in knowledge and expertise, but domestic investment has always accounted for a far more important share of total investment in China.

10. This is largely because government policy depressed the cost of capital artificially, diminishing the advantage of capital-rich foreign firms over domestic enterprises.

Name: Justin Yifu Lin (林毅夫)
Born: Oct. 1952 (age: 72)
Position: Boya Distinguished Professor of Economics and Honorary Dean of National School of Development, Peking University
Previously: Senior Vice President and Chief Economist of the World Bank (2008-2012)
Other: Councillor of the State Council and a member of the Standing Committee, Chinese People’s Political Consultation Conference (CPPCC); Fellow of the British Academy and of the World Academy of Sciences
Research focus: Developmental Economics
Education: MA-BA National Taiwan University (1971-1978); BA Peking University (1980-1982); PhD Chicago University (1982 -1986)

THE “GREAT INDUSTRIAL POLICY DEBATE” BETWEEN ZHANG WEIYING AND LIN YIFU
Arguments from Justin Yifu Lin (林毅夫)
Published by The Paper on 21 November 2016
Parsed and put together by James Farquharson
(Illustration by OpenAI’s DALL·E 3)

N.B. The following is a condensed overview of Justin Yifu Lin’s arguments from a 40,000 character debate transcript.

1. Defining Industrial Policy

• Industrial policy refers to any measure deliberately implemented by a central or local government to foster the development of a particular industry.

• This definition extends to intellectual property law, which rewards first-movers—in other words, “the first person ever to eat a crab” [第一个吃螃蟹的人]— thereby incentivising innovation, as well as to environmental policy designed to address negative externalities.

  • Zhang Weiying, whose views we will cover next week, dismisses this as overly broad, preferring a narrower definition of industrial policy. He argues that such measures fall under universalist policies [普遍性的政策] rather than selective interference [选择性干预], and thus belong to a different category.

• The US government has historically acted as an “entrepreneurial state” [企业家型政府], accounting for 40% of national R&D spending in 2013 [研究与试验发展], with business providing the remaining 60%.

  • Note: Lin is most likely referring to investment in basic research here, as figures are significantly lower than that for overall R&D spending.¹

2. Why Is Industrial Policy Necessary?

• An “active government” [有为政府] is required to sustain an “effective market” [有效市场] and to correct market failures [市场失灵].

• This should be understood as a government working with market mechanisms rather than one that “causes trouble” [乱为].

• Under a neoclassical understanding of human behaviour, entrepreneurs require appropriate government incentives to invest in productive industries and to avoid negative externalities [外部性的问题].

  • This point lies at the core of the disagreement between Zhang and Lin: Zhang rejects the neoclassical understanding of market failure and negative externalities, favouring instead a Hayekian model, which he interprets as holding that market inefficiencies are precisely what generate the impetus for entrepreneurial innovation.

• Governments always invest in industry to some extent; the task of industrial policy is to determine which industries to prioritise given limited resources.

  • Lin: “In fact, it is just as Chairman Mao said: “concentrate superior forces to fight battles of annihilation” [集中优势兵力打歼灭战], as there are simply too many areas in need of improvement.”

• Although industrial policy is not always successful, it remains essential to any national economy.

  • Lin: “I have still not seen an example of a developing country that did not employ industrial policy and yet caught up with developed countries […] nor have I seen a developed country that maintained its lead without recourse to industrial policy.”

  • Zhang calls this argument a fallacy [伪命题] confusing correlation with causation; governments simply tend to intervene and sometimes “score a lucky hit” [歪打正着] by investing in industries that would have prospered anyway.

3. “Hard and Soft Infrastructure”

• The core of industrial policy lies in improvements and adjustments to both “hard infrastructure” [硬的基础设施] and “soft institutional arrangements” [软的制度安排].

• Hard infrastructure includes electricity, roads and ports. Private initiative cannot be relied upon to invest in these as it tends to invest only in types of infrastructure with the potential for monopoly profits [垄断利润], such as mobile telecommunications.

  • Lin: “This has meant that for the whole of the 80’s and 90’s the majority of developing countries suffered from infrastructure bottlenecks [瓶颈], while infrastructure in developed countries tends to be outdated [普遍老旧].”

• Soft institutions, meanwhile, include the legal system, intellectual property protections and financial institutions; they serve to reduce transaction costs [降低交易费用] and secure the highest possible returns on future investments in technology and industry.

4. “New Structural Economics” and Comparative Advantage for Developing Countries

• This understanding of industrial policy falls within the framework of “New Structural Economics”, which applies David Ricardo’s theory of comparative advantage to an economy with an active government.

• Comparative advantage is, in fact, a “prescription” [药方] for development.

• Successful industrial policy involves identifying a country’s “latent comparative advantage” [潜在比较优势].

• A country’s comparative advantage [比较优势] at any given time is determined by the “factor endowments” [要素禀赋]—the relative availability of capital, labour and natural resources—within its economic structure.

  • Lin: “If all of a country’s industries aligned with its comparative advantage [as determined by] its factor endowments, that country should be the most competitive and it will possess an optimal industrial structure [产业结构].”

• For less developed countries, factor endowments usually take the form of low labour costs, whereas for more developed countries they are typically abundant capital.

• Improvements in the standard of living [生活水平] rely on increases in labour productivity [劳动生产力], which in turn require technological innovation and shifts towards higher value-added industries.

• As a country’s factor endowments evolve, the government needs to “guide action according to circumstances” [因势利导], adjusting its industrial policy rather than supporting outdated production practices and industries.

5. Identifying Growth Industries

• In general, other countries that can act as models for development have a GDP per capita 1-2 times—at most, 3 times—larger than one’s own; anything beyond that will be unattainable for the time being.

  • Zhang criticises this method, noting that both Japan and Korea’s rapid development in the 20^th century relied on cultivating industries present in countries whose GDP per capita exceeded this multiplier.

  • Lin counters that Korea’s car industry is a perfect example of the principle; it initially failed to develop—despite attempts—before it possessed the requisite factor endowments, only succeeding in the 2000’s after it had become richer.

• The country chosen as a development model should itself be growing rapidly; in such cases, capital accumulation [资本积累] will eventually raise labour costs, eroding the comparative advantage that sustained earlier growth and thereby opening space for less developed competitors.

  • Note: Given lower relative labour costs in India, Lin has suggested that economic cooperation between China and India has potential, with India taking over labour-intensive industries as China moves into capital-intensive ones; this stands in contrast to the more mercantilist arguments presented in a recent speech by Di Dongsheng.

• If growth industries are identified effectively, resource use will be more efficient and profits greater, leading to a higher savings rate and, in turn, a higher rate of capital accumulation.

• A higher rate of capital accumulation can facilitate a shift up the value chain to more capital-intensive industries—if the requisite hard infrastructure and soft institutional arrangements are in place.

6. What Government Can (And Can’t) Do for Industry

• The government’s role is to help entrepreneurs “resolve problems of coordination” [解决协调的问题]; it can assist with specific issues by “addressing anxieties and resolving difficulties” [排忧解难].

  • As an example, Lin cites the support provided by the Indian government to industrialists through installing fibre optic cables during the 1970s; as a cheaper alternative to satellite communications, these helped India emerge as a world leader in the information industry.

• This is not the same as arguing that industry ought to be government-directed [政府指导], nor that the government should subsidise specific companies.

  • Note: In a World Bank policy document, based on his research as the Bank’s chief economist from 2008 to 2012, Lin argues that what distinguishes his theory of New Structural Economics from more dirigiste developmental economics is its emphasis on market mechanisms and comparative advantage as constraints on government action.

  • Zhang, however, argues that little distinguishes Lin’s model from these traditional approaches—i.e. the government support Lin advocates either amounts to subsidies by other means or merely to the removal of restrictions that should not have existed in the first place.

• Concerns that officials cannot make effective business decisions are misplaced; officials and academics, as well as businessmen, may possess an “entrepreneurial spirit” [企业家精神].

• Furthermore, under a rational [理性] model of human behaviour, officials can be motivated by incentives tied to aspirations for a continued mandate [希望能够继续执政] and a desire to “leave their mark on history” [青史留名].

  • Zhang argues that such an incentive system is unlikely to function effectively in practice, since the drivers of innovation are far more complex.

• Government investment is particularly imperative for basic research, as the research cycle [研发周期] is too drawn out for private businesses to have sufficient profit incentive to invest adequate capital.

7. Why Industrial Policy Can Go Wrong

• The government is not “omniscient and omnipotent” [全知全能]; rather than directing industry, it should focus on shaping the policy environment [政策环境] to enable market competition to function advantageously.

• For developing countries, industrial policy can go awry when—while still “poor and backward” [一穷二白]—they overreach in trying to catch up immediately with far more advanced economies, thereby “doing bad things with the best of intentions” [好心干坏事].

  • Lin: “This is like when, in the 1950s, we spoke of ‘surpassing England in ten years and catching up with America in fifteen [十年超英，十五年赶美]’.” [Note: this target referred to steel production and was set in the run-up to the Great Leap Forward.]

• For developed countries, failures arise when politically motivated subsidies sustain uncompetitive industries long past their period of viability, resulting in resource misallocation [资源错误配置] and rent-seeking [寻租].

  • Lin: “We know that the European Union subsidises each dairy cow at two euros per day. Why such a subsidy? Because [the sector] has already lost its comparative advantage and they should exit but are unwilling to do so. This is the typical reason for the failure of industrial policy.”

8. Industrial Policy in China

• In certain sectors, China once held a comparative advantage that has since eroded—for example, in labour-intensive industrial processing.

  • Lin: “We should not follow the EU’s example of subsidising each dairy cow at two euros per day; instead, we should make [these sectors] transition.”

  • Rather than letting them collapse entirely, efforts should focus on shifting producers to the high-value ends of the “smile curve” [微笑曲线]—research, branding, and supply chain management.

• Human-capital-intensive industries with short research cycles [短周期，人力资本为主的产业] offer the most promising opportunities for China to “overtake on the curve” [弯道超车] and narrow the gap with advanced economies.

  • Lin: “In industries where we aim to ‘overtake on the curve’ […], we can leverage our vast domestic market and the world’s most comprehensive supporting ecosystem in hardware [全世界配套最齐全的硬件] to provide incubation platforms, venture capital and intellectual property protections.”

• Sectors critical to national security should remain priorities for state investment, even in the absence of comparative advantage.

  • Lin: “National defence and security violate the principle of comparative advantage and can only be protected and subsidised by government.”

• Given China’s size and regional disparities in development, industrial policy is best determined at the provincial rather than the national level.

9. Foreign Investment

• In industries identified as having development potential, government should actively promote investment [招商引资], with the goal of attracting human capital and know-how.

• Although foreign investment has been a valuable source of human capital and know-how, it has never represented more than a modest share of total investment in China. At its peak, following Deng’s “southern tour” [南巡], it accounted for 10-15% of the total.

• Chinese firms outcompeted foreign rivals on costs through “financial distortion” [金融的扭曲] and “artificially low capital costs” [人为地压低资金的价格] for state-owned enterprises—constituting a government-induced form of comparative advantage.

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1. Figures vary across sources, but the number of 40% tends to exceed OECD estimates, government spending on R&D in 2013 accounted for 27% of the total in the US, 33% in the EU and 21% in China (percentages are slightly lower for all three today, though absolute figures are higher). However, for R&D spending in basic research, US government spending has indeed consistently reached 40%.