front page
source url: www.lse.ac.uk/Depts/intrel/ibis/PEGB/index.html

back to table of contents
to previous chapter

The study of international political economy or cross-border business is generally labelled as a social science. That is to say, it has some scientific properties (if import taxes increase, the amount of imports will fall), but it has difficulty with magnitudes (trade might fall a lot, or it might only fall a little). One area where the uncertainties involved provoke heated debate relates to the role of the state in the economy.

As was discussed in the first lecture, there are vastly different forms of capitalism across the world. At some level or other, the distinguishing features are nearly all dependent on the behaviour of the government. The state can intervene directly in the economy, via regulation, ownership, taxation policies, or through tariffs. It can also affect the factors which help to determine the underlying economic make-up; such things as education, infrastructure, legal framework, and health care. Unsurprisingly then, within the general classification of "capitalism" there are differing opinions of what are legitimate areas for state involvement, and different economic systems based (but not solely due to) the degree of state intervention.

Aware of growing public hostility to state interference in their daily lives, the common pledge of political parties of all shades is for "smaller government". As table 3.1 shows, this is not actually borne out by the data, largely due to growing social welfare spending. However, it is reflected in attitudes towards state interference in the running of the economy. Privatisation and deregulation are one aspect of this curtailment of government activity. Related to this is the changing attitude towards government interference in the economy to promote competitiveness. In its most overt forms this is known as industrial policy and strategic trade policy, but it also comes in other, more subtle, guises.

Table 6.1 Total Government Spending as a Percentage of GDP

The rationale for industrial policy is similar to that for regulation. The free market is seen as containing inefficiencies which mean that it does not direct resources into the right areas. Common government concerns are that the result is too little investment, inadequate research and development (R&D), or poor education, leading to a sub-optimal growth rate in the future.

The idea of industrial policy has its attractions. For example, throwing cheap loans at the electronics industry could well lead to a higher level of investment in that industry than would otherwise be the case. This could give domestic electronics makers an advantage when competing in world electronics markets.

General equilibrium analysis provides some cautionary input, however. The idea is to look at the economy as a whole, where giving more to one hungry mouth means taking away from another. For example, cheap loans for one industry will mean more expensive loans for the whole of the economy, or higher taxes to pay for the subsidy.

US trade policy in the 1980s offers more substantial examples. Eager to protect the US automobile industry so that it could modernise and compete with Japanese assemblers, in 1981 the Japanese government was "persuaded" to adopt Voluntary Export Restraints (VERs) which limited Japanese automobile exports to the US. The consequence of restrictions on Japanese exports was less competition and so higher prices for automobiles in the US, which resulted in a transfer from US consumers to automobile producers of between $5.8 billion and $10.3 billion. This meant bigger profits for the US Big Three, helped to rescue Chrysler, and allowed them to invest to meet the Japanese challenge. Unfortunately, Japanese makers also gained from the higher prices, providing funds for the R&D which enabled them to move into the higher end of the market. So although VERs on Japanese automobiles had the desired effect of strengthening the US car industry, it came at a cost to US consumers, as well as bestowing a benefit on the US?s main competitor.

Note the asymmetry of costs and benefits that usually surrounds state intervention. Typically, the benefits will be felt by relatively few producers and they will be significant, which makes it worthwhile for them to lobby the government for favourable treatment (for example the Big Three US car makers). Conversely, the costs are usually borne by a large number of consumers or producers, and are relatively insignificant (such as slightly higher prices for automobiles), which makes lobbying against the policy difficult.

So the question for state intervention in the economy is not as simple as whether the government action is of benefit to the targeted sector. It is whether the benefits to that sector exceed the costs to the rest of the economy. Hard line "Chicago school" economists would argue that the market always knows best. Others are less equivocal.

It is worth listing the various ways in which the state can try to affect the competitiveness of firms operating within its borders.

• Targeted loans
• Export incentives
• Import restrictions
• Government procurement
• Public ownership
• Tax breaks
• Investment subsidies
• R&D subsidies

No single policy is necessarily more appropriate than any other, but as a general rule the best policy is the one which addresses the problem most directly. For example, it is often argued that countries should use tariffs to give temporary protection from foreign competition to infant industries. For infant industries, time is usually a factor in the market failure. For example, an infant industry may be profitable in the medium term, after the labour force has gone through a learning process, but capital markets are biased against investment in human capital and so the firm is unable to secure finance for investment. This is a reflection of inefficient capital markets rather than inadequate trade policies. In this case the "hierarchy of policies" is that the most efficient means of tackling the problem is to reform capital markets to remove their bias against this type of invisible investment; the second best policy is to subsidise training, third best could be to subsidise the employment of labour that contributes to the pool of skilled labour. Tariffs are inferior to all these options.

The general left-of-centre viewpoint is that the market will not necessarily direct resources to the areas where they will help to generate economic growth. A major criticism of economic efficiency arguments is that they try to maximise the output from a given set of resources (i.e. they are static), while the role of government should be to try to increase the resources available (i.e. dynamic). Other important elements are the positive externalities generated by some activities. For example, producing electrical consumer goods does not just bring the direct benefit in terms of the product itself, it also incorporates a learning process which at some stage might enable the workforce to move on to making high-tech electronics.

Michael Porter has conducted major studies into the "Competitive Advantage of Nations" and sees the government?s role largely as a facilitating one. Porter used a diamond structure to demonstrate his theory of competitiveness, where the four corners of the diamond are:

• Factor conditions. Classical trade theories (Ricardo, Heckscher-Ohlin) argue that the resource endowments of a country determine its pattern of trade. To this Porter adds the ability of a nation to improve its factors of production and to allocate them efficiently.
• Demand conditions. Firms which face active competition and a sophisticated consumer base in home markets will be better prepared to compete internationally.
• Related and Supporting Industries. Where a firm is operating closely with other industries, factors such as timeliness of product and information flows, and general co-operative behaviour are crucial to competitiveness.
• Firm Strategy, Structure and Rivalry. These are the conditions which determine how firms operate and the nature of competition. Porter argues that no single managerial, ownership or operational strategy is universally appropriate.

In Porter?s eyes the role of government is to maintain and shape the efficient working or the four factors outlined above. The government provides the conditions for the nation to be competitive, rather than actively involving itself in the sphere of production. The government has the ability to influence almost every aspect of economic activity (although whether it chooses to do so or not is another question).

One problem with Porter?s theory is the vagueness of the term "national competitiveness". Is it a relative or an absolute concept? Is competitiveness a "zero sum game"? - that is, does an increase in one country?s competitiveness automatically imply a similar decline in another country?s. (As an aside, note the occasional surveys of attitudes of American students. Given a situation where the per capita income in the US and Japan is, say, $50,000, they are then asked their views on a rise in US incomes to $60,000 and Japanese incomes to $55,000. Nearly all are in favour. They are then presented with a situation where US incomes again rise to $60,000, but this time Japanese incomes rise to $70,000 and the response is much less clear - even though the rise in US incomes is the same.)

The idea behind protectionism is that a gain for one country implies a loss for another. In contrast, liberal trade theory is based on the idea that both sides can benefit from trade. Moreover, greater prosperity for one country implies higher demand for products from other countries, which in turn boosts their economies. Note the problems encountered in various South East Asian economies in the early 1980s when the United States - their major export market - went into recession.

Competitiveness is a term which is easily applied to companies, but more problematic when analysing countries. Whether or not in 1952 the then head of General Motors, "Engine Charlie" Wilson ever actually said "What is good for America is good for General Motors" (or as some versions would have it "What is good for General Motors is good for America"), the sentiment is clear. More recently, President Clinton described America as being "like a big corporation competing in the global marketplace".

Porter argues that it is misleading to look at the competitiveness of a nation as a whole and concentrates instead on trying to explain what causes productivity and productivity growth. This is also at the heart of Krugman?s criticism of the obsession with competitiveness, arguing that people miss the point when focusing on America?s relationship with the rest of the world, when what is important for prosperity is the increase in productivity generated domestically.

Contrast this with politicians of most countries, who are regularly trying to promote "the competitiveness of our nation". There is even an annual "World Competitiveness Report" produced by the World Economic Forum which ranks countries according to various objective criteria and an opinion poll of businessmen. Singapore always comes in the top three, presumably because the government has the same attitude to filling in surveys as it does to chewing gum or flushing public toilets.

A more concrete criticism is that Porter?s Diamond neglects the impact of international production. In the 1990s, foreign production of multinational corporations exceeds the value of exports, so it is a mistake to underestimate MNC?s role in determining national competitiveness.

Another problem, highlighted by John Stopford and Susan Strange, is that Porter can perhaps explain average national competitiveness, but he cannot explain why the points in his diamond have a different effect on different companies. It tells us nothing about why one firm succeeds and another fails, and it could even be argued that it does not explain why one industry succeeds and another fails. Ford has become a global automobile maker - but who remembers Packard Motor? Why did American become the largest airline company, while Pan Am failed?

Krugman argues that the government has shown itself to be so bad at trying to boost economic growth that it should not interfere at all. In a damning critique of industrial policy, he argues that the government mistakenly talks of competitiveness when it means productivity, that it does not know which are the most productive industries and that it does more harm than good when it tries to promote favoured parts of the economy. The article is worth reading for the sharpness of thought alone.

Opinions on the role of the state depend more on social and economic ideology than on any demonstrable facts. Unsurprisingly then, there is no single version of the generic capitalist system which receives general approval. Perhaps the main lesson of the past two decades is that we know which economic system doesn?t work: the failure of the former communist countries of Eastern Europe to produce efficiently, innovate or grow resulted in their collapse in the late 1980s.

It is worth considering exactly what are the factors which determine levels of growth or national competitiveness. Inevitably, no country can be good at everything. The productivity and flexibility of Japanese manufacturers may be legendary, but its distribution and retail system is highly inefficient. The United Kingdom has become a leading financial centre, but lost much of its industrial base in the 1980s. Germany excels at making machine tools, quality automobiles and pharmaceuticals, but is weak in consumer electronics and has an underdeveloped financial sector. The United States leads the world in computer software, telecommunications and high-tech electronics, but has seen its consumer electronics and automobile sectors battered by foreign competition.

It is extremely rare for a country to dominate an industry entirely. Japan makes excellent automobiles, but that does not prevent countries from Sweden to Brazil from competing. In the case of semiconductors, just as Japanese makers thought that they might achieve dominance, Korean manufacturers emerged to provide renewed competition. Trade between developed economies is largely of the "intra-industry" variety; that is to say even though Germany sells machine tools to the USA, the USA also sells machine tools to Germany.

No country appears to possess the magic formula which will allow them to gain a lead in all major industries. However, some have done better than others and it is worth considering why that has been the case.

There are some examples of colossal waste as a result of government intervention, just as there are some success stories. Japan is typically taken as the prime example of an economy which has successfully implemented industrial policy to promote economic growth. However, even there, the evidence is mixed. For example in the 1960s the Ministry of International Trade and Industry famously advised Honda to stay away from the automobile sector and to concentrate on making motorbikes. Of course there have been successes, most notably Japan's campaign to catch up with US technology in making semiconductors. The Very Scale Integrated Circuit (VLSI) project of the late 1970s provided a significant boost to Japanese technological capabilities. However, the "fifth generation" successor to VLSI drew participation from fewer major firms and was not seen as a great

success, as the domestic industry leaders were reluctant to work with potential competitors.

The extent of government intervention in Japan cannot be determined from factors such as the size of government spending in promoting R&D, the direct restrictions on imports and the legal framework in which business operates. There is also substantial (but declining) "administrative guidance", whereby a ministry will offer suggestions for conduct in a particular aspect of the industry it oversees. For example, until the late 1980s the Ministry of Finance would periodically offer guidance to banks on the amount that their loans should increase, if there were fears about economic overheating. Deregulation and entry of foreign companies means that such guidance is no longer a practical method for conducting policy and the trend in recent years has been for a more explicitly rule-based system, but to an extent Japan is still an extra-legal society.

Most people consider the United States to be a strongly free market economy, with a relatively limited role for government. However, there is one long-term industrial policy as well as a couple of more recent ones. The US has no equivalent to Japan?s MITI, but it does has the Department of Defence. The massive funding available for defence constitutes a form of industrial policy, with much defence related R&D having relevance for non-military products. More recently the government has also approved support for high-tech research projects such as the 1994 plan to develop flat panel displays and Sematech (to develop semiconductors).

Trade policy is another mechanism used by the US government to try to safeguard the prosperity of its domestic firms. Restrictions on imports and pressure to force open foreign markets are have repeatedly been used to the advantage of US companies.

In Europe the situation has been complicated by the rise of the European Union as a central institution. The post-war welfare state brought with it the attitude that the state had a role in promoting economic growth. The clearest example (and perhaps also the most effective) was the dirigiste system in France, where the government drew up five year plans and directed resources at favoured sectors.

In the 1990s, the use of industrial policy within the European Union is severely constrained. The European Commission frowns upon state subsidies for industry, although they persist in some strategic industries such as steel. State assistance in member countries is scrutinised by central authorities with the objective of ensuring that no company is gaining advantage over its rival across the EU.

European industrial policy is moving to a Union-wide basis when it exists at all. In a counter-example to the hugely expensive Anglo-French Concorde venture, Airbus is put forward as an example of how European firms and governments can co-operate in order to develop an expertise in a strategic industry. In the 1980s Europe attempted to replicate Japanese semiconductor research with its JESSI project, which also provides a useful example of the effects of globalisation. JESSI was aimed at assisting semiconductor makers, and just as Sematech was closed to foreign subsidiaries, it was explicitly for European firms. However, IBM obtained indirect access through its alliance with Siemens and the situation became even less clear when Fujitsu bought 80% of the British computer firm ICL in 1990. ICL was initially excluded from JESSI, but later re-admitted on a limited basis.

There is a debate as to whether the successful development of East Asia can be attributed to an active involvement of the state in the economy. Whether East Asian growth was a result of direct state intervention, or simply derived from the state providing the right conditions for the economy to flourish, the governments of the region were doing something right. Contrast this with the experience of Latin America through the 1970s (and up to a point in the 1960s and 1980s), when a desire for a strong, independent economy led to misguided industrial policies. Several states erected high import tariffs, subsidised exports, maintained uncompetitive exchange rates and poured money into heavy industry without ever exposing it to competitive pressures. The results of such policies were the development of domestic "white elephants", large trade and budget deficits, rampant inflation and burgeoning external debt. Latin America provides a case study of the disastrous consequences when a state thinks that it can pursue policies which ignore the sobering effects of competition and run counter to market forces.

Singapore is often held up as a shining example of successful government intervention in the economy. Persistently strong growth rates over three decades have seen its income level rise to those comparable with OECD economies. While some of Singapore?s success may be ascribed to its geographic position and consequent role as an entrepôt for trade with Malaysia and Indonesia, positive government action also appears to have played a part. Restrictions on wages and union activity, a welcoming environment for FDI and a government forced-savings scheme all contributed to strong rates of investment in the economy. There was also judicious use of public ownership to fill gaps where the private sector might be inadequate, such as telecommunications. At the same time an educated an enlightened bureaucracy pursued sound macroeconomic policies, with limited but effective levels of regulation.

On paper (at least in the article by Huff) it does not appear that the government of Singapore did anything particularly special. It created the right environment for healthy growth and then intervened or stood back as necessary. While some developing countries have seen a negative impact as a result of choosing the wrong industrial policies, others have failed because the state has not been strong enough to resist interest groups within the country. In Singapore the system was democratic, but the government always had a firm grip on power.

The correct role of the state in the economy is controversial. There are examples of successful intervention helping to boost economic development, but there are just as many counter-examples of the government interfering and distorting the market and diverting resources away from where they can be best used. There will always be a temptation for governments to "do something"; self control is needed to make sure that they do not do too much.

to next chapter