Tuesday, January 31, 2012

Democracies and Industrial Policy

Fareed Zakaria had an interesting comment about industrial policy on his show yesterday:
Andrew Liveris, the CEO of Dow Chemical, has been arguing for a national policy aimed at reviving manufacturing. In his book, Make It In America, Liveris argues that not only would a manufacturing policy produce good, long-term jobs, it would upgrade the job skills that are crucial to keeping innovation alive.

"Innovation doesn't just happen in laboratories by researchers," he told me. "It happens on the factory floor. The process of making stuff helps you experiment and produce new products. If everything is made in China, people there will gain the skills, knowledge and experience to innovate. And we will be left behind." He worries that with tablets like the iPad and Kindle being made mostly in Asia, the next generation of these products could well be imagined there.

Companies can't compete with countries, he says.

Take solar energy, an industry largely invented in America, in which the manufacturing has largely moved to China thanks to massive state subsidies. Or consider wind turbines: China's biggest windmill makers have received more than $15.5 billion in credits from state-owned banks.

As a result, despite many concerns about quality, they won their first major foreign orders in the past year.

In theory, I am deeply skeptical of government industrial policy. Government doesn't know how to pick winners and losers, it makes mistakes, the process gets politicized.

And yet, when I look around the world, particularly in Asia, I see governments playing a crucial role. They do make mistakes – their versions of Solyndra – but they seem to view it like venture capitalists.

Their role is to seed many companies, only a few of which will succeed. Once successful, the government helps these companies to compete against big American multinationals.

There used to be a joke about Marxist economists who would say of a deviation from pure Communist economics: "It might work in practice, comrade, but it doesn't work in theory."

That's what industrial policy looks like these days.

The theory doesn't make much sense but it's hard to argue with the results.
I'm more than deeply skeptical about government industrial policy, but I think the key difference between Fareed and me is that I'm mostly skeptical of such policies in a democracy.  China and most of the former Asian tigers aren't democracies; they're authoritarian capitalist economies.  When you've got only marginally accountable leaders, they can indeed act like venture capitalists, because they can make nimble decisions about where to invest.  (The fact that a certain number of those nimble decisions would be considered corrupt by a democracy is almost irrelevant to the leaders of such states.  An authoritarian system exists to perpetuate the power of the leadership and its friends.)

The Chinese government in particular is its own venture capital firm, because the government has no compunctions about being a shareholder in whatever companies it views as interesting.  Tian and Estrin estimate that the Chinese government holds a majority shareholder position in  31% of all Chinese publicly listed companies.  The government is perfectly content to reap a big chunk of the profits from these companies, something that would be unheard of in the US.

If a democracy tries to do the same thing, it is immediately besieged by rent-seekers whom it is not allowed to shoot.  Every decision will be lobbied, questioned, and criticized, with no risk of acquiring unsightly holes in the back of one's head.  This has two effects:  First, it makes all investment decisions incredibly bland, and bland investing tends to have a lousy return.  But more important, it makes every investment decision permanent.  Once the rent-seekers get involved, the machinery becomes impossibly ponderous.

So the real question is, can democracies have a government-funded venture capital system that makes intelligent investment decisions, but is relatively immune to rent seeking?

As I understand it, most venture firms raise capital for their investments as private equity funds.  Large investors form limited partnerships and commit capital for the fund, which is then called down by the fund managers as investments are made in the startups in the portfolio.  This is very different from a typical public LLC, which would just sell stock and raise capital from the sale.  I'm sure there are lots of good reasons to use the private equity model, but it does necessarily tend to keep the amounts of capital bounded, and there is less incentive to scale the investments up, or across more startup companies.

I keep wondering how this would change if there was some kind of GSE that could securitize debt for venture capital firms, giving them a much larger access to cheap capital than they'd have from private equity partners.  If this all sounds a little iffy after September, 2008, you're right--it is.  But you could presumably issue the debt instruments so that you couldn't write credit default swaps against them.  It would then be fairly easy for the government to select sectors to invest in, and direct more or less money to each sector by changing the securitization commitments, without ever getting involved in picking the individual companies.   The government could even buy the bonds themselves if the private sector didn't have an appetite for them.

This is hardly immune to rent-seeking, but at least the lobbying is occurring at the sector level, rather than at the level of individual companies.

I'm sure when I wake up in the morning this will sound like a terrible idea.  Still...

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