Is Industrial Policy Making a Comeback?

Introduction

As the United States confronts a series of challenges—climate change, global supply chain instability, and the rise of China foremost among them—experts are again debating the role of industrial policy, or government support for industries that are deemed strategically important. 

To its supporters, a new U.S. industrial policy is essential to respond to China’s state-led development, secure a supply of critical materials and products, and develop technologies that could preserve the planet. They point to the use of industrial policy not only in China, but also in countries such as Germany, Japan, and South Korea, as well as its historical use in the United States. To critics, such a policy inevitably distorts the free market and rewards companies not for the quality of their products and services but for their skill at lobbying lawmakers. President Donald Trump upended the Republican Party’s traditional stance on economic policy by imposing new barriers to trade, while President Joe Biden has overseen the passage of major industrial policy legislation, including the CHIPS and Science Act and the Inflation Reduction Act.

What is industrial policy?

Industrial policy generally refers to efforts to promote specific industries that the government has identified as critical for national security or economic competitiveness. In a Council  Special Report, CFR experts Jennifer Hillman and Inu Manak define industrial policy as “government action that encourages or directly subsidizes the expansion of certain economic sectors over others.”

Industries often included are those with heavy manufacturing or that have military applications, such as aerospace, semiconductors, and electric vehicles. Policy measures could be protective tariffs or other trade restrictions, direct subsidies or tax credits, public spending on research and development (R&D), or government procurement (goods and services, such as military equipment, that the government buys). “It’s about the government putting a thumb on the scale, rather than just assuming that market outcomes are going to produce the maximum benefit,” says CFR’s Edward Alden.

How has it previously been used in the United States?

Alexander Hamilton is widely considered to be the first major proponent of industrial policy in the United States. In his famous 1791 “Report on the Subject of Manufactures,” the nation’s first treasury secretary advocated supporting the fledgling U.S. manufacturing sector through a combination of tariffs and subsidies.

This Hamiltonian tradition has been expressed in various forms throughout U.S history, such as Henry Clay’s vision of an “American System”—a combination of tariffs, a national bank, and infrastructure development—in the early nineteenth century, writes Ganesh Sitaraman of Vanderbilt University. Sitaraman ascribes several other traditions of U.S. industrial policy to early American leaders, including a “Franklinian” tradition focused on promoting research and infrastructure, rather than particular industries, and a “Madisonian” tradition centered on creating a competitive market through the use of antitrust and other regulations. 

However, among advanced economies, the United States has historically been “the most averse to using industrial policies in any kind of consistent fashion,” says CFR’s Alden. Washington has typically embraced it only in response to a perceived external threat, he says.

Experts cite many of President Franklin D. Roosevelt’s (FDR) New Deal programs of the 1930s as early examples. These include the National Recovery Administration, which sought to regulate wages and prices across a slew of industries. The massive, government-directed World War II mobilization that followed was also an extreme case.

After the war, U.S. industrial policy was largely driven by competition with the Soviet Union, including the space race. The Pentagon’s Defense Advanced Research Projects Agency (DARPA)—conceived in response to the Soviet Union’s launch of Sputnik, the first artificial satellite—has been credited with paving the way for the modern internet and the Global Positioning System (GPS), among other breakthroughs. Massive government purchases of semiconductors spurred the growth of the U.S. chips industry. But competition with Japan in the semiconductor sector in the 1980s stoked fears of a U.S. decline. This slump led to the creation of Sematech, a government-backed consortium of fourteen U.S. companies aimed at strengthening the industry by coordinating R&D spending and setting common standards.

More recent examples include ARPA-Energy, founded in 2009 to develop new energy technologies as the Department of Energy’s own version of DARPA. Through September 2022, the program had distributed more than $3 billion to almost 1,500 projects, according to the Department of Energy. President Barack Obama’s Manufacturing USA initiative, started in 2016, established more than a dozen public-private research institutes focused on promoting advanced manufacturing.

What about other countries?

Many countries, including Germany, Japan, South Korea, and most Latin American countries, have implemented industrial policies with varying degrees of success.

Europe. Industrial policy has a long tradition in Europe, including in France, Germany, and the United Kingdom (UK). The economist Ha-Joon Chang has detailed, for example, how England fostered the development of wool manufacturing as early as the fourteenth century using tariffs, export restrictions, and other measures. Germany’s nineteenth-century Chancellor Otto von Bismarck, who created a unified German state, introduced tariffs to protect both agriculture and industry, known as the “marriage of iron and rye.” Chang explains that state-owned enterprises continue to play an important role in several European economies. The French government today is still a major shareholder of the automaker Renault, while the aerospace giant Airbus is the result of a collaborative effort by the British, French, Spanish and German governments.

The 1980s saw a turn against heavy state involvement, with UK Prime Minister Margaret Thatcher and other leaders privatizing nationalized industries such as steel and airlines. More recently, however, UK Prime Minister Rishi Sunak announced plans to invest in renewable energy and electric vehicles to help make the country carbon neutral by 2050. In Germany today, research is supported by a network of public-private institutes, and manufacturing is aided by an apprenticeship program. Berlin has also developed an “Industry 4.0” plan to boost high-tech manufacturing through research subsidies and other initiatives.

The European Union, meanwhile, has recently adopted a climate-focused industrial policy, which includes the European Battery Alliance, a network to coordinate research and subsidize battery manufacturing across the continent. In July 2023, the bloc adopted the European Chips Act, which is aimed at increasing its market share in the global semiconductor market.

Asia. Many experts argue that industrial policy stoked the “East Asian miracle,” the rapid post–World War II economic development of countries in the region, including Japan and South Korea. The Japanese government fostered the development of industries such as steel and semiconductors using a combination of trade and investment restrictions, subsidies, and other policies. By the 1980s, Japan had transformed into an economic powerhouse rivaling the United States. Yet, some experts argue that [PDF] the effects of industrial policy on Japan’s economic growth are overstated, and that other factors, such as entrepreneurship and the country’s high savings rate, played bigger roles. After more than thirty years of rapid growth, Japan suffered what some have called a lost decade in the 1990s, and it has since struggled with low growth and deflation.

South Korea also sought to rapidly modernize its economy [PDF] in the 1960s and 1970s, including by developing its steel, shipbuilding, electronics, and automobile manufacturing sectors. This led to the creation of the chaebol, massive conglomerates such as Samsung and LG that dominate South Korea’s economy. Seoul also heavily subsidized its semiconductor industry, helping it become one of the world’s largest. In Taiwan, meanwhile, the government played a crucial role in developing its semiconductor industry—also a global leader—by funding research and recruiting U.S.-trained engineers. However, some economists have argued that South Korea’s and Taiwan’s success is the result of their embrace of trade, not industrial policy [PDF].

China, under Communist Party leadership since 1949, has long had a state-directed economy despite some market-oriented reforms beginning in the late 1970s. In recent years, Beijing has embraced an aggressive industrial policy aimed at achieving global dominance in several high-tech industries.

Latin America. Many countries in the postwar era, worried that they were too dependent on low-value-added commodities in sectors such as agriculture and mining, experimented with import substitution industrialization (ISI). This approach sought to promote domestic industries by discouraging the importation of manufactured goods through tariffs and other trade restrictions. Experts say the results were mixed: some new industries and successful companies were formed, but it also resulted in corruption, inefficiency, and unsustainable government budgets.

Why is it controversial?

The debate over industrial policy is heated because it gets to the heart of a deeper, long-standing controversy over the role of free markets and the role of the government in the economy.

Proponents argue that the government has both the ability and the duty to structure the economy in the national interest, since the free market may fail to do so. For example, manufacturing industries provide broad societal benefits, such as stable, well-paid employment, that are not factored into an individual company’s decision-making, argues Oren Cass, executive director of right-leaning think tank American Compass. Harvard Business School professors Gary Pisano and Willy Shih have long argued that offshoring production hinders the United States’ ability to innovate, as manufacturing know-how is lost.

What’s more, a country could determine that it needs to domestically produce critical goods, such as medical supplies or military equipment, for national security reasons. Supporters also argue that the government should fund R&D because the societal benefits go far beyond what companies will invest in.

A smart industrial policy should focus on high-value industries that compete internationally, have civilian and military applications, and are difficult to revive once lost, says Robert D. Atkinson of the Information Technology and Innovation Foundation. Atkinson cites semiconductor manufacturing as one example.

Some experts say that industrial policy can serve a valuable purpose, but warn against its potential pitfalls. “Moving toward industrial policies and increasing subsidies is warranted and indeed essential,” CFR’s Hillman and Manak write. “However, the urgency of the problems does not mean abandoning well-founded concerns that industrial policy—done wrong—can stifle innovation, create substantial inefficiencies, exacerbate the concentration of corporate power, waste precious taxpayer funds, and fuel crony capitalism.”

What is the current U.S. debate about?

Industrial policy fell out of favor in the 1980s and 1990s with the development of the Washington Consensus, by which mainstream economists saw economic development as the result of free-market policies such as the privatization of state enterprises and promotion of free trade. But there is renewed interest among policymakers on both sides of the aisle due primarily to the rise of China, increasing economic inequality, the threat of climate change, and supply-chain vulnerabilities revealed by the COVID-19 pandemic.

Democrats have increasingly put forward bold proposals that intentionally hearken back to FDR-era interventionism. For example, the proposed Green New Deal envisions a broad, climate-centered industrial policy focused on clean energy, infrastructure, and manufacturing. On the right, President Trump broke with long-standing Republican economic orthodoxy with the stated goal of bringing back American jobs, particularly in manufacturing. He imposed tariffs on imported steel and aluminum products, washing machines, and solar panels; he took aggressive action against China, slapping additional tariffs on hundreds of billions of dollars worth of Chinese goods and blocking several high-profile Chinese acquisitions of U.S. tech firms. But many experts criticized Trump’s tariffs as ineffective, saying they generated few jobs at a huge cost to consumers and other industries.

Some other Republicans have followed suit. “The market will always reach the most efficient economic outcome, but sometimes the most efficient outcome is at odds with the common good,” Senator Marco Rubio (R-FL) said in a December 2019 speech [PDF] advocating for a new U.S. industrial policy to counter China and bring back “dignified work.” His plan includes increasing federal R&D spending, encouraging investment in “strategically important industries” such as aerospace and rail, and incentivizing businesses to invest more in factories and machinery. 

Cato’s Lincicome warns against [PDF] overstating the success of China’s state capitalism, noting that Chinese semiconductor companies have failed to become global leaders despite billions of dollars in subsidies. Moreover, he says, “the United States should lean in to what makes the United States great”: increasing high-skilled immigration, cutting taxes and regulations, and securing new trade agreements with allies. Lincicome further argues that industrial-policy proponents paint a picture of U.S. decline that is far bleaker than reality. Though employment has declined, the value of manufacturing output has risen over the past two decades, and the sector’s declining share of the economy is consistent with those of other advanced economies as service industries expand.

What has Biden done?

President Biden campaigned on a pledge to “Build Back Better,” proposing hundreds of billions of dollars in new spending to improve U.S. economic competitiveness and promising a foreign policy “for the middle class.” One of his first actions in office was an executive order aimed at strengthening so-called Buy American laws, which require the federal government to purchase goods and services from U.S. companies. In another executive order, he began the process of replacing the federal government’s massive fleet of vehicles with clean-energy models made in the United States, a potential boon to the domestic electric vehicle industry.

In 2022, negotiations with Congress resulted in bipartisan support for two major bills with significant industrial policy implications. The CHIPS and Science Act, passed in August of that year, will direct some $280 billion toward scientific R&D and semiconductor production in the hopes of encouraging advanced technology manufacturing to move to the United States and away from China. In the weeks following the law’s passage, half a dozen semiconductor manufacturers announced plans to use federal subsidies to bolster their U.S. manufacturing. To access funds from the legislation, companies must commit to not build certain types of facilities in China, Iran, North Korea, or Russia. The Biden administration also took unprecedented action to out-compete China on emerging technologies, introducing strict export controls that restrict China’s ability to obtain advanced computing chips, maintain and develop supercomputers, and manufacture semiconductors. Gregory Allen, director of the AI Governance Project at the Center for Strategic and International Studies, writes that the “landmark” controls “begin a new U.S. policy of actively strangling large segments of the Chinese technology industry—strangling with an intent to kill.” The measure was soon complemented by similar regimes in Japan and the Netherlands. In August 2023, Biden followed up the controls with an executive order banning some U.S. investment in the Chinese technology industry.

The Inflation Reduction Act, also passed in August 2022, contains an additional $60 billion in tax credits, grants, loans, and investments to bring advanced transportation and technology manufacturing back to the United States. The law includes billions of dollars in new subsidies for consumers and manufacturers of electric vehicles whose final assembly takes place in North America and whose batteries contain components and critical minerals primarily sourced from the United States or its trade allies. Beginning in 2024, automakers whose battery components are manufactured in China will not be eligible for the subsidies.

However, CFR’s Shannon K. O’Neil has warned that the push to reintroduce some domestic manufacturing to the United States could actually make supply chains less resilient. Instead, she writes, the United States should coordinate with allies such as Canada and Mexico to create joint supply chains and strategic stockpiles. Hillman and Manak offer a slew of proposals to maximize the benefits of industrial policy while reining in what they view as inefficient distortion of international trade. These include limiting overall subsidy levels while maintaining areas of common international interest, penalizing countries that fail to disclose subsidies, and empowering the World Trade Organization (WTO) to enforce international subsidies rules. Leading the way on these reforms “would give the United States a powerful tool to address its twin concerns over competition with China and fighting climate change,” they write. “It would also allow the WTO and the world to come closer to a more equitable, resilient, and sustainable international economic order.”