This guest post is by occasional contributor Ilya Podolyako, a third-year student at the Yale Law School and an executive editor of the Yale Journal on Regulation.
In my last post, I compared Obama’s plan for the automakers to that of the Chinese government. I concluded that the two shared goals, but that these goals fit poorly into the traditional American ethos of free enterprise. For better or worse, the administration will have to remedy this mismatch sometime soon, either by letting the automakers fail or by openly stating that jobs, national pride, and a green fleet justify a government-backed industry.
Some of the comments to that piece strongly favored the latter course of action. Accordingly, I think it is worthwhile to take a normative look at directed industrial policy generally. In the abstract sense, this system is the opposite of laissez-faire capitalism – the government owns enterprises and dictates both the nature and quantity of their output. This description naturally evokes images of the USSR, Cuba, or the People’s Republic of China (before 1992), all countries with “command” economies. The distinctive characteristic of these nations, however, was not the presence of state-owned enterprises (SOEs) per se, but the absence of a legal, noticeable private sector.
Countries like Sweden, South Korea (before 1988), and, indeed, the modern China have demonstrated that directed industrial policy is not an all-or-nothing game.
The state can own some firms while the private sector owns others; these groups can compete in the same industry or service different sectors of the economy. Examples of the middle-ground approach also abound in developed economies: in Norway, the government owns over 60% percent of Statoil, the country’s largest employer (now part of Statoil Hydro); in France, the government owns over 80% of the giant power company EDF; Germany, France, and Spain effectively control the management of the defense contractor EADS, despite the fact that 41% of the company’s stock is publicly held; until 2006, the Republic of Ireland held 85% of the shares in Aer Lingus, the country’s largest airline, a share that has since fallen to 25%; and Canada’s government owns dozens of so-called Crown Corporations. Of course, these statistics have lost much of their panache now that the US Treasury owns 80% of AIG, but the figures still show that (intentionally) state-owned industry is not altogether unusual.
That is not to say that SOEs are entirely benevolent. Over the years, economists have identified several key flaws. First, the absence of the profit motive, which often runs along with the guarantee of lifetime employment, removes incentives for employees to work hard. Second, the people involved in managing these conglomerates may retain their profit motive and act on it, even if the companies officially do not, leading to widespread corruption. Third, a company that decides what to produce based on official decree, not market demand information, will have an extremely difficult time determining the “right” amount of output. If said firm makes widgets, it will make either too many or too few widgets, creating waste in the first instance and shortages (assuming that the government regulates price) in the second.
A government committed to firing lazy workers, who could then fend for themselves in the remaining, robust private sector, would seem to be able to solve the first problem with SOEs. A robust criminal code that punishes corruption, when coupled with politically ambitious prosecutors, would probably mitigate the second. The third flaw, however, appears immutable, not merely because of societal momentum or even the laws of human nature, but because mathematically, pricing information appears to be the only way to measure efficient output.
Where do the above observations leave us? Conventional wisdom argues strongly against government control of industry if this control leads to an outcome different than what the market would otherwise dictate (passive taxpayer ownership poses a somewhat different set of problems). Yet the last 24 months have forced everyone, including old-guard, free-market purists in charge of the Fed to reexamine conventional wisdom. If the central bank can selectively lend to industries that appear to be failing in the open market, one would think that Treasury or the Department of Commerce could also selectively push certain industries to generate products that they believe would improve the national economy.
Such intervention could come in one of two forms. The government could try to dictate business strategy to firms that receive a substantial amount of bailout money, but as I explained before, this would amount to stacking an inefficient bureaucracy on top of a underperforming business. Alternatively, the President and Congress could fund brand-new entities that would lay high-speed rail, construct nuclear power plants, and build a modern national electric grid. These companies would be staffed with regular employees and managers who would have to answer directly to someone high up in the executive branch. They would also compete alongside their private sector peers, who could choose to provide variations on the basic product (like UPS or FedEx) or attempt to displace the basic product altogether (like private charter school operators).
Normally, this setup would raise concerns about “crowding out” private-sector capital or innovation, but this theory applies equally to indirect government spending, not just direct industrial participation. True, private firms may be reluctant to compete with organizations backed by “infinite” treasury pockets willing to absorb a loss, but this fear cant get much worse than it is now. Moreover, Congress could fix this problem by specifying early on that these new enterprises will have to shut down after posting 3 years’ worth of consecutive losses.
Here’s the crux: current strategies for economic recovery focus on stabilizing financial institutions and melting credit markets, but they fail to provide an internal engine of growth for the American economy. Theoretically, this growth should continue to come from private-sector innovation, but the private sector is in deep and worsening trouble. According to the latest Fed report, consumers continue to be saddled with roughly as much revolving (non-mortgage, non-auto) debt as they were in Q2 of 2008. This debt load would have to decrease by 17% to get us back to 2004 levels, when an average household owed around $6500 on their credit cards. At the current rate of revolving debt change, the adjustment would take at least two years, but this calculation does not account for the decrease in individuals’ personal income, which is falling at around 1.5-3% a year. A sharp decline in domestic production means that the US will also continue to be a net importer. These characteristics are part of the reason why the country got to where it is in the first place. Without a new strategy, it is unlikely that the ingenuity of a few individual entrepreneurs will be sufficient to pull us out of this depression.
Of course, the government shouldn’t pick its areas of economic involvement arbitrarily. A smart policy would be to attack problems that the private sector has traditionally been unable to address (producing cars doesn’t fall into this category). The new enterprises should first engage projects that suffer from free-rider and coordination issues which only a central authority can overcome – public works and infrastructure. No one wants to build the first mile of a road to a store if the guy at the other end can get its benefits for free. Next, the government should invest heavily in pharmaceutical, engineering, and biotech research, both at universities and newly invigorated national labs. Since anyone can build on fresh advances, basic science carries many of the same unpleasant investment characteristics as physical public goods.
The above programs aren’t that far from the status quo. Congress already chartered Fannie and Freddie; the Pentagon already subsidizes an enormous defense sector. It is time, however, to try and change federal involvement in industry from covert efforts to promote opaque policy goals to thought-out measures designed to help firms and workers prosper. In the worst-case scenario, we privatize our way back to the present.
B y Ilya Podolyako