The Myth of National Industrial Policy; D. Bechara

Dennis Bechara CALLShave come in recent years for a new industrial policy as a certain cure for economic stagnation. Be tween 1969 and 1976, the Northeast and Midwest sections of the country lost about a million manufacturing jobs. It was common to refer to some of the more blighted areas as the "rustbelt" of America, foreshadow ing· ominous things to come. Al though the recent economic rebound has in some ways muted the ur gency, the call for government plan ning is still very much with us. Demands for a new industrial pol icy no longer originate solely from academic circles. Prominent busi ness leaders are espousing such a so lution to our economic evils. Lee la cocca, for instance, asks for the implementation of a "rational" inMr. Bechara is an attorney in Washington, D.C. 498 The Myth of National IndustrialPolicy dustrial policy. In fact, he has stated that, "Any debate over whether the [United States] should have an in dustrial policy is outdated and way off course. We already have one but it's all messed up. The real issue is, should we have a rational industrial policy." In a sense, he is right. We have a hodgepodge of Federal poli cies that affect investment decisions in a significant fashion. Whether these policies could ever be "ra tional" is, of course, a debatable point.

Two Variations of a Theme Two names are commonly associ ated with the proposal for a national industrial policy-Felix Rohatyn and Robert Reich. Rohatyn acquired na tional prominence when he became the chairman of the ,Municipal As sistance Corporation (MAC), an offTHE MYTH OF NATIONAL INDUSTRIAL POLICY 499 budget enterprise created by the State of New York, which issued $10 billion in bonds. MAC was credited with saving New York City from bankruptcy, and Rohatyn, as its chairman, basked in the so-called success of the rescue operation. He became affectio~ately known as "Mr. Fixit." New York City by 1975 had bor rowed $724 million to cover current expenses. Its short-term debt amounted to $4.5 billion. MAC was devised as a way of financing the short-term debt and averting out right default. MAC was able to func tion only with the backing of the fed eral government. This was achieved by measures that guaranteed to the capital markets that even if the City of New York defaulted, the taxpay ers would cover the bonds. New York City was saved from bankruptcy by the spreading of its risks to the na tional level.

Rohatyn's proposed national in dustrial policy is to revive a scrapped agency called the Reconstruction Fi nance Corporation (RFC) which would target decaying industries and regions and inject them with much-needed capital. Rohatyn also calls for easy credit by the Federal Reserve System to encourage the ex pansion of the housing and construc tion industry. The new RFC would not be vulnerable to public pressure, according to Rohatyn, because it would make its investment decisions behind closed doors, after consulta tion with appropriate business, la bor and government representa tives. As part of the conditions for granting financial assistance, the RFC would require certain policy and management changes, and it would obtain a share of equity in the enterprise. Thus, dying industries, such as steel, textiles, rubber and automobiles would be favored and strengthened by the RFC. Robert Reich, a Harvard Professor, proposes to favor industries with po tential future technology. In con trast to Rohatyn, Reich's version of the RFC would conduct its deliber ations in public and would welcome the participation of all segments of society.

Interestingly enough, Reich and Rohatyn criticize each other's pro posals. Reich feels that Rohatyn's closed-door RFC represents a dan gerous concentration of power and a threat to our democratic institu tions. Rohatyn's criticism is that an open-door RFC would only lead to politicized decisions. Both criticisms are valid arguments against the cre ation of an RFC. Credit Is Earned The unfettered market extends credit according to the profitability of an enterprise. If a business ven ture seems headed for failure, the credit markets either charge higher borrowing costs or simply do not 500 THE FREEMAN August grant any further financial assis tance. On the other hand, if an en terprise has a probability of success, credit is allocated to it. This is a healthy phenomenon, because prof itable enterprises are rewarded by the credit markets and unprofitable industries are penalized. A profita ble enterprise is one that has cor rectly judged desires of consumers and thus is allocating resources in the most efficient way. An unprof itable enterprise, on the other hand, is one that has failed to adjust to con sumer demand and misallocates resources.

By granting financial assistance to dying industries, the proposed RFC would, in effect, lower the rate of eco nomic growth because resources would be allocated to inefficient uses. In addition, the RFC would be the lender of last resort. Industries whose prospects are so bleak that they cannot obtain further financ ing from the private markets, would flock to the RFC seeking assistance. The funds granted to these poorer risks would crowd out more deserv ing users of funds. This may happen either because interest rates go up as a result of government opera tions, or, because one borrower ob tains actual physical capital goods let's say tractors on farms-at the expense of others. So we would be al locating resources to those poorer risks, who would either fail, or pro duce inefficiently. Therefore, it is not just a mere re-allocation of capital that is involved in an industrial pol icy. Also involved is the reduction in the country's wealth.

There is no guarantee that govern ment is any better equipped than the credit markets to judge what will be the technology of the future. A few years back, France and England joined in a common government en terprise to develop a new airplane that would be the fastest in the world. The result was the Concorde, a massive white elephant that is no longer in production. The test of profit and loss is the crucial one to determine what industries have po tential for growth, and the credit markets are better equipped to judge this. Under Socialism The incentive to be careful in al locating credit would be removed if credit were socialized, because gov ernment is not under the constraint of having to turn a profit. Other con siderations, such as "the public in terest," are prone to political manip ulation. On July 25, 1983, Senator Proxmire, when discussing the de sirability of instituting a national industrial policy, wondered how re sources would be allocated, and he answered the question in this fashion: Money will go where th,e political power is . .. It will go where the union power is mobilized. It will go where the cam1985 THE MYTH OF NATIONAL INDUSTRIAL POLICY 501 paign contributors want it to go. It will go where the mayors and governors as well as Congressmen and Senators have the power to push it. Anyone who thinks government funds will be allocated to firms according to merit has not lived or served in Washington very long.

In addition, it is easy to envisage dying industries, with their lobby ists, Congressmen and labor unions influencing an RFC and persuading it to grant further economic assis tance. The so-called "new" or "prom ising" industries that Reich would like to aid would simply not have the political clout that the established industries already have. An RFC would provide a further incentive for groups to engage in rent-seeking be havior. Political considerations w:ill enter into play in the allocation of capital, and those firms that are eco nomically efficient but politically unpopular, will suffer the conse quences. Government Allocation Distorts the Economic Message To the extent that the proposed RFC channels resources to indus tries less favored by consumers, we distort the economic information which is essential to entrepreneurs. Where the relative profitability of industries is forcibly altered by the government, the wrong signals are sent to entrepreneurs, and further malinvestments take place. An RFC could only perpetuate inefficient firms at the expense of the efficient ones.

In fact, this is happening right now. Ifwe look at the activities of the federal government, we observe that there are over $30 billion in direct loans and over 150 agencies that guarantee loans to different groups in the country. All of this activity amounts to approximately $100 bil lion a year. Economist Herbert M. Kaufman of the University of Ari zona studied the effect of Federal loan guarantees and his conclusion should not surprise us. For every $1 billion in Federal loan guaran tees, between $736 million and $1.2 billion in private investments that otherwise would have taken place is crowded out. In addition, the current tax code provides a series of incentives and deductions that skew production and the allocation of resources away from where the market would have put them. For example, by fiscal 1986, the combined tax breaks provided to people and businesses will be in the neighborhood of $400 billion. It has been estimated that in 1983 alone, the wealthy legally avoided paying taxes on more than $35 billion of in come by placing investments in such qualifying ventures as oil drilling, avocados, dairy farms, real estate and other tax-sheltered enterprises.

This is one of the reasons Lee Iacocca is correct when he states that we al ready have an industrial policy.

502 THE FREEMAN August There is no question that a substan tial segment of our economy is di rectly influenced by considerations that are outside the free market. History of the RFC Perhaps a better way of under standing the proposals for a na tional industrial policy is to study the actual record of the much trumpeted Reconstruction Finance Corporation. The RFC was established on Jan uary 22, 1932, as part of Herbert Hoover's programs to combat the Depression. Its purpose was to pro vide financial assistance to a num ber of institutions, public and pri vate, in order to promote economic recovery. During the first few months of its existence, the RFC re fused to divulge to the public the names of the institutions that were being considered for or which were granted financial relief. It was feared that the public would lose confidence in any corporation that received funds from the RFC, perceived as the lender of last resort. Congress, how ever, revised this policy and man dated that the RFC's activities be come publicly known. It soon became evident that loans were granted on the basis of political considerations, as shown by'the following: (a) $90 million to the Central Re public Bank of Chicago, whose "hon orary chairman," Charles G. Dawes, was the past president of the RFC.

(b) $14 million to Union Trust Company of Cleveland. Its chairman was the treasurer of the Republican National Committee. (c) $12.3 millioll to the Guardian Trust Company also of Cleveland. Atlee Pomerone, president of the RFC, was a director of this company. (d) $7.4 million to the Baltimore Trust Company, whose vice chair man was a Republican Senator. (e) $13 million to the Union Guardian Trust Company of Detroit, a director of which was Roy D. Chapin, Secretary of Commerce. Aside from banks and trust com panies, over the years the RFC provided financial assistance to insurance companies, mortgage companies, credit unions, agricul tural credit corporations,railroads, and eventually even to topless bars and massage parlors! Over 13 years, the RFC distributed more than $35 billion. Although some apologists of the'RFC claim that when it ceased operations it left a surplus 'of $500,000,000, a closer analysis re veals an $11.5 billion loss due to loans that defaulted and were oth erwise written off.

Did the RFC achieve its goals? If we consider unemployment as a re liable indicator, we have to conclude that the RFC failed. In 1931 unem ployment stood at 8 million. By 1939 there were 9 million people unem ployed. Unemployment declined only after Pearl Harbor. All the RFC 1985 THE MYTH OF NATIONAL INDUSTRIAL POLICY 503 achieved was to misallocate re sources. Capital was diverted from more efficient uses to less efficient, but politically more savvy uses. No one will ever know how much in vestment was crowded out by the RFC, but if the study by economist Kaufman is an indication, the ef fects were substantial. Japan One of the shining examples uti lized by many proponents of a na tional industrial policy is Japan. According to this version, ~Japan's economic miracle is due to the guid ance provided by the Ministry of International Trade and Industry (MIT!). Therefore, all we have to do is set up our own MITI and perma nent economic recovery will be with us. Before we do that, it would be in structive to analyze just what MITI has done in Japan. Is the Japanese miracle due to MITI's omniscience?

Or is it due to a policy of limited gov ernment and laissez-faire? At the end of World War II, Japan was devastated militarily and eco nomically. Two of its cities, Hiro shima and Nagasaki, were obliter ated by atomic bombs. Food was scarce, and only 16per cent ofJapan's land is arable. In 1947 more than half the Japanese population was engaged in farming. Although lack ing capital and technology, Japan had a vast amount of cheap labor. So labor-intensive industries began to prosper and produced such items as foodstuffs, textiles, ceramics, and beverages. These export industries in turn brought foreign currency into the country, enabling Japan to ac quire foreign technology, manage rial expertise and raw materials. As the evolution continued in the 1960s, capital intensive industries began to emerge, producing such items as automobiles, motorcycles, television sets, radios and cameras.

Japan's success in exporting its goods was the result of thousands of private companies which imported cheap raw materials, acquired for eign technology and exported goods. What was the role of the Japanese government and of MIT! in partic ular during this time? During the 1950s, MITI was con vinced that there were no commer cial possibilities for the transistor. After all, a change to transistors was simply too revolutionary an idea. So for two years, MITI attempted to prevent Sony from acquiring man ufacturing rights from Western Electric. Similarly, MITI felt that Japan's automobile manufacturers could not compete in the world mar kets. So they attempted to dissuade the manufacturers from getting into the export market. In addition,MITI felt that there were just too many automobile plants in Japan, so it at tempted to force all ten firms into merging into two-Nissan and Toyota.

504 THE FREEMAN August Needless to say, MITI failed to per suade the Japanese business com munity of the wisdom of its advice. Robert Reich points at the Japanese semiconductor industry as the one example where the government suc cessfully targeted an industry. But, if we take a closer look at the sta tistics, the U.S. government has been spending 10 times as much money as the Japanese government spends on the semiconductor industry. There fore, government spending is not the answer to the success of the semi conductor industry. In fact, the Jap anese government's share of all re search and development (including defense) is amazingly low.In the U.S. it is 48 per cent, whereas in Japan it is 28 per cent. Not surprisingly, during the 1950s and 1960s, the Japanese govern ment was concerned with rebuilding the nation's infrastructure. Roads, harbors and airports were built. The government balanced its budget during this time, and taxes were kept low. The tax system did not pe nalize savings, and the share of na tional income taken by taxes was and still is the lowest among the de veloped nations. In addition, the devastation of the Second World War took away the power enjoyed by the old bureaucratic elite, the Zaibatsu, and this in turn has spurred competition.

Perhaps the most astonishing fact is that contrary to what the proponents of a national industrial policy contend, most loans recently issued to business in Japan have come from the private sector. There has been, in other words, no massive financial targeting of industries by the gov ernment. In fact, the industries that have received government financial assistance have been politically powerful, but economically weak. Farmers receive a substantial amount of protection in the form of outright subsidies and import re strictions. Coal mining has bene fited from low interest loans. Yet output has decreased from 54 mil lion metric tons in 1962 to 19 million tons in 1978. The shipbuilding in dustry also received low interest loans. Yet it is operating at 35 p~ cent capacity and, after 1977, 46,000 workers had to be laid off. Petroleum refining, petrochemicals and al u minum have also received govern ment aid. None of these industries, however, is responsible for the out standing rate of growth experienced in Japan. Rather, the "secret" of Ja pan's success may be reasonably at tributed to the government's policy of keeping spending under control, and of providing a favorable busi ness climate.

Is it true that in spite of having a general policy of favoring free en terprise, we are nevertheless expe riencing a deindustrialization of our economy? A brief review of some of the statistics will be revealing.

1985 THE MYTH OF NATIONAL INDUSTRIAL POLICY 505 The Changing Pattern of The American Economy A common observation among the proponents of a national industrial policy is that the economy has shifted away from manufacturing. Non-agricultural employment has increased from 60.6 million in 1965 to 90.8 million in 1980. The manu facturing sector has, during this same period of time, fluctuated be tween 18.5 and 21 million jobs. Be tween 1969 and 1975, about a mil lion manufacturing jobs were lost. Yet, 3 million manufacturing jobs were created between 1975 and 1979. Some of the manufacturing in dustries contracted as a result of the recent recession, but manufacturing employment has subsequently sta bilized. Fears that our manufactur ing sector was on the verge of ex tinction were unfounded. The importance of the manufac turing sector, however, has declined during this same period of time. In 1965, 30 percent of all non-agricul tural employment was in manufac turing, whereas in 1980, it was 22 per cent. The growth in jobs has oc curred in the service and the gov ernmental sectors. But this does not mean that we are fast becoming a nation ofjanitors. The share of man ufacturing jobs in Japan, Germany and England has fallen even more sharply than in this country.

Although the reasons for the con traction of the relative share of manufacturing jobs are varied, they do not defy logical analysis. One reason is that some industries, like the steel industry, paid exorbitantly high wages to its unionized labor force at a time when their productivity was declining. The average wage rate for a Japanese automobile' worker is half what his American counterpart earns. Paradoxically, many employees have voluntarily left the manufac turing sector and joined better-pay ing jobs in the service sector. The service sector created 9 million jobs in the decade of the 1970s. Of these, about 8 million were in the profes sional and business service area. In addition, the growth of the service sector has been made possible by the entry in the market of many part timers, such as teenagers and the el derly, who seek temporary assign ments that demand few skills. Clearly, there is a need for these jobs.

However, there is no danger that the manufacturing sector is about to dis appear. Even if the manufacturing sector were in the decline, that in and of itself is insufficient to justify an industrial policy. Conclusion As we have seen, the proposals for a national industrial policy are founded upon a misunderstanding of basic economic issues. The role of the price system; the allocation of re sources; supply and demand-these 506 THE FREEMAN are all crucially important issues that we must understand if we are to prevent one economic folly from being implemented on top ofanother. As Friedrich Hayek once said, the fundamental problem in economics is that knowledge of all the relevant circumstances "never exists in con centrated or integrated form but solely as the dispersed-bits of incom plete and frequently contradictory knowledge which all the separate in dividuals possess." This is the fundamental reason all central planners, from the 5-year plan in the Soviet Union to national industrial' policy, are bound to fail.

Understanding why this is so is an important step. This is why it is so crucial that groups, such as the Foundation for Economic Education, exist. As each one of us strives to im prove his understanding of the mar ket order and its moral underpin nings, we shall approach a more just and freer society. , IDEAS ON LIBERTY Voluntary Cooperation To suggest that America's greatness lies not in trying to frame national goals and purposes, but in making it possible for mil lions of individual Americans to realize their goals and purposes is not to intimate that America is devoid of ideals or lacking in the capacity for voluntary cooperation. Quite the contrary. The American pioneer, by his very way of life, was more self-reliant than the European peasant who was dependent for his livelihood on the local country squire in England, or nobleman in France. But,· in the case of an Indian raid, the lives of the pioneer and his family might depend on the willingness of his neighbors to come to his help. There was also cooperation in building cabins, in clearing woods, in husking corn. And this tradition of vol untary mutual aid finds expression in the very different con ditions of modern life, in the service club that looks after hand icapped children, in the alumni group of a small or medium-sized college that raises funds for scholarships for the students who have followed them and whom they wish to help.

WILLIAM HENRY CHAMBERLIN, "America is Many Million Purposes"