When governments pick industries, industries start picking governments

By Dhananath Fernando

Originally appeared on The Morning

I had a friend who got three A passes for his A/Levels in Biology. Then he sat for the A/Levels again, this time in Mathematics, got three A passes again and entered the Engineering Faculty.

I once asked him why he did his A/Ls twice. He said the first time his parents wanted him to become a doctor. So he studied Biology. But what he really wanted was to become an engineer. So he did his A/Ls again and followed what he actually wanted.

I was reminded of this story with the renewed discussion on industrial policy. Governments, economists, and multilateral agencies are once again talking about industrial policy as a way of developing economies.

At the surface level, there is nothing wrong with it. Everyone wants more industries, more exports, more investment, and better jobs. The real question is how we get there. One school of thought believes the government should identify certain industries that have future potential and actively support them. The government can provide subsidies, tax concessions, cheap loans, tariff protection, and infrastructure.

The other school of thought is that the government should create the right environment for industries to grow, without deciding which industries should become winners.

These two approaches may sound similar, but they are very different. For example, imagine the government spending $ 1 billion to build research laboratories, testing facilities, and common infrastructure that can be used by all exporters. Now imagine the government selecting three industries and giving those industries a subsidy package of $ 1 billion.

Both may be called industrial policy. But the outcomes are very different. The first creates a public good. The second creates a group of beneficiaries.

The problem for Sri Lanka 

This debate has become more relevant with the World Bank itself taking a more open position towards industrial policy in its recent work. The World Bank was traditionally associated with the view that governments should avoid picking winners and focus more on markets, competition, and openness.

That view has now changed to some extent. But the change should not be misunderstood. The new thinking is not that every government should suddenly start choosing industries and writing subsidy cheques. The argument is that governments already intervene in economies, and in some cases there can be legitimate reasons to do so.

The problem for Sri Lanka is what happens after the Government decides to pick an industry. Let us say the government identifies a few ‘strategic industries’. The first request will be protection from imports. Then they will say they cannot compete because electricity is expensive. Then they will ask for cheaper loans. Then tax holidays. Then special land concessions. Then further protection because they still need more time to become competitive. What started as industrial policy can quickly become permanent protection.

This is where the problem really starts. Initially the government picks the industries. Then the industries become dependent on the government. Finally, the industries become powerful enough to influence the government.

At that stage, industries start picking governments. They will support politicians who promise to maintain tariffs. They will lobby against competition. They will oppose trade agreements. They will argue that removing protection will destroy jobs.

A temporary subsidy becomes permanent. A temporary tariff becomes a permanent wall. The so-called infant industry never really grows up. This is not because businesses are bad. Businesses respond to incentives. If the easiest way to make profits is by becoming more productive, they will invest in productivity.

If the easiest way to make profits is by influencing government policy, they will invest in lobbying. That is the danger. Sri Lanka has seen this many times. We introduce protection to support local industries. But while one industry benefits, thousands of consumers and other businesses pay higher prices.

For example, if a tariff is placed on an imported raw material to protect one local producer, every downstream industry using that raw material becomes less competitive.

The protected company wins. The rest of the economy pays. 

The other problem is information. How does the government know which industry will succeed in 10 years? Can any ministry predict future technology, global demand, energy prices, or consumer preferences?

Entrepreneurs cannot predict these things perfectly either. But there is one major difference. Entrepreneurs normally take risks with their own money or investors’ money. Governments take risks with taxpayers’ money. This takes me back to my friend who did his A/Levels twice. His parents knew him better than most people. They had his best interests at heart. Yet even they could not make the perfect decision on which career suited him.

The need for a careful approach 

That does not mean parents should have no role. They can provide education, guidance, and opportunities.

But there is a difference between creating opportunities and deciding the outcome. The same applies to government. Government can create the conditions for industries to succeed. But it should be very careful about assuming it knows in advance which industry should become the next national winner.

When a private business makes a bad decision, it eventually runs out of money. When a government programme fails, very often the answer is another budget allocation.

This does not mean the government has no role. Sri Lanka definitely needs a policy towards industry. But policy towards industry is different from picking industries.

Government should focus on the problems faced by almost every business. Expensive and unreliable energy, complicated taxes, unpredictable tariffs, difficulty accessing land, Customs delays, poor transport, policy uncertainty, and skills shortages.

Instead of giving cheap electricity to a selected industry, fix the electricity market. Instead of giving tax holidays to selected companies, create a predictable tax system. Instead of protecting selected producers from imports, reduce the cost of raw materials and intermediate goods for all industries. Instead of trying to predict the next winning sector, allow thousands of entrepreneurs to discover it.

There is also a valid role for government in areas such as climate change, research, and common infrastructure. But even there, government should be careful.

Suppose the government decides that solar panel manufacturing is a strategic green industry and places high tariffs on imported solar panels. We may create a small protected solar panel industry. But we will also make solar panels more expensive for every hotel, factory, and household. We may protect a green industry while slowing down the green transition. That is why the question is not whether government should do anything. The question is what government should do.

The lesson for industrial policy

Sri Lanka cannot compete with the United States, China, or Europe by offering bigger subsidies. We do not have that fiscal capacity. Our advantage should be different.

Simple regulations. Competitive energy. Fast approvals. Open trade. Efficient ports. Better skills. Strong property rights. Predictable policies. Those are the areas where government should be active.

In the end, my friend became an engineer not because his parents stopped caring about his future, but because they eventually allowed him to choose the path that suited him.

That is perhaps the better lesson for industrial policy as well. Government should create the opportunities, remove the obstacles, and provide the common infrastructure. But it should be careful about choosing the career of the economy. Because once governments start picking industries, industries may eventually become powerful enough to start picking governments.