Mercantilist industry policy versus free markets

If you take an interest in the ‘free trade versus protection’ debate – which I’ve tried to use a rather more general formulation of in the heading above – and you are alive to the possibility that the debate might be about something rather than just the ranting of people who just don’t understand Ricardo against those who do, you end up understanding the lie of the land rather like Dani Rodrik does in the post which I’ve reproduced below the fold.  After considering the arguments, and especially in a place like Australia, I come down fairly strongly in the free trade camp, but mainly for political reasons.  Our own attempts at picking winners remain woeful.  And the advocacy of ‘active’ industry policy is pretty awful too, dominated as it is by unions and manufacturing firms. Not normally where I go for enlightenment or inspiration.

Still, I would probably think differently if this were a developing country.  And even if one is in favour of free trade (I’m actually in favour of very but not completely free trade if we’re talking about Australia’s interests acting unilaterally as I’ve explained numerous times on this blog to the apoplexy of one or two commenters) it’s a great pity that we head for the ‘free trade v protection’ trenches whenever we’re discussing policy.  One of the strengths of Dani Rodrik’s view of the world is that recipes for countries have to be suited to them – have to pick their most important bottlenecks in economic expansion and deal with them, rather than apply a kind of template approach to any and all issues.

Anyway for those who are interested, Rodrik’s column on the subject is over the fold.  I could quibble with bits of it, or with its emphasis here or there, but it sets out the issues well enough for me to want to mark it here so I can come back to it if I want to in the future.

CAMBRIDGE A businessman walks into a government ministers office and says he needs help. What should the minister do? Invite him in for a cup of coffee and ask how the government can be of help? Or throw him out, on the principle that government should not be handing out favors to business?

This question constitutes a Rorschach test for policymakers and economists. On one side are free-market enthusiasts and neo-classical economists, who believe in a stark separation between state and business. In their view, the governments role is to establish clear rules and regulations and then let businesses sink or swim on their own. Public officials should hold private interests at arms length and never cozy up to them. It is consumers, not producers, who are king.

This view reflects a venerable tradition that goes back to Adam Smith and continues a proud existence in todays economics textbooks. It is also the dominant perspective of governance in the United States, Britain, and other societies organized along Anglo-American lines even though actual practice often deviates from idealized principles.

On the other side are what we may call corporatists or neo-mercantilists, who view an alliance between government and business as critical to good economic performance and social harmony. In this model, the economy needs a state that eagerly lends an ear to business, and, when necessary, greases the wheels of commerce by providing incentives, subsidies, and other discretionary benefits. Because investment and job creation ensure economic prosperity, the objective of government policy should be to make producers happy. Rigid rules and distant policymakers merely suffocate the animal spirits of the business class.

This view reflects an even older tradition that goes back to the mercantilist practices of the seventeenth century. Mercantilists believed in an active economic role for the state to promote exports, discourage finished imports, and establish trade monopolies that would enrich business and the crown alike. This idea survives today in the practices of Asian export superpowers (most notably China).

Adam Smith and his followers decisively won the intellectual battle between these two models of capitalism. But the facts on the ground tell a more ambiguous story.

The growth champions of the past few decades Japan in the 1950s and 1960s, South Korea from the 1960s to the 1980s, and China since the early 1980s have all had activist governments collaborating closely with large business. All aggressively promoted investment and exports while discouraging (or remaining agnostic about) imports. Chinas pursuit of a high-saving, large-trade-surplus economy in recent years embodies mercantilist teachings.

Early mercantilism deserves a rethink too. It is doubtful that the great expansion of intercontinental trade in the sixteenth and seventeenth centuries would have been possible without the incentives that states provided, such as monopoly charters. As many economic historians argue, the trade networks and profits that mercantilism provided for Britain may have been critical in launching the countrys industrial revolution around the middle of the eighteenth century.

None of this is to idealize mercantilist practices, whose harmful effects are easy to see. Governments can too easily end up in the pockets of business, resulting in cronyism and rent-seeking instead of economic growth.

Even when initially successful, government intervention in favor of business can outlive its usefulness and become ossified. The pursuit of trade surpluses inevitably triggers conflicts with trade partners, and the effectiveness of mercantilist policies depends in part on the absence of similar policies elsewhere.

Moreover, unilateral mercantilism is no guarantee of success. The Chinese-US trade relationship may have seemed like a marriage made in heaven between practitioners of the mercantilist and liberal models, respectively but in hindsight it is clear that it merely led to a blowup. As a result, China will have to make important changes to its economic strategy, a necessity for which it has yet to prepare itself.

Nonetheless, the mercantilist mindset provides policymakers with some important advantages: better feedback about the constraints and opportunities that private economic activity faces, and the ability to create a sense of national purpose around economic goals. There is much that liberals can learn from it.

Indeed, the inability to see the advantages of close state-business relations is the blind spot of modern economic liberalism. Just look at how the search for the causes of the financial crisis has played out in the US. Current conventional wisdom places the blame squarely on the close ties that developed between policymakers and the financial industry in recent decades. For textbook liberals, the state should have kept its distance, acting purely as Platonic guardians of consumer sovereignty.

But the problem is not that government listened too much to Wall Street; rather, the problem is that it didnt listen enough to Main Street, where the real producers and innovators were. That is how untested economic theories about efficient markets and self-regulation could substitute for common sense, enabling financial interests to gain hegemony, while leaving everyone else, including governments, to pick up the pieces.

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derrida derider
derrida derider
12 years ago

It does seems that a certain degree of mercantilism is a necessary condition for escaping grinding poverty. But the history of Africa and South America show how it is far from a sufficient condition.

The case for such an approach for developed, or even middle income, countries is far weaker. In fact it has often seemed to be a huge problem for middle-income countries seeking to get really rich. China is already straining at its limits, and the hangover from it is a big part of Japan’s decline. Once you build a mercantile state it is very hard to switch to a more sustainable regime.

Tel_
Tel_
12 years ago

Our own attempts at picking winners remain woeful. And the advocacy of active industry policy is pretty awful too, dominated as it is by unions and manufacturing firms. Not normally where I go for enlightenment or inspiration.

I’m quite annoyed at the recent union-driven effort to force the Aus government into a protectionist “buy Australian” position, supposedly to save jobs. What really ticks me is that these guys think they are so incredibly clever, that no one else on Earth would have come up with the idea of also switching over to protectionism, especially when they see Australia do it.

On the whole, so far Australia has barely been scratched by this recession (compared to a lot of other countries) and international trade is doing us a heap of good right now. Protectionism is nothing more than Isolationism in disguise.

This view reflects an even older tradition that goes back to the mercantilist practices of the seventeenth century. Mercantilists believed in an active economic role for the state to promote exports, discourage finished imports, and establish trade monopolies that would enrich business and the crown alike. This idea survives today in the practices of Asian export superpowers (most notably China).

The mercantilist strategies of the empire-building and colonial days had a strong military component. The British East India company operated it’s own private militia and the use of force (especially at sea) between rival company fleets was almost normal. Applying this logic to the present day has some limitations, because (for the most part) we don’t do business the same way anymore. However, in the case of China I’m confident that they are acutely aware of their defeat during WWII (and several earlier defeats to the British) at the hands of technologically superior forces and this makes them want to be as self-reliant as possible.

There’s another theory about Asia which requires a bit of lateral thinking. Suppose you consider skilled engineers (such as those that work in the auto industry) to be valuable. Suppose you further consider that skilled engineers only keep their skills when actively occupied. Then the USA is exporting the “valuable” commodity of human skills to Asia (i.e. the number of skilled engineers in China is growing, while the number of skilled engineers in the USA is shrinking). The balance of trade might not be so far out of whack, depending on how you value some of the intangibles.

It is doubtful that the great expansion of intercontinental trade in the sixteenth and seventeenth centuries would have been possible without the incentives that states provided, such as monopoly charters.

Trade continuously expanded at every stage of human history. I mean the Vikings traded slaves, wood and metal over great distances in small determined bands with no real government to speak of. Rumour has it they got to America that way, but certainly not on a reliable basis.

You could just as easily give credit to advances in cartography, shipbuilding, firearms (which gare Europeans a substantial advantage when it came to establishing the part military / part commercial colonial outposts they were famous for), and George III’s bounty on Longitude measurements (which came a bit later but still significantly improved intercontinental travel). Or just thank the Enlightenment that gave Europeans some measure of independent thought allowing them to have ideas and try new things.

Probably a more significant feature of the colonial era was that the big players had become so powerful and so well organised that being independent was hopeless. National governments got behind their trade fleets (and backed them up with guns) because that was the only viable way to manage a trade fleet in the face of other national governments doing the same thing. Not a shortage of incentive (even one ship worth of successful trade was highly lucrative) but a shortage of survival prospects for a single-ship operator.

In modern times we have a much cleaner division between the tasks of national defence, police force, and profit-making business (probably a good thing).

pedro
pedro
12 years ago

I wonder if anyone can point to an example of a country that followed free market rather than merchantilist policies when developing, had the other attributes for a successful economy, and then didn’t develop. I think you have to do that to say that merchantilism is an advantage while developing.

I get the impression that, Hong Kong perhaps excepted, merchantilism has been the rule for developing countries. It is not hard to understand why that might be. Popular governments want to be seen to do something and autocratic governments are naturally disposed to manage their property.

“The mercantilist strategies of the empire-building and colonial days had a strong military component. The British East India company operated its own private militia and the use of force (especially at sea) between rival company fleets was almost normal.”

Yes, and no surprise here, that is just an example of Rothardian anarchy in practice.

Tony Harris
Tony Harris(@tony-harris)
12 years ago

On the Australian attitude to protection, there is a wonderful chapter in a book by Keith Hancock (the other one) called simply “Australia” (1930). You can find the link on this page, along with a historical study of commercialism in cricket and a link to Peter Bauer who had some things to say about third world development.

I got into trouble for backing Dani Rodrik in a small way, accepting that the best strategy for economic development at a particular time and place might be the second or third best option simply because the best or second best was not going to happen any time soon. However you have to be very careful with the examples of S Korea and the tigers, sure, they did better than other places but someone (I think Lal) looked more closely and within the subset of tigers (who all deviated in various ways from the ideal), the less they deviated, the better they did!

Francis Xavier Holden
12 years ago

The mercantilist strategies of the empire-building and colonial days had a strong military component. The British East India company operated its own private militia and the use of force (especially at sea) between rival company fleets was almost normal.

It looks like that the Somali pirates may have created a situation whereby only those with a military backu pwill be able to trade through certain routes.

Tel_
Tel_
12 years ago

I wonder if anyone can point to an example of a country that followed free market rather than merchantilist policies when developing, had the other attributes for a successful economy, and then didnt develop. I think you have to do that to say that merchantilism is an advantage while developing.

If you regard protectionism as a defining component of merchantilist policies then Singapore would be a good example of a successful non-protectionist economic development. That’s not to say Singapore is exactly “free trade” because they have always had strong central-planning components in their economy — just so happens that the central planners were keen on international trade (probably relating to their history as a trade port).

Richard Tsukamasa Green
Richard Tsukamasa Green(@richard-green)
12 years ago

Firstly I’d like to suggest that the sample size is too small to really be confident about many hypotheses about corporatism, mercantilism and laissez faire in development. Already we’ve had what was success in one decade turn to failure in the next and virtue becomes vice almost overnight (such as Japan in the early 90s or Iceland/Ireland today). Confucianism was cited as China’s curse but Japan’s saviour.
We may end up discovering in a few centuries that it was of no consequence at all.

I think it is illustrative to note that success stories of the 20th century include. Japan, Taiwan, Singapore, Iceland, Ireland, South Korea and Hong Kong. The first 5 are islands, South Korea has no open land borders (like an island) and Hong Kong is an island in public perception.
This is illustrative because I have no satisfactory explanatory hypothesis here, and the sample is too small to determine if a binary variable meaning “island” actually has an effect. We’d have to assume that this is just an interesting co-incidence found by human pattern recognition.
In development, if we think we’ve found something interesting, we have be careful to determine if it’s more than this “island effect”.

One observation however. The corporatist success stories have generally had chance for primary exports (Japan, Korea etc…). The old resource curse in the negative. I don’t have the time to fully describe the hypotheses here, but the absence of easily acquired rents may lead corporatist systems to rely on systems that involves quid pro quo with labour, which grants a stability and lower uncertaintly that can foster human capital investment etc.