Intro. [Recording date: October 18, 2022.]
Russ Roberts: Today is October 18th, 2022, and my guest is Mike Munger of Duke University, here for his 43rd appearance on EconTalk. Mike, welcome back.
Michael Munger: It is such a pleasure as always, Russ. Thank you.
Russ Roberts: Our topic for today is industrial policy, and our conversation we base on a recent article you’ve published in the Journal of Law, Economics, and Policy that we will link to. But let’s start with a basic definition. When people talk about industrial policy, what do you think they have in mind today? And, it may have changed over time, but it’s a very popular topic. What do people have in mind?
Michael Munger: Well, if you do nothing, you still have an industrial policy in the sense that there’s a set of things that are going to happen, and your policy of honoring profit and loss is a policy. What people mean by industrial policy, though, is a set of decisions about what industries to invest in, what industries to discourage, what tax policies to have to encourage investment that we think is beneficial to the entire society.
So, industrial policy is not macroeconomic policy. Industrial policy is the set of conditions in which a market economy operates. And I think it is possible to talk about that as being the entire set of legal and financial infrastructure within which the economy plays out.
Russ Roberts: And, most people when they’re advocating for it, are unhappy with some aspect of what you call the–and I think we should call–the profit-and-loss system. Neither of us are anarchists: we’re not talking about unfettered capitalism run rampant. We’re talking about allowing profits and losses, given the legal structure: profit and loss to determine which industries survive, which fail, which expand, which contract.
And, of course, throughout history, and certainly today in the United States and elsewhere, people often don’t like what the profit-and-loss system produces and think it can be improved on. And, I think, advocates of industrial policy argue that steering outcomes, either through the tax and subsidy policies you alluded to or more explicitly through trade policy or other limitations, achieve different outcomes.
And, what are some of the things people are concerned about? What’s the argument that the people who don’t like the profit-and-loss system–what are they going to argue?
Michael Munger: Well, let’s start by making it clear what the profit-and-loss system actually entails, because I find a surprising number of people don’t know the basic argument for capitalism. And so, let me spend one minute on that.
So, Ludwig von Mises probably was the clearest articulator of the system of profit and loss as a industrial policy, but there was a book on industry–on industrial economics–by Mary Paley Marshall and Alfred Marshall that was published in the 1890s that I think is the first clear articulation of industrial policy.
And it goes like this: So, if I am a producer–if I decide I want to produce something–I go around and I enter into a bunch of voluntary contracts with the owners of inputs. So, owners of labor, owners of steel, owners of electricity, owners of wood; and I make a voluntary contract with each of those people.
And since they’re not obliged to contract with me, it must by definition be true not only that they’re better off, but they’re better even than their opportunity costs–alternatives–for selling those products. So all of those people are happy.
I now go and I put these things together in some kind of form that I think consumers will like, and there’s actually a specific test because consumers only buy that if they actually want it.
And so, again, every transaction I engage in the output market, each consumer who buys it is made better off because they’re not obliged to buy my product. Just as the input suppliers were not obliged to sell it to me, in the output market they’re not obliged to buy this product. So, every one of them is made better off by what economists call the amount of consumer surplus. And in some cases that might be very large.
Now, their question is: Is this a good activity or not? Because, so far I’ve made a bunch of people better off. Is this a socially desirable activity?
And the answer, according to the profit-and-loss idea, is that there’s a particular price in a capitalist system which is, I compare the amount of revenue that I get from consumers, and I compare that to the costs of what it took me to make the thing. And, if my revenue exceeds my cost, we call that particular price a profit; and that profit is an indication that this activity is socially valuable.
Now, there’s a bunch of problems with that argument, but that, in the main, is: I have produced benefits for all the input suppliers. I have produced benefits for all of the consumers in the output market. And I have created some benefit for myself in the form of profit. It is a signal. If those profits are significant, it is a signal to other holders of resources in the society that they should either enter into this industry and produce more, or, if they’re already in the industry, that they should increase the amount of output because, at the margin, this activity is more socially beneficial than other opportunity-cost activities.
Russ Roberts: And, just a couple of footnotes there, that, obviously you could buy my product and decide you don’t like it. You wanted it, you thought it was going to be a good product, and you find out you don’t like it.
So, you might be able to sell it once, but to continue to sell it to be what we would say an English is a going concern–very strange phrase meaning an ongoing, a business that is sustained–a sustainable business has to cover its costs.
And it has to cover its costs with enough extra–it doesn’t have to be a huge amount–but enough extra to make it worthwhile for me to continue to spend my time combining those inputs to do so. If that happens, there’s a net gain, say economists, to the society; and the business continues.
If, however, the profits are not large enough to cover the costs, I can’t make payroll after a while, or I can’t pay for my raw inputs; and I disappear. I go out of business.
So, that’s the–and, I just want to add: Milton Friedman liked to say that capitalism is a profit-and-loss system, and he liked to emphasize the loss in that conversation. Because ,if you make losses, you can make them for a while. You can borrow money to try to keep your business afloat. But if you continue to make losses, usually you’re done. And no one has to make–there’s no vote. No board has to decree whether you should be sustained or not. It’s over. And, that is a very powerful system that underlies what you and I think of as capitalism.
So, what’s wrong with it? It sounds great.
Michael Munger: Well, we make it sound as if it’s smoothly functioning. And I emphasize profit, and I talked about shrinking or growing at the margin.
But, in fact, if you look at the Schumpeterian version of this, it actually may involve violent and wrenching changes, creative destruction. And so, workers who work in some industry may find themselves out of a job through no fault of their own because the business they were employed by not only failed to make profits, but started making losses; and investors pulled their money out of this industry, and the business had to close.
And so, through no fault of their own, people are unemployed, and that just seems unfair. So–
Russ Roberts: It is. It is unfair.
Michael Munger: It is absolutely unfair, because they did not deserve this.
And, I’ve actually written a few things about the question of desert–that is: deserving, [N.B. desert pronounced de-sert’, meaning that which is deserved. So, neither an arid sand-covered land area (pronounced de’-sert), nor a sweet food treat–spelled ‘dessert’ and pronounced de-sert’.–Econlib Ed.] is too high a standard because what we have created in a capitalist system is what you may call legal entitlements. And a legal entitlement means that if I earn profits, I am entitled to keep them even if in some sense I got lucky.
Now, the question is: What are the entitlements of workers who lose their jobs through no fault of their own? And, we’ve actually created, as part of our industrial policy, a set of government programs to make it easier. We call it Trade Adjustment Assistance. Unemployment.
That’s actually part of an industrial policy also, in the sense that people who lose their jobs get assistance from the government precisely because it wasn’t really their fault.
Now, they don’t get their old salaries–usually they don’t get their old salaries completely given back to them. But it reduces the cost of participating in a capitalist system.
Look: the reason that I wanted to start with my sort of stripped down version of profit and loss without any other government policies is usually what we say is, ‘Oh, that company is making giant profits and they don’t deserve those.’ The argument really is the benefit to input suppliers and the benefit to consumers.
How would you measure those?
Well, they’re literally unmeasurable. We can’t possibly measure consumer surplus. And this is something that we’ve talked about before on this show. What is the benefit to having iPhones? Well, people would pay a lot more–even though they’re really expensive, people would pay a lot more for the iPhone than it actually costs them. Some of them would probably pay $10,000. So, and it costs $1000. That’s a benefit to the consumer, just that one consumer, of $9,000.
But we can’t measure that. What we can measure is profits.
So, the difficulty with the system of profit and loss is that once you account for what are called ‘market failures,’ then profits are neither necessary nor sufficient for saying that this is a socially beneficial activity.
Russ Roberts: And, I’ll just put that into English, if I may: Once you start worrying about what are called market failures–and we’ll talk about those in a second–profit is not a really good measure of whether a business deserves to be sustained or not. So, you might want to bring in a different measure–say, the critics: that’s their word.
Michael Munger: Right? But the necessary and sufficient part is important in the sense that if I tell you that a company is earning profits, it doesn’t mean it’s socially beneficial. And if I tell you that a company is making losses, it doesn’t mean it should be closed. And so, that means that neither of the two supposed signals is correct, and we need government action to put a thumb on the scale one way or the other, is the argument for industrial policy.
Russ Roberts: Correct.
Russ Roberts: Okay, so, let’s hear some of the arguments that these critics would invoke to argue why the profit or the loss is an insufficient signal. You hinted at it a minute ago. It could cause disruption in employment, and therefore we should soften that, and some would argue more than soften it. That was just one example of how government policy might respond to it.
Michael Munger: So, the usual set of market failures are not at the core of the argument for industrial policy. So, let’s put those to the side. Because, those are a justification for regulation. So, asymmetric information, public goods, externalities–all of those things are reasons why we have regulatory agencies, so let’s put those to the side.
The reason for an industrial policy is that we get changes over time that are bad–that we should limit–and we fail to get changes over time that would have been good–that we should focus a fire hose of public infrastructure or investment because the market gets wrong what we should invest in.
Then there’s also social programs. So, it’s not just that the mix of investment is incorrect from the perspective of what economists tend to think of as an omniscient, benevolent dictator.
And so, usually the government’s problem is to say: Here’s the set of socially optimal investments. And then we look at the actual pattern of investments, and then we try to at least reduce the divergences between actual investment in the market and the socially optimal ones which the bureaucrat as the omniscient, benevolent dictator actually knows.
And so, so many times, if you’re in an economics job talk or seminar, they’ll start out by saying, ‘Well, we’re going to assume the existence of an omniscient, benevolent dictator and then ask what is the correct tax policy? What is the correct set of subsidies for industry?’ So, we know the answer because we can study optimality and efficiency. And, then the question is, how can we reduce the distance between what’s actually in the world and that pattern?
So, the sort of things that matter are employment, stability and employment, the concern for things like the environment writ large. So, we’re investing too much in fossil fuels and not enough in alternative energies, and so we’re going to subsidize investments in alternative energies, electric vehicles, solar panels, and bring the cost of those things down.
Russ Roberts: And, just to look at that example for a minute, because I think your point about regulatory policy versus industrial policy is helpful. Many would argue that we overinvest in fossil fuels, so what we need to do is, say, subsidize maybe research into electric battery performance rather than relying on market-based efforts by companies like Tesla and others. We should put our thumb on the scale and maybe have a government lab design a better battery, because the profit-and-loss incentive is too slow. People tell me that it’s just a matter of time before we have profitable electric batteries in different sizes and quantities than we currently do, better. And so, we should spend a large sum of money now to get there quicker because it’s better for the environment, is the argument.
Of course, these arguments are often more complicated than we’re talking. We’re going to get to some of the complications.
But, that would be the argument: That the acquisitive nature of humanity is not sufficient to speed up the innovation process in a particular area. Or the opposite: We need to slow something down that’s aggressively expanding, and so we need attacks or some kind of regulatory restriction.
Those restrictions are usually different than the regulatory kind that we normally would talk about in public policy. These are specifically designed–the distinction I would make–these are specifically designed to either increase or impede the flow of capital into certain areas of the economy that, left to the profit-and-loss motive, would do so either too slowly, too quickly, not at all, or should be ended.
And so, what industrial policy is often trying to do is not so much tax this and subsidize that–although it does involve that sometimes–but more to make sure that certain industries are thriving that are under-invested in, or are curtailed that are over-invested in, if the only signals are profit and loss. Is that a good summary?
Michael Munger: It’s a good summary. And the reason I want to emphasize what you said: the over- and the under-, is with reference to what is known to be correct by the omniscient, benevolent bureaucrat. So, a central figure here is: We know what is to be done. We know the correct thing to do because we are scientists. And that’s an essential feature of the claims for industrial policy. The basis of ‘We can do better’ is: We know what is good.
Russ Roberts: And, sometimes there’s a logical–what we might call an analytical–argument, which might be: Corporate America has the wrong time preference. Corporate America operates on a quarter-to-quarter profitability. We need a longer-term perspective. It’s not going to come from capitalists. It’s going to come–try not to smile–it’s going to come from politicians or policy makers or bureaucrats who will not be constrained by the stock market’s insistence on quarterly profits.
And in a minute, we’ll talk about why that’s hard to say with a straight face. But that would be the argument. Right? That would be the claim. And that’s not, ‘I know what’s best.’ Literally it’s, ‘I detect a flaw in the underlying structure of the profit-loss system. It’s shortsighted. It’s myopic.’ Or it might be–what would be another–I’m having trouble to give another example that would be analytical rather than pretending to know exactly what needs to get done.
Michael Munger: Well, the time horizon is certainly an important one, and another–
Russ Roberts: Oh, the environment would be another one–
Michael Munger: the environment is–
Russ Roberts: Climate change.
Michael Munger: Yeah. Now, you could say that’s time-horizon also, but if you [inaudible 00:19:35] it’s different.
Russ Roberts: Nyeah–it’s a different kind.
Michael Munger: So, what you just said is great because I think–a listener commented on one of our earlier podcasts and says, ‘Munger just has this trope that he always uses.’ Aand that’s true. I didn’t realize that I do. But, what I always say is: This is a really hard problem. I thought about it for a long time, and I realized I was wrong. And, in fact, this is the way you should think about this.’ And dammit, I’m going to do that again.
Russ Roberts: Go for it.
Michael Munger: So, the story that you just gave is the one that I always told. Because–you say it’s hard to say it with a straight face–politicians are going to do this. That’s the usual public choice objection.
And so, in fact, when I teach Public Choice I say, ‘There’s this nonsense that somehow capitalism has a shorter time horizon.’
Look, elected officials have a two-year time horizon until the next election. And that’s in November. So, in December they have a 23-month time horizon. So, politics has a really, really short time horizon, and that’s why these people who advocate for an industrial policy, they’re all wet. All they need to do is read basic Public Choice, and we would stop hearing about all this nonsense.
So, we’re really lucky at Duke to have such great History of Economic Thought people–so Bruce Caldwell and Steve Medema. Now, Steve Medema is a student, among other things, of A.C. Pigou–Arthur Cecil Pigou. We don’t hear ‘Cecil’ enough, so I think that’s important.
Russ Roberts: Right.
Michael Munger: Now, if you look at Pigou’s writing as early as 1912, Pigou was talking about the fact, and I think I can quote it, this is–
Russ Roberts: While you’re looking for it, I’ll just–Pigou is P-I-G-O-U, for those of you who are googling at home. Go ahead.
Michael Munger: So the usual story, and I don’t want to go into this too much, but Steve Medema has a particular bone to pick with one of my heroes, Ronald Coase, and I think he’s right. Ronald Coase just mischaracterizes Pigou’s thought in the 1960 paper, “The Problem of Social Cost.” So, the Pigovian solution that Coase talks about is: We’re going to solve the problem of externalities with a system of taxes on negative externalities and subsidies on positive externalities.
That’s not really an industrial policy, as we said. Because, that’s on the output. It’s not subsidizing investment. Investment policy is subsidizing or taking away investment. This is a tax on the output price for externalities.
And, Coase said that Pigou said, this was the only way to solve this problem and that we had enough information to do it.
In fact, if you look at Pigou’s writings, and so Wealth and Welfare–this is 1912:
It is not sufficient to contrast the imperfect adjustments of unfettered private enterprise with the best adjustments that economists in their studies can imagine. For we cannot expect that any state authority will attain, or even wholeheartedly seek, that ideal. Such authorities are liable alike to ignorance, to sectional pressure, and to personal corruption by private interest. A loud-voiced part of their constituents, if organized for votes, may easily outweigh the whole.
Now, that’s 1912. So, Pigou is actually an ur-text[?] of Public Choice.
And so, after golfing with Steve Medema, I went back and looked at the history of industrial policy, advocates for industrial policy. And I was just wrong. It is not that they misunderstand the problem of political incentives. That’s actually their primary concern. The reason that they think industrial policy may not work is the set of incentives that distort industrial policy politically.
So, it’s not that they’re saying, ‘Oh well, just do this and it won’t be a problem.’ They recognize that politics are going to distort industrial policy.
So, the reason that I wrote this paper was that in 2000 I had come up with the idea of policy conflicts.
So, my notion of this–and so, that, it forms a triangle: the vertices are markets, politics, and experts. And, my claim in that 2000 book was that policies always seem strange if you look from the outside because it seems like they’re just not rational.
Well, the answer is, they’re a conflict. They’re a compromise between two of the vertices of this triangle. So, markets and politics fight things out. Experts and markets have antitrust policy; experts and politics have a variety of constitutional concerns. And so, nobody–none of these sources of legitimate authority ever get exactly what they want.
So, experts, if they’re going to try to regulate markets, have to deal with politics. But this actually had been a core inside of the people who had advocated for industrial policy all along.
And so, the question then is, what is–if there is an objection to industrial policy, what is the correct objection?
And so, I went back to the work of William Riker and the sort of equilibrium theorists in the Political Science branch of Public Choice, and came up with–and that’s the reason the title of the paper–“A Good Industrial Policy Is Impossible.” So, it is impossible to come up with a coherent way to solve the political problem.
So, recognizing the problem is not enough. The people who advocate for industrial policy actually have the–I claim this is a kind of impossibility theorem. It is impossible to achieve the experts’ goal for an industrial policy in a democracy.
Now, it is possible in a dictatorship, but presumably that’s not what is being advocated for. So, the difficulty that has happened all along for the people who favor industrial policy–and if you look at industrial policy in the 1930s under the Roosevelt Administration, there was a lot of admiration for Mussolini, for Fascism. And, the reason is that it was insulated from politics. Now, not the political program of Fascism, but the insulation from politics of experts.
Russ Roberts: And the plus ça change, plus c’est la même chose [‘the more it changes, the more it is the same thing’–Econlib Ed.]–here we are in the modern era, and of course, for the last–I don’t know–20 years, 15 years, 25 years, people have admired China because it does not–many of its policies are seen as admirable and impossible in the United States because we have the meat-grinding, sausage-making political system, whereas in China you don’t have to worry about that. They’ve got an autocrat at the top who can just listen to experts and do the right thing. Where the right thing is presumably what’s good for China as a whole. Whatever that means.
Michael Munger: Right. Because there are political problems in democracies at arriving at that.
Public Choice people–I was taught, say, ‘Oh, well industrial policy will fail because of political incentives.’ What I have always thought is that the devastating Public Choice response to claims that we should have an industrial policy is just to point out that political incentives are going to prevent us from having any kind of good industrial policy.
And, in fact, famously, in the ‘Keynes-Hayek Rap Video, Part 2’, Hayek said,
With political incentives, discretion’s a joke.
Those dials you’re twisting, just mirrors and smoke.
And so, the point of that is that politics are going to distort industrial policy, and so we shouldn’t even talk about it.
Now, the answer of people–and I think the best; in the paper I single out as I think, the best, articulate, and most logically coherent advocate for industrial policy–is Dani Rodrik.
And, he says that there are two core problems. One is the problem of incentives and the other is the problem of information.
And, in reading the historical development of this–the sort of Cambridge Economics, and it’s interesting, but it’s Cambridge on both sides of the ocean, and so you can use it, the Cambridge description is whether it’s actually Cambridge or whether it’s Harvard and MIT [Massachusetts Institute of Technology]–but that form of macroeconomics worries both about the information and the incentives problem.
And Rodrik points out, probably rightly, that we should think of the information problem in terms of tatonnement, because in economics, tatonnement is trial and error. We’ve looked for the equilibrium, we grope for it.
And, Rodrik said that the government should do the same thing. The fact that the government doesn’t really know what to do in advance is not a problem: We need to experiment. And, in fact, the more mistakes the government makes, the better, because that’s a sign we’re actually experimenting robustly. And, then Rodrik–
Russ Roberts: Get more information–
Michael Munger: Well, the AB testing where you did experiments, maybe within local school districts where the districts are otherwise pretty similar. This is something you’ve talked about on the show a number of times. That’s one thing.
But, experiments at the macro level, where you have just a sequence of unexpected, unexplained changes in taxes and investment, those are not experiments.
Those are the sort of things that Amity Shlaes talked about in The Forgotten Man as being one of the reasons why the Great Depression lasted for so long–because we were never sure what the industrial policy was going to be.
Those are not experiments: That’s uncertainty. That’s a different thing. [More to come, 30:31]