Government economic steering

Lane Kenworthy, The Good Society
August 2023

Economic growth is an important goal for a good society. Over the long run it’s a key source of increases in living standards. And other aims are more readily achieved in the context of an affluent, growing economy.1

We know that markets are good for economic growth. One reason is resource allocation. The scale and complexity of a national economy make effective planning and coordination via commands very difficult. Market prices work better. Markets also spur innovation and improvement. Competition creates incentives to develop new products and services, to improve existing ones, and to increase efficiency.2

Sustained growth requires more than markets, however. Daron Acemoglu and James Robinson note that “Secure property rights, the law, public services, and the freedom to contract and exchange all rely on the state, the institution with the coercive capacity to impose order, prevent theft and fraud, and enforce contracts between private parties. To function well, society also needs other public services: roads and a transport network so that goods can be transported, a public infrastructure so that economic activity can flourish, and some type of basic regulation to prevent fraud and malfeasance.”3 For the most part, it is governments that provide these things. Economic growth thus depends in part on effective government.

It’s one thing for government to provide the conditions that underpin economic growth — laws and their enforcement, public goods, public services. A host of analysts and observers have argued that government should go farther. They contend that government steering of economic activity is key to rapid economic growth4:

“Large investments are necessary to keep up with technological change, increased process scale, and shorter product generations. In many businesses, international competition has become a race in which the first producer to achieve high volume and gain experience can underprice and maintain leadership relative to potential international rivals. Because of this disparity between the conservatism of capital markets and the need for speed in international competition, governments in many advanced industrial countries have devised selective schemes to encourage greater risk-taking and to assist with particularly large projects. Unless the U.S. adopts similar measures, U.S. firms and private investors may continue to opt for safer investments that do not build long-term competitiveness.” -Ira Magaziner and Robert Reich, 1982

“The tools in the hands of [Japan’s] economic bureaucrats included control over all foreign exchange and imports of technology, which gave them the power to choose industries for development; the ability to dispense preferential financing, tax breaks, and protection from foreign competition, which gave them the power to lower the costs of the chosen industries; and the authority to order the creation of cartels and bank-based industrial conglomerates (…), which gave them the power to supervise competition. This high-growth system was one of the most rational and productive industrial policies ever devised by any government.” -Chalmers Johnson, 1982

“The influence of government policies on the dynamics of comparative advantage over time becomes clear when one allows for the possibility of differing production technologies in different countries…. Discretion in the provision of industrial finance — in the selective allocation of credit — is necessary for the state to enter continuously into the industrial life of private companies and to influence their strategies…. The Japanese system is one of controlled competition. There is every evidence of intense competition between firms but that competition seems to be directed and limited both by state actions and by the collaborative efforts of the firms and banks themselves. Though the state bureaucrats do not dictate to an administered market, they do consciously contribute to the development of particular sectors and they help in a detailed way to establish conditions of investment and risk which promote their long-term development and international competitiveness.” -John Zysman, 1983

“In order to understand the role of the Plan [in France] we must appreciate the political dimensions of its task. Behind the motif of ‘indicative planning’ lay an apparatus with the capacity to put real pressure on private sector actors to conform to the government’s economic strategy. Behind the rhetoric of the planners concerning participatory democracy, economic enlightenment, and rationality, French planning performed several latent functions even more crucial to the success of the overall project as its professed goals. The Plan provided an institutional framework within which the state could build alliances with key sectors of industry to effect industrial reorganization…. The very success of the Plan generated extraordinary rates of economic growth, urbanization, and industrialization that changed the face of French society.” -Peter Hall, 1986

“In developing national strategies, the Japanese goal is to focus on those industries with high income elasticities of demand, high rates of growth in productivity, and high value added per employee…. Certain industries are seen as key industries with linkages (externalities) affecting other industries. Strengthen them, and other industries get stronger. Machine tools and key component suppliers, such as semiconductor chip manufacturers, are seen as linkage industries. A stronger machine-tool industry and a stronger semiconductor industry allows Japan to be more competitive in automobiles and consumer electronics…. Above all, government has an important role to play in accelerating economic growth. This means raising investments in plant and equipment, skills, infrastructure, and R&D above the levels that would occur in unfettered markets. Market participants are believed to have too much interest in the present. Government essentially represents the interest of the future in the present. It works to speed up markets and to encourage firms to go down their learning curves faster than they would if they were on their own.” -Lester Thurow, 1992

“In countries that owe their growth to innovation — and in regions within those countries, like Silicon Valley — the State has historically served not just as an administrator and regulator of the wealth creation process, but a key actor in it, and often a more daring one, willing to take the risks that businesses won’t. This has been true not only in the narrow areas that economists call ‘public goods’ (like funding of basic research) but across the entire innovation chain, from basic research to applied research, commercialization, and early-stage financing of companies themselves. Such investments (yes governments invest, not only ‘spend’) have proved transformative, creating entirely new markets and sectors, including the Internet, nanotechnology, biotechnology, and clean energy. In other words, the State has been key to creating and shaping markets not only ‘fixing’ them.” -Mariana Mazzucato, 2013

“We define industrial strategy as the purpose-driven coordination by the state of its supply-side economic policies. The ‘supply side’ refers to the economy’s productive capacity and the market conditions in which investment and production occur. Industrial strategy therefore encompasses a number of familiar policy areas, such as infrastructure, skills, R&D spending, land use planning, competition, business taxation, regional economic development, and export promotion. All of these policy areas provide means by which the state seeks to raise business productivity and output by improving the conditions in which the private sector invests (…). Industrial strategy should be aimed at strengthening and expanding the [country’s] innovative and exporting sectors, raising productivity across the economy as a whole, and rebalancing its uneven economic geography.” -IPPR Commission on Economic Justice, 2018

“Pentagon planning and procurement have functioned as a kind of closet industrial policy, leading to great successes in defense projects and their commercial offshoots, like aircraft, biotech, and the Internet. World War II and the cold war showed what can be achieved when a capitalist democracy commits the heresy of national planning…. China, adopting an even more aggressive version of the mercantilism that had built Japan, South Korea, and Taiwan, demonstrated that state-led capitalism could far outpace the laissez-faire variety.” -Robert Kuttner, 2021

“Historically, broad, inclusive economic growth comes when the public sector seeds the development of a transformative new technology. Such state investment is often driven by a national mission to boost development or security.” -Rana Foroohar, 2022

What does the empirical record tell us?

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GOVERNMENT STEERING AND ECONOMIC GROWTH

There are three main pathways through which advocates hypothesize that government steering will tend to boost economic growth.

Research and development

A key contributor to innovation, knowledge, and technological advance is research. Some have suggested that particularly important here is government investment in basic research. Firms may underinvest in basic research, because it’s risky and the payoff is very uncertain. So we may need government to spend more in order to reach the optimal level.

Figure 1 shows US federal government spending on research and development going back to the early 1950s. That spending increased after World War II, climbing to a peak of 2.0% of GDP in the mid-1960s. But it then began to decline, falling to just 0.7% by the 2010s. According to some accounts, these patterns of government investment in research played a key causal role in America’s rapid economic growth from the end of World War II through the 1970s and the slowdown in growth since the late 1970s.5

Figure 1. R&D expenditures
Expenditures on research and development as a share of GDP. Data source: Mark Boroush and Ledia Guci, “Research and Development: U.S. Trends and International Comparisons,” National Science Board, 2022, figure RD-3, using data from the National Center for Science and Engineering Statistics, National Patterns of R&D Resources.

However, the strong economic growth during that mid-twentieth-century “golden age” almost certainly was in part a catch-up process coming on the heels of the Great Depression and World War II. Economic growth since 1980, in the United States and in other rich democratic countries, has been roughly on track with the historical average for the past century and a half.6

Moreover, as we see in figure 1, private expenditures on research increased to fill the gap left by decreased government expenditures.7 Is private spending less effective? Just as effective? More effective? We don’t know.

Figure 2 shows the cross-country pattern since 1980. There is a positive association between R&D expenditures and economic growth. But it’s quite modest in strength, and in any case it’s driven by four countries in the lower-left corner of the graph that have had very low research and development investment and lower-than-average economic growth. Among the countries in which R&D spending has averaged at least 1% of GDP, there is no association with rates of economic growth. So very low investment in R&D may well be bad for growth, but beyond that it’s not clear there’s any impact.

Figure 2. Research and development expenditures and economic growth
Catchup-adjusted economic growth: residuals from a regression of 1979-2019 growth rates on 1979 level of GDP per capita. Data source: OECD. Research and development expenditures: Gross domestic spending on research and development as a share of GDP. Total expenditure (current and capital) on R&D carried out by all resident companies, research institutes, university and government laboratories, etc., in a country. It includes R&D funded from abroad, but excludes domestic funds for R&D performed outside the domestic economy. Data source: OECD. “Asl” is Australia; “Aus” is Austria. The line is a linear regression line. The correlation is +.35. With Italy, New Zealand, Portugal, and Spain excluded, the correlation is -.05.

Managed trade

Most economists believe that trade increases economic growth, by increasing competition and by giving firms access to less expensive and/or higher quality inputs.8 Other voices argue that limits on imports will boost a nation’s economic health by shielding domestic firms from foreign competition and thereby giving them more opportunity to grow.9

Figure 3 shows that imports were quite low in the United States until 1970, while since then they have grown rapidly. As with government R&D, this pattern fits with the over-time growth story: economic growth was rapid during the era of low imports and slower during the period of higher imports. But as noted above, this is likely to mislead us, because the rapid growth in the three decades following World War II were exceptional and not likely caused by the US economy’s limited exposure to foreign competition.

Figure 3. Imports
Share of GDP. Data source: Federal Reserve Bank of St. Louis, FRED database, series B021RE1A156NBEA.

Figure 4 shows the cross-country picture. There there is no association across the rich democracies between imports (as a share of GDP) and economic growth.

Figure 4. Imports and economic growth
Catchup-adjusted economic growth: residuals from a regression of 1979-2016 growth rates on 1979 level of GDP per capita. Data source: OECD. Imports: share of GDP. 1979-2015. Data source: OECD. “Asl” is Australia; “Aus” is Austria. The line is a linear regression line. The correlation is -.02.

Industrial policy

Proponents of limited government point to the potential for government failings: governments have limited information; they are buffered from competitive pressures; their ability to flexibly adapt may be hindered by bureaucracy; they are subject to pressure from rent-seeking interest groups who aim for their own benefit rather than the most productive allocation of investment. Yet while markets are good at allocating resources to productive use, they are far from perfect in doing so. Private investors may have short time horizons, emphasizing near-term profits over productivity, long-run returns, market share, or export competitiveness. They may have limited information. They may not care about spillover benefits from particular firms and industries. They may benefit from, and thereby accentuate, limits to competition. In these ways, market allocation of resources may be growth-inhibiting.

Government can help to remedy these sorts of market failure via proactive steering of capital toward particular firms or sectors. It can do this via subsidies, favorable loan terms, assistance with coordination, export help, import protection, and public ownership. This type of state guidance sometimes is referred to as “industrial policy.”10

Most discussions of state guidance or industrial policy have not attempted a thorough empirical assessment of the hypothesis. Many single out Japan and France as the exemplary cases. But careful studies of these two cases suggest reason to doubt that government steering contributed significantly to economic growth.11 And a dichotomous scoring in which Japan and France are coded as “high” and all other countries “low” isn’t correlated with economic growth, as figure 5 shows.12 A recent examination of US industrial policy efforts concludes there is little reason to think they have contributed to economic growth.13

Figure 5. State guidance and economic growth
Catchup-adjusted economic growth: residuals from a regression of 1979-2016 growth rates on 1979 level of GDP per capita. Data source: OECD. “Asl” is Australia; “Aus” is Austria. The line is a linear regression line. The correlation is -.12.

WE DON’T KNOW WHAT DRIVES ECONOMIC GROWTH IN RICH DEMOCRATIC COUNTRIES

The unfortunate truth is that scientists have little understanding of what drives variation in economic growth within and between the world’s affluent democracies.

Begin with patterns of economic growth in these countries over time. At any given moment, there typically is a country or two lauded as having unlocked the key to rapid growth. “Modell Deutschland” and “Japan Inc.” in the 1970s and 1980s, the “great American jobs machine” in the 1980s and 1990s, the “Dutch miracle” in the 1990s, and the “Celtic tiger” in the 1990s and 2000s are among the more prominent recent examples. It turns out, however, that economic growth rates in many of the rich democratic nations have been remarkably constant over the past century or more. Countries that do especially well or poorly during a particular decade or business cycle often subsequently revert back to their long-run rate of growth.

Figure 6 shows GDP per capita in each nation since the early 1800s. The data are shown in logarithmic form, along with a regression line that begins in 1870. If GDP per capita grows at a constant rate, the data points will fall along this line. That’s exactly what we see for a striking number of the countries. For a handful of others there is a clear break that occurs around World War II, with growth accelerating after the war. In those cases, two lines are shown in the figure.

Figure 6. GDP per capita (log)
Natural log of inflation-adjusted GDP per capita. A log scale is used to focus on rates of change. “k” = thousand. The vertical axis does not begin at zero. The lines are linear regression lines; they represent a constant rate of economic growth since 1870. For Ireland, Italy, Japan, South Korea, Portugal, and Spain the data suggest a break in growth patterns, so there is one line for 1870-1945 and another for 1945-2018. Data source: Maddison Project Database 2020, Groningen Growth and Development Centre, rug.nl/ggdc.

What about cross-country differences in economic growth? Since the late 1970s, some of these economies have grown more rapidly than others. This owes partly to “catch-up”: countries that begin with a lower per capita GDP are able to grow more rapidly by borrowing technology from richer nations. In addition to government steering, social scientists have offered a slew of hypothesized determinants of post-1970s cross-national variation in economic growth that isn’t due to catch-up: education, modest economic regulation, government taxing and spending, government debt, government effectiveness, interest group organization, corporatist concertation (“corporatism”), left or right government, interest group-government coherence, cooperation-promoting institutions, institutional coherence, income inequality, financial crises, ethnic diversity, and trust. But none of these is robustly linked to national differences in rates of economic growth.14

So when it comes to rich democratic nations, we have very little clue about what yields faster economic growth over the medium to long run. Though not widely appreciated, this isn’t unknown. Paul Krugman wrote in 1994 that “There are many economic puzzles, but there are only two really great mysteries. One of these mysteries is why economic growth takes place at different rates over time and across countries. Nobody really knows why….” Two decades later his assessment hadn’t changed: “The reasons some countries grow more successfully than others remain fairly mysterious….”15

GOVERNMENT STEERING AND OTHER AIMS

It’s worth emphasizing that there is a strong case for government steering in pursuit of other goals, such as investment in research to enhance national security, import restrictions to promote economic resilience, and guidance of funds toward “clean” (non-greenhouse gas) energy sources in order to save the planet. But the aim in these instances isn’t to boost economic growth.16

SUMMARY

Government steering — increased public spending on research and development, guidance of investment toward particular sectors, creation of barriers to certain imports — may have helped to increase economic growth in particular nations at particular moments. But the available evidence doesn’t support the notion that, in general, state guidance is an effective strategy for a rich democratic country to boost economic growth.

  1. Benjamin M. Friedman, The Moral Consequences of Economic Growth, Knopf, 2005; Ronald F. Inglehart, Cultural Evolution, Cambridge University Press, 2018; Lane Kenworthy, “Affluence and Progress,” The Good Society. Does economic growth impede our ability to save the planet from climate change? No. Reducing greenhouse gas emissions is compatible with continued expansion of output. We already have the capability to generate the amount of energy we currently use and more from clean sources. What we need isn’t a significant reduction in energy use but rather a shift to clean energy. Indeed, there is a case that continued economic growth will be helpful in achieving reduced greenhouse gas emissions, because people are more likely to support altruistic rather than selfish policies when the economy is advancing. See Kenworthy, “Climate Stability,” The Good Society. ↩︎
  2. Friedrich Hayek, “The Price System as a Mechanism for Using Knowledge,” American Economic Review, 1945; Alec Nove, The Economics of Feasible Socialism, George Allen and Unwin, 1983. ↩︎
  3. Daron Acemoglu and James Robinson, Why Nations Fail: The Origins of Power, Prosperity, and Poverty, Crown, 2012, pp. 75-76. See also J. Bradford DeLong, Slouching Towards Utopia: An Economic History of the Twentieth Century, Basic Books, 2022. ↩︎
  4. Ira Magaziner and Robert Reich: Minding America’s Business, Vintage, 1983, pp. 339-340. Chalmers Johnson: MITI and the Japanese Miracle, Stanford University Press, 1982, p. 199. John Zysman: Governments, Markets, and Growth, Cornell University Press, 1983, pp. 38, 76, 237. Peter Hall: Governing the Economy, Oxford University Press, 1986, pp. 162-63, 174. Lester Thurow: Head to Head: The Coming Economic Battle among Japan, Europe, and America, William Morrow and Company, 1992, pp. 145-47. Mariana Mazzucato: The Entrepreneurial State: Debunking Public vs. Private Sector Myths, Anthem Press, 2013, p. 4. IPPR Commission on Economic Justice: Prosperity and Justice: A Plan for the New Economy, Polity Press, 2018, pp. 88-89. Robert Kuttner: “Bringing the Supply Chain Back Home,” New York Review of Books, 2021. Rana Foroohar: Homecoming: The Path to Prosperity in a Post-Global World, Crown, 2022, p. 25. ↩︎
  5. Mariana Mazzucato, The Entrepreneurial State: Debunking Public vs. Private Sector Myths, Anthem Press, 2013; Jacob S. Hacker and Paul Pierson, American Amnesia: How the War on Government Led Us to Forget What Made America Prosper, Simon and Schuster, 2016; Jonathan Gruber and Simon Johnson, Jump-Starting America: How Breakthrough Science Can Revive Economic Growth and the American Dream, PublicAffairs, 2019. ↩︎
  6. Lane Kenworthy, “Economic Growth,” The Good Society. ↩︎
  7. Lane Kenworthy, “Finance,” The Good Society. ↩︎
  8. Lane Kenworthy, “Trade,” The Good Society. ↩︎
  9. Clyde V. Prestowitz Jr, Trading Places: How We Are Giving Our Future to Japan and How to Reclaim It, Basic Books, 1988; Robert Kuttner, “Managed Trade and Economic Sovereignty,” Economic Policy Institute, 1989; Laura Tyson, “Managed Trade: Making the Bests of the Second Best,” in An American Trade Strategy, edited by Robert Z. Lawerence and Charles L. Schultze, Brookings Institution, 1990; Dani Rodrik, Has Globalization Gone Too Far?, Institute for International Economics, 1997; Michael Lind, “The Cost of Free Trade,” The American Prospect, 2011; Robert Kuttner, “Bringing the Supply Chain Back Home,” New York Review of Books, 2021; Rana Foroohar, Homecoming: The Path to Prosperity in a Post-Global World, Crown, 2022. ↩︎
  10. Andrew Shonfield, Modern Capitalism, Oxford University Press, 1965; Chalmers Johnson, MITI and the Japanese Miracle, Stanford University Press, 1982; Ira C. Magaziner and Robert B. Reich, Minding America’s Business, Vintage, 1983; John C. Zysman, Governments, Markets, and Growth, Cornell University Press, 1983; Lester C. Thurow, “Building a World-Class Economy,” Society, 1984; Peter A. Hall, Governing the Economy, Oxford University Press, 1986; Alice Amsden, Asia’s Next Giant: South Korea and Late Industrialization, Oxford University Press, 1989; Lane Kenworthy, In Search of National Economic Success, Sage, 1995, ch. 4; Mazzucato, The Entrepreneurial State; IPPR Commission on Economic Justice, Prosperity and Justice: A Plan for the New Economy, Polity Press, 2018; Todd Tucker, “Industrial Policy and Planning,” Roosevelt Institute, 2019; Mariana Mazzucato, Mission Economy: A Moonshot Guide to Changing Capitalism, Harper Business, 2021. ↩︎
  11. Richard Beason and David E. Weinstein, “Growth, Economies of Scale, and Targeting in Japan (1955-1990),” Review of Economics and Statistics, 1996; Marcus Noland and Howard Pack, Industrial Policy in an Era of Globalization: Lessons from Asia, Institute for International Economics, 2003; Takatoshi Itoh and Takeo Hoshi, The Japanese Economy, 2nd edition, 2020. ↩︎
  12. Harold Wilensky and Lowell Turner (Democratic Corporatism and Policy Linkages, Institute of International Studies, 1987, p. 32) attempted to rank-order eight of the countries on degree of industrial policy intervention, based on their reading of the secondary literature. This ranking too is negatively associated with economic growth. ↩︎
  13. Clyde Hufbauer and Euijin Jung, “Scoring 50 Years of US Industrial Policy, 1970-2020,” Briefing 21-5, Peterson Institute for International Economics, 2021, p. 103. ↩︎
  14. Lane Kenworthy, “Economic Growth,” The Good Society; Kenworthy, “Institutions, Wealth, and Inequality,” in Oxford Handbook of Comparative Institutional Analysis, edited by Glenn Morgan, John L. Campbell, Colin Crouch, Ove Kaj Pedersen, and Richard Whitley, Oxford University Press, 2010. ↩︎
  15. Paul Krugman, Peddling Prosperity, W.W. Norton, 1994, p. 24; Krugman, “The New Growth Fizzle,” New York Times: The Conscience of a Liberal, 2013. See also Angus Deaton, The Great Escape, Princeton University Press, 2013, p. 237; Ryan Avent, “Economists Understand Little about the Causes of Growth,” The Economist: Free Exchange, 2018; Kenworthy, “Economic Growth.” ↩︎
  16. Paul Krugman, “Biden and America’s Big Green Push,” New York Times, 2023. ↩︎