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INSTITUTIONAL FRAMEWORK

FOR
INDUSTRIAL POLICY

Designing a modern institutional framework using best practice design principles for
the evaluation, formulation, and deployment of industrial policies.

Prepared by
Dr. Ohan Balian

Dubai
United Arab Emirates
January 22, 2010
Table of Contents

1. Introduction .......................................................................................................... 3
2. Rationale for industrial policy............................................................................. 4
2.1 Informational failures ........................................................................................ 4
2.2 Coordination failures ........................................................................................ 4
3. Design elements .................................................................................................. 5
3.1 Embedded autonomy ....................................................................................... 5
3.2 Generic design elements.................................................................................. 5
3.3 Top 10 design principles .................................................................................. 6
4. Proposed structure of framework ...................................................................... 8
4.1 Brief description of existing structures.............................................................. 8
4.2 Generic components ........................................................................................ 8
4.2.1 Ownership.................................................................................................. 8
4.2.2 Coordination Councils................................................................................ 8
4.2.3 Carrots-and-Sticks ..................................................................................... 9
4.3 Other components............................................................................................ 9
4.3.1 Formulation................................................................................................ 9
4.3.2 Monitoring and Evaluation ....................................................................... 10
4.3.3 Deployment.............................................................................................. 10
5. Concluding remarks .......................................................................................... 11
References ............................................................................................................. 12

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1. Introduction

Diversification strategies in many countries have been driven primarily by


what is known as industrial policy defined as government intervention in the form of
support programs to the private sector. This broad definition encompasses almost all
types of economic policies except monetary and fiscal policies which are known as
stabilization policies. Industrial policy thus includes policies to enhance competitive-
ness, develop clusters, build free zone areas, support SMEs, encourage public-
private partnerships, attract FDI, and a host of other economic policies1. Even with
the proliferation of government support programs in recent years, the empirical evi-
dence on the effectiveness of industrial policy has been inconclusive2. Some ob-
servers have even suggested that the ‘lost-decade’ of economic stagnation in East
Asian countries in the 90’s may have been caused by inappropriate industrial poli-
cies in the 70’s. 3

The argument against industrial policy is that it is impossible for the govern-
ment to consistently pick winners because of the existence of market failures. A cen-
tral question in industrial policy is therefore how to take into account these market
failures such that industrial policy maximizes the likelihood to contribute to economic
growth. In other words, what is the best institutional framework or process through
which the effectiveness of industrial policy is maximized? This modern institutional
framework is known as embedded autonomy (Evans 1995) – a discovery process in
which the government and the private sector come together to learn and discover
underlying challenges and opportunities, and engage in strategic cooperation.

Once industrial policy is conceptualized in terms of this discovery process, the


traditional argument against industrial policy is considerably weakened because the
government’s ability to target specific sectors and activities (in response to market
failures) is substantially improved. The efficacy of this discovery process is condi-
tional upon the incorporation of best practice principles in designing a modern insti-
tutional framework for industrial policy. This short paper outlines the main design
elements of a modern institutional framework using best practice design prin-
ciples for the evaluation, formulation, and deployment of existing and new in-
dustrial policies. This will be achieved by linking 13 best practice design elements
(3 generic and 10 principle) to the structure of the existing institutional framework.
Hence, the purpose is not to design a completely new framework. It is to upgrade
the existing traditional principal-agent model to the modern embedded autonomy
one.

1
‘Industrial’ here is a generic term and includes services and other non-manufacturing ‘weightless’
products such as high-tech, tourism, banking, and many others.
2
Most notably in Japan and Taiwan, but not in Singapore, South Korea, and China. See Beason and
Weinstein (1996), Nehru and Dhareshwar (1993), and Smith (2000).
3
See Noland and Pack (2003).

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2. Rationale for industrial policy
The rationale for industrial policy can be explained by two types of market
failures: informational failures, and coordination failures.

2.1 Informational failures

Government support to investors is necessary because when entrepreneurs


explore new business opportunities, they incur high discovery costs with no guaran-
tees of success. When the economy is going through a diversification process, en-
trepreneurs need to self-discover the economy’s cost structure – i.e. what are the
new4 products that can be produced at a sufficiently low cost to be profitable? Entre-
preneurs must experiment with new technologies, new processes, and other new
innovative ways of producing this product (self-discovery) which might have a large
social benefit but is poorly rewarded for the individual entrepreneur. If the entrepre-
neur fails in these experiments, he will bear the full cost of the investment. If she
succeeds, she has to share the benefits with entrants into this new product which
will reduce its profitability. The government’s response aims at reducing the entre-
preneur’s self-discovery costs.

2.2 Coordination failures

Governments also intervene because for some industries to succeed, other


industries must also be established simultaneously. This is the general idea behind
clustering where an entrepreneur contemplating whether to invest in a specific in-
dustry needs to know that there is an electricity supply he can access readily, the
logistics and transport networks are in place, the country has been marketed abroad
as a dependable supplier of that particular new product, and so on. This business
enabling environment, a term freely used by economic commentators, is very costly
to supply and can only be provided by the government.

Because of these two market failures, it is not surprising that entrepreneurs


require considerable government support. Scratch the surface of export success sto-
ries all over the world and you will find industrial policies such as public R&D, export
subsidies, preferential tariffs, and various types of tax incentives all lurking beneath
the surface. The main reason as to why East Asian economies are more successful
than in Latin America (and to some extent in the expanded European Union) is that
industrial policies in East Asia are evaluated, formulated, and deployed using care-
fully crafted modern institutional frameworks.

4
‘New’ does not necessarily imply new in the traditional sense. It can be an already existing good or
service but is not yet produced domestically.

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3. Design elements
3.1 Embedded autonomy

The main consideration in designing a modern institutional framework is that


the government, however efficient it might be, does not have complete market infor-
mation. Even if it has some information, it is less than the information that the private
sector has about the location and nature of market failures discussed above. Gov-
ernments may not even know what it is that they need to know. For this reason, the
institutional framework for conducting industrial policy must be one in which the gov-
ernment is able to elicit information from businesses on an ongoing basis about the
existing challenges and the available opportunities. In the traditional institutional
framework, industrial policy making is a top-down approach (principal-agent model)
where the private sector is kept at a distance and autonomous policy makers issue
directives. In the modern approach, industrial policy making is embedded within a
network of linkages with the private sector without any loss of autonomy – hence the
term embedded autonomy. This is a much more flexible form of strategic collabora-
tion between the government and the private sector that is specifically designed to
elicit information about objectives, formulate policies for solutions, and evaluate pol-
icy outcomes as they appear.

3.2 Generic design elements

The first design element of a modern institutional framework is that it should


have high-level government support. Just like monetary policy has a champion ad-
vocate in the form of a Central Bank Governor (or the Federal Reserve Chairman in
the US), industrial policy should have such an advocate who has the ear of the
Prime Minister or the President, or both. This advocate should also coordinate, over-
see, and monitor the agencies and government officials entrusted with carrying out
industrial policy. If these agencies are to have autonomy in industrial policy making,
it is critical that their performance be closely monitored by such a high-ranking offi-
cial.

The second design element of the modern institutional framework is that it


should have Coordination and Deliberation Councils within which information ex-
change takes place. These are public-private bodies that include representatives of
relevant groups. This would be the setting in which entrepreneurs would communi-
cate their requests for assistance to the government, and the government would in
turn direct them into new investment opportunities. The roles and responsibilities of
these Councils would be to gather information on investment ideas, coordinate
among different implementing agencies, propose changes in regulations to reduce
red-tape, generate subsidies and financial backing for new activities, and group
these various support programs along with appropriate conditionalities.

This leads to the third key design element which is the requirement that in-
dustrial policies should have both an incentive and a conditionality structure - what is
known as a carrot-and-stick policy where the carrot represents the incentive and the

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stick is the conditionality, say, the discontinuation of the incentive if targets are not
met. This is to ensure that mistakes are not repeated and bad projects are automati-
cally phased out5. However, even if an optimal support program is adopted, some
investments will inevitably fail. In reality, if there are no failures, it might be an indica-
tion that the support program was not aggressive or generous enough.

3.3 Top 10 design principles

1. Provide support only to ‘new’ activities: ‘New’ refers to products and services that
are new to the domestic economy, or existing products and services produced by
new technologies. Industrial policy should target investments that expand the range
of capabilities in the domestic economy. This type of targeting differs substantially
from targeting, say, SMEs. SME support programs are based on the criterion of size
– not on whether the SME in question has the potential to create new areas of spe-
cialization. It is this potential that drives economic growth.

2. Prepare criteria/benchmarks for success and failure: These are necessary to pre-
vent support recipients to ‘game’ the government. The criteria for success should
depend on productivity – both its absolute level and its rate of increase – and not on
employment or output6. Also adopt benchmarking by looking at the experiences of
similar industries in other countries, especially at the experiences of countries with
similar cost structures and macroeconomic characteristics. Another indicator would
be performance in international markets (export levels) which would provide a ‘quick-
and-dirty’ way of measuring how well an industry is doing relative to its global com-
petitors.

3. Use built-in ‘sunset’ clauses: Support programs should have built-in termination
clauses (‘sunset’ clauses) which are triggered automatically after an appropriate pe-
riod of time has passed. This is necessary to ensure that scarce resources are not
tied-up in activities that are unprofitable. Should there be a need for continuing the
support, the program should be reviewed before its automatic termination trigger
mechanism is activated.

4. Target activities, not sectors: It is common for industrial policy in the traditional
principal-agent model to specify support programs in terms of sectors – tourism,
manufacturing, biotech, high-tech, aerospace, etc. This type of targeting provides
across the board generic support to this or that sector. But when a support program
is targeted at an activity, it directs the support to fix a specific market failure. For ex-
ample, instead of providing support in the form of a subsidy to the tourism sector, the
program should subsidize bilingual training for receptionists, for taxi drivers, for tour
operators, and the like. Similarly in other sectors, support programs should subsidize
feasibility studies, adaptation of new technologies from abroad to make them more
5
East Asian industrial policies have typically used both carrots and sticks with the ‘right’ balance
while Latin American policies have used too much of the carrot and too little of the stick which ex-
plains their relative industrial inefficiencies compared to East Asian economies.
6
While productivity can be notoriously difficult to measure, project audits by technical consultants can
provide useful indications.

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adaptable to local conditions, venture capital, and so on. Such cross-cutting support
programs that target activities have the advantage that they span several sectors
simultaneously and target market failures directly.

5. Support activities that generate spillover and demonstration effects: Industrial pol-
icy should support activities that have a clear potential to attract other complemen-
tary investments (demonstration effects), or activities that generate technological
spillovers (spillover effects). Moreover, activities that are already being supported
should be those that maximize the spillovers to subsequent entrants.

6. Choose competent implementing agencies: Although this might seem obvious, the
implication of this design feature is that the choice of the implementing agency can
determine the industrial policy instrument. For example, if the development bank is
competent but tax administration is a mess, then it is better to use a directed credit
policy managed by the bank rather than a tax incentive managed by the tax authori-
ties. This may be a good compromise especially in countries with a shortage of ad-
ministrative skills. It is better to adopt second-best policies effectively than to use
first-best policies badly.

7. Monitor implementing agencies closely: Although the implementing agency should


have some degree of autonomy in the management of its support programs, it
should be monitored closely by the principal (at the Cabinet level) to ensure ac-
countability. Close monitoring of the support programs by the principal who has in-
ternalized the agenda of diversification and who shoulders the main responsibility for
its success, is essential. Such monitoring guards against self-interested behavior on
the part of the implementing agency and also protects it from private interests.

8. Maintain channels of communication: Even after support programs have begun,


implementing agencies must maintain their channels of communication with their en-
trepreneurs. This would provide a rich information-base on business realities without
which sound policy making would be very difficult.

9. Minimize the cost of ‘picking losers’: The objective of industrial policy is not to
minimize the chances that mistakes will occur - this could result in zero self-
discovery by the entrepreneurs. What the government needs to do is to minimize the
costs of the mistakes when they occur. If governments don’t make any mistakes, it
may be an indication that they are not trying hard enough.

10. Adopt programs with a capacity to renew themselves: When the government
adopts support programs with a capacity to renew themselves, then the cycle of dis-
covery for entrepreneurs becomes an ongoing process. Just like there is no blue-
print for undertaking a support program for a specific market failure, the needs and
circumstances of entrepreneurs in the self-discovery process are also changing over
time. This requires that the implementing agencies have the needed capacity to re-
invent themselves and modify or change support programs. Over time, some of the

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key tasks of industrial policy programs need to be phased out while new programs
are adopted.

4. Proposed structure of framework


4.1 Brief description of existing structures

Industrial policy making has traditionally followed the principal-agent model


where the principal (the government) has issued directives to the agent (the private
sector) in its provision of various types of support programs. These programs have
been channeled mostly through various implementing agencies such as Chambers
of Commerce and Industries, Municipalities, Departments of Economic Develop-
ment, Councils of Economic Development, and the like. To a large extent, these
programs (such as support to free zone areas, clustering, SME support, and many
others) have addressed both the informational and coordination market failures dis-
cussed at the beginning of this paper by creating a business enabling environment.

The questions that need to be asked at this juncture basically determine the
parameters of the institutional framework, namely, are these support programs de-
signed such that they provide support to ‘new’ activities? Do they have built-in termi-
nation clauses? Do they generate spillover and demonstration effects? Are they im-
plemented by competent agencies? Are they monitored closely? All of these ques-
tions ultimately determine the parameters of an institutional framework for industrial
policy. In short, it is safe to say that existing institutional frameworks for conducting
industrial policy is closer to the traditional principal-agent model, albeit with some
performance indicators and monitoring mechanisms.

4.2 Generic components

4.2.1 Ownership
Even though there might be some desirable characteristics in the institutional
frameworks of various regions within the same country, there exists no such frame-
work at the National level. This is partly due to the high degree of industrial policy
independence at the local level, and partly because of the absence of a principal ad-
vocate for industrial policy. One of the key design elements of a modern institutional
framework for industrial policy is that it should have government support at the high-
est level, just like a Minister of Finance for fiscal policy, or a Governor of a Central
Bank for monetary policy. This advocate should also coordinate, oversee, and moni-
tor the agencies and officials entrusted with carrying out industrial policies at the Na-
tional level. If these agencies are to have autonomy in industrial policy making, it is
crucial that their performance be closely monitored by a high-ranking official.

4.2.2 Coordination Councils


The second component of a modern institutional framework is that it should
have National Coordination or Deliberation Councils for information exchange.

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These are public-private bodies in which entrepreneurs would convey their requests
for assistance to the National government. Apart from other roles and functions, the
main task of these Councils would be to coordinate among the various implementing
agencies at the National level.

4.2.3 Carrots-and-Sticks
These are institutional design elements at the program support level for better
monitoring and evaluation of existing programs which need to be looked at on a
case-by-case basis. The general idea is to ‘condition’ the recipients of these support
programs on certain performance indicators and targets. As explained earlier, the
‘carrot’ represents the support, and the ‘stick’ is the condition. (For a better under-
standing of this analogy, imagine the support program in the shape of a carrot which
extends into a stick at the other end).

4.3 Other components

4.3.1 Formulation
The primary consideration in the formulation of industrial policy is its contribu-
tion to economic growth7. Although this is easier said than done, the trick is to pro-
vide support only to new activities because these are the activities that expand the
range of production possibilities8. Support programs also need to be ‘armed’ with
automatic termination triggering mechanisms after a certain period of time has
elapsed. This is especially important in a country pursuing a diversification strategy
in which there are constant movements of resources between sectors caused by
changes in sectoral profitability. To ensure that scarce resources are not stuck in
unprofitable activities, these termination triggering mechanisms must be installed in
the support programs during their formulation stages.

Although sectors and activities have been sometimes used interchangeably in


this paper, the formulation of effective industrial policy requires that support pro-
grams target activities rather than sectors. The principal-agent approach to institu-
tional design targets sectors which provide across the board support to a specific
sector. In the embedded autonomy approach, programs target activities such as
skill upgrading in a specific sector, better methods of performing an existing task,
improving healthcare services (rather than building new hospitals), teacher training
(rather than building new schools), and so on. The main advantage of targeting ac-
tivities is that they have a direct impact on reducing the cost of self-discovery to en-
trepreneurs in the ongoing process of diversification. Moreover, it is activities (not
sectors) that generate spillover and demonstration effects. All of these considera-
tions need to be taken into account when formulating industrial policies to minimize

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The concern of this paper is not to determine the effectiveness of industrial policy per se – we all
know that they are effective. The issue is how to improve this effectiveness by designing better poli-
cies by taking into account the design elements of a modern embedded autonomy institutional frame-
work.
8
In the jargon of economics we say they shift the Production Possibility Curve to the right.

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the costs of mistakes when some losers are inevitably picked in the diversification
process.

4.3.2 Monitoring and Evaluation


Perhaps the most important criterion for the evaluation of support programs is
their impact on productivity. When economic commentators speak of productivity,
they do not specify the productivity of which input. Normally, it is labor productivity
that needs to be measured for evaluation purposes although labor productivity also
depends on the amount of capital and other inputs such as years of schooling,
health, infrastructure, and many other factors which may not be observable – what is
known as total factor productivity. Other less accurate evaluation criteria are the ef-
fects on output and employment, but these can be problematic due to the difficulty in
measuring value-added for activities as opposed to value-added in sectors. For
evaluation at the international level, the standard criterion is the level of exports
which measures how well an industry is doing relative to its competitors in world
markets.

Benchmarking should also be adopted by looking at the experience of coun-


tries with similar cost structures. Implementing agencies must also be closely moni-
tored by the principal (at the Cabinet level) especially since these agencies will have
autonomy in the supervision and management of expensive support programs. Bear
in mind that the circumstances of entrepreneurs are constantly changing and evolv-
ing over time in the self-discovery process for new products and activities. Support
programs must therefore have the capacity to renew themselves. For this reason,
the implementing agency must possess the capacity to modify the support program
over time. This is often a neglected aspect of the evaluation process in industrial pol-
icy which can have serious consequences especially in long-term diversification
strategies where the discovery process by entrepreneurs can be an ongoing process
over long periods of time.

4.3.3 Deployment

There are two requirements in the effective deployment of industrial policy:


choose competent implementing agencies, and maintain broad channels of commu-
nication. Although the competency requirement is self-evident, it is not something
which can be done easily especially when a country is pursuing a diversification
strategy. Since diversification requires entering into new products and activities,
even the most competent implementing agency may not be equipped to deal with
this requirement. For this reason, the first-best optimal policy may not be deployed
because of lack of know-how and capacity. To upgrade this capacity in a relatively
short period of time, communication channels between the implementing agency
and the principal, and between the implementing agency and the entrepreneur, must
be broadened. This would nurture a learning-by-doing effect through which the im-
plementing agency acquires a better understanding of the effects of the policy. This
communication channel would allow the implementing agency to ‘fine-tune’ its sup-

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port program to changing conditions in the self-discovery process of the entrepre-
neur.

5. Concluding remarks
The recent turmoil in the global economy has reinforced the role of the gov-
ernment as an indispensable provider of support the private sector. For over a cen-
tury, different economic schools have been grappling with various ideologies for
more or less government intervention in the economy. Although the argument for
more government intervention has been gaining the upper hand in recent years,
government intervention must be done the ‘right’ way such that it provides an incen-
tive to entrepreneurs in their self-discovery experimentations with new products and
technologies. The effectiveness of industrial policy on economic growth is not at dis-
pute here - we all agree that most governments provide a so-called business ena-
bling environment to their citizens and foreign investors. However, the institutional
framework for conducting industrial policy is seldom in place and is more of an after-
thought as evidenced by the poor performance of many industrialized countries in
recent years. The main benefit of designing a system of industrial policy perform-
ance management is to enable governments to formulate, evaluate, and deploy eco-
nomic policies based on best practices gleaned from the experiences of many suc-
cessful economies, especially in East Asia.

Economics has many shortcomings as demonstrated in its failure to predict


financial catastrophes. But it also provides many solutions to existing problems by
taking a closer look at the incentive structure of markets - a central theme of support
programs in industrial policy. Moreover, institutional economics has demonstrated
that institutions matter, which can annul the unrealistic assumptions of traditional
economics. No wonder this year’s Nobel Prize in economics was granted to two in-
stitutional economists - Oliver Williamson and Elinor Ostrum - with truly formidable
policy implications if, and only if, they were more successful in conveying their poli-
cies on-the-books to policy makers on-the-ground. This short paper is an honest and
genuine attempt in that direction.

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References

Beason, R. and R. Weinstein (1996). Growth, economies of scale, and targeting in


Japan. Review of Economics and Statistics 78, No.2: 286 - 95.

Evans. P. (1995). Embedded Autonomy: States and Industrial Transformation. Princ-


eton, N J: Princeton University Press.

Government of Abu Dhabi (2008). The Abu Dhabi Economic Vision 2030. Abu
Dhabi, United Arab Emirates.

Nehru, V. and A. Dhareshwar (1994). New estimates of total factor productivity


growth for developing and industrial countries. Policy Research Working Pa-
per No. 1313, Washington D.C., The World Bank.

Noland, M. and H. Pack (2003). Industrial policy in an era of globalization: Lessons


from Asia. Institute for International Economics, Washington D.C.

Rodrik, D. (2004). Industrial Policy for the Twenty-First Century. Paper prepared for
UNIDO. Kennedy School of Government, Harvard University, Cambridge.

Smith, H. (2000). Industrial policy in Taiwan and Korea in the 1980s. Cheltenham,
Edward Elgar.

The Executive Office (2006). Highlights: Dubai Strategic Plan (2015) Dubai, United
Arab Emirates.

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