Abracadabra Prosperity

Advocates of an industrial policy are curiously like primitive Melanesians, who thought that the magic of ritual could bring them wealth.

In the vast openness of the Pacific Ocean lies a group of islands inhabited by tribes known collectively as Melanesians. For thousands of years, these tribes existed in a primitive state, depending primarily on domestic pigs, garden produce, and copra (dried coconut) as staples and producing no important commercial product. Nevertheless, during the early 1900s, the Imperial German government established a settlement there and attempted to develop copra and rubber industries on the larger islands. Predictably, using central planning to build such an industrial base was unsuccessful. Among other problems, rubber and copra market prices were insufficient to cover shipping expenses. While the Europeans were unable to develop viable commercial activities, their presence generated a series of increasingly costly cultural adaptations among the natives, which anthropologists have labeled "cargo cults."

Study of the Melanesians and their odd cargo cults can provide more than satisfaction of anthropologists' intellectual curiosity. As economists coming upon the phenomenon, we found that there are illuminating analogies to be drawn between the cargo cults and modern practices not yet widespread but advocated by a growing chorus of analysts and politicians—the collection of measures called "industrial policy."

Like other primitive peoples, the Melanesians had developed unique and highly complex rituals. In the Melanesians' case, the object was to increase pig and soil fertility, control the weather, and influence other factors contributing to their wealth. They believed, for example, that a concoction of male semen and female secretions would increase the fertility of everything from men to soil. "No soil would produce good foodstuffs unless the husband and wife first copulated in the new garden, made a brew of their collected juices and certain leaves, and buried portions of the mixture in various parts of the garden," writes K.O.L. Burridge in Oceania.

In this setting, the arrival of Europeans created understandable shock among the residents. Turning up in ships and later airplanes with seemingly endless supplies of goods, the Europeans made a striking impression on a people whose status symbols had hitherto included dogs' teeth, porpoise's teeth, and pigs' tusks. The Melanesians reasoned that magic was the only force powerful enough to generate the Europeans' obvious wealth. They believed that if they were able to imitate European "rituals," the gods would bless them with cargo just as the Europeans had been so blessed. They confused ends with process; and in mimicking European forms, they wasted substantial portions of their scarce resources in pursuit of wealth.

Consider the following "rituals":

• During World War II, one tribe spent weeks preparing and building an "airport," because it had observed US soldiers "attracting" cargo planes with landing strips and control towers. The natives hacked an airstrip out of the jungle and built a bamboo flight tower, complete with wooden microphones, instrument panels made from bamboo, and earphones made of bark.

• Some tribesmen noticed that the Europeans kept vases and bowls of flowers on tables and windowsills, so they proceeded to decorate their own houses and in some cases entire villages with freshly picked flowers to entice the flow of wealth in their direction.

• American troops stationed on the islands during World War II watched in wonder as natives, dressed in khaki pants and armed with wooden rifles, marched in formation with "US" painted on their bare backs.

Other cargo rituals were less amusing. The natives' search for wealth often reached destructive and wasteful proportions as the tribes adopted new customs and sacrificed precious possessions. In attempting to please the cargo gods and demonstrate their faith, they destroyed crops, slaughtered pigs, burned houses, and threw valuables into the ocean. This kind of behavior peaked when the tribal society suffered shock or trauma. In New Guinea, for example, cargo cults twice replaced traditional ceremonies when diseases brought by the Europeans to the islands raged through the villages. Droughts, earthquakes, and tropical storms precipitated similar activities.

Although these results seem odd to us today, they are not, on reflection, all that surprising. Here was a group of people confronted with the spectacle of incomprehensible and unattainable wealth. They failed to understand how wealth is created. They were experiencing trauma. They looked for desperate, quick-fix measures.

With a spin of the globe, the Melanesian islands disappear, the expanse of the blue Pacific appears briefly, and North America appears. Both culturally and geographically, the comparison is extreme. But parallels can be found in the way people in both societies react to new events.

From the Constitution's inception until the 1970s, the US economy grew at an annual rate of roughly 2.4 percent. From the 1970s until quite recently, annual productivity dropped to 0.5 percent. Double-digit inflation, increasing bankruptcy filings, high interest rates, growing deficits, record joblessness, and shrinking old-line manufacturing production accompanied this stunted growth. These factors have affected Americans much as natural catastrophes affected the Melanesians. After being exposed to European wealth and especially during or after a period of extreme calamity, the natives confused ends with process and squandered much of what they had in efforts to secure wealth from the cargo gods. To us it is obvious that such efforts are fruitless, but a sobering parallel can be drawn.

We have watched Japan and several European countries steadily outperform our economy, which is just pulling out of a slump labeled by some as the Great Recession of 1981–83. Furthermore, nearly every Democratic candidate vying for the 1984 presidential nomination constructed political platforms containing a major plank in support of some form of industrial policy. These candidates have called for tougher laws restricting plant closings, for expanding protection against foreign imports, and for increasing governmental spending on unemployment compensation and worker retraining, and most seriously, for the allocation of capital to boost the fortunes of certain industries.

These promised economic programs have the intellectual support of prominent liberal thinkers such as Lester Thurow, Robert Reich, and Felix Rohatyn. Policymakers, too, have joined the "reindustrialization" bandwagon. Bills presented before Congress spell out plans to create something similar to the Reconstruction Finance Corporation of the 1930s. The object is to allocate low-interest loans and subsidies to both sunrise ("promising") and ailing industries, while providing workers with federal subsidies to purchase their closed plants.

Lack of consistency and internal contradictions permeate industrial policy proposals. But, as with the Melanesians' cargo cult activities, the problems and misconceptions inherent in these proposals drive much deeper than inconsistency and lack of definition.

Consider, first, the Melanesians. If the natives from the various islands were to hold a cargo convention and agree on cult procedures, establish standards, and spell out objectives, they might agree to adopt the "airstrip" ritual as the optimal strategy for attracting wealth. As a result, airstrips might be constructed on all of the islands according to uniform standards. Despite uniformity, organizational efficiency, and cooperation, the consequences are predictable. First, potentially productive resources—gardens and livestock—would be neglected as human and physical capital were diverted from productive activities. Second, no planes, unless in need of an emergency landing, would land on the makeshift airstrips. Third, some local leaders would gain in the process.

Proponents of industrial policy, hoping to create wealth through governmental planning and allocation, suffer from a similar "Melanesian misconception." There is a belief that centralized planning and capital allocation, along with controlled economic stimulation, yield results superior to those produced by a spontaneous order of individuals operating with clearly defined, enforced, and transferable property rights. But when government is responsible for distributing capital, decisions are determined by concentrated special interests, appointed experts, and bureaucrats who are buffered from the long-run, real-world effects of their actions. Under such conditions, industry's attention is diverted from the market, where enhanced efficiency determines survival, to the political arena, where resources are increasingly channeled in attempts to influence government. Thus, in our modern culture, too, it appears ends have been confused with process, and we risk losing substantial quantities of resources through the proposed industrial policies.

Just as the natives observed and imitated the Europeans, US business executives, labor leaders, and policymakers study Japanese actions in search of clues that can help explain the phenomenal economic growth of "Japan Inc."—that magically efficient Japanese productivity machine. As foreign-made automobiles, televisions, stereos, and high-tech imports, with their lower prices and higher quality, have claimed large shares of our domestic markets, industrial-policy advocates claim to have discovered Japan's key to success: MITI—the Ministry of International Trade and Industry. As the National Journal reports, the perception is that "the Japanese government [through MITI], working closely with the private sector, sets a specific goal for a particular industry and then initiates a series of government and private-sector actions designed to help achieve it."

Katsuro Sakoh, former director of international economics at the Council for a Competitive Economy and now a researcher at the Heritage Foundation, offers a contrary view:

Many observers of Japan have committed the classic fallacy of elementary logic—cum hoc ergo propter hoc (false association). Since Japan has something those observers choose to call an industrial policy and since the country's industrial capacity has been growing dramatically, they conclude that there must be a causal relationship between the two. Yet other concurrent factors just as easily could be selected to explain Japan's successes. There is, for example, Japan's generous tax treatment of investment income—similar to supply-side economics. There is Japan's determination to improve quality control. And there is, of course, the "uncorking" of Japanese entrepreneurship due to the explosion of political and social freedom after 1945. Strangely, these factors are ignored by advocates of an American industrial policy.

Efforts to enlighten advocates are most often met with stiff resistance. When the Europeans realized the impact they were having on the Melanesian culture, they tried to discourage the belief that wealth was brought by "cargo gods." The Europeans, frustrated with trying to stifle the cults, finally arranged for several tribal chieftains to visit Europe to see that wealth was not created by magic or ritual. When the chieftains arrived, they were taken through factories, plants, and warehouses so that they might grasp the entire process by which goods were produced. The Melanesian leaders understood how the resources were used, what the assembly lines produced, and how these inputs were converted into final products. The Europeans were confident that the visit had convinced the chiefs to put a stop to the cargo cults.

Back home, however, the chieftains told tribal members that the Europeans' cargo in the foreign country was far greater than it was on the islands but that they produced the cargo in factories from raw materials. The raw materials had been delivered by the gods, the chieftains pronounced; so it was imperative that the natives be more dedicated to cargo ritual. A flurry of new magic and ritual ensued.

Industrial advocates suffer from similarly narrow vision. Even though the evidence clearly shows that it is not MITI that is responsible for Japan's extraordinary success, the proponents of an industrial policy push for tighter MITI-like governmental planning in the United States. If there were a cause-and-effect relationship between MITI and economic growth, however, it should not be difficult to uncover by comparing the records of MITI-backed industries and those that have been left relatively untouched.

In a report compiled for the Heritage Foundation by Katsuro Sakoh, several relevant questions about Japanese industrial policy were examined:

• Do governmental expenditures dominate the economy?

• Is governmental aid a major contributing factor to the phenomenal growth of Japan's most successful industries?

• How successful have the targeted industries been?

Sakoh first discovered that the amount of resources a government allocates to research and development is inversely related to the economic success of that country. By the late 1970s, the percentage of research and development funded by government was lower in Japan than it was in both West Germany and the United States. The government's share of R&D funding was about 50 percent in the United States, 40 percent in West Germany, and 30 percent in Japan. Moreover, only 5 percent of Japan's government spending on R&D flows into private industrial research, compared with 50 percent in the United States. This indicates the rather limited influence of Japan's governmental investment program, especially on private industry.

When one conjures up images of Japanese industrial strength, computers, automobiles, and electronic products come to mind. Should MITI be credited with this success, as industrial policy proponents insist it must? When Japanese industries that are experiencing substantial growth are examined, it is evident that there is an inverse relationship between MITI's involvement with any specific industry and the growth of that industry.

The machine and information industries in Japan receive a meager 0.8 percent of its Fiscal Investment and Loan Program's (FILP) total annual investment from special loans. Technological development as a whole has received considerably less than what has been loaned to ocean shipping, urban development, or energy resource sectors, according to the Heritage Foundation study. Technological development places second to dead last on FILP's priority budget list (perhaps helping explain its phenomenal growth).

It is also useful to examine those industries with which MITI has been most involved. Areas targeted for heavy financial assistance include agriculture, coal mining, shipbuilding, petroleum refining, and petrochemicals. Agriculture is by far the most inefficient of Japan's significant industries. The coal-mining industry, despite large influxes of government capital, has steadily declined since 1972, and production has fallen off to less than half of its 1962 level. Until the oil shock in 1973, a seemingly prosperous Japanese shipbuilding industry had been cushioned with subsidies. The oil crisis, accompanied by a decline in world demand for ships, highlighted the problem of excess capacity that the subsidies had engendered. Since the oil crisis, 19 companies have closed, 46,000 workers have been laid off, and output has fallen by 65 percent.

It seems that Japanese industrial policy has contributed as much to Japan's economic success as magic, ritual, or cargo gods did to the Europeans' wealth. In the 1960s, MITI attempted to conglomerate the Japanese auto firms into one corporation. Only by their refusal to join together have these auto producers become independent, internationally competitive firms. Perhaps a more appropriate observation is that Japan has experienced economic success despite MITI's actions. Rather than "magic or MITI," credit must be given where it is deserved: to European and Japanese entrepreneurship.

Because of entrepreneurship, a dramatic economic transition is occurring in what has become known as the Asian Crescent. Economic growth has been astounding during the past decade in countries such as Japan, Taiwan, and South Korea and cities such as Hong Kong and Singapore. There is a lesson here for the United States. Noel Barber observes in The Singapore Story:

It is a success achieved despite tremendous odds stacked against it. The island has no resources—no food, no space, no raw materials—nothing but people. Yet the inhabitants of today's Singapore have taken part in an economic miracle that has staggered the world. They enjoy the highest per capita income in Asia after Japan; their economic growth is the envy of many a western nation; the city has become the fourth largest port; the country has no unemployment.

In the Asian Crescent, policymakers and entrepreneurs recognized true wealth-creating processes, moved to establish the institutions necessary to initiate and sustain economic growth, and then adopted modern technology to improve efficiency. In a free-market system, individuals have freedom of choice, are encouraged to take initiative, and are rewarded for their efforts. The economy is "closely integrated with the international marketplace…tax rates are low and business is by and large unregulated," notes Melvyn Krauss, author of Development Without Aid. Government intervention is described as moderate and being primarily concerned with increasing the size of the economic pie rather than with allocating a fixed amount of wealth. Taiwan, Singapore, Korea, and Hong Kong have developed their economies not through governmental design but through the market forces of comparative advantage.

MITI has failed to promote economic growth in Japan. It is mostly market forces that have determined the fate of the Japanese economy. Japan's industrial base has undergone an economic metamorphosis, evolving from a rubber-textile-steel industrial base to the automobile-electronic phase and on to the frontiers of several high-tech markets, such as robotics. US policymakers and labor leaders would do well to note that in the process of this transition, real wages during the last 20 years have tripled.

As the Japanese economy evolved from labor- to capital-intensive production, its producers began investing heavily in such neighboring countries as Taiwan, South Korea, Hong Kong, and Singapore—where labor is abundant—by packing up many of Japan's steel and textile mills and shipping them to its Asian neighbors. Now Taiwan, South Korea, Hong Kong, and Singapore are also progressing from labor- to capital-intensive production. Korea, for example, is now successfully manufacturing automobiles. Clearly, both the Japanese and their neighbors benefit from exchanges that increase the productivity of labor.

Contrast the above with the entrenchment mentality taken by US labor, business, and governmental representatives;

• Union leaders and collectivist Democrats have introduced bills in 24 states and at the federal level proposing that businesses be prevented from closing their plants and moving to new locations. In all but the short run, such restrictions would hurt the workers that the bills are intended to help. When a firm is legally prevented from moving to a location where expenses are lower, it is at a disadvantage relative to firms in less-costly regions. The latter firms can undersell those "locked in" by law, and hence failure can be expected. Such laws also hurt the region, as new companies are reluctant to open plants in places from which they cannot escape. Despite these problems, two states (Maine and Wisconsin) and one city (Philadelphia) have passed such bills.

• Similar bills initiating more-extensive protectionist measures and more-restrictive import quotas are before Congress. Such protectionist coddling of businesses does not lead to recovery; rather, it encourages, breeds, and compounds unproductive behavior. For example, the US government first began protecting the steel industry during the late 1960s by forcing the Japanese into an agreement that involved "voluntary" restrictions on its exports. In 1977 the Japanese accepted even more restrictions with pressure from Pres. Jimmy Carter. Since then, the annual capital expenditure growth in the American steel industry has fallen to a meager 4 percent. Rather than retooling and upgrading capital and technology during the breathing space provided by the restrictions (as originally promised), the industry diversified into more-promising areas. In 1979, for example, US Steel sold 13 steel and fabricating plants while opting to build a shopping center near Pittsburgh, purchase the Marathon Oil Company for $6.4 billion, and construct a chemical plant in Texas. The scenario is frighteningly similar in US automobile manufacturing, consumer electronics, and the footwear, textile, and apparel industries.

• By March 1984, at least seven bills were before Congress proposing the resurrection of the Reconstruction Finance Corporation (RFC), a bureaucracy designed to pump billions of tax dollars into both sunrise and ailing industries. Such a "corporation," however, does not allow for the industrial transition necessary for long-term economic growth. Those in charge of allocating RFC subsidies would have no way to predetermine which allocations would most significantly enhance productivity. Lacking both the information and incentives provided by the market, administrators would predictably bend to the pressures of political concerns and narrow special-interest groups.

If productivity is to be increased, we must allow our industrial base to evolve with natural forces rather than adopt the entrenchment mentality advocated by industrial-policy proponents. US collectivist politicians, however, seek to replace the spontaneous order of the market process with a system similar to the ineffectual MITI. One would hope we have the wisdom to avoid constructing such obstacles to economic growth.

Why does support for an industrial policy exist? Like the tribal chieftains whose power was temporarily enhanced by cargo cult activities, industrial-policy advocates presumably feel that their welfare and that of their clientele will be improved by moving decisionmaking away from the market and toward coercive allocation. That this outcome ultimately shrinks the economic pie is of little consequence.

How can we avoid this outcome? Let us propose at least a benchmark for evaluating industrial policy. It is this: any policy that encourages a constituency for general efficiency is good policy. Clearly, a "supply-side" industrial policy—that is, one that minimizes governmental involvement—is superior to the alternatives that are currently being propounded by the collectivists.

We face a choice between two industrial policies. The more commonly advocated choice views government allocation as the key to a solution. In contrast, we believe that governmental distortions are the primary problem. A supply-side industrial policy employs the engine of market prices—condensed sets of information and incentives—to move resources to more highly productive uses. This is the industrial policy we should adopt as we approach the bicentennial of the US Constitution—the best recipe ever written for an industrial policy.

John Baden is executive director of the Political Economy Research Center based in Bozeman. Montana, and a professor of public policy at Utah State University.Tom Blood is a graduate of Purdue University and is a Murdock Fellow at the Political Economy Research Center. This article is adapted from their chapter in the forthcoming book Taxation and Capital Markets, edited by Dwight R. Lee, to be published by the Pacific Institute for Public Policy Research and Ballinger.