Industrial Policy: The Road Not Taken

By the mid-1970s, cracks in the American industrial base were already visible. For the first time in the 20th century, the United States began running trade deficits. Factory closings that had earlier been limited to apparel, shoes, and plastic toys spread to steel, small appliances, and auto parts. And the decision by the Arab states to control oil prices signaled that the era of cheap energy that had fueled American manufacturing was coming to an end.

These early signs of trouble set off this country's last serious debate over the question of whether the government should have a policy for supporting a healthy manufacturing industry -- that is, an "industrial policy."

For its advocates, industrial policy seemed a no-brainer. The manufacturing sector was the generator of productivity and innovation. It had been the engine of America's rising prosperity and the bedrock of its political as well as economic power. Without America's capacity to become the "arsenal of democracy" -- churning out the tanks, ships, planes, and ordnance that overwhelmed its enemies across two oceans -- World War II might well have ended differently.

The war's end left the U.S. as the dominant manufacturing power in the world for some three decades. But with large-scale U.S. government help, Europe and Japan reindustrialized and quite naturally began to regain their old markets and compete with U.S. companies at home.

So if our government could help rebuild the manufacturing capacity of Germany and Japan, why would helping U.S. manufacturing stay competitive be beyond the pale? Moreover, aid to economic sectors deemed critical for our future was an American tradition. The early debates between Hamilton and Jefferson were over which sector -- manufacturing or agriculture -- should have priority. In the 19th and 20th centuries, tariffs, taxes, procurement, and even public ownership had been employed to pick such industrial winners as clipper ships, railroads, airplanes, telephones, long-distance radio, and television.

In fact, went the argument, government policies were constantly affecting the allocation of investment to private enterprise, but with little regard to the longer-run development needs of the country. Much of it came as a by-product of military spending. Conscious, direct aid -- such as the 1970s bailouts of the Penn Central Railroad, Lockheed, the Franklin National Bank, and the Chrysler Corporation -- was ad hoc, panic-driven, and crudely political. While this might not have mattered when the U.S. was the industrial king of the global mountain, it was now time to get our act together.

Specific proposals for carrying out an American version of industrial policy included:

n a national development bank, in-spired by the Depression-era Reconstruction Finance Corporation, which had provided investment funds to manufacturers when private banks were not lending;

n tax-code revisions, such as ending the favorable treatment of foreign over domestic investment, and the introduction of a "border adjustable" value-added tax that other countries used to give an advantage to domestic production;

n civilian adaptations of the Department of Defense's use of procurement contracts to spur technological innovation;

n generous government financing of technical education and training and lifetime learning to upgrade skills.

The idea of a purposeful industrial policy was also connected to a growing interest in how the nation should think about its long-term future. Toward the end of his presidency, Dwight Eisenhower had established a Commission on National Goals. John Kennedy had given the country an example of how modern goal-setting could work in his pledge to go to the moon. Richard Nixon in 1970 had proposed a national growth policy that would guide public and private investments. Later that decade, Sens. Hubert Humphrey (Democrat) and Jacob Javits (Republican) introduced legislation for a national economic policy commission to counterbalance Washington's penchant for short-term economic fixes with a longer-term perspective. Similar bills started to make their way through the House, and the Joint Economic Committee held extensive hearings.

Concern about the future was not limited to the Washington elite. Organized around the celebration of the nation's bicentennial in 1976, state and local governments around the country sponsored citizen forums to develop plans for what their community might look like by the year 2000. Issues included energy conservation, land-use and transportation planning, poverty and equal opportunity and -- especially in declining industrial areas -- the future of manufacturing. Around the same time, local grass-roots movements for industrial revitalization formed, generating a mix of ideas about community development, employee ownership, and the mutual responsibilities of citizens, business, and local government.

But the democratic discussion of the future of the nation in general, and its industrial base in particular, had powerful enemies. Opposition from conservative Republicans was to be expected, especially given the Reaganite takeover of the GOP after the party's defeat in the 1976 election. But with Jimmy Carter in the White House and his party in control of Congress, the critical debate was among Democrats. Its outcome has had a profound impact on the course of the U.S. economy over the last three decades.

Within the administration, opposition was led by the chair of the Council of Economic Advisers -- Charles Schultze from the Brookings Institution. His argument was basically ideological: Government could not make better decisions than the market. And even if it could, what the private economy produced -- whether it should have a manufacturing sector at all -- was none of the public's business.

Schultze's view reflected the postwar "neoclassical synthesis" of two strains of capitalist economic thought. One was the post-Depression macro-economic focus on economy-wide aggregate numbers, symbolized by the gross domestic product -- the dollar value of everything the economy produces. The other strain came from 19th-century microeconomics -- the modeling of how perfectly informed rational autonomous individuals maximizing short-term profits respond to price changes. The synthesis conceded to the liberals that government had a responsibility for fiscal and monetary policies to stabilize the overall economy. It conceded to the conservatives that all other decisions should be made by the unfettered market.

About the vast, messy meta-economy in between, where most corporate managers, workers, investors, speculators, inventors, schemers, and rent-seekers actually lived and worked, synthesis economists had nothing to say. This world could not easily be fit into the mathematical modeling that economists felt was necessary to assert their discipline's claim to being a science. Moreover, understanding it required tools beyond the economists' training -- engineering, psychology, politics, management, marketing, labor relations, law, and most of all, the study of how complex institutions behave and change over time.

Such an approach to economics has a distinguished American intellectual tradition reaching back to figures such as Thorstein Veblen, John R. Commons, and Adolph Berle. But by the late 1970s their work was largely swept outside the economic policy mainstream -- as were even prominent economists whose support for industrial policy came from their study of business institutions. These included John Kenneth Galbraith, whose widely read books dissecting the behavior of the modern corporation were deemed by the synthesis majority as insufficiently mathematical; Nobel Prize winner Wassily Leontief, whose pioneering "input output" methodology analyzing the flow of resources to and from economic sectors made him seem too friendly toward planning; and Lester Thurow of the Massachusetts Institute of Technology, who seemed too interested in studying the way businessmen actually behaved and the effect of their behavior on the distribution of income and wealth.

Over the next decade, a widening circle elaborated the case for a conscious nurturing of a high-wage road to future prosperity as an alternative to the low-wage road on which the country was traveling. Analysts at the Business Roundtable on the International Economy at the University of California, Berkeley, insisted that we had something to learn from the Japanese. Robert Reich, a lawyer, and Ira Magaziner, a business consultant, argued that sectoral policies were essential for growth. Labor economists at the Economic Policy Institute showed how the erosion of wages from the manufacturing sector was spreading throughout the labor force. Economists Barry Bluestone and Bennett Harrison wrote a book whose title, The Deindustrialization of America, became the iconic phrase in the policy debate.

But policy debates are rarely settled on their philosophical merits alone. To a large degree, the conflict within the policy class was a proxy for the conflict of interests among those with power and money at stake. For example, the State Department, representing the foreign-policy establishment, which favored helping foreign industries to capture U.S. markets as a way to gain Cold War allies, was opposed.

More important was the hostility of the Treasury Department, which represented the interests of financiers who were against giving the government power to guide private investment in ways that would serve the interests of American producers, rather than American global investors. It was one thing for the government to subsidize capital with tax breaks, loan guarantees, and bondholder bailouts. But for the government to do it on some systematic and thought-out basis -- that was the road to socialism, if not worse. America's financial elite was also aware that if manufacturing industries were to shrink, so would the political power of the strongest American unions.

The industrial-policy debate consummated the marriage of Wall Street and the mainstream economics profession that continues today. For believers in the neoclassical synthesis, financial markets are easy to romanticize; buyers and sellers reacting almost instantaneously to minute price changes that are supposed to reflect all of the available information on businesses, about which neither buyer nor seller has to know anything at all. This simulated perfect market lent itself to the mathematical models needed to gain tenure and win Nobel Prizes in economics. And global investors, like neoclassical economists, are free-traders, indifferent to where exactly investment goes, so long as it maximizes what economists call efficiency -- and financiers call profit.

A dowry helped. Wall Street firms contributed funding to friendly economics departments and think tanks and gave consultant contracts to economists to build models showing that their exotic derivatives were low-risk bargains.

On the other side of the debate, support for industrial policy within the Carter administration came from the departments of Commerce and Transportation, and the Labor Department where economist Ray Marshall, an institutionalist from the University of Texas, was secretary. Their allies outside the government included the AFL-CIO and CEOs of several industrial corporations, such as Ford, Cummins Engine, RCA, and Bendix. Though most of the business press was skeptical, the editors of Business Week were friendly. Even a few Wall Street mavericks joined up. Felix Rohatyn, of Lazard Freres, commented that "the thought that this nation can function while writing off its basic industries ... is nonsense." Vice President Walter Mondale was very sympathetic.

Carter himself seemed conflicted. Ideologically, he was a free-marketer, a sentiment that the aggressive Schultze skillfully exploited. On the other hand, as an officer in the Navy's nuclear program to power submarines, he had been involved with long-term strategic planning, and he certainly understood the role of government in maintaining his family's peanut business.

But Carter never quite grasped that the great and tragically aborted cause of his administration -- a long-term alternative-energy policy financed and nurtured by government -- was, in fact, industrial policy.

Still, had Carter won a second term, manufacturing and energy policy might have been integrated, which could have significantly changed the direction of the U.S. economy over the last 35 years. At the very least, the country would be way ahead of where it is now in the development of green industries, energy-efficient transportation, and a 21st-century work force. It would likely have a much smaller trade deficit and foreign-debt burden. And having a Democratic Party conscious of the importance of a healthy domestic industrial base could have prevented the Clinton administration from later making two decisions that undermined the long-term health of the U.S. economy -- the deregulation of finance, which shifted growth from production to overleveraged consumer debt, and the abandonment of U.S. industry to unwinnable competition with low-wage Chinese mercantilism.

But it was not to be. Following the advice of his Brookings economists, Carter went into his re-election year with back-to-back recessions and double-digit inflation. Upon becoming president, Ronald Reagan immediately ripped out the solar panels that Carter had installed in the White House. Industrial policy was dead.

A brief hope for its revival flickered when Mondale announced his bid for the 1984 presidential election. But surrounded by the Wall Street/Brookings crowd, Mondale abandoned industrial policy in favor of a macroeconomic attack on Reagan's deficit spending. He proposed a tax increase to balance the budget -- and was obliterated at the polls.

By the next presidential election, industrial policy among Democrats had shrunk to Michael Dukakis' proposals to subsidize high-tech research and development. This was ideologically more acceptable. But without a manufacturing policy, it was perverse. Subsidizing new ideas that are then outsourced for production only further undercut U.S. manufacturing competitiveness.

The end of the Cold War seemed to provide another opportunity to shape the country's industrial future. In the campaign of 1992, Bill Clinton promised government help to redirect the technological resources and talents of the military-industrial complex to work on such civilian projects as medical technology and high-speed public transportation. When he selected Laura Tyson, who had studied under Thurow and been an industrial-policy advocate at the University of California, Berkeley, to chair his Council of Economic Advisers, mainstream economists went apoplectic.

But they had little to worry about. Clinton quickly abandoned his promised conversion policy. Tyson just as quickly accommodated herself to the center of economic-policy gravity in the new administration -- the partnership of Goldman Sachs' Robert Rubin and Harvard's Larry Summers. Under Clinton, economic policy was reduced to cheap money, tight budgets, and free trade. Seeing the writing on the wall, U.S. manufacturers accelerated their flight to factories overseas.

Today, despite the catastrophes they have engendered, the Wall Street?-Economics Department bond remains tight. Summers is back as Barack Obama's chief economic adviser, and his indifference to manufacturing's fate is more than matched by his enthusiasm for bailing out bankers and brokers.

So, what lessons from this history might we draw today, for what may be our last chance to escape a future in which we can only compete globally by lowering our wages?

First, the revitalization of U.S. manufacturing must be linked to the pursuit of national goals so that people can understand the stakes involved. Two in particular are especially resonant: the transformation to an energy-efficient future and the reduction of our trade deficits and our massive and relentlessly growing foreign debt. Neither of those widely understood objectives can be achieved without a robust and competitive manufacturing sector.

Second, the goal of industrial policy cannot be bigger profits for hollowed-out companies with American names but the enhancement of U.S.?based production.

Third, economic policy-making must be open to skills other than macroeconomics and hedge-fund trading. The history of industrial policy reminds us that the future of the American economy is much too important to be left to financial speculators and the economists who give them cover.

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