Post-Crisis Industrial Policies: Facilitation of corporate metabolism should be the target

The global financial and economic crisis that began in the autumn of 2008 prompted governments across the world to implement financial and fiscal measures to restore stability in the financial markets and boost aggregate demand. At the same time, they have introduced various support measures to help industries and companies to weather the crisis. In Japan, the government recently adopted the New Growth Strategy (Basic Policies), a policy package which includes a range of measures targeted at specific industries such as environment and energy, health, and tourism. I participated in a symposium on " Industry Related Government Policy and the Global Economic Crsis " held in December 2009 (under the auspices of the Research Institute of Economy, Trade and Industry). Drawing on what I have gathered from discussions with fellow participants at the symposium, i.e. practitioners and experts both from Japan and abroad, I would like to provide my personal view regarding government's involvement in the economy.

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From the mid-1980s through early 1990s, Japan's industrial policies attracted much attention from researchers both in Japan and abroad. Works resulting from research efforts during this period include Nihon no Sangyo Seisaku [Industrial Policy of Japan] by Ryutaro Komiya et al. Meanwhile, I conducted empirical research on the effects of tax policies and the fiscal investment and loan program (FLIP) during Japan's high growth period. Through those research efforts, it became apparent that there exist various market failures that may be effectively corrected by industrial policies. It was also found that the role of industrial policies in fostering Japan's postwar high growth was not as significant as generally believed. Subsequently, theories suggesting the effectiveness of industrial policies were refined with respect to the assumptions underlying these theories and limitations in applying them to real world situations, which culminated in the new industrial organization theory and the new trade theory.

Meanwhile, Japan's industrial policies came under fierce attack from the United States. In the course of the Structural Impediment Initiative (SII) negotiations or elsewhere, the U.S. criticized these policies for being intended to promote specific industries and unfairly improve their competitiveness in the international market. Against this backdrop, the Japanese government became circumspect about implementing industrial policies. While the government proceeded to pursue policies that are market-oriented and emphasize private-sector initiatives, Japan's economic bubble burst and its economy entered into the prolonged recession. Under these circumstances, interest in industrial policy subsided.

More recently, however, there has been a resurgence in interest in industrial policy. For instance, in the field of development economics, Harvard University Professor Dani Rodrik emphasized the importance of industrial policy in developing countries. At the Annual World Bank Conference on Development Economics (ABCDE) held in June 2009, "Industrial Policy and Development" was one of the main themes. In reality, the governments of the U.S. and advanced European countries have had various industrial policies in place, including subsidies for technology development and support measures for small and medium enterprises (SMEs). What has changed following the global economic crisis is that they are now pursuing new kinds of policies that focus on specific companies and industries.

In the U.S., the government purchased shares in General Motors and Chrysler after they ran into financial difficulties. Under the American Recovery and Reinvestment Act of 2009, the U.S. government has introduced subsidies for the development of electric vehicle batteries and tax credits for the purchase of plug-in hybrid vehicles.

In France, the national Strategic Investment Fund (abbreviated as FSI and also referred to as Sarkozy's fund) was set up to invest in the nation's key industries. Specifically in support of domestic automakers, the French government has been offering investments, loans, subsidies, and debt guarantees in exchange for their commitment to the development of environmentally-friendly vehicles. Germany expanded loans through the state-run KfW banking group and enhanced a debt-guarantee system to support key industries such as shipbuilding and automobile, in addition to subsidies for new car purchases and the implementation of a "bad bank" program to relieve ailing banks of bad assets. Japan has also put in place a series of measures. Apart from those designed to stabilize the financial markets such as the provision of emergency loans, these measures include: the purchase of shares in Elpida Memory Inc. by the state-backed Development Bank of Japan as provided for under the revised Act on Special Measures concerning Industrial Revitalization and Innovation (Act No. 131 of 1999, as amended), incentive plans to promote the purchase of environmentally-friendly vehicles and electric appliances, and support for open innovation in such areas as environmental energy and biotechnology through the establishment of the Innovation Network Corporation of Japan (INCJ). As a more recent development, support measures are currently under consideration for the faltering Japan Airline Group (JAL), by way of equity investment through the Enterprise Turnaround Initiative Corporation of Japan (ETIC), which is a government-backed company.

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Industrial policies implemented in each of these countries are a mixture of temporary support measures to help businesses running into financial difficulty due to significant exogenous shocks and forward-looking measures focusing on potential growth areas. Emergency support measures are warranted in cases where otherwise viable businesses are suffering a sharp drop in sales because of such exogenous shocks. However, continuing support to declining industries is tantamount to prolonging the life of structurally declining businesses, often referred to as "zombie" companies, with the resulting outcome being a greater fiscal burden and a delayed shift in the industrial structure.

This indicates that an increasingly important role will be played by those capable of scrutinizing and discerning industries and businesses strictly from the viewpoint of specialists. In providing support to JAL, it is important for the government to have the troubled carrier draw up a viable business strategy, one that would render a competitive edge over overseas rivals, and only then move to help rebuild its business. It also needs to be remembered that such support measures, if not designed to contribute to the growth of the Japanese economy, would be short-lived in their effect and result in an increase in fiscal deficits.

Government policies implemented in the wake of a crisis tend to be a mixture of wheat and chaff because of time constraints and the urgency of the situation. However, despite this drawback, the Lehman shock has led to renewed recognition among policymakers across the world of the need to implement financial support in the event of a liquidity crisis induced by a huge external shock. But now that the world economy has bottomed out thanks to a host of emergency measures implemented by governments around the world, it is about time to make a sober assessment and screening of policies.

For instance, temporary measures to support financial firms, industries, and companies stricken by a financial crisis have been implemented because financial markets were thrown into turmoil by macroeconomic shocks resulting from the dysfunction of financial markets - i.e. market imperfection in the provision of accurate information - or attributable to the provision of securitized financial instruments carrying excessively high risk. Drastic changes in the economic environment, as has been the case in the recent crisis, increase uncertainty for businesses and industries particularly regarding their future potential. Under such circumstances, the key question is how to build in a mechanism for scrutinizing and discerning policies in the policymaking process as discussed above.

As a provider of such a mechanism, those engaged in corporate revitalization, a line of business that has developed in recent years. Performing an assessment of assets and pushing forward business restructuring, corporate revitalization professionals remove uncertainty about the future of its client company and of the industry concerned, thereby helping improve the overall market environment. That is, they are playing the role akin to that of public policy. In providing emergency loans to SMEs, it is extremely important that decisions are made by "discerning eyes," i.e. the loan examiners at quasi-governmental financial institutions in charge.

Government policies, depending on what areas are targeted and for how long, could end up undermining the market function of facilitating corporate metabolism, as exemplified by the aforementioned zombie problem. In other words, there exists a trade-off relationship between short-term goals that need to be addressed by certain government policies and long-term efficiency that may be undermined by such policies. Meanwhile, in designing and implementing government policies, careful consideration should be given to the potential effects of incentives so as to prevent support measures from creating a moral hazard. In this regard, the loan guarantee program in France is designed to cover up to 70% of a loan amount. Likewise, Germany limits the guarantee to 80 to 90% of a loan amount. Providing a 100% government guarantee for loans could undermine private-sector banks' ability to screen loan applications.

The same holds true for support measures targeted at areas with long-term growth potential such as solar power generation, environmentally-friendly vehicles, and bio-pharmaceuticals. Environmental problems are a textbook case of market failure. It is also well known that in the area of research and development (R&D), where significant social benefits can be derived from the spillover effects of technology, market failure often occurs in the form of underinvestment. Meanwhile, in newly emerging growth areas, government authorities and businesses would need to collaborate with each other in various aspects ranging from the development of relevant infrastructure and the promotion of standardization to the education and training of human resources. Thus, such areas are prone to coordination failure.

Some countries are striving to win recognition as a world standard for their home-grown technologies or to reform the mark-to-market accounting rules to make them more compatible with the customary practices of companies in their countries. Against this backdrop, there have been calls in Japan for cooperation between the government and the private sector. Another point in question is what approach should be taken in implementing policies in order to maintain organizational efficiency. For instance, the aforementioned INCJ has been established as a temporary organization that is independent from the government. It has been designated to recruit a wide variety of discerning specialists to ensure the right investment decisions are made. However, where human resource mobility is not high enough, a temporary organization would not be able to attract top level people, rendering institutional plans futile, regardless of how ingenious they might be.

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The recent financial crisis served as an opportunity for renewed recognition of the role of the government. However, given the enormous size of Japan's fiscal deficits, it is essential to introduce private-sector funds, specify the duration of time for the policy implementation organization to remain in operation, and perform an after-the-fact review of the cost-effectiveness of policies. To that end, it is necessary to establish a system that ensures information disclosure and thus allows for a quantitative analysis, not only of the short-term effects of policies but also of their long-term effects, which would promote economic growth in the future.

In light of Japan's current fiscal situation, the government cannot afford to support declining industries. Government policies must be in line with the nation's long-term growth strategy and limited resources must be directed to areas that will lead to an increase in tax revenue in the future. We need to reinvigorate economic growth to increase tax revenue by implementing efficient policies at minimum costs through the combined use of public and private-sector funds, a scheme in pursuit of a small government. The government's forward-looking support in the form of growth strategy is a crucial prerequisite to achieving that end.

>> Original text in Japanese

* Translated by RIETI.