Kelvin Teo
The 2008 Financial Crisis has revived interest in the Austrian School of economics, particularly the boom-bust cycles or the Austrian Business Cycle theory (ABCT). The Austrian economists were for their part spot on in their prediction of the crisis in comparison with peers from the other schools of thought. What brings about the boom phase in a nutshell? It is when central banks lower interest rates and increase money supply through a phenomenon known as fractional reserve banking (the explanation for increasing money supply through fractional reserve banking is in the box below, appended from a previous article).
Suppose the central bank has a sum of $10,000. The bank keeps a certain percentage of this sum of money, say 10% as cash reserves. Thus, it will have a cash reserve of $1000, and the other $9000 will be loaned out and deposited into a member bank. The member bank will keep 10% as cash reserves and loan out $8100 which will be loaned to another private bank. This private bank will keep 10% of the $8100 as cash reserves and loan out $7290 to another bank. Thus, this process of storing a fraction of deposits as cash reserves and loaning out the rest goes on. The total money supply is the summation of deposits ($10,000 + $9000 + $8100 + …. and so on)
Increasing money supply, in fractional reserve banking
Lowered interest rates and increase of money supply will create a hype among entrepreneurs who take up loans and invest in projects in order to gain an edge over their rivals. However, they are limited by their ability to predict future patterns of demand, and there will come a time when the realisation hits that such projects are not feasible, and will be aborted. This is known as malinvestment and we are now in the bust phase of the cycle.
The interest in this article is not so much with the ABCT of boom-bust cycles, but rather to critically examine the topic of industrial targeting policies by governments using ideas from the Austrian school.
Government-sponsored industrial targeting policies can very much bring about the same boom-bust effect as that covered in the ABCT. In fact, the anatomy of a boom brought about by industrial targeting policies is similar to that in traditional ABCT, except that the main players involved are completely different. In ABCT, the main actor is the central bank creating a hype among the entrepreneurs. In government-sponsored industrial targeting, a particular industry is targeted with the projection that there will be a demand for its goods and services when established. As such the government hypes up the industry, promoting it to entrepreneurs and providing capital for their venture into the targeted industry. Entrepreneurs respond to the hype, investing in projects with government-provided capital and loans from banks. This represents the artificial boom phase of the cycle created by the industrial targeting policy.
The issue and criticism faced by the entrepreneur is similar to that faced by the one in ABCT – is he able to predict future patterns of demand for goods and service provided by the industry that he is venturing into? Will the project that he is investing in end up as malinvestment when the realisation hits that there is not much of a demand for the goods and services provided by his project venture? For the larger picture, and one for the government targeting a particular industry to consider is whether the resources they dedicated to this venture could have been used for more efficient and profitable purposes, in areas where there are likely to be real demands, as decided by the market out here.
Consider this scenario. A special type of mushroom (fungus) happens to grow well within a country with limited land space but having the right mix of soil and climate. There is local and global demand for the mushrooms, with revenues generated from local market and exports overseas. Now, there was a worldwide outbreak of bacterial infection and the government of the country has targeted the pharmaceutical industry to venture into, with the goal of producing antibiotics to treat the bacterial infections. Land that otherwise could be used for farming the mushrooms is cleared to create space to establish a pharmaceutical hub. The government of the country hypes up the pharmaceutical industry and promises of good returns from the production and sale of antibiotics that can treat bacterial infections. The government also provides funding for entrepreneurs to start up their ventures.
Thus, the entrepreneurs invest in projects with government funds and bank loans and establish a wide range of companies ranging from antibiotic drug screening, antibiotic drug discovery and antibiotic drug synthesis. This is the boom phase generated by the government hype. However, somewhere down the track, it is discovered that improved hygiene, use of alcohol sprays, antiseptic soaps and washes reduced the incidences of bacterial infections. Dwindling rates of bacterial infections drastically reduced demands for these antibiotics. The entrepreneurs soon realise that such projects are not feasible in light of the much less than expected demands. As a result, they are aborted. This is now the bust phase of the cycle.
From here, there are two possible courses of action for the government to take – to continue to sustain the pharmaceutical hub that it has funded by continually injecting funds usually from tax payers’ money, or to allow the firms within the hub to undergo a natural course of liquidation to free up resources that can be otherwise used for more efficient purposes. Continuing to inject funds to sustain the hub is not considered a corrective mechanism if the market demand for its products and services remains below expectations. In any sense, it is just delaying the eventual liquidation course.
This scenario represents an example of a government industrial targeting policy resulting in a boom-bust cycle. Besides the eventuality of a bust, the other issue facing such a government is that of opportunity cost. In the earlier scenario, limited land that could otherwise be used for mushroom farming is set aside for building the pharmaceutical hub instead. Thus, the opportunity cost is lost revenues from the sales of the mushroom. This is specifically known as the opportunity cost in production.
The situation could be even worse when the hype results in residents of the country pursuing education and training related to the industry targeted by the government. Residents who are influenced by the hype pursue training programmes in the pharmaceutical sciences. However, when the bust comes about especially during the liquidation phase, there will be unemployment, and in these cases, structural unemployment will result because such workers lacked skills in other areas besides the pharmaceutical field; and where there are actually demand for workers from other sectors, especially for those possessing skills from other domains.
Government-sponsored industrial targeting can have the same effect as ABCT in generating booms through hypes and funding of projects by entrepreneurs, followed by busts when these projects are no longer feasible. Whilst in most cases, governments may have the best of intentions for their countries in placing bets on industries that will hopefully be future engines of economic growth, the adverse effects of such a venture may make a country worse off. What makes the country worse off is attributed to misallocation of resources which could otherwise be directed towards more efficient and profitable purposes, lost revenues as a result of opportunity costs and increased unemployment during the bust phase, of which structural unemployment is the main culprit as workers are trained in roles within the targeted industry by the government and lack skills for other jobs where there are demand for workers.
Sometimes, a hands-off approach in allowing the market to decide what it wants results in a better outcome than intervening against the desire of the market.
Photo courtesy of ifmuth, Flickr Commons
Sure, some government interventions lead to bad outcomes. However, bad entrepreneurs (a.k.a. the free market) can make bad decisions equally well. The premise that governments are incompetent, and will do much worse than the private sector is inconclusive from the article. It may well be false in reality. I don’t think you have named sufficient evidence to support this claim.
Jonas, industrial targeting, you are referring to a bet on an entire industry, whereas in the private sector, you can have multiple entrepreneurs.
Prof Linda Lim from Uni of Mich did commented once, multiple entrepreneurs, they pour in their own resources, some may win and succeed, others will not and be liquidated.
Joseph Schumpeter, described the concept of creative destruction, where innovation is the key. More nimble, more innovative entities will have advantage.
Entrepreneurs tend to be more nimble, and there is a drive to innovate
Prof Linda likened a government-vehicle placing a huge bet as a big aircraft carrier..one topedo and it can sink. Entrepeneurs, on the other hand are what she described as smaller, and nimbler gun boats.
When the carrier sinks, the economy may go down with it. However, for gunboats, some float some sink, but u will not sink an entire economy.
Hi Jonas,
Thanks for your posting. I think you probably need tweaking in framing your question.
If you are interested in issues of private versus government sector, your earlier comment is more appropriate for this article. http://newasiarepublic.com/?p=32838
Keynes and Hayek debate is an illuminating example of such.
In my article, I wasn’t so much into private and public sector comparisons. In the example, when I described government-related hyping of an industry to entrepreneurs, you can infer a collaboration of private and public sector, government and entrepreneurs in my article. That is why I said industrial targeting can create the same boom bust cycles, as governments assume the role of central banks, analagously creating hype, which the entrepreneurs believed and jumped on the bandwagon.
Note this paragraph:” In fact, the anatomy of a boom brought about by industrial targeting policies is similar to that in traditional ABCT, except that the main players involved are completely different. In ABCT, the main actor is the central bank creating a hype among the entrepreneurs. In government-sponsored industrial targeting, a particular industry is targeted with the projection that there will be a demand for its goods and services when established. As such the government hypes up the industry, promoting it to entrepreneurs and providing capital for their venture into the targeted industry. Entrepreneurs respond to the hype, investing in projects with government-provided capital and loans from banks. This represents the artificial boom phase of the cycle created by the industrial targeting policy.”
I think you probably may have understood this article differently from end phrase “Sometimes, a hands-off approach in allowing the market to decide what it wants results in a better outcome than intervening against the desire of the market.”.
I used the word “sometimes”, not all the time, and it is a statement of fact. Don’t you agree that sometimes, the government should just let the market do its job?
And to address you on the performance of government linked entities, there are actually literature describing poor performance of government-linked entities. The one that I attach is the GLCs of malaysian government
https://www.econstor.eu/dspace/bitstream/10419/49040/1/665970951.pdf
@ Johann
Yes, I have come across some of the rhetoric for free enterprise and laissez-faire economies as opposed to direct government intervention.
The author noted that bad business decisions (or over-investment) results in the boom-bust cycle, first postulated by the Austrian school. Government funding for private enterprises tends to be large, hence a mistake will aggravate the boom-bust cycle.
In fact, I would argue that a loss-making government initiative would be more counter-cyclical in the short term compared to a corporate group with a profit motive. If job security and economic stability are social objectives worth pursuing, then a laissez-faire economy is the anti-thesis of these goals.
Isn’t that better than providing unemployment insurance for those routinely unemployed by failed ‘entrepreneurs’?
Jonas, I have a curious question for you, if you think a loss making government initiative is an effective countercyclical tool, then my question to you is who will foot bill for this government initiative?
You cannot expect citizens during a crisis to be paying taxes, even if you consider progressive forms of taxation..they would have received salary cuts..or regressive taxation like VAT/GST, they would have reduced consumption.
In fact, I actually have a research to show that rather than government spending, tax cuts is a more effective countercyclical tool.
There is taken from an analysis of how Asian countries coped with the crisis from the Asian Development Bank -
http://www.adb.org/documents/working-papers/2010/economics-wp211.pdf
Hi Kelvin,
Thanks for responding.
I disagree with your conclusion that governments should consider adopting a hands-off approach, until I noticed you said ‘sometimes’. Perhaps the two of us are on the same page.
Then on closer inspection, I realize you oppose even indirect interventions like industry promotion on top of direct interventions in the economy through state-controlled enterprises.
I stated in my first comment that bad decisions are not the sole domain of governments – the private sector has lapses in judgment too.
In your example, the entrepreneurs in the pharmaceutical industry did so without being coerced. How is it the fault of the promoter (which in this case is the government) when commercial failure resulted from the biomedical entrepreneurs’ decision?
If you are referring to the collective impact of industry promotion (hype as you call it) and favorable funding terms, yes I agree this creates a distortion in the economy as resources are being redirected.
There is a price to pay for government intervention in the form of industry targeting. The social and economic goals achieved through success should be weighed against the consequences of failure. You made your point on the possible consequences, that boom-bust cycles are exacerbated.
I am suggesting the issue be reframed and viewed from a different perspective: Are failures of government interventions more devastating to the economy than private sector failures? Is the facilitation and financial support of a commercial activity (industry targeting) misguided because it was the government, and not the private sector that initiated it? Suppose the government had social and economic goals that ultimately benefit citizens, isn’t it ‘sometimes’ worth the risk?
Hi Jonas, thanks for your reply. With regards to socio-economic goals, the problem is again the issue of perfect info, can the government really predict what is right for citizens at a later time?
One of the main reasons why governments promote industry(s) that i can recall comes from Krugman’s New Trade Theory where they hope to produce world class national by specialisation industries.
I sometimes think from a libertarian perspective, is governments is really necessary if we want to pursue social and economic goals? I mean there are Non government orgs, private enterprises, capable of filling the gap.
Hello again Kelvin,
Thank you for the links. To respond to your earlier points:
1) Who will foot bill for this government initiative?
Taxpayers naturally. These include residents and profitable corporations, and money is collected in the form of direct and indirect taxes. Industrial targeting creates jobs and a skilled workforce in the field where there is none. Wage earners pay income and consumption taxes and contribute to the economy. If it does not pay for itself, it is a social cost bourn by taxpayers. Some taxpayers, aka citizens, decide on aggregate whether they like existing economic policy (among others) via the ballot.
2) Claim: Tax cuts are better counter-cyclical tools
No comments on the above-mentioned claim. If you can make a case for tax cuts in another article, you may find me here in the comments section.
With regards to the ADB paper, I would like to highlight that methodology matters when inference are drawn from the conclusions. Impulse fiscal stimulus (defined roughly as one time spending programs during economic downturns) naturally will not work well in open economies. This study ignores sustained fiscal spending for economic programs, which may include industrial targeting (for direct intervention). Hence, such government programs should not be invalidated because of an empirical study that does not specifically address this.
3) Can the government predict what is good?
Anecdotal evidence have shown that corporations can be colossal failures too. Unless you wish to bring up the failures of central planning within the Soviet Union. Industry promotion is a ‘soft touch’ approach to kick-start industries by creating critical mass, it can hardly be considered central planning. It is the corporations that decide what it will take to get things started, and the government that decides if the terms are worth it.
When things give way, people suffer lasting consequences. Don’t just blame governments. Blame TBTF megabanks, fair-weathered MNCs and fly-by-night startups.
4) Is it necessary for governments to pursue social and economic goals?
No. But will doing nothing lead to a 5-8% ‘natural unemployment rate’ faced by the democracies in the western world? If this is true, would you still advance the libertarian cause? Do you truly believe in the fable of heroic innovators hidden away in Galt’s Gulch would suddenly be unleashed upon the world and take up the slack when governments fail?
Who else, other than those we can influence via the ballot, even if they do it badly?
Dear Jonas:
You see, that is the issue, if you say tax payers foot the bill, the issue is that during the bust phase of the cycle, there will be unemployment and salary cuts. There is a drop in overall production, so how much tax can the government collect? And again, government spending as a countercyclical tool has to be carefully managed, countries do end up with sovereign debts after financial crisis, that is they end up borrowing externally to fund their countercyclical programmes.
I can see the merits of tax cuts. An across the tax cut will have an immediate impact, businesses pay less tax, people pay less tax and more to consume.
Even if you talk about spending and prolong (sustained) spending by the government even industrial targeting, how sure of you of the trickle down effect? Yes, the government invests in certain industries, but how sure of you that the money will eventually tricke down to all. Do sustained spending alleviate the problem?
If it was a flavour of the day industry, say pharmaceutical sciences, and the government continues to target, how sure are you of the trickle down effect?
That is why I argue that tax cuts is a better countercyclical fiscal tool. Impact is immediate and benefits all and sundry, individuals and businesses.
Industrial targeting, government spending on stimulus packages may not benefit everyone.
Hi again Kelvin,
I do not think there are fiscal packages that benefit everyone, other than the notorious pre-election “Grow and Share Package”.
I initially thought tax cuts wasn’t related to the issue of industrial targeting, so I refrained from commenting.
Now you have related tax cuts as a more equitable and direct benefit to people (everyone, you say) compared to industrial targeting, which benefits some, I feel the need to respond.
1) Tax cuts does not benefit everyone, nor does it ‘trickle down’ anywhere other than the profits of captive banks and corporations
It primarily benefits employed persons and profitable companies, who get rewarded for choosing to work in a stable profitable company (like SMRT).
When there is an economic downturn, companies in cyclical industries and those with high operating leverage slip into the red precisely because product demand and product prices collapse, causing an avalanche impact on the topline corporate performance.
Neither unemployed people nor temporarily unprofitable corporations facing cyclical pressures would benefit from tax cuts.
2) Industrial targeting also does not benefit everyone, but it benefits more than just the companies targeted
When an nascent industry starts up, there is growth in demand of ancillary services to support the industry, especially when offshoring of such services is not feasible. For instance, it was claimed that the ‘Integrated Resorts’ will bring about a broader economic benefit to the economy in terms of business and family tourism dollars.
Every initiative has its own unique dynamics. As for SG promotion of pharmaceutical sciences, you may be a better person to judge. If you elaborated about what is wrong with the way it was promoted, or whether it should have been promoted at all in another article, I would be inclined to comment if I grasp the dynamics of the industry.
So policies never benefit everyone, or everyone equally. There are benefits of industrial targeting that should not be dismissed, even if governments screw up sometimes. As if private corporations in the western hemisphere do not screw up either.
Dear Jonas:
To clarify, I mentioned tax cuts in the context of countercyclical fiscal tool. You say it does not benefit everyone, I probably respectfully disagree and will probably cast the issue of how much benefit each and every agent or entity derives. In the context of tax cuts, I am referring to progressive and regressive tax cuts. Regressive being GST or value-added tax. Of course, those industries that are more or less protected from busts like the medical industry will derive the most benefits, as compared with businesses hardest hit by the reduction in consumption. Yes, it benefits everyone. For example, all of us know that a regressive tax increase affects poor the most. A cut in regressive tax will reduce their expenditure on consumables. So yes, tax cuts benefits all, though some more than the others.
I believe we are on the right page as regards to who benefits from industrial targeting. With regards to Singapore’s promotion of pharmaceutical sciences, I am not too sure if the government ever did. They were aiming for biomedical, biotech and drug discovery research as a whole, as in the generalised target. My article is just a hypothetical scenario, nothing to do with Singapore. We were never mushroom farmers as my scenario suggests.
I do not disagree that private corporations screw up. The issue is that a what a previous poster commented, in the example by Prof Lim from the University of Michigan, government entities making a huge bet is like a huge carrier ship, one torpedo and the whole ship sinks, dragging the economy down with it. For private corporations, it is an evolutionary struggle, some die, some prosper, but they are less likely to drag down an entire economy with it.
To revisit the point on industrial targeting, it appears to me it has some roots in Krugman’s new trade theory, a bid to establish and protect nascent industries that will grow into the world stage as national by specialisation industries. But many variables will ultimately affect the relevancy of such industries, e.g. competition, consumer interests, etc. Yes, Toyota may be a success story from the Japanese government’s protection of nascent industries, but the odds of failure could be high too.
My personal take is that I am not too into industrial targeting, I am for what they are doing in Taiwan, where the government runs and funds institutions that conduct research into emerging technologies. They will be transferred to entrepreneurs or the private sector who are familiar with the best way to package such products. In this case, the government does not set the direction into what products to aim for. The institutions will rather welcome innovative research of any form by engineers and scientists. The institution should also seek to establish ties with entrepreneurs and other industries. From there, the entrepreneurs will take over and commercialise the products. I must emphasize that the government here SHOULD NOT set the direction of research, it is more of a facilitator in building and running these research institutions.
Agree that permanent cuts on VAT would benefit residents and businesses. VAT retards consumption and economic activities conducted domestically. However, releasing a constraint on consumption and investment does not necessarily mean it is a countercyclical tool to cushion economic cycles. It simply reduces government receipts, and puts more money into the pockets of residents and businesses. Consumption and investment decisions may be based on job market and business sentiments, and more money in the pockets does not mean companies and households will spend or invest more during an economic downturn. It is doubtful if additional liquidity in the monetary system would fund productive activities or fuel speculative asset bubbles.
By sustained fiscal spending, I mean either directly through state-controlled entities or government interventions such as venture funding and subsidies to favoured industries. These measures are at least one level off from industry promotion, but I suggested these as means to cushion economic cycles (in order to support social goals such as full employment). Is it equitable? Not really, but worth considering if economic stability (the thrust of your article) gains priority. Even Hayek despaired about how the free market failed to correct the Great Depression.
On the ‘carrier’ analogy, all eggs in one basket may be risky, but scale and scope is how corporations gain competitive advantage. Doing many things relatively well, yes if a company or an industry fails, it will not bring down the house, which I agreed in an early comment. But will it lead to the growth of an exportable product or service industry capable of competing globally? Industrial targeting is a measure to direct entrepreneurs to that end, usually a worthy goal and should not be dismissed because of its associated risks.
I am not against industrial targeting and tend to be slightly in favour for it. My only concern pertains to the stewardship of such initiatives – how decisions were made, and the economic impact of these initiatives. When public money is spent, one should consider commercial feasibility and quantifiable outcomes like most of the private sector. With research-based industries like emerging technology and life sciences, the dynamics can be entirely different in nature and warrant a separate discussion.
You may be right to say that governments should not set the direction of research, but ultimately it may suffer from a lack of focus and not do enough to grow a nascent industry. Therein lies the reason for the divergence of our conclusions. You prefer a system that provides handouts to anyone with an idea (like your example Taiwan), whereas I prefer a system that provides handouts to entrepreneurs with similar ideas to create scale, scope and network effect in order to engineer a national competitive advantage.
In both systems, accountability is crucial because bureaucrats are dealing with public money. In practice, it would be a challenge to provide venture funding for varied fields when the funding organization does not have the right person with relevant specialization to assess the ideas’ commercial viability. Furthermore, with targeting, the government is attracting ideas not just locally, but on a global scale if the marketing is done right.
Where there are good ideas outside the targeted industries, private venture capital will fill the gap and governments cannot be justified to compete with seasoned financiers on multiple fronts.
Ok, I think I overdid it there. I know NAR has a pro-libertarian bias, but respectfully I think pure ideologies are difficult to advance. Industry targeting and promotion in our nation’s context, is an improvement from the authoritarian, state-directed stance taken by the Party over the last 50 years. Perhaps I may suggest aiming criticisms on the weakest and most controversial elements of the current system.
There are many weaknesses of the national socialist ideology that, when exposed can perhaps help promote a shift in opinion towards a freer market. Depending on how aggressive your paper is, perhaps you can focus your attention on the problems of collusive behavior among firms, high dependence on domestic markets (weak export capabilities), influence of business costs such as labour and commercial space, political party/family influence on GLCs through amakudari practices distorting risk taking (do nothing, or bet the house and expect bailout) and innovation. Once people see the establishment’s excuses as untenable, they may gradually agree with your call and support a freer market. You should not take it for granted that people should naturally support the free market; it is sometimes against their interests.
My take is that SG is largely organized as a national socialist state, hence in terms of economic ideology it is on the far right, as is libertarianism. Only problem with free trade and laissez-faire, private businesses care about survival and profit motive, and will tend to deploy where it can obtain the lowest costs for factors of production. And while the SG government and GLCs also care about survival and the profit motive, they can squeeze the local inhabitants (citizens and FTs) but jobs and the company operations stay rooted here as they cannot get their monopolistic / oligopolistic profits elsewhere in the world. Hence from a cursory standpoint, people see status quo as the lesser of the two evils.
Furthermore, a free market does not happen immediately. An innovative entrepreneurial class is generally missing from our economy (all hiding in Galt’s Gulch?) and may never emerge strong enough as an alternative (like our alternative political parties) to the economy if situations do not improve. And as long as this is so, libertarianism will have few supporters from the common man.
Unlike good political parties, profitable private businesses rooted to the nation are more likely to uplift the masses with good jobs. SG needs to be discerning about businesses it promotes.
Finally I apologize if I sounded like an asshole. People tend to dispense with social norms online, I like to think I’m a much nicer person in real life. Good luck and looking forward to good articles from you and your team.
Dear Jonas:
Actually it is fine. We have Keynesian leaning writers too. Not all of us subscribe to the Austrian School.
Thanks for clarifying. Perhaps I shall start reading from the paper’s first post to notice.