The Infant Industry Argument And Its Relevance For Industrial Policy In The European Union

Volkswagen plant in Wolfsburg, Germany (photo by VW_Werk_Altes_Heizkraftwerk.jpg: Richard Bartz derivative work: Diliff via Wikimedia Commons)

A white paper released by the British government in 2017 described the United Kingdom as an "open, liberal market economy", whose foundation lies in "the power of the competitive market - competition, open financial markets, and the profit motive". Despite recognizing the government's "strategic power and leadership role" in developing and disseminating technologies and industries, the white paper rejected protectionism and equated industrial policy mostly with Research and Development (R&D), education and infrastructure.

Nowadays there is a widespread belief that countries develop because of "free market". Therefore, economically poorer regions, such as Greece, southern Italy or Portugal, are responsible for their own poverty, either because of their cultural shortcomings, or because of corruption, or because of too much government intervention - laissez-faire advocates argue. As a result, there is nothing governments can do to help their population except for voluntarily reducing the size of the government itself so that the unfettered, self-balancing market may work unhindered.

This view, however, is flawed. In this article we shall discuss the so-called "infant industry" argument, which explains how industries develop thanks to government protection and assistance. We shall argue that the infant industry strategy should be studied and applied to help poorer regions of Europe develop their manufacturing sector.

The Rise Of English Industry And The Role Of Government

Between the end of the 18th century and the first half of the 19th century the United Kingdom achieved an unprecedented degree of economic supremacy. By the 1850s Britain produced between 50% and 60% of world output of cotton, iron and coal. In 1880 it accounted for 41% of the world's manufacturing exports. In 1913 per capita income in the UK was about 30-40% above the level of France and Germany (David Greasley and Les Oxley, Competitiveness and Growth, in: The British Industrial Decline, ed. Jean-Pierre Dormois and Michael Dintenfass, 1999, p. 76). Between 1750 and 1860 the British share of world industrial production rose from 2% to nearly 20% (Jeff Horn, The Industrial Revolution: History, Documents, and Key Questions, 2016, p. xxiii).

Textiles were at the centre of Britain's industrial development. In the mid-18th century textiles and clothing made up almost half of British manufacturing. Between 1770 and 1841 British output of cotton textiles grew 125-fold (Joel Mokyr, ed., The British Industrial Revolution: An Economic Perspective, 1999, pp. 166-167).

But how did Britain achieve such astounding development? Many factors have been taken into account, including Britain’s geographical location, its expanding overseas trade network, technological innovation, key natural resources such as coal, supply of capital for investment, supply of cheap labour, risk-taking entrepreneurs etc. (see Lee T. Wyatt, III, The Industrial Revolution, 2009, p. 40). However, here we want to point out one aspect of British industrial history that is often neglected or simply ignored by advocates of market autarchy: state intervention.

According to economist Erik Reinert, after 1485 England emulated the economic policy of the rich city-states of continental Europe in order to create a "triple rent structure"  based on manufacturing, global trade and raw materials (see Erik Reinert, How Rich Countries Got Rich . . . and Why Poor Countries Stay Poor, 2008, Chapter 3). In particular, wool was one of England's most important raw materials and one of the foundations of its industrial development. 

In the late Middle Ages and early modern era the wool trade was one of England's key economic activities. English wool was valued for its high quality, and manufacturing of textiles in Italy and the Low Countries was largely dependent on English wool (Eileen Power and M. M. Postan, eds., Studies in English Trade in the Fifteenth Century, 1933, p. 39).

So important was the English wool trade that in the 15th century Parliament described wool production as "the greatest occupation and living of the poor commons of this land". Cloth-making was regarded as "one of the pillars of the State" and "the chief wealth of this nation" (E. Lipson, The Economic History of England, vol. 1, 1959, p. 440).

But far from being entrusted to the self-balancing of market forces, textile manufacturing was one of the earliest economic sectors that were brought under government control and purposely nurtured through state intervention. The protection and development of the textile industry was promoted by means of legislation that survived until the 19th century (ibid., p. 441).

First attempts at regulating the woolen industry began in the 13th century. During the reign of Henry III (1207 – 1272) the Oxford Parliament prohibited the export of wool. At the same time, it ordered that all wool should be worked up in England, that it could not be sold to foreigners and that the people should use woollen cloth made in England (Lipson 1959, p. 448). In some cases export prohibitions were not carried out just for economic reasons, but also to punish rival countries by depriving them of the coveted raw material (ibid., p. 449). 

Trade restrictions were not yet part of a coherent economic policy. Export prohibitions were discontinued and reintroduced several times over the next two centuries, showing that there wasn't a long-term strategy. For instance, in 1337 both the import and the export of wool were forbidden by statute. Coupled with incentives for foreigners to settle in the realm to manufacture woollen goods, those measures were aimed at developing the local textile industry. The need for immediate revenue, however, prompted the government to freely allow the export of wool in 1347. Prohibitions were again put in place in 1377 (ibid. p. 454). 

The beginning of a coherent protective industrial policy can be traced back to the reign of Henry VII (1457 – 1509). Having grown up in Burgundy, France, he had been impressed by the wealth of the local manufacturers and craftsmen. Particularly, he had observed that cloth-makers enriched themselves by importing English wool, processing it and reselling it for a profit. When he became King of England, which was then poor and bankrupt, Henry realized that it would be more advantageous for his country to nurture a local manufacturing sector and thus make sure that English producers could earn the added value.

Henry levied export duties that discouraged exports and made foreign woollen products more expensive than English ones. English wool manufacturers enjoyed tax exemptions and were granted monopolies in certain areas. Foreign entrepreneurs and craftsmen were attracted through various incentives. The woollen industry was so successful that a century later Elizabeth I placed an embargo on all raw wool exports from England (Reinert 2008, Chapter 3). In the 16th century wool manufacturing became the driver of England's early industrial development (Lipson, 1959, p. 473). A century later Daniel Defoe summed up the policies of the Tudor Dynasty in his treatise A Plan of the English Commerce.  

Contrary to what mainstream economists suggest, until the early 18th century there was a general consensus in England that the government played a decisive role in the economy, promoting economic policies that are described as "mercantilist". Mercantilism was based on the notion that the state had to promote manufacturing and trade, as opposed to laissez-faire, which was based on the concept of a self-balancing market (B. E. Supple, Commercial Crisis and Change in England: 1600-1642, 1959, p. 230). Not only in Britain, but also in continental Europe and in America the idea of government-led economic development was widely accepted.

We have already discussed in a previous article how the small principalities of Germany pursued their own version of mercantilism, known as cameralism. Here we shall briefly examine how the newly-founded United States of America adapted British mercantilism to nurture their own manufacturing sector.

In 1791 Alexander Hamilton, the first US Secretary of the Treasury, submitted to Congress a Report on the Subject of Manufactures. Therein Hamilton refuted the tenets of laissez-faire and proposed a state-sponsored industrial policy that included protective tariffs, export restrictions, government subsidies to targeted industries, tax exemptions and infrastructure projects (Richard D. Bingham, Industrial Policy American Style: From Hamilton to HDTV, 1998, p. 21). Hamilton's argument is known as the "infant industry" argument, because it outlines how to nurture a nascent manufacturing factor in an agrarian economy. Contrary to the laissez-faire notion that each country should specialize in what it is good at producing, Hamilton believed that the government should promote its nascent industries through government intervention.

Following Hamilton's proposals the US adopted a protectionist economic policy. Due to the emergence of "free market" mainstream economics in the 1970s, the memory of American protectionism has been erased, replaced by a myth of the US as a "free market" and "free trade" nation. Nothing could be farther from the truth.

As Edward C. Kirkland explained in the 1950s, the "core of American international economic policy was the tariff". The tariff was indeed a linchpin of the entire American system. Until the passage of the income tax amendment in 1913, tariff revenues were the single main source of federal income (Edward C. Kirkland, A History of American Economic Life, 1951, p. 527).

The first tariff was passed by Congress in 1789, with an average rate of merely 5%. In 1790 Alexander Hamilton and James Madison successfully pushed through Congress a new tariff which raised the average rate to between 7% and 10%. Tariff rates were further increased in 1792, 1794 and 1795. The 1796 tariff reduced the duty on wine and spirits, but increased rates on sugar, molasses and other items (for a comprehensive analysis of the US tariff see Cynthia Clark Northrup and Elaine C. Prange Turney, comps., Encyclopedia of Tariffs and Trade in U.S. History, vol. 1-3).

However, it was only after the 1812 war between Britain and the US that Congress decided to fully implement Hamilton's recommendation. In 1816 it passed a substantially higher tariff that was, for the first time, protectionist in nature (Cynthia Clark Northrup and Elaine C. Prange Turney, comps., Encyclopedia of Tariffs and Trade in U.S. History, vol. 3, 2003, p. 18). Milestones of US tariff history include the 1890 McKinley Tariff, the 1894 Wilson-Gorman Tariff, and the 1897 Dingley Tariff.

The first major decrease of the tariff after the Civil War occurred in 1913 with the Underwood-Simmons Tariff which lowered duties from 41% to 27% (Northrup and Prange Turney, 2003, p. 442).

In 1922, however, Congress passed the Fordney-McCumber Tariff, which raised tariff rates from 15% to 36% in order to protect the US market from cheap European imports. Some believe that the tariff stimulated the economy, leading to the prosperity of the 1920s (ibid., p. 506). New tariff increases were passed in 1930 (Hawley-Smoot Tariff).

After the Second World War, the US repudiated 150 years of protectionism, leading a global trend towards trade liberalization that culminated in the establishment of the World Trade Organization (WTO). Since then the tariff has been delegitimized as a tool of economic policy, despite the fact that the US and most industrialized countries have used or are using protective measures to develop infant industries.

Case Studies

1) Samsung

In 2017 South Korea's Samsung was the world's second-largest tech company with $174 billion in sales, $19 billion in profit and $217 billion in assets. Samsung surpassed Intel as the world's largest chipmaker and has a 21.9% market share in the worldwide smartphone market.

But how did Samsung achieve such remarkable success? Especially considering the fact that South Korea once was a third-world country. In 1961 South Korea had a per capita annual income of $82, less than half that of Ghana, which stood at $ 179 (Chang Ha-Joon, Bad Samaritans: The Guilty Secrets of Rich Nations and the Threat to Global Prosperity, 2008, p. 3).

According to Business Insider and Lifewire, Samsung was founded by Lee Byung-chol in 1938 in Taegu, Korea, then part of the Japanese Empire, with a starting capital of 30,000 won (about $27 USD). The company initially exported foodstuffs like dried fish, vegetables, noodles and flour to China and had about 40 employees.

Due to the Korean War, Lee left Taegu and relocated to Busan, where after the end of the conflict he started a sugar refinery and later expanded into textiles. His business was successful, and he built the then largest woollen mill in the country. But it was only in the 1960s that Samsung's rise truly began.

Syngman Rhee, South Korea's first elected president, strongly focused on economic development in order to reduce the appeal of Communism. He prohibited the import of foreign goods except for raw materials (import substitution strategy). Companies allowed to import foreign raw materials needed a special license. In exchange for the allocation of foreign aid and profitable import licenses, Korean companies had to contribute to Rhee's political fund. Among those companies were Samsung, LG and SK, which during the Rhee era became large oligopolistic industrial conglomerates (chaebols) (Chang Sea-Jin, Financial Crisis and Transformation of Korean Business Groups: The Rise and Fall of Chaebols, 2003, p. 47). 

Rhee, however, resigned after mass protests in 1960. The new elected government was ousted by a military coup led by Park Chung-hee. The Park regime pursued an even more aggressive developmentalist economic policy.

Park ordered three young economists, only one of whom had experience in economic planning, to draft an ambitious five-year-plan within 80 days. The plan, which was finished ahead of schedule, aimed at doubling gross national product (GNP) within ten years and achieving an annual rate of economic growth of 7.1% (Kim Hyung-A, Korea's Development under Park Chung Hee: Rapid Industrialization, 1961-1979, 2004, p. 79).

Park viewed the business conglomerates that had collaborated with the Rhee government as potentially dangerous. However, he needed their expertise and industrial infrastructure in order to deliver quickly on his promise of improving the people's living standards. As a result, he chose a carrot and stick approach.

Park ordered the arrest of 51 prominent businessmen on charges of "illicit profiteering" and confiscated their property. As the condition for their release they had to sign an agreement stating: "I will donate all my property when the government requires it for national construction". Lee Byung-chol, who was in Japan at that time, allegedly sent an agreement by letter. Thus Korean capitalists were made clear that their personal safety depended on their allegiance to the Park regime.

In return, Park provided them with state assistance and incentives to enrich themselves: protection from foreign competition through import restrictions and tariffs, subsidies, foreign loan guarantees, a fixed wage system and the suppression of trade unions. These measures had the specific goal of turning existing companies into large national conglomerates as drivers of fast industrialization (Kim 2004, p. 81).

On July 17, 1961, three days after the release of the arrested businessmen, Park ordered thirteen of them to establish the Promotional Committee for Economic Reconstruction (PCER) to develop six industries that the government had chosen as top priorities: cement, synthetic fiber, electricity, fertilizer, iron and oil refinery. The government decided to manage oil refinery itself and allocated the remaining sectors to each company: cement went to Kumsong Textile (now Ssangyong); fertilizer to both Samsung and Samho Textile; electricity to Taehan Milling; iron to Taehan Cement, Kukdong Marine, Taehan Industry, and Tongyang Cement; and synthetic fiber to Hwasin, Choson Silk Mill and Hanguk Glass (ibid., p. 82).

As we can see, this industrial programme was not "free market". Not only was competition limited, but many companies were forced to enter economic sectors against their will. That seemed to have been an intentional decision by the government aimed at compelling businesses to develop new ideas and technologies. The regime's strategy was a hybrid between Communist planning and market economy. In many respects, it was a modernized version of the infant industry strategy (ibid.).

Korean companies were still backward. Consequently, they sought to copy foreign firms' technology and design. Later they relied on licensing and OEM (original equipment manufacturing). The government funded research and development to help Korean businesses upgrade and become more innovative. The first Five-Year Plan (1962–6) and the Second Five-Year Plan (1967–71) were overall successful. The Korean economy grew at an annual rate of 8.9% and 11.1% respectively (Chang 2003, pp. 47-49). 

The Korean government picked winners and losers and allocated resources. Because interest rates in the export sectors were lower than inflation rates, a government loan was at the same time a subsidy. Banks could not independently evaluate whether projects were good or bad. The government chose the projects in which it wanted to invest. Obviously, not all projects were successful. The implicit understanding that the government would bail out conglomerates that lost money doing what the government had told them created a culture of debt and irrational risk-taking (ibid., p. 50).

Consistently with the infant industry argument, Korean companies were protected by the government from foreign competition. That allowed them to produce for the local market and gain an oligopolistic, or even a monopolistic, position (Chang 2003, p. 51). However, if South Korea had opened up its markets and allowed free competition, Korean companies would have had little chance of developing their own capabilities.

While the national market had limited competition, the Korean government pursued an export-oriented policy. This allowed Korean companies to earn foreign reserves, and also exposed them to a competitive environment. As a result, protection at home and competition abroad contributed to the growth of Korean industries.

With the third economic plan (1972–6) the government decided to promote heavy industries: steel, petrochemicals, nonferrous metals, machinery, shipbuilding, and electronics. These were designated as strategic industries and received about 70% of government development funds between 1975 and 1979 (ibid., p. 53).

The government commissioned Hyundai and Daewoo to develop power plant facilities and Hyundai, Samsung, and Daewoo to invest in shipbuilding. From 1971 to 1979 the export-to-GNP ratio rose from 16% to 36%, while the share of heavy industry and chemical production grew from 39% to 55% of total manufacturing output.

During this period, foreign companies were not allowed to make direct investments in South Korea. The only way in which foreign multinationals could profit from the country's growth was by entering into joint ventures with Korean firms. This was a deliberate strategy by the government. Joint ventures allowed Korean companies to learn foreign technologies and business practices, and thus benefitted national development. By 1978, South Korea had achieved the government's targets of $1,000 per capita GNP (ibid., pp. 54-56).

Thanks to protectionism and government assistance, the chaebols experienced phenomenal growth. Samsung benefitted greatly from its relationship and compliance with the government. Lee Byung-chol invested in the strategic industries designated by the government, he handed over to the government its banks and its subsidiary Hankuk Fertilizer (ibid., pp. 65-66).

By 1997 Samsung had assets of 50 trillion won and had diversified its operations into food processing, electronics, petrochemicals, machinery, shipbuilding, financial services, real estate etc. and it accounted for 15% of South Korea's GDP (ibid. p. 64).

2) Volkswagen

With 10.7 million sold cars in 2017 German-based Volkswagen Group was the world's largest automaker, ahead of Japanese rival Toyota. The company employs nearly 600,000 people (2014) and posted a record revenue of 220 billion euros last year.

The Volkswagen success story is not the result of the unfettered spirit of the "free market" embodied in individual entrepreneurship. Rather, it was the outcome of the cooperation between state and private sector.

In 1922 Ferdinand Porsche, an automotive engineer born in the Habsburg Empire, designed a small lightweight car called "Sascha", but it never went into production. After becoming a freelance designer in Stuttgart, in 1931 Porsche developed for the motorcycle manufacturer Zündapp a “quality small car for everyone",  a two-door model with four seats. In 1933 he created a similar car for NSU Vereinigte Fahrzeugwerke. However, due to the financial crisis those projects never went into mass production. 

After seizing power in 1933, Adolf Hitler held a speech at the International Automobile and Motorcycle Exhibition in Berlin, announcing that his government would provide funds for the automotive industry and mass motorization. The aim was both to create jobs and promote an industrial sector which the regime viewed as strategic.

In January 1934 Porsche submitted to the Ministry of Transport a "Memorandum on the construction of a German People's Car" (Volkswagen), a "fully practical vehicle" for four adults with a speed of 100 kilometres per hour, suitable for the highway network which had become part of Hitler's vision for a modern Germany. Adolf Hitler personally endorsed Porsche's proposal.

The regime's propaganda promised that anyone who saved "five marks a week" would soon be able to buy a "people's car". About 300,000 Germans signed up for a special savings agreement. But not a single "people's car" had been produced, yet.

The first Volkswagen factory was inaugurated only in May 1938. Adolf Hitler personally took part in the ceremony. However, one year later the Second World War broke out, and the dream of the affordable car for the middle class vanished.

Volkswagen readily shifted its industrial production to serve Hitler's war aims. Instead of manufacturing civilian cars, the company now made military vehicles. Volkswagen's involvement in the Nazi war economy also included the use of forced labour. At the height of its production in 1943, Volkswagen made over 26,000 vehicles.

After the war Volkswagen resumed operations as a repair shop for British military vehicles. Later it started producing the original prototype of the "people's car". Production volumes grew from 2,000 in 1945 to 50,000 in 1949.

When the British forces withdrew in 1949, Volkswagen was run as a state company. In 1960 the West-German parliament passed the Volkswagen Act which turned Volkswagen Works Limited into a public limited company (AG). 20% of its shares were owned by the federal state of Lower Saxony and 20% by the German government, while the rest were sold to private investors, including many company employees. Subsequently the shares belonging to the federal government were sold, too. The Volkswagen Act, among other things, allows the state to protect the company from hostile takeovers, and it guarantees that the interests of the public are taken into account, since important decisions require 80% of the vote in the general meeting of shareholders, one of whom is the state of Lower Saxony (Ulrich Jürgens, The Development of Volkswagen's Industrial Model, 1967-1995, in: One Best Way?: Trajectories and Industrial Models of the World's Automobile Producers, ed. Andrew Mair, Koichi Shimizu, Giuseppe Volpato, and Michel Freyssenet, 1998, 274).

3) TSMC

We have already discussed the role of the government in Taiwan's economic development. Here we will briefly outline the story of Taiwan Semiconductor Manufacturing Company (TSMC).

TSMC is the world’s largest foundry chipmaker with a market value of about $185 billion as of 2017 and the 9th company in the world in terms of profit per employee. It is also one of Apple's top chip suppliers.

TSMC was not founded by a visionary entrepreneur who relied solely on his or her own hard work and creativity. Rather, it was the outcome of the Taiwanese government's strategic planning and investment. TSMC's development must be seen in the context of Taiwan's post-war economic boom, an era in which the state acted as "initiator, regulator, strategic decision maker and entrepreneur" (Kyoko Sheridan, ed., Emerging Economic Systems in Asia: A Political and Economic Survey, 1998, p. 62).

Sun Yun-suan (孫運璿; pinyin: Sūn Yùnxuán; 1913 – 2006), who served as Minister of Economic Affairs and later as Prime Minister, and who is often credited as being the "father of Taiwan's economic miracle", played a key role in launching Taiwan's semiconductor industry. Contrary to free market dogmas, Sun believed that dynamic economic development couldn't be based on the acceptance of existing comparative advantage. The goal of the government was to shift comparative advantage (ibid., pp. 62-63).

In 1969 the government drafted the National Science Development Plan (1969-80). The Industrial Technology Research Institution (ITRI) was set up in 1973 and the Electronics Research and Service Organization (ERSO) in 1975. ERSO was commissioned with the development of an integrated circuit production facility. In 1978 United Microelectronics, a state-private-sector joint venture, was established, followed in 1987 by TSMC (ibid., p. 62).

In 1980 the government set up the Hsinchu Industrial Park, a fully government-planned and -funded research centre. Its purpose was to develop R&D and industrial infrastructure aimed at attracting high value-added enterprises. The government provided a wide range of incentives such as tax holidays, duty-free import of equipment and raw materials, low-interest loans and funds for R&D (ibid., p. 63).

Relevance of the "Infant Industry" Argument for Europe

The economic policy of European states and the EU is too dependent on neoliberal economic dogmas. Not only has Europe forgotten its own history of industrialization, but it is now competing with economies that have adopted and perfected similar government-led strategies as many European economies used to pursue.

In order to develop distressed areas of the continent, a more flexible, outcome-oriented economic policy is necessary. One example could be the introduction of a preferential value-added tax. We shall outline in future posts other proposals that could help the development of Europe's poorer areas.

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