How Economic Nationalism Hurts Nations

Times are tough for market liberalism. Pressures to embrace protectionist policies are intensifying, as are calls for the state to intervene more widely to bolster those occupations, industries, and regions considered net-losers from economic globalization. Governments, according to economic nationalists, should be more actively shaping economic life to realize specific national goals.

Many market liberals have responded by defending economic liberalization’s benefits inside and across borders. But direct critiques of economic nationalism per se are equally necessary. There is good reason to believe that economic nationalist policies will negatively impact the long-term well-being of those nations pursuing them—including America. Before demonstrating this, however, we need concrete definition of what economic nationalism means.

Who’s an Economic Nationalist?

On one level, economic nationalism is associated with protectionism. Policies like tariffs, subsidies and import-quotas seek to protect companies and industries in a given nation from foreign competition. In other instances, economic nationalists have argued that emerging domestic industries require protection from foreign competition until they have become sufficiently stable.

Economic nationalism also expresses itself in the form of industrial policy. In a 2006 World Bank paper, Howard Pack and Kamal Saggi define industrial policy “as any type of selective intervention or government policy that attempts to alter the sectoral structure of production toward sectors that are expected to offer better prospects for economic growth than would occur in the absence of such intervention, i.e., in the market equilibrium.”

These economic interventions go beyond governments providing basic public works or making the necessary provisions for national defense with which most market liberals from Adam Smith onwards have had little quarrel, at least at the level of principle. Rather, industrial policy involves governments acting selectively to shape a national economy’s structure rather than leaving this to markets operating in a context of rule of law and private property arrangements.

After 1945, virtually every nation embraced industrial policies. The question was one of degree. The specific goals also varied. Sometimes industrial policy sought to correct perceived market failures. In other instances, the aim was to replace particular imports to encourage local production.

Between 1945 and 1982, for example, successive French governments pursued a range of industrial policies that became known as dirigisme. The objective was not to comprehensively replace entrepreneurship, free prices, market-based allocations of production and investment, or private accumulations of capital. Instead, dirigisme involved:

  • Nationalizing specific industries, especially utilities and energy companies, considered too important for national well-being to be entrusted to private businesses.
  • Targeted government interventions into specific economic sectors through measures like subsidies, preferential tax-treatment, government loans at below-market interest-rates, etc.
  • The state assuming responsibility for infrastructure that went beyond basic public works to provide services such as relatively-sophisticated forms of telecommunications.
  • The government creating, managing, and sustaining (often through state-owned enterprises) particular industries like aerospace, defense, and nuclear energy—especially those sectors deemed important for national security and prestige.

The impetus for these policies included the desire to accelerate France’s postwar recovery, fast-track the economy’s modernization, address perceived pre-war injustices, and realize certain national security goals. Over time, dirigisme sought to mold France’s economy through incentivizing industry to undertake activities they might otherwise not, especially in R&D. Dirigiste policies also sought to help certain French economic sectors attain and maintain comparative advantage in the global marketplace. In other cases, the objective was to preserve sectors like agriculture deemed important for cultural and political reasons in the face of foreign competition.

One distinguishing feature of dirigisme is the extent to which it was devised and implemented by professional civil servants. Having been among the few accepted into the grandes écoles like the École Nationale d’Administration that dominate the French elite, such people thereafter rotated between the private sector, the civil service, state-controlled enterprises, and politics. Whatever their political orientation, these individuals were confident there were instances in which they could and should outsmart the market in ways that benefited France.

These policies went together with a qualified embrace of trade liberalization, and after 1958, especially vis-à-vis other European nations. From 1947 onwards, most Western countries witnessed the implementation of industrial policies alongside controlled and uneven openings to varying degrees of foreign competition.

In other instances, economic nationalism has assumed the characteristics of outright state capitalism. A central aspect of the development of Chinese state capitalism from the mid-1990s onwards has been the extensive involvement of the Communist party, the state bureaucracy, and the military in all economic sectors.

One expression of this is greater use of fully- or partly-owned state enterprises throughout the economy after 1989. Such businesses are closely monitored and directed by party, state and military officials. They are also subject to extensive regulation at local, regional, and national levels. This has been accompanied by efforts to deprive more genuinely private businesses of credit since the late-1990s as party apparatchiks began asserting more direct control over investment.

Economic nationalism Chinese-style has maintained some openness to foreign trade and capital. This, however, began to decline in the mid-2000s under the leadership of Hu Jintao (despite China joining the World Trade Organization) and has accelerated under China’s present leader, Xi Jinping.

For the most part, today’s economic nationalists aren’t proposing to dismantle market economies, let alone embrace state capitalism. Nevertheless, they do believe that nations should rethink, and sometimes reverse, the diminishment of protectionist measures across the world initiated by the 1947 General Agreement on Tariffs and Trade (GATT). Others also want to expand existing industrial policies and experiment with new policies in this vein.

Inefficiency and Cronyism

The attraction of economic nationalist policies is their promise of immediate action to reverse economic decline and promote national greatness. The evidence, however, suggests that such measures, especially when maintained in place indefinitely, have long-term negative effects upon national well-being.

In the first place, economic nationalism makes it harder for individuals, regions, and nations to discover their comparative advantage. Broadly speaking, comparative advantage means that a nation gains by (1) exporting what it has a comparative advantage in producing and (2) importing those things which other countries have a comparative advantage in producing.

This holds even if a country possesses an absolute advantage in every single sector of its economy over another nation. Israel may be able to produce more manufacturing goods and technology than Australia. It’s still, however, the case that Israel can obtain more manufactured goods from Australia by specializing in technology and trading some of that output for imported manufactured goods.

Protectionism, however, gradually dulls a nation’s awareness of its comparative advantages. Tariffs, subsidies and import quotas seek to offset foreign competition’s impact on a given industry—and even occasionally succeed. However, one side effect is to discourage that industry from adapting and becoming more efficient under the pressure of foreign competition. The more you protect the industry, the more inflexible and inefficient it will likely become.

Economic nationalists point out, correctly, that protectionist measures were a major feature of American trade policy until 1947. Some consequently argue that these policies, especially after the Civil War, played a major role in America’s emergence as an economic superpower between 1776 and 1890.

There is, however, widespread evidence that protectionist policies actually impeded America’s march to economic greatness. Douglas A. Irwin’s detailed analysis of the late 19th-century American economy indicates that economic growth during this period was driven primarily by population growth, capital accumulation and entrepreneurship, rather than the productivity improvements that come from pursuing comparative advantage. Not coincidently, productivity growth was more rapid in those economic sectors “whose performance was not directly related to the tariff.”

Another major study of America’s post-Civil War economy determined that protectionism weakened the gains made by America through technological innovation. The artificially high price of imported capital goods, for instance, made it more difficult and expensive to build America’s transportation and industrial infrastructure. From this perspective, America’s economic success throughout the nineteenth century occurred despite protectionist policies.

Protectionist measures also did considerable damage to the twentieth-century American economy. A prime example is the Smoot-Hawley 1930 Tariff Act. In Peddling Protectionism: SmootHawley and the Great Depression (2011), Irwin demonstrates that increasing tariffs on over 20,000 imports not only resulted in higher prices for American consumers during the Great Depression; it also provoked retaliation against America, thereby hurting those American businesses which produced for foreign markets. As a consequence, Irwin states, “America’s share of world trade fell sharply in the 1930s.”

Then there are protectionism’s negative political repercussions, which have been well known for some time. In his lengthy book The Tariff History of the United States (1888), the Harvard economist F.W. Taussig showed how the 1864 and 1867 tariff acts were primarily drafted by those whose businesses were to be protected. The implementation of import duties, Taussig noted, thus had the “chief effect” of putting “money into the pockets of private individuals” with political connections.

A similar picture of rampant cronyism emerges from Irwin’s study of Smoot-Hawley. The Act amounted, he demonstrates, to “a mass of private legislation carried out with little regard for national interest.” Predictably, numerous industries began lobbying for protection as soon as the prospect of tariff increases became politically real. Smoot-Hawley’s drafting was thus characterized by “logrolling, special interest politics, and [an] inability of members of Congress to think beyond their own district.” Ironically, economic nationalism’s protectionist dimension encouraged legislators to put sectional interests first rather than the nation’s well-being.

A Warning from Japan

Similar problems manifest themselves in the realm of industrial policy. Japan’s postwar economic history underscores the point.

Japan’s recovery from World War II was remarkable. The reasons include high rates of domestic private savings that fueled capital and investment accumulation, significant levels of domestic economic freedom, and comparatively low-tax rates. Decisions made by the postwar American occupiers to weaken the power of the Zaibatsu—the industrial and financial conglomerates which dominated Japan’s pre-1939 economy—also made it harder for Japan’s economic establishment to maintain the privileges which had impeded competition in Japan’s economy.

Extensive use of industrial policy is often cited as a major reason for Japan’s postwar success. In addition to selective use of tariffs and subsidies, the Japanese Ministry of International Trade and Industry (MITT) favored particular industries through industrial policies such as attempts at forced mergers and trying to control who owned manufacturing rights. So powerful was MITT and so extensive were its attempts to outguess the market between 1949 and its eventual absorption into Japan’s economics ministry in 2001 that the very phrase “industrial policy” became synonymous with “the Japanese model.”

In the early-1990s, however, Japan’s economy began slipping into what is called the “Lost 20 Years.” The reasons include an aging population, heavy private sector indebtedness, serious monetary policy errors, and asset bubbles. But industrial policy also played a role. As no less than the Japanese Ministry of Finance’s Policy Research Institute stated in 2002: “The Japanese model was not the source of Japanese competitiveness but the cause of our failure.”

What did they mean by this? First, the proceeds of industrial policy had been heavily tilted to those businesses politically connected to the Liberal Democratic Party that dominated Japanese politics from 1955 until 1993. This undermined efficiency and facilitated widespread cronyism. That in turn created major obstacles to economic reform.

Second, industrial policy in Japan—like everywhere else—involved state officials trying to second-guess the insights and choices of millions of entrepreneurs, investors, businesses, and consumers. For at the heart of industrial policy is the assumption that governments can often better identify which industries are more worthy of investment than others.

But this supposition runs afoul of the knowledge problem. No individual or government ministry can acquire and process all the information needed to determine a nation’s optimal economic structure at any one point in time—let alone in 5, 10 or 20 years in the future.

Worse, government attempts to build up some industries via preferential treatment also undermine the market’s ability to furnish the accurate information needed by entrepreneurs, investors, and businesses to identify the most optimal economic path for each of them to follow—a process which constantly allows millions of piecemeal improvements to the overall economy. By contrast, if industrial policies become a central feature of economic life, inefficiencies will grow throughout the economy as people act on the basis of increasingly bad information. As Japan discovered, that serves no one.

Seen and Unseen

Economic nationalists also maintain that the nation’s common good requires governments to bolster industries in those sectors and regions that are doing less well than others. We cannot simply allow, the argument goes, whole regions of America to slip into economic decrepitude or entire economic sectors to disappear.

Nationalists regularly attribute such decline to unfair foreign competition. Yet the primary reasons for change are far more likely to be technological change and shifts in comparative advantage.

In a concise analysis of American manufacturing, the economist Pierre Lemieux observes that American manufacturing jobs declined from 19 million in 1979 to about 12 million in 2016. Throughout the same period, however, total employment in America grew from 99 million to 151 million, thus dwarfing the loss of manufacturing jobs. Moreover, Lemieux demonstrates that the net manufacturing job decline has been driven by technological innovation and America developing comparative advantage in high-skilled manufacturing.

Contrary to popular myth, America is not in fact deindustrializing. “Physical things continue to be produced,” Lemieux states, “but production occurs more efficiently.” In fact, manufacturing’s contribution to America’s GDP actually increased between 1997 and 2016, while real manufacturing production grew by 180 percent between 1972 and 2007. Today it has exceeded pre-Great Recession levels. This is what happens when countries and industries are entrepreneurial, embrace new technology, and adjust to domestic and foreign competitive pressures.

Conversely, as we have seen tariffs and subsidies will, over time, facilitate significant inefficiencies in resource-allocation and widespread distortions of economic information as well as growing cronyism. This is precisely what is occurring in mainland China today. Faltering under the combined weight of an aging population, falling productivity, a dramatic decline in growth, widespread reform-impeding cronyism, and a total debt-level of 300 percent of GDP, China’s own government estimates, as a recent Foreign Affairs article stated, “that it blew at least $6 trillion on ‘ineffective investment’ between 2009 and 2014 alone.”

Blaming unfair foreign competition also obscures other reasons why particular American industries have declined. Could it be that decades of management complacency and acquiescence with unreasonable union demands have sapped their productivity? Perhaps such businesses were reluctant to adapt to new technologies or chose to invest more energy in playing efficiency-sapping cronyism games. Maybe many American industries have been nudged in particular directions by industrial policies that turned to be less-than-effective than hoped while simultaneously incentivizing less-than-optimal allocations of capital and other resources.

If these causes of decline are real, it is surely counterproductive to use industrial policy and protectionism to rectify the situation. Moreover, isn’t it positively irresponsible to encourage Americans to enter particular occupations and industries that, absent dramatic reform, will provide fewer opportunities because of declining comparative advantage and technological change? Certainly, policy-makers must think harder about how to smooth the social changes that accompany the economic upheavals associated with markets. But instead of using tariffs or import-substitution schemes, wouldn’t it be better to scrutinize all those local, state, and federal ordinances and regulations that dis-incentivize and impede individuals, businesses, localities and regions from adapting?

Then we need to consider economic nationalism’s unseen dimension. This goes beyond American consumers and businesses paying more for goods because of America imposing import tariffs. If the state directs resources to particular businesses, this means those resources are not going to those enterprises which would have received them if markets had been allowed to determine where such resources were allocated.

Take, for instance, the Department of Energy’s $535 million loan-guarantee to the Solyndra enterprise as a result of the Obama Administration’s 2009 American Recovery and Reinvestment Act. The rationale for this failed investment was America’s apparent need to develop solar-energy as a fossil-fuel alternative and the market’s ostensible failure to deliver. Leaving aside the widespread evidence of cronyism driving this particular decision, the broader point is that these resources were effectively diverted away from other businesses because of the perceived necessity to increase America’s solar-energy supply.

Developing fossil-fuel alternatives may or may not be desirable for America. Nevertheless the Solyndra case illustrates how industrial policy necessarily means selecting some solar-energy companies over many other such businesses—not to mention the thousands of other companies seeking to promote other energy-renewables. Given, however, the sheer amount of ever-changing information needed to be absorbed and processed by state officials if they were to make the optimal investment choice, it’s hard to believe that governments can know which solar-energy companies are more worthy of investment than others or, for that matter, which energy-renewables will be more profitable and sustainable than others.

Present Problem, Future Blindness

These facts point to a more general challenge: economic nationalist policies are handicapped by the fact that no one can know what will be the future growth businesses in any given nation. No one knows what technological innovation or entrepreneurial insight will upend the present economic landscape in America—or any other country. Nor can such developments be anticipated by economic nationalist policies.

By all means, America should confront authoritarian mercantilist states like China that, among other things, steal intellectual property and routinely violate WTO rules. A concern for free trade, not to mention justice, demands aggressive action in these areas. In the long-term, however, economic nationalism damages the common good of those countries which embrace it. That’s the paradox which economic nationalists need to address.