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The passage of the CHIPS and Science Act and economic competition between the United States and China over strategic technologies have reinvigorated the exploration of “industrial policy” as a means to bolster national security. With such attention comes an onslaught of ideological rhetoric, references to the “valley of death”, and lobbyists. Unfortunately, emerging industries and technologies are often very complex and dynamic, and many policymakers (including legislative staffers) suffer from shortages of expertise, time, and accountability. This does not mean that strategic economic policy is hopeless, but it does highlight the importance of being able to efficiently filter out misleading arguments and dubious proposals. To support such filtering, this article highlights two simple but insightful questions that policymakers can use to evaluate claims that the market is predictably and fixably inefficient: (1) If it is true that markets are predictably inefficient, why is it that some investors or companies have not exploited this inefficiency to profit until the inefficiency is fixed? And (2) Is the government not similarly susceptible to this problem?” Satisfactorily answering these questions does not guarantee that the government should intervene in the economy, but policymakers can use these questions to identify dubious claims about market inefficiencies, which are an important part of the case for intervention. After briefly discussing market failures, this article will apply the questions to two common but unreliable arguments for intervention: (1) that markets are irrationally risk-averse; and (2) that markets are irrationally short-sighted. Applying this logic helps to scrutinize advocates’ arguments, reducing the chance that governments intervene in a counterproductive or unnecessary way.
With the economy making important contributions to national security, it is imperative that policymakers develop a better understanding of market dynamics and the potential pitfalls of economic policymaking.
Markets Are (Almost Always) “Smarter” Than Policymakers
Advocates of economic intervention can cite many justifications, with some more credible than others. Some of the more dubious arguments are those that do not mention market failures and instead suggest businesses are ignoring or throwing away profits, whether due to factors such as “herd mindsets,” short-sightedness, or risk aversion. These mistakes are apparently so obvious and fixable that a thoughtful layperson can see the problem and solution, yet the market still does not adjust even once these findings are made public.
Businesses are not abstractly “perfect,” but they generally have much stronger incentives to reliably pursue their objectives (mainly, profit maximization) compared to politicians pursuing voters’ (or donors’) interests. Individual businesses occasionally make irrational decisions, but this is distinct from systematically predictable and fixable inefficiencies across the overall market. Thus, when policymakers hear arguments that seem to imply the market is being “dumb” (e.g., leaving profit on the table) the policymakers should ask a pair of questions (herein referred to as the “profitable inefficiency” and “government susceptibility” questions):
1) If it is true that markets are predictably inefficient in this way, why is it that some investors or companies have not exploited this inefficiency to profit until the inefficiency is fixed?
2) Is the government not similarly susceptible to this problem?
To be clear, this is not the efficient market hypothesis; market failures clearly do exist and, under certain circumstances, merit intervention in a market. Satisfactorily answering these questions does not guarantee that intervention is warranted; precisely when and how governments should intervene is beyond the scope of this article. However, this article argues that there are many responses—especially those implying that the policymakers and “experts” are more intelligent/accurate than markets—that policymakers should be very skeptical of.
Market Failures and Distortions
Market failures and distortions can be a valid answer to the two questions above: there may be significant discrepancies between private profitability and public benefits which often cannot be fixed through private negotiations, whereas governments are not bound by similar constraints. Some of the well-established conditions where markets tend to perform inefficiently or suffer from distortions include:
- Externalities: Some economic activities harm or benefit third parties who do not consent to the harm or pay for the benefit. Information spillovers are a very important positive externality in the context of industrial policy and technology competitiveness, especially with regard to research and development (R&D). Economists have long observed that a company conducting basic research may only receive a fraction of the benefits that such efforts produce for society, given that patents and related protections cannot cover all the information acquired through R&D—especially if the findings were “this method does not work.” Coordination problems can also undermine activities such as clustering (which can also increase information spillovers).
- One particularly important type of externality is public goods. For example, the military provides national security and might significantly benefit from strategically valuable domestic industries and innovation. Thus, if the government were a rational consumer that cared about national security it ought to be willing to pay for such benefits—although some critics allege this argument has been overapplied in some cases at the cost of billions of dollars with little benefit.
- Domestic governmental distortions: Sometimes the government may directly distort the market through broad policies (e.g., regulations, subsidies) that achieve goals in some cases but have undesirable consequences elsewhere, such as permitting regulations that can impede clean energy projects and domestic semiconductor manufacturing. A ten-year-long permitting process may prevent an eager investor from constructing an otherwise-profitable fabrication plant.
- Foreign governmental distortions: Some justifications regarding foreign distortions are very susceptible to misrepresentation or misuse. Nonetheless, some candidate justifications include subsidies, weak regulations (such as lax environmental standards), and trade barriers (notoriously including forced technology transfer).
When interpreted correctly, these conditions are often legitimate responses to the profitable inefficiency and government susceptibility questions. These conditions still do not always justify economic intervention, but identifying them and measuring their impact can help a policymaker both diagnose the roots of market inefficiencies and subsequently develop more appropriate responses.
Dubious Claims About Fixable Market Irrationality
There are many sources that explicitly reject the emphasis on market failures and instead attempt to answer the profitable inefficiency question by suggesting (or implying) that markets are predictably and fixably irrational. Sometimes these responses are a mixture of anti-market/anti-capitalist rhetoric and poorly-labeled appeals to market failures. Two particularly common narratives invoke risk-aversion and short-termism:
“This field is too risky for private investors”
Some sources will say that certain industries or sectors (e.g., manufacturing) are too “risky” for the private market, where investors are supposedly “more likely to be risk-averse.” Thus, proponents say, the government should invest or at least “de-risk” investments.
There are some legitimate kernels of truth here. First, many companies may be slightly “risk-averse” due to principal-agent problems: it is even difficult for profit-motivated shareholders to evaluate and enforce perfect risk neutrality among mid-level managers and CEOs. However, when analyzing a supposed market inefficiency, it is important to ask the government susceptibility follow-up question (or “inefficient compared to what?”). Principal-agent problems also severely affect government politicians, and bureaucrats are somewhat notorious for their risk aversion. Second, failed R&D projects may inform competitors on what not to do—a positive externality—while also failing to secure patents or related protections for the results. However, this becomes an appeal to market failures or distortions, not broad market irrationality around risk.
In reality, there are many examples of high-risk investing (including venture capital) and many ways of mitigating risk. Furthermore, appealing to riskiness is a double-edged sword: if a proposal has a high cost or probability of failure, that can be a good reason to not invest in it. Ultimately, this narrative does not satisfactorily answer the profitable inefficiency and government susceptibility questions.
“Private investors focus too much on the short term”
Many commentators like to claim or at least imply that markets are systematically too short-termist—even to the point of irrationality—and that there simply is not enough “patient capital.” Some sources argue this is partially why the “valley of death” traps “good ideas […] before they can become profitable.” Advocates thus claim the government should provide longer-term investments.
Again, there are kernels of truth here regarding principal-agent problems: it might be difficult even for profit-motivated shareholders to ensure a CEO optimizes for long-term profits rather than short-term gains. Additionally, longer investment/R&D horizons can increase the chance that an organization cannot capture all the public benefits (e.g., research externalities). However, the responses to these points are similar to those for risk-aversion: governmental policy is often incentivized to be short-sighted (due to factors such as voters lacking the motivation to evaluate distant effects and decision-makers retiring before the benefits/drawbacks of policies arise), and R&D externalities should be the focus of rhetoric, not long time horizons.
A company’s share price will generally reflect investors’ expectations about future profitability (after accounting for discount rates); if they did not, it would be far too easy for investors to accumulate enormous above-market returns by simply waiting a few years. Unsurprisingly, there are many examples of companies receiving investment for years without profiting. However, longer time horizons come with serious drawbacks: forecasting further into the future generally takes more effort/analysis and is more error-prone given the greater uncertainties, and opportunity costs in the short term are sometimes significant given compound rates of return. Ultimately, this narrative also is an unsatisfactory answer to the aforementioned questions.
The Importance of Reliable Explanations for Market Inefficiency
Some may ask why it is important to satisfactorily answer the profitable inefficiency and government susceptibility questions. For example, advocates may argue that a given problem is just too important to trust to the private market and that even if the government is not perfectly efficient,it is probably adequate to address the policy question at hand.
There are two primary reasons why it is valuable to satisfactorily answer the questions: First is that the government may assume there are fixable problems when there are none. If there are no actual market inefficiencies in a given case, then the government presumably cannot make improvements and policymakers should direct their limited attention to other supposed problems. Additionally, inaccurate beliefs about how the market does or does not work in a given case can contribute to flawed analytical foundations for identifying future problems. Second, failing to understand why the inefficiency exists undermines the ability to develop good policy solutions. It is not ideal for a doctor to treat a patient without knowing the exact cause of their symptoms, especially when the recommended treatment is expensive and not well-tested. Failing to understand why and how a market is inefficient can lead to policies that inflate the original problem or only solve a small part of the problem while leaving other issues unsolved.
As a recent report from the Center for Strategic and International Studies (CSIS) argues, the CHIPS and Science Act provides valuable funds for domestic semiconductor manufacturing, but without simultaneous reforms to the burdensome permitting process in the United States, the industry may not fully benefit from the funding. As the CHIPS and Science case shows, answering the profitable inefficiency and government susceptibility questions can help policymakers identify where fixable inefficiencies actually exist and what kinds of policy interventions can mitigate the root causes of the inefficiency.
No Principle is Perfect
There are no panaceas for charlatans and lobbyists: asking the two questions does not perfectly protect against definitional stretching around market failures. However, with practice, it should become easier to identify unreliable answers. Additionally, demanding that policy advocates answer the two questions at least induces some advocates to either shed bad arguments or try to jump through analytical hoops. This test can help a policymaker distinguish between better-faith advocates who perhaps rely on unreliable arguments by habit (but shed them when prompted to reconsider) versus some bad-faith or incompetent advocates who knowingly or negligently concoct unreliable arguments to persuade audiences. Of course, this test will likely have some drawbacks, such as discouraging advocacy for policy ideas that are sound because the case for intervention is complicated, but given the asymmetries in time and expertise between advocates and policymakers, advocates should submit to high-quality standards.
The debate over industrial policy and broader government intervention is not new, and similar examples (e.g., Sematech, Solyndra) and arguments show up repeatedly, often without addressing the longstanding counterarguments. Sorting through such debates can be time-intensive and error-prone for policymakers, especially when the justifications stray from well-established patterns of market failures and distortions. Some critics claim that focusing on market failures is “insecurity mode”—that it reflects excessive hesitance to intervene and “shape markets.” However, policymakers should show some epistemic humility in the face of the complex, more knowledgeable, and reliably-incentivized market. At the same time, they should not ignore the reality of market failures and global competition and should focus on tractable and important problems that are neglected or exacerbated by the market. Asking the profitable inefficiency and government susceptibility questions and scrutinizing advocates’ responses is one simple method for filtering out bad arguments. Answering these questions can also aid in diagnosing the underlying problems facing the industrial and technological bases of our national security.