Today’s political environment will result in the return of industrial policy at the expense of “free markets”

Legislation was introduced in the US Congress this week to allocate $25 billion to encourage local semiconductor manufacturing. The relevant bills have bipartisan support, suggesting that there is a degree of consensus in going down this path.

The US is the pioneer in this area and even today it dominates the global market through its R&D and design. However, the expansion of a highly specialized global supply chain has meant that East Asian countries such as Taiwan have emerged as essential manufacturers of semiconductors.

Therefore, an attempt to bring back more semiconductor manufacturing to the US through financial incentives marks the return of industrial policy, or the strategic effort by government to influence manufacturing through incentives. While there is no truly “free market” anywhere, the return of industrial policy in the US in a strategic industry is significant.

One implication of this is that the boom in global value chains, where supply chains were split across countries, has probably ended. Global value chains will continue to exist but the political environment which encouraged them has come to an end.

Technological progress is often identified as an important driver of GVCs over the last three decades. Arguably, politics played an equally important role.

The story goes back to the early 1990s. In terms of technology, we were at the peak of the 3rd Industrial Revolution, where there was a transition from analog to digital and the use of electronics increased manifold.

In terms of politics, the US had won the Cold War and the prevailing ideology was that market orientation was the route to prosperity. This period was very different from that at the end of World War II when many multilateral institutions took shape in the shadow of a serious contest between two ideologies, capitalism and communism.

When the World Trade Organization (WTO) took shape in1990s, there was no real ideological contestation. Perhaps that is one reason why WTO, in its organizing structure, also emerged as very democratic set up. In practical terms, a handful of countries did not enjoy veto powers. Everyone did.

Economist Dani Rodrik, who has written about the political economy of trade and globalisation for over two decades, says that WTO and later trade agreements had an implicit assumption that economic practices across countries will converge over time. 

Presumably, this assumption was based on the belief that the superior ideology triumphed and everyone would naturally follow it.

Separately, the 3rd Industrial Revolution meant that trade agreements now came bundled with stringent intellectual property standards. Not everyone was happy, but there was little choice.

It’s in this backdrop that the US played a role in China entering the WTO.

Clearly, the implicit assumption that economic practices would converge was wrong. It was also wrong, with the benefit of hindsight, to assume all countries would transition to a democratic and market-based political and economic systems.

These wrong assumptions however did benefit countries, including China and India. GVCs thrived and so did cross-border trade. While some these things began to unravel after the global financial crisis in 2008, it’s the emergence of China as a strategic rival to US that has triggered a change in the way many countries want to organize themselves.

More industries will be regarded as strategic in nature and industrial policy will be used to encourage domestic production. If it’s semiconductor manufacturing in the US, it is pharmaceutical bulk drugs in India.

To go back to one of Rodrik’s formulations, consider his impossibility theorem for the global economy. Democracy, national sovereignty and global economic integration are mutually incompatible; only any two of the three can be combined. It is not possible to have all three simultaneously and in full.

In an era of another Cold War or “hot peace”, countries will prioritize national sovereignty. It will come at the expense of global economic integration.