The Return of Industrial Policy

As governments play a bigger role in the economy, we think businesses and investors will need to think more about inflation, location and taxation.

If you’ve read our Solving for 2024 outlook, which came out last week, you may have noticed some common threads running through many of our macro themes for next year. One such thread is the return of industrial policy.

• We see the U.S. consumer flagging as the focus of fiscal policy shifts to supporting industry and COVID-19 cash balances dissipate.
• We anticipate stickier inflation in part due to that fiscal impulse.
• We expect dispersion of fiscal policy among countries, as well as rising debt-sustainability questions: Those who can afford industrial policy will likely diverge from those that can’t, and some of those that can’t afford it may try to spend the money anyway.
• Lastly, the response to environmental-sustainability challenges, alongside geopolitical tensions, are to some extent being used as “flags of convenience” to justify political choices—with the U.S. Inflation Reduction Act (IRA) and CHIPS Act being exhibits A and B.

The ubiquity of this super-theme is a testament to its importance. So, what do we mean by industrial policy? Is it a good thing or a bad thing, and how might investors respond to it?

What Do We Mean by Industrial Policy?

The economist Ruchir Agarwal recently defined industrial policy as subsidies, tax incentives, legislation, regulations and other “government efforts to shape the economy by targeting specific industries, firms or economic activities.”

Both qualitative and quantitative evidence suggest that industrial policy is “gaining momentum in many countries,” both emerging and developed, and it is often driven by, as well as a response to, more populist dynamics.

Is It Good or Bad?

We are unlikely to settle one of the greatest debates in economic theory in a single paper. At its simplest, however, whether industrial policies are good or bad, in economic terms, boils down to whether they are rational and wealth-generating or profligate and wealth-destroying.

Such policies may be necessary to achieve objectives that are difficult for the market to achieve alone (such as limiting global warming or protecting national security). They may spur investments that enhance productivity, and thereby raise the growth rate above the cost of the government debt incurred to make them. They can be positive-sum social goods—like the internet, COVID-19 vaccines or investments that help cut greenhouse gas emissions.

But industrial policy can also be damaging, wealth-destroying and zero-sum.

Some things may be difficult to achieve with the market alone, but that doesn’t mean the state will achieve them—let alone efficiently. Politics (and in democracies, short-termist and “pork-barrel” politics) can often outweigh or distort economic objectives. “National champions” that deliver immediate political and employment benefits often prove costly and inefficient over time. Worse, projects can fall victim to cronyism and corruption. Overall, industrial policy is inflationary, as it raises prices either by incorporating externalities or cutting off access to cheaper, market-based solutions.

Moreover, even policies that are apparently rational and wealth-generative at the local level can be zero- or negative-sum at the global level.

Subsidizing or protecting employment in strategic industries is likely to suck employment from somewhere else in a way that does not allow for a competitive response. “Friend-shoring” may address legitimate concerns about supply chain security, but it is also about furthering geopolitical aims and relationships—and it is rarely economically optimal, especially over the longer term. And as European disquiet over the U.S. IRA demonstrates, the more autarkical the measures, the more likely they are to upset allies as well as opponents.

Winners and Losers

Where wealth is being destroyed as well as created, and where zero- and negative-sum games are being played, there will be economic winners and losers. Investors are likely to want to identify who they are.

Because these industrial policies cost money to implement and push up prices, in economies with close to full employment and high debt, they can create fears around overheating and debt sustainability. The piper will eventually have to be paid. We think investors should assess countries and regions based not only on whether their policies are likely to meet strategic objectives, but also on their ability to manage the inflation and pay for the costs.

If investments don’t pay for themselves, debt sustainability could become an issue. None of the solutions are good, but defaulting or substantial tax hikes (which would likely slow growth even further) are arguably worse than inflating the debt away or using “financial repression” to keep the cost of capital low.

Those “better” solutions require coordination among monetary, fiscal and regulatory authorities, so investors might be wary of governance weaknesses. The U.K.’s LDI crisis and the mini-banking crisis in the U.S. showed that the “central bank put option” remains available and effective, even during a monetary tightening cycle, in countries where institutional boundaries are clear. In contrast, the eurozone’s Transmission Protection Instrument evolved in recognition of the difficulties of managing inflation when monetary policy is shared, but fiscal policy isn’t, and when institutional boundaries are blurred.

Inflation, Location and Taxation

At the company level, we think investors should focus on inflation, location and taxation.

While we expect more industrial policy to result in slower real growth, overall, it is worth noting that higher inflation would imply relatively high nominal growth. For businesses with robust balance sheets, competitive moats and pricing power, that is not a bad backdrop.

Government money is going to be spent in particular places. For companies, getting the benefit may often literally be about location; for example, those nimble enough to move to those countries that can afford an industrial policy may benefit, and those embedded in current supply chains may struggle while others take advantage of newly emerging local networks. For investors, it may be more about allocation—to companies with specific country exposures, but also to the sectors and sub-sectors likely to get government support.

However, it always comes back to how governments will pay for it all.

It may be tempting to think that investors simply need to identify the “national champions,” but national champions often become national cash cows: When governments deal out the support, it’s reasonable for them to have more of a say in how the profits are distributed. The key may be to identify businesses that benefit from the spending trends in less-visible ways, and which generate genuine added value rather than merely extracting industrial-policy rents.

In short, industrial policy is back. Its impact is widespread by nature and is already being felt at the macro, regional, country, sector and company levels. Investors who fail to take account of it may be missing one of the most important emerging risk factors in their portfolios.