Industrial policy is not a ‘magic bullet’ for economic problems, IMF warns

Industrial policy should not be seen as a “magic bullet”, the International Monetary Fund (IMF) cautioned, as more and more countries around the world turn to an active state to support the economy.

The approach has grown in popularity as governments seek to spur productivity growth and nurture strategically important industries, but the Washington-based body warned there were risks.

“History is full of cautionary tales of policy mistakes, high fiscal costs, and negative spillovers in other countries,” it said. “This recent turn to industrial policy to support innovation in specific sectors and technologies is not a magic bullet”.

The IMF said that industrial policy can only generate productivity and welfare gains under “stringent conditions”.

The government must have a “strong capacity to administer and implement such a policy”, the IMF said, and should not discriminate against foreign firms.

Discriminating against foreign firms can prove self-defeating if such policies trigger “costly retaliation”. Most countries rely on innovation done elsewhere, it noted.

Support should also only be targeted in areas which can generate measurable social benefits, such as lower carbon emissions or high knowledge spillovers.

It warned that the tax breaks or subsidies which accompany industrial policy can often be detrimental to an economy’s productivity if not targeted effectively.

Although the IMF warned about the risk of industrial policy, it suggested that state support for innovation could be valuable, particularly because it is often underfunded.

Increasing support for R&D by 0.5 percentage points annually could raise GDP by up to two per cent, the IMF said, although it noted funding might be problematic for countries with “immediate fiscal constraints”.

The recent enthusiasm for industrial policy started in the US. The Biden administration has implemented the Chips Act to support domestic manufacturing of semi-conductors as well as the Inflation Reduction Act, a monumental set of subsidies for green investment.

Biden’s ambitious green proposals prompted the EU to launch its own Green Deal Industrial Plan, which supports the bloc’s own transition to net zero.

In the UK, Rachel Reeves, the shadow chancellor, has expressed her own ambition to develop a “modern industrial policy”. Reeves said any such policy would be “selective”, reflecting the UK’s comparative advantages in the global economy.

Industrial policy is seen as when a government actively attempts to shape an economy by offering targeted support for certain sectors, such as tax breaks or subsidies.

This has often been criticised as the state interfering in the market by ‘picking winners’.