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Industrial policy must not lose sight of the underlying economic issues that prompt intervention in the first place, and these problems are not always industry-specific.
September 15, 2021
With Responses From
Sep 15, 2021
9 Min read time
Industrial policy must not lose sight of underlying economic issues.
Image: Zhu Difeng / Adobe
Industrial policies are too often perceived solely through the lens of the sectors they target. With respect to practical design and implementation, this orientation is to some extent necessary and desirable: at some level, any industrial policy true to its name will involve identifying and prioritizing certain strategic sectors and capabilities. At the same time, industrial policy must not lose sight of the underlying economic issues that prompt intervention in the first place, and these problems are not always industry-specific. In other words, it is necessary to address the failure of the private sector and financial markets to direct sufficient investment to critical sectors and technologies. Industrial policy, especially those designed to foster the sustainable industrial ecosystems that Mazzucato and her colleagues describe, cannot succeed in sectoral steering unless it also targets these systemic obstacles.
Industrial policy must also address the failure of the private sector and financial markets to direct sufficient investment to critical sectors and technologies.
In the abstract, it is easy to identify various externalities and free-rider problems that prevent firms from investing sufficiently in basic research or worker training or allow them to ignore national security and environmental considerations. But economic theory offers at best an incomplete picture of the specific reasons why the United States lost its lead in semiconductor manufacturing to Taiwan’s TSMC, for example, or why it abandoned the manufacturing of telecom equipment, solar panels, and other key traded sector goods, despite their economic importance and security implications.
Three core problems have warped U.S. corporate and financial market capital allocation in recent decades, limiting growth investment to a narrow set of industries—mostly software and other intellectual property businesses with low capital intensity. First is the persistent gap between firm (and investor) hurdle rates and cost of capital. Second are the various corporate strategies that aim to separate profits from capital and labor costs. And third is the emergence of Big Tech as a defensive, comparatively low-risk sector in public markets. Of course, these problems are all somewhat interrelated; at bottom, they result from strategies to maximize equity valuations and shareholder returns, though not necessarily profits and growth. But they are worth disentangling for conceptual clarity.
High Hurdle Rates, Low Investment
In theory, firms should invest in a new project whenever the expected returns on the investment exceed the firm’s cost of capital. In practice, however, firms have maintained “hurdle rates”—the expected return a project must meet to warrant investment—significantly above their cost of capital; multiple studies have shown that hurdle rates typically exceed firm cost of capital by up to 7.5 percent. Moreover, hurdle rates themselves have largely remained constant at around 15 percent for decades despite falling interest rates (and thus lowered cost of capital) in recent years. As a result, corporate sector capital investment has been weak in recent decades relative to previous history, with many critical, capital-intensive sectors essentially abandoned.
From the standpoint of economic theory, this represents an irrational refusal to maximize profits—and thus should call into question substantial portions of economic theory. But high hurdle rates persist for several, now deeply entrenched, reasons.
Corporate sector capital investment has been weak in recent decades relative to previous history, with many critical, capital-intensive sectors essentially abandoned.
First, although investing at lower hurdle rates might increase a firm’s profits, it would likely degrade earnings quality. In other words, metrics like return on assets would deteriorate, or the business might come to be viewed as slower-growth or more cyclical. In the eyes of many firms, the resulting compression in valuation multiples (e.g., a lower price-to-earnings ratio) would outweigh the gains of investing at a lower hurdle rate. Such concerns were clearly a factor in the abandonment of the U.S. telecom equipment manufacturing industry, which the United States dominated as recently as 2000. They were also likely at issue in U.S. firms’ more recent refusal to consider making any offers to purchase Ericsson, despite the Trump administration’s assurance of financial support in order to establish a U.S. competitor to China’s Huawei.
Second, an increasingly powerful and sophisticated financial sector adds further upward pressure on hurdle rates. As Jeremy Siegel has pointed out, firms that distribute a high amount of cash to shareholders generally out-return those that reinvest, even if the latter grow and innovate more. The highest-returning stock of the twentieth century, to use Siegel’s quintessential example, was the tobacco company Philip Morris, thanks largely to its high dividend—not Ford, Boeing, IBM, or other industrial titans that defined the “American century.” Today’s financial investors are not unaware of this reality and exert strong pressure on firms to return cash to shareholders whenever new investments cannot meet extremely high hurdle rates. For instance, Apple, the largest U.S. company by market capitalization, was subject to an activist campaign led by Carl Icahn demanding that the company return more cash to shareholders. As a result, over the last six years, Apple’s operating income has fluctuated in a narrow band of around 15 percent, but its stock price has more than quintupled, thanks in large part to more than $300 billion of share buybacks.
A third factor behind high hurdle rates is the warping effect that the U.S. software industry has had on the rest of the economy. The financial characteristics of software (and similar intellectual property businesses) allow for unusually high returns. Unlike manufacturing firms, they require relatively little capital to scale and usually have low marginal costs of sales. And without large fixed capital costs, it is also easier for them to manage downturns. Thus growth capital is likely to go to software sectors, while other industries simply cannot compete on a risk-adjusted return basis. Researchers at Yale University have argued that because of these effects (among others), the rise of software and venture capital industries introduces a sort of “Dutch disease” into the economies they dominate.
In sum, persistently high hurdle rates severely constrain the U.S. private sector’s willingness to invest, especially in manufacturing or other capital-intensive businesses, and pose a difficult problem for policymakers. Conventional approaches to lowering the cost of capital (such as reducing interest rates) or increasing earnings (like cutting taxes)—or in some cases even direct subsidies—are unlikely to lead to more investment because firms will typically prefer to maintain high hurdle rates in order to maximize earnings quality and valuation.
Although firms’ interactions with capital markets are important, changes in the structure and operations of the corporate sector are arguably even more significant. Over the last several decades, the U.S. corporate sector has pursued a major reorganization that Gerald F. Davis has termed “Nikefication.” In this process, firms seek to disaggregate high-margin intellectual property rents from the capital- and labor-intensive aspects of production, much like Nike pioneered a model of outsourcing the manufacturing of its designs to Asia. Nikefication is now present throughout the economy, not only in high-profile cases like fabless semiconductor companies. For example, Hilton’s primary business is no longer owning and managing hotels, but owning and managing its brand portfolio. The hotel real estate is typically owned by private equity firms or REITs, while operations are outsourced to various third-party management companies, cleaning service providers, and so on.
The Nikefication strategy both reinforces and is reinforced by hurdle rates and financial market dynamics.
The result, as Herman Mark Schwartz explains, is an increasingly polarized economy. In the previous, “Fordist,” era, the most profitable firms were also large capital spenders and employers. Today, by contrast, profits are sequestered into a handful of “superstar” firms—which have few internal opportunities to reinvest these profits—while capital- and labor-intensive firms are often cut off from profits, and therefore investment capital as well. This has profound effects on both labor income and overall corporate investment.
The Nikefication strategy both reinforces and is reinforced by hurdle rates and financial market dynamics. It also interacts powerfully with Asian industrial policies. When Asia subsidizes manufacturing, it puts pressure on U.S. manufacturing returns, further encouraging U.S. firms to outsource and offshore these low-return business units, while reaping the benefits of Asian subsidies (and often labor and regulatory arbitrage) through intellectual property rents.
U.S. tech and internet companies are typically perceived as dynamic, risk-taking, and innovative. In truth, however, the large public tech firms are the most defensive stocks in the market. During the downturn of 2020, the tech-heavy NASDAQ traded more in line with Treasuries (the “risk-free” asset) than the broader S&P 500 index. Since the financial crisis, the volatility profile of information technology stocks has resembled that of ultra-defensive sectors like utilities and consumer staples. Companies taking serious risks with their capital in order to innovate do not trade like bonds and utilities.
This “risk-aversion” among leading U.S. tech companies is likely related to the issues discussed in the previous sections. Another factor may be increasing monopolization within the sector, as described in a recent House subcommittee report. Despite their extraordinary resources, monopolies or near-monopolies facing little competition have little incentive to take risks and innovate.
In a polarized economy, this risk aversion is especially problematic. Eight out of the ten largest companies in the S&P 500 are tech giants, and just a handful of tech companies hold over a quarter of the cash balances of all 500 index members. Outside of tech, the U.S. corporate sector is leveraged at unprecedented levels. Such high indebtedness limits the ability of most companies to take risks. While venture capital funds may still be risk-friendly, they remain predominantly focused on software and internet sectors. Thus, in many cases, the government may be the only source of risk capital, absent policy changes that significantly alter private sector incentives.
Any successful U.S. industrial policy will need to address these issues, in addition to identifying and supporting strategic sectors. This is especially necessary if the goal is to build sustainable industrial ecosystems, instead of merely funding discrete projects.
With respect to hurdle rates, policymakers must recognize that the U.S. corporate sector may be uninterested in certain industries even if they are heavily subsidized. It may therefore be necessary to explore alternative strategies, such as de-risking projects to make lower returns more attractive to financial sponsors, instead of relying on corporations. (This may also necessitate new methods of evaluating outcomes, much like Asian countries have used export performance as a criterion for determining future rounds of industrial policy support.)
Policymakers must recognize that the U.S. corporate sector may be uninterested in certain industries even if they are heavily subsidized.
The prevalence of Nikefication means that even if new industries are developed, they will face intense pressure to isolate profits and rents from the capital- and labor-intensive elements of production. Insofar as integrated companies are no longer viable, policymakers must undertake efforts to ensure that the latter elements can remain on U.S. shores and that both labor- and capital-intensive aspects of production retain access to profits and capital.
Finally, it is necessary to acknowledge that, in many cases, the government may be the only source of risk capital, whether through existing programs like the U.S. Small Business Administration’s SBIC program or new financing initiatives that will need to be developed to support any serious industrial policy. In addition, competition policy should be guided by a dual mandate: ensuring that firms face sufficient competition to incentivize risk-taking and investment, while allowing firms to retain adequate profits with which to undertake such risks.
All of these challenges suggest that developing successful industrial policies in the United States today is likely to be even more difficult than it has been in the past or in other countries. But, for the same reasons, it is all the more important.
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September 15, 2021
9 Min read time
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