Put yourself in the shoes of a finance minister or, perhaps, an economic development minister. You can spend part of your budget to promote the expansion of particular economic activities or sectors. How should you decide which ones should be fostered using policy intervention, if any at all?

Following the pandemic, this question is once again at the center of policy debates. The COVID-19 crisis uncovered hidden weaknesses in the global economic system, prompting a strong policy reaction. The shift is particularly evident in three areas.

First, governments and firms are considering reshoring and friend-shoring—i.e. relocation to friendly countries—of critical production units in response to strains in trade and global value chains emerged even prior to the pandemic.

Second, national security concerns—further boosted by the Russian invasion of Ukraine—led to increased use of trade policy tools, such as export bans, to protect food and other supplies, as well as restrict foreign direct investment and international technology flows. Food security concerns due to climate change have sharpened this reaction.

Third, the COVID-19 emergency has re-legitimized a more prominent role for the state in the economy, which seems set to remain a key feature of the post-pandemic new normal.

These trends have coalesced in a renewed focus on industrial policy—that is, a comprehensive policy strategy to allocate resources among different sectors with the government playing a key role. Once tainted with such a bad reputation that it was jokingly called “the-policy-that-shall-not-be-named”, industrial policy is now seen by many as the main vessel via which governments can navigate post-pandemic security, economic, and environmental challenges.

Advanced economies have taken the lead. In the United States, the CHIPS and Science Act and the Inflation Reduction Act approved in 2022 will provide a total of $680 billion in the next 5-10 years, to catalyze domestic investment in strategic manufacturing sectors such as semiconductors and electric vehicles. Similarly, the European Union has committed to spending EUR 750 billion by 2026 for investment in priority policy areas, such as green and digital technologies.

To the extent that their more limited resources allow, emerging economies are likely to adopt similar approaches. In the region, the People’s Republic of China is transitioning from the “Made in China 2025” initiative—approved in 2015 and aimed at fostering high-tech industries—to the “dual circulation” approach, put forward in 2020 and focused on boosting domestic sourcing by local firms and self-sufficiency in key sectors.

In India, the Production Linked Incentives scheme, also launched in 2020 and now covering 14 sectors, aims at promoting domestic manufacturing output and employment.

These trends have coalesced in a renewed focus on industrial policy—that is, a comprehensive policy strategy to allocate resources among different sectors with the government playing a key role.

Should other economies in Asia and the Pacific follow suit?

Many are already implementing industrial policies in different shapes and sizes. Some focus on particular sectors like tourism, fintech, IT-enabled services, electronics assembly, and semiconductor production. Others involve selected types of firms including small and medium-sized enterprises or startups.

Various instruments are also being used, such as “ease of business” reforms, economic zones, and targeted subsidy programs. To a large extent, this variety of approaches and tools reflects uncertainty on whether and how to use industrial policy. This is still very much an open question, which should be answered based on expected benefits and costs for society at large.

The green transition is a clear example of an area where expected social benefits exceed costs and, thus, policy action is justified. The switch to cleaner production technologies will produce very large social benefits in the longer-term, but is likely to impose costs on producers and consumers in the short term. Policy intervention is thus needed as, reflecting individual producers’ and consumers’ incentives, market forces alone would fail to deliver the socially desirable outcome of greener economies.

Market failures are also present in other sectors, but the net benefits of policy intervention are often less clear-cut. Industrial policies that may hold great promise include measures to ‘de-risk’ GVCs—e.g. by reshoring or friend-shoring—, to incentivize the development of technological innovations with great potential, or to foster structural change toward particularly innovative sectors. However, the potential drawbacks are also large, for several reasons.

To start with, assessing the size of externalities and potential net benefits in these areas is problematic, so that policymakers risk falling into “picking winners” strategies which have often failed in the past. Additionally, slow bureaucracies, rent-seeking behavior, and other public sector inefficiencies mean that government failures can be larger than market failures.

Meanwhile, the use of industrial policy in association with trade restrictions can be a slippery slope to mercantilist policies, which reduce overall social welfare and could boost rather than reduce geopolitical risks.

Policymakers should evaluate industrial policy on a case-by-case basis, considering the following factors: if the identified market failure justifies the policy; whether policy action can be properly calibrated to address it; and whether institutional capabilities are sufficiently strong to design and carry out policy as needed.

With the right approach, governments in Asia and the Pacific can use industrial policy to direct resources toward a path to sustainable growth.