Industrial policy puts global cooperation at risk

“How to rebuild the global financial architecture?” is a multibillion-dollar question that will keep the world busy for years to come. So far, everybody agrees that effective international cooperation is key, and the international financial summit scheduled this weekend in Washington takes a step in the right direction.

Yet domestic industrial policy could easily put any cooperative efforts into jeopardy. By now, the financial crisis is hitting the real economy in the US, Europe and elsewhere. Against this backdrop, economic patriotism becomes increasingly popular, with governments once again called upon to help domestic industries through times of economic turmoil.

What looks like necessary help to ailing industries at the domestic level may quickly translate into unfair competition from other countries’ perspectives. Resorting to activist industrial policy, for instance, could easily trigger subsidy races and fuel protectionism.

Unfortunately, retaliation and playing tit-for-tat bode ill for any common international effort to reform the global governance of financial markets. Cooperation on financial issues will not materialise when countries annoy potential partners by erecting trade barriers.

US carmakers were among the first to ask for support, hoping to receive money from the bailout plan originally designated for banks. They were promised soft loans worth $25 billion by the Bush administration to encourage the development of new models as customers increasingly favor smaller and more fuel-efficient vehicles.

On the other side of the Atlantic, responses were quick and the European automotive industry turned to the European Commission for assistance. “The Commission has been told to come up with proposals by the end of December so that the European automobile industry does not lose out in terms of competition” said Luxemburg’s Prime Minister Jean-Claude Juncker.

US carmakers now argue that given their truly dire state, the support promised a few weeks ago is just nowhere near enough. This week, President-elect Barack Obama urged the Bush administration to support emergency aid for automakers.

In blatant contradiction, European manufacturers often warn against distorting competition, while introducing a “junkyard bonus” to encourage consumers to get rid of their old cars and buy new ones instead.

Certainly, carmakers suffer from decreasing demand as consumers increasingly worry about fuel costs and their own financial situation. Yet some of the problems that automobile producers claim, are not so recent. In fact, it was apparent before the financial crisis that concentrating on big gas-guzzling models offered a less promising business concept.

German carmakers, which have concentrated on premium cars, are also hit by the crisis as consumers favor more modest models in times of economic slowdown. BMW, Daimler and Volkswagen have announced cutbacks in production, temporary shutdowns of plants or extended holiday breaks.

National governments in Europe and the US carefully weigh demands by the car industry. They must consider potential job losses not only at car-production plants but also in supplying industries. It’s hard to explain why bankers get help while blue-collar workers must cope with troubles on their own.

Moreover, cars are goods that spur emotions. Even people who do not work in the automotive sector have strong feelings about its products. Which politician wants to be accused of abandoning industrial icons? Still, it’s debatable whether state subsidies are the right cure because funds would merely ward off market competitive pressure and postpone necessary restructuring.

And, given carmakers successful lobbying so far, other industries look likely to follow suit. Airlines already claim that they need government support, and construction businesses or retailers could be next.

It’s not only about firms increasingly demanding state-aid. Politicians also opt for pre-emptive protection. French President Nicolas Sarkozy called on European member states to establish sovereign wealth funds to protect ownership stakes in strategic industries. His proposal was met with reluctance by fellow European leaders, but the idea seems to go down well with the general public.

Although the German government criticised his proposal, a poll by the German weekly “Der Stern” found that an overwhelming majority, or 77 per cent of respondents, would appreciate nationalising energy suppliers. About two thirds favor a more active role for government in banking and finance, and 60 per cent agree that railways and airlines should at least partly be state-run.

As for France, Sarkozy walked the talk and set up a national fund to provide an “industrial response” to the financial crisis. The idea to protect strategic industries from foreign takeovers is not new. Two years ago, France drew up a list of industrial sectors designated for protection. The rise of sovereign wealth funds from emerging economies like China or the Gulf countries further fueled this debate. Thus, why not create your own sovereign wealth fund to keep others at bay?

Apart from the question of whether this is necessary, as France already has laws that regulate foreign investments in selected industries, it certainly sends an alarming signal given the current state of the world economy. National politics and the desire for effective international cooperation are particularly incompatible in times of economic crisis.

People demand palpable help from their governments whereas talks to reform global governance structures for the financial system remain abstract. But industrial policies that skew competition and promote protection, imperil much needed cooperation on reforming financial markets.

To be clear, the point is not about strictly opposing government efforts to stimulate the economy. Rather, it’s about keeping in mind that actions at home often create repercussions abroad. Protectionism is popular, particularly in times of economic turmoil. But it does not provide a solution. Instead, it sends a dangerous signal just when cooperation is needed most.

In hindsight, it’s easy to look at the stock market crisis of 1929 when some government intervention went wrong. The crash led to the adoption of the Smoot-Hawley tariff act, which in turn triggered retaliation worldwide. Resorting to unilateral protectionist measures turned out to be a slippery slope, a lesson from the Great Depression that’s still valid.

Upcoming talks to rebuild the global financial architecture will take place based on the G-20 format, involving the United States, several European countries but also Russia, China, India and Brazil. With the US and large parts of Europe facing recession, growth in emerging markets is crucial to keep up the world economy.

Chinese efforts to counter falling export demand with a huge stimulus package could provide a boost to other economies in the region and help cushion the global economic slowdown. Emerging markets have gained in economic importance over the last decade and this trend looks most likely to continue.

Therefore, a new financial architecture can only be effective if carried by industrialised as well as emerging markets. It involves technical issues as well as highly politicised questions such as determining the future role of the International Monetary Fund. Therefore, talks this week only mark the start of a long process to come.

Rebuilding the global financial architecture requires sustained cooperation between the US, Europe and emerging markets. José Manuel Barroso, president of the European Commission was right to make this point at the recent EU-Asia summit “either we swim together, or we sink together”.