Europe's budget troubles may have afforded a small victory to laissez-faire capitalists in the heated debate over what policies should guide the economic recovery. But across the globe, proponents of more government are making steady gains, even as public coffers dwindle. In Europe, enterprise and industry ministers look poised to gain more control of so-called 'industrial policy' -- a term used to describe government-led growth strategies -- as part of the EU's 'Europe 2020' economic agenda. It's no secret China is ratcheting up its public support for a massive manufacturing hub to churn out cheap solar panels and wind mills. And in South Korea, the government's five-year growth plan includes $85 billion -- roughly 10 percent of its 2009 GDP -- to boost production of solar-powered batteries and hybrid vehicles.
But in the United States, where former investment bankers continue to rule the Obama administration's economic team (see Larry Summers), the idea of government teaming up with business to drive long-term innovation and growth is still struggling to gain attention. Even the Obama administration's national innovation strategy, announced last year, dismisses the idea of government-supported innovation as a flawed pursuit of "picking winners." To staunch pro-market advocates, even Obama's approach is overreaching. But by other accounts, the absence of more government could leave U.S. innovators trailing woefully behind global competitors in years to come. A recent study by the Information Technology and Innovation Foundation's Robert Atkinson and Scott Andes, for instance, found that government-led R&D in China was rising twenty times faster than in the United States over a seven year period, while the U.S. lead over EU countries was shrinking.
Washington isn't the only one shunning new lines of thinking on innovation and growth. The ivory tower is also still kowtowing to free-market thinkers, thanks to decades-long ties between Wall Street captains and university economics departments. The result has been a homogenized body of economic thought that lacks "a whole set of government policies needed to make innovation happen," says Ken Jarboe, an innovation researcher and former Georgetown business professor.
The narrowing of economic discourse in the U.S. traces back to the turn of the century, when the proliferation of U.S. business schools put pressure on traditional economics departments to study business practice, with its proclivity for unfettered markets. A 1926 Journal of Political Economy article predicted that the growing rivalry between universities' business and economics departments would result in "the old story of the lion and the lamb, with the old economics department playing the part of the lamb." The evolution of the Chicago School of Economics -- now the preeminent school of laissez-faire thought -- exemplified this trend. Allen Wallis, one of the university's first business school deans (and later éminence grise at the right-leaning American Enterprise Institute), strove to expand the reach of business studies in economics, attracting Wall Street-minded economists such as Merton Miller, a corporate finance professor who served as director the Chicago Board of Trade, and James Lorie, whose 1960s research on stock prices attracted major funding streams from banking titans like Merrill Lynch.
Over time, this finance-focused migration in economics produced a raft of economists who "trained themselves for so many years to think that any alternatives" to the laissez-faire approach were "not economically productive," says Clyde Prescowitz, a commerce advisor to the Reagan administration who has advised the Obama administration on its current approach.
Rising unemployment and inflation in the 1970s and 1980s revived the debate over government's role in the market. Democratic candidates in the 1984 presidential election championed various proposals for a U.S. industrial policy, as joblessness continued to rise. Walter Mondale -- a two-term senator from Minnesota -- wanted bigger government to revive traditional industries, while Gary Hart -- a little-known Colorado senator -- argued for a government-led high-tech innovation strategy. But with Reagan's reelection, academia's free-market advocates prevailed. Larry Summers, then a newly-minted Harvard professor coming out of Reagan's Council of Economic Advisors, dismissed the campaign proposals as "chiropractic economics. At best, it would be ineffectual. At worst, it would be a wrenching experience." More left-leaning economists, such as the University of Pennsylvania's Richard Klein and MIT's Lester Thurow, meanwhile continued to tout the virtues of the Japanese approach, where soaring government-led growth was turning heads both on and off Wall Street.
Over the next decade, government-led economic "miracles" continued across Southeast Asia, attracting the attention of more left-leaning economists such as Paul Krugman, Jeffrey Sachs, and Joseph Stiglitz. But the collapse of the Tokyo Stock Exchange in 1989, and the economic stagnation that followed in Japan, strengthened the fervor of the laissez-faire set. In a 1991 interview, Milton Friedman concluded that: "Japan is not a model for us to follow at all. On the contrary, Japan did well ten, twenty years ago when government in Japan was much smaller."
Most economists agreed the Japanese model had suffered from rigid state mandates and too little attention to profitability. These flaws, along with failed industrial policies in France, "discredited the idea" of industrial policy in academia, says Harvard Business School professor Josh Lerner. But economists also showed little interest in studying successful cases of industrial policy in countries like Germany, says Alan Tonelson, research fellow at the U.S. Business & Industrial Council, now the eurozone's strongest economy.
The lack of attention to cases like these may now be hurting the U.S. approach. Economists and policymakers fret endlessly over an undervalued Chinese yuan, for instance, but of greater concern should be the troublesome migration of American factories to China, says Tonelson, which trades away the hubs of U.S. innovation (its factories) for cheap Chinese labor. Prescowitz agrees. Recent decisions by U.S. companies like Applied Materials and General Electric to move factories and R&D labs to China reflect the success of China's government-led approach, thanks to the massive rebates, free grants, free infrastructure, and favorable regulations China is using to poach innovative U.S. practices and high-tech jobs. Under the rule of Laissez-faire economics, says Prescowitz, "the U.S. should have those jobs, because it's more competitive. But that's not happening."