The EU’s green gamble could make it a low-carbon leader

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We are living through a renaissance for industrial policy. After three decades when most governments were content to leave economic change to the market’s invisible hand, politicians of all stripes have become convinced of the need for a stronger political steer on growth.

Many things have caused this change of heart: the rise of China, the backlash against globalisation, climate change, regional inequality, and unpreparedness before the pandemic.

Whatever the spur, the result is that supply chains are now seen as a matter of state interest, and reshored manufacturing as a tool to “level up” left-behind places. Everyone and their uncle wants a version of Darpa, the US’s Defense Advanced Research Projects Agency, whose research grants have supported innovations ranging from the internet to mRNA vaccines.

Sensibly enough, tough questions from when activist government was previously in vogue have also returned. Can governments pick winners, or are they bound to end up picking losers when they try? Will subsidies simply serve as a boondoggle for the well-connected, or stifle competition and its impulse for innovation?

What goes unquestioned is the basic notion that industrial policy consists of government support for the activities, entities, or places with the greatest potential (if only one can identify them) to deliver innovation and productivity. Paradoxically, however, the exact opposite approach has also been making headway. We are starting to see governments trying to improve economic performance not by coddling businesses with subsidies but by making things more challenging for them.

The prime example of this “tough love” is the EU’s decarbonisation programme. Beyond the political goal of carbon neutrality, the bloc sees it as an instrument to boost industrial and technological development, and even leadership, in Europe.

Last week’s policy package will make many companies pay much more for the carbon they emit, and charge whole new sectors for emissions for the first time. Brussels hails it as not just an opportunity, but an “advantage for our companies”. Particularly harsh treatment is dispensed to road transport: sales of new fossil fuel-powered cars are to end from 2035. Far from a millstone around the industry’s neck, however, “our green transport shift . . . will create world leading companies which can serve a growing global market”.

Is this mad? Judging by the opposition to the plan, there are many in business who think so. The argument that putting burdens on business is a way to make it perform better is, at the very least, unusual. But if this is madness, there is method to it.

The commissioner in charge of the green deal, Frans Timmermans, puts it succinctly by comparing “a price on carbon [to] a premium on decarbonisation”. In economics, relative prices matter more than absolute ones: a penalty on those who can’t improve means greater profits for those who can.

This is fine in theory. Does it work in practice? There are reasons to think it can. The Nordic economies’ high level of productivity are not in contradiction to their union-enforced egalitarianism but a consequence of it: the inability to hire workers at low wages incentivises the private sector to choose capital-intensive business models.

Research on minimum wages similarly suggests that rather than causing unemployment, wage floors reallocate labour from less productive to more productive jobs. Put the other way round, permitting companies to adopt business models based on cheap but unproductive labour leads to exactly that.

The same sort of thinking can be seen in the Chinese interest in adopting tough technical standards to force technological upgrades on its corporate sector.

What do these cases have in common? They are examples of governments reinforcing the market’s Darwinian selection. When capitalism does not deliver enough creative destruction, the state intensifies the pressure — in the process making “natural” selection favour politically preferred outcomes.

Of course complementary policies — subsidised R&D and socially sensitive redistribution, in the case of the carbon transition — are needed for this to work. Even then it is a gamble: arguably the EU is taking a greater risk with its long-term green industrial policy than the US with its massive short-term macroeconomic stimulus. But if the result is European leadership in green technology, the impact on policy thinking will be much bigger than a revival of old-style industrial policy.

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