EU countries are increasingly turning to industrial policy to boost growth and productivity, while accelerating the green transition, in an environment of limited fiscal space. This column uses a multi-country general equilibrium model to compare the effects of unilateral industrial policies by individual countries to coordinated policies at the EU level. It argues that deeper coordination of industrial policy initiatives at the EU level is essential to achieving successful outcomes, mitigating inefficient relocation of resources and fragmentation risks within the Single Market.
After decades of scepticism toward industrial policy by economists and policymakers, there is renewed debate and research about the costs and benefits of industrial policy (Juhász et al. 2023, Millot and Rawdanowicz 2024). In Europe, state aid data suggest that industrial policy has been steadily rising over the past decade and is about 1.5% of GDP (as of 2022), compared to around 0.5% of GDP a decade ago. In a recent paper (Hodge et al. 2024), we tackle a specific angle of this debate by asking the following question: if there is a sound economic rationale for industrial policy in Europe — such as to correct market failures, should industrial policy be coordinated at the EU level? To answer this question, we investigate the general equilibrium effects of industrial policy in Europe, comparing outcomes when European countries implement policy unilaterally to when they cooperate or set uniform policy through the EU.
Industrial policy can have adverse spillovers at home and abroad
We build on the modelling framework of Lashkaripour and Lugovskyy (2023), including every EU country and selected G20 partners. Each country has multiple sectors, and within each sector, monopolistically competitive firms produce differentiated varieties of goods using only labour. There is free entry of firms (upon paying a fixed cost), and labour is perfectly mobile across sectors but cannot cross international borders. Production exhibits external scale economies, which differ by sector and can be interpreted as agglomeration externalities from knowledge spillovers, so that net entry of firms boosts sectoral productivity. Without government intervention, production in some sectors can be inefficiently low because firms fail to account for the externalities when making entry decisions. This creates a potential role for industrial production subsidies to eliminate the externality wedge and incentivise a level of production that increases sectoral productivity.
But this is not the end of the story. While industrial subsidies implemented by a single European country can increase productivity, they will not necessarily be welfare maximising at the national or regional level in Europe. There are two key reasons for this – both traditionally discussed in the trade policy literature:
- The first is the firm relocation effect (Ossa 2011). Increasing the output of a sector with agglomeration externalities will boost domestic productivity, but will also cause a reduction in production, and thus of productivity, in the same sector elsewhere in the world. An increase in domestic production efficiency does not necessarily lead to an increase in global production efficiency.
- The second reason is a terms of trade effect (Bagwell and Staiger 1999). If an economy is very open to trade, then changes in terms of trade have a strong impact on domestic welfare. Industrial production subsidies can be used to expand production and productivity in sectors with high scale economies, which will reduce production and productivity in other domestic sectors. This can lower the terms of trade if the elasticity of foreign demand in the subsidised sectors is low (so export prices fall), compared with other sectors. Evidence from micro data suggests that there is indeed a negative relationship between the size of scale economies and foreign demand elasticity. In these circumstances, export revenue gains in the subsidised sectors will be smaller than export revenue losses in other sectors. The net losses can be large enough that industrial policy is welfare-reducing overall.
Policy coordination avoids firm relocation effects to boost EU-wide productivity
Our first set of simulations demonstrates that coordinated industrial policy can neutralise the firm relocation effect, mitigating adverse international spillovers. We consider the case of hypothetical production subsidies to the Electrical and Optical Equipment sector, which empirical evidence suggests exhibits the largest scale economies. We compare two illustrative situations: one where industrial policy is implemented only in Germany and one where the policy is implemented also in the rest of the EU.
The left part of Figure 1 shows the case of assumed industrial subsidies to this sector being implemented unilaterally by Germany, causing a significant increase in German employment in this sector and a corresponding sectoral productivity improvement of 5.5%. Naturally, the employment that is gained by the subsidised sector is lost by all the other domestic sectors which experience some productivity loss. In net terms, the weighted average total factor productivity (TFP) of the German economy rises by 3%. The German unilateral policy, however, reduces productivity in trading partner countries such as France, because of the firm relocation effect, as shown by the left part of Figure 2. This illustrates the problem with unilateral policies: they may be well-designed to exploit domestic production externalities, but they don’t consider similar externalities existing in other countries, so they can’t achieve a globally efficient level of production.
Figure 1 Germany: Change in employment and total factor productivity from industrial policy in electrical equipment
Figure 2 France: Change in employment and total factor productivity from industrial policy in electrical equipment
The right parts of Figures 1 and 2 show what this globally efficient level of production looks like for the EU. It is defined by the changes in employment and total factor productivity obtained when all EU countries achieve a minimum level of policy coordination via a simultaneous implementation of subsidies that eliminate externalities. In this case, while TFP still increases in Germany, although less than under unilateral policies, TFP also increases in France and other EU countries. The simultaneous implementation of well-designed industrial policies spreads productivity gains more evenly across countries, without distorting underlying patterns of comparative advantage.
EU-wide industrial policy mitigates adverse terms of trade effects to improve welfare
Our second set of simulations focuses on the impact of industrial policy on welfare, considering terms of trade effects as well as changes in productivity. We calculate welfare changes in three cases: (i) when industrial policies that eliminate the externality wedge are implemented only unilaterally, (ii) when policies are coordinated across all EU countries, and (iii) when the EU is treated as a fully-integrated country.
In the first case, we consider the welfare impact of an ‘average’ EU country implementing industrial subsidies to eliminate externalities, while all other countries do nothing. The welfare loss is significant (see Figure 3, first column). The reason is that the increased production in the sectors targeted by industrial policy causes a significant reduction in export prices, given the inverse relationship between scale externalities and the elasticity of foreign demand – and exports are an important source of income for an ‘average’ EU country.
Of course, this deterioration in the average country’s terms of trade is matched by improvements in the terms of trade of trading partners, which see their import prices decrease. As a result, the ‘average’ EU country fares better when its EU trading partners also implement well-designed industrial policies (see Figure 3, second column). The ‘average’ EU country’s welfare still decreases, but less than before. The remaining welfare loss reflects the ‘average’ EU country being relatively open to extra-EU trade, so it suffers from a terms-of-trade deterioration vis-à-vis these non-EU trading partners.
Increasing intra-EU trade relative to extra-EU trade can help mitigate these remaining welfare losses from industrial policy. One way to boost intra-EU trade is to increase the internal integration of the EU internal markets. For modelling purposes, it is convenient to consider the extreme case and treat the EU as a single country, in which case EU-level industrial policy that eliminates externalities generates a welfare gain (Figure 3, third column).
Figure 3 EU welfare impact of production subsidies
Note: The first and second bars report the welfare change for an ‘average’ EU country defined as the GDP weighted average of welfare losses.
Conclusion
As highlighted in recent reports by Letta (2024) and Draghi (2024), Europe is grappling with a ‘size gap’. Transforming Europe into a fully integrated single market could leverage market forces to drive consolidation and achieve scalable growth, while remaining in full compliance with EU competition rules (Caffarra and Lane 2024). As Draghi (2024) has observed, these are investments that will benefit all member states, yet no single country can undertake them alone. Indeed, as argued in this column, coordination of industrial policy initiatives at the EU level is essential to achieving successful outcomes, mitigating fragmentation risks within the single market, and addressing the backdrop of rising geopolitical tensions outside the EU.
Source : VOXeu
