Industrial policy is making a comeback in the West. The US, Europe and other governments have introduced new incentives to the private sector in hopes of bringing supply chains closer to home, boosting domestic industries, and building strategic advantages in key technologies such as semiconductors and EVs. But success is not guaranteed. Can governments pick winners and losers? Do the potential benefits of industrial spending, such as driving innovation and economic growth, outweigh the consequences of higher debt and interest rates?

This episode of The OUTThinking Investor gathered insights from three experts on economics and fiscal policy to help investors assess how industrial strategies will affect financial markets and the global economy. Our guests are Paul Romer, economics professor at Boston College and former Chief Economist at the World Bank; Simon Johnson, professor at MIT Sloan School of Management and co-author of Power and Progress: Our Thousand-Year Struggle Over Technology and Prosperity; and Katharine Neiss, Deputy Head of Global Economics and Chief European Economist at PGIM Fixed Income.

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>> The Erie Canal in upstate New York is one of the greatest achievements of industrial strategy in the United States. Built in the early 1800s to connect the Great Lakes to the Atlantic Ocean, this massive engineering feat transformed the transportation and distribution of goods. It also set up New York City to become the center of global trade. The huge project called for processes that hadn't yet been tried, equipment that hadn't yet been invented, and funding that seemed unattainable. A combination of New York state-issued bonds and private investment was eventually secured. After eight years of construction, the canal opened in 1825 as an overnight success, immediately increasing shipments and slashing prices. The project debt was paid off in around 10 years, and by the 1850s, the canal transported most trade goods in the US. Agriculture blossomed, along with logging, mining, textiles, manufacturing, and more. Beyond New York, it led to rapid growth in Detroit and Chicago. It also made way for the field of engineering to take up new infrastructure projects and prompted the first school of civil engineering. Shipping in the area was eventually overtaken by railroads and then trucking, but the Erie Canal remains the original disruptor of trade and transportation. Massive projects like the Erie Canal require true visionaries. The stakes are high, and timing is everything. Even then-president Thomas Jefferson gave it a hard pass, saying it was just short of madness. In today's era of increasing industrial strategy, how can we know which industrial strategies are worthy and which are not? And how can investors look beyond the logistics to consider long-term effects on the financial markets and even the broader economy? To understand today's investment landscape, it's important to know how we got here. Welcome to Season 4 of The Outthinking Investor, a podcast from PGIM that examines the past, the present-day opportunities, and the future possibilities across global capital markets. In this episode, three experts share their views on potential impacts of large-scale industrial strategy. Paul Romer is currently a university professor in economics at Boston College. He was formerly chief economist at the World Bank and a recipient of the 2018 Nobel Prize in Economics. Simon Johnson is a professor at MIT Sloan School of Management and co-author of the book "Power and Progress: Our Thousand-Year Struggle Over Technology and Prosperity." Katharine Neiss is deputy head of global economics and chief European economist at PGIM Fixed Income. Governments use industrial strategy to influence certain economic sectors. That's often through infrastructure or science-based initiatives with high investment hurdles and the potential for great spillover effects. Big government typically likes big projects. The current era of industrial strategy may seem unusual or even questionable, especially given the gradual decrease in initiatives over the previous decades. Simon Johnson reflects on the history.

>> The really big change in everyone's thinking about what government can achieve in partnership with the private sector came during World War II. So, prior to 1940, the US federal government did very little to support science or fundamental engineering. And obviously, there were some cozy relationships with some big industrial companies, but mostly R&D was left to the private sector. What happened during 1940 was a gentleman called Vannevar Bush, who was a former dean of engineering at MIT, actually, persuaded President Roosevelt that now was the time to take existing scientific capacity and apply it to the war effort. And out of that came such things as the very helpful modern versions of radar and, of course, the Manhattan Project, which developed the atomic bomb. By the end of World War II, Bush had another proposal to Roosevelt and, of course, then to Truman, which was, okay, let's not rely next time on just using our existing stock of knowledge. Let's try and develop that stock, including a basic knowledge. And that became the National Science Foundation. That became a sort of reprioritization of how government thought about science. And that became 2% of GDP at its peak in the 1960s. Now since then, it's waned. And I think we've taken our eye off that ball. But let me remind everyone that when COVID came along, it was repurposing of existing scientific talent and inventions, including mRNA, which was able to more quickly develop COVID vaccines. And that's an important part of how we got the world economy back sooner than would otherwise have been the case.

>> Another pivotal moment came in 1957 when the Soviet Union launched Sputnik, which was the first artificial satellite to go around the world. It was a big shock to most Americans and the rest of the world.

>> President Eisenhower had an interesting response, which is, first of all, he appointed the president of MIT to be his chief science advisor. That was something that apparently was quite reassuring to the nation. But secondly -- and on perhaps a deeper basis -- launched a bipartisan effort and worked with a bipartisan effort on Capitol Hill to put more money and resources into science and engineering and -- here's the key piece -- to train more scientists and engineers. So the National Defense Education Act of 1958 came directly out of the response to Sputnik. And the view that the Soviet Union was pulling ahead of the United States in terms of scientific talent, that legislation put money into high schools. It helped finance people from less well-off backgrounds to go to college. And really turned the giant ship of American talent definitively towards math, physics, and other sciences in a way that lasted for generations. And I think that's what we need to do today, which is focus definitely on putting money into projects that can be brought to fruition over the next five to 10 years, but also help younger people who have the ability to become very smart scientists and engineers, help them get the kind of education that they need at a reasonable cost, and then have opportunities that they can find through the labor market, where they can take that talent that they've developed and plug that into useful innovation.

>> Much of the current industrial strategy getting underway looks quite different from that of the past. Technology is one cornerstone. Fossil fuels and reducing greenhouse gas emissions to slow down climate change is another. Paul Romer offers some context.

>> If you think about global warming or climate change, the policy that economists always talk up is something like a tax on the thing that's doing harm, the emissions of the greenhouse gases. Politically, that has been impossible to implement. So they have shifted to policies where we're subsidizing the beneficial types of energy sources rather than trying to tax the harmful ones. And in this context, I think you want to quote Deng Xiaoping, that famous capitalist who said, "It doesn't matter what color the cat is as long as it catches the mouse." So if you're trying to get a cleaner energy system, you can tax the bad thing, you can subsidize the good thing. But what matters is that we get to clean energy. I think the difference that we're recognizing right now is that there are other policy concerns besides expanding global trade that the government has to attend to. We have a growing problem with climate change. We have also a growing problem with inequality. And there was a period of time where the easy focus was, well, let's promote free trade. And implicitly, let's promote US firms who can then go sell around the world. There was a double-edged message here, because many of the countries that we were encouraging to trade also benefited significantly from that. So there was both enhance the US situation and help promote globalization, freedom, trade, progress around the world. But that was an easy kind of policy to follow. It didn't address climate change. It didn't address this problem of growing inequality in the United States. So now we're turning towards some of the issues that we neglected when we focused primarily on pushing free trade. But we're still in the early stages of figuring out how as a nation we want to both have rapid growth and make sure that everybody has a reasonable chance of participating in some of the benefits from that growth.

>> While this is happening, the US, along with much of the developed world, is seeing major macroeconomic effects of industrial strategy and spending at a time of heightened uncertainty. Katharine Neiss explains.

>> This is a real change in the rules of the game when it comes to managing economies. At a very high level, we're moving away from a world where we had, you know, free markets, global trade, according to, you know, agreed global trading rules, to a situation where governments are effectively subsidizing and encouraging and identifying sort of industrial champions in order to increase economic sovereignty, if you like, to a degree. And really ensure that countries are resilient and have a degree of self-sufficiency when it comes to ensuring their economic outlook. If we think about the world that we came from, where we had very active central banks supporting the macro outlook, but fiscal authorities that were stepping back and essentially following a period of austerity, we're now morphing into the exact opposite of that, with central banks not stepping in and helping. They're having to tighten, raise interest rates in order to get inflation under control. And it's the fiscal authority that's really doing the heavy lifting through these industrial policies to support macroeconomies. If we're really changing the rules of the game, I think it stands to reason that it is going to have an impact on some really important financial variables that investors do need to focus on. We are already seeing much higher debt levels, for example, and that is pushing up on long-term interest rates. Now, you know, the downside to that is higher interest rates through higher public spending risks crowding out private investment. And if this increased public investment doesn't translate eventually into higher growth, you know, that could lead to some very painful adjustments. But on the plus side, with governments clearly signaling the direction of travel that they see through these industrial strategies, it does sort of give the private sector, you know, a north star of where we're going over the medium term. That helps to coordinate in a way that can have positive spillovers. And to the extent that we do see stimulated innovation and research, those things tend to have very positive spillovers on other areas that we can hardly anticipate. I mean, we've all sort of heard, you know, the stories about, you know, getting the first man on the Moon is ultimately what sort of led to us all having iPads and even sneaker technology. So sometimes these goals that were very specific that led to all this spending can actually lead to an explosion of new thinking, new ideas that have applications elsewhere. But they come at a cost. And that cost is often through higher longer-term interest rates.

>> As the wise Yogi Berra once said, it's tough to make predictions, especially about the future. It can be difficult for governments to identify the winners and even then to execute effectively.

>> The most important thing we've learned is that if you're a venture capitalist, and you have one success and nine failures, that one success can pay for everything and you can be regarded as a cultural hero. If you're the government and you have nine successes and one failure, that one failure will be called Solyndra and you'll have congressional investigations for the rest of your administration. And that becomes the story. And so I think we are quite a long way from being able to turn that around and say, look, government should place bets like the private sector does. The government should not be stepping on the toes of the private sector. That's sort of pointless. The government should be making investments in basic science that have the potential to have big spillover effects and big positive effects on our economy, on the world economy, on climate change, on global health, whatever your criteria are.

>> Katharine Neiss points to a couple of lessons we can take going forward to improve our chances for success.

>> Past experiences certainly do offer a lot of lessons. One is for the public sector to really, you know, leverage off the private sector through these partnerships because generally private sector is going to be much better placed to identify, you know, winners and losers and where best to focus resources. Another element is to have a lot of accountability and transparency about how these funds are used, especially since, you know, ultimately these are being, you know, backstopped and funded by the taxpayer. So that's, of course, a very important governance element to this spending. For example, in the US and in the Euro area, the US is very much following approach of offering subsidies in order for the private sector to think how best to deploy those funds that are then subsidized. In Europe, you're seeing a lot of important, you know, governance overlay and accountancy, accountability, and transparency associated with the use of the centralized, what they call in Europe, NextGenerationEU funds that many countries that were hard hit in the pandemic are able now to use for investment purposes.

>> How might this large-scale spending in certain countries impact the broader global economy? Could it improve growth prospects for certain regions or countries? Could it exacerbate existing troubles?

>> The countries that can be nimble and spot a policy opportunity and pursue it are likely to be the ones who benefit. And these benefits can be of that classic form of making the pie bigger and then capturing a slice of it for yourself. A good example of this is a very heavy pattern of investments, very expensive pattern investments in China to subsidize solar panels. Solar electricity generated by these solar panels is much cheaper now or the panels are much less expensive because of the innovation that we've seen in China. So China will help the world shift away from carbon-based energy and will probably capture some domestic benefits in terms of profits for firms and employment. Europe is afraid that the United States will do the same thing. So instead of trying to say that we should use trade law to shut down the US from subsidizing new renewable energy sources, Europe should get its policy act together and find a way to do the same thing. The type of investment that the United States has been doing as China was pursuing solar panels has been to invest in a whole new generation of nuclear reactors, the small modular reactors. And I think this could prove to be as important, maybe even more important than solar panels as part of a broad solution to the problem of getting to zero carbon energy system. So this is in a way what you'd like to see. Visit one country, bets on one technology, and see some benefit for it in the world than that. Another country bets on another one. In the best case, we'll be selling modular reactors to China and we'll be buying the solar panels and it'll be a win-win for everybody.

>> Is there a size effect here in terms of a country's effectiveness of spending? Looking back, it seems that large-scale government industrial spending has often worked better for smaller countries than for larger ones. Are there other factors that larger countries can emulate to improve their outcomes?

>> In order to really, you know, have a big impact through these industrial strategies, you need a lot of financial firepower. The US obviously has that. They've put a lot towards this, and that puts a region like the Euro area at somewhat of a disadvantage. They have the resources but they don't really have the institutional framework, the structure to share those resources in the same way that the United States does. And so that creates some rigidities and stickiness for the Euro area to be able to step up to the plate and to try to implement policies at a similar level to what you're seeing in the US. And of course, it's much harder for very small countries like the United Kingdom, who have clearly the institutional structure for the sharing but are more financially constrained. And we saw in September, October of 2022 that when the UK tried to sort of strike out and do something bold on the fiscal side, financial markets had a bit of an allergic reaction to that. And so they will be more constrained in being able to sort of boldly adopt some of these, you know, quite large industrial strategies.

>> I don't think that the small or big matters directly as much as people think. But it can matter indirectly because it influences the willingness of the government and the capacity of the government that take the decisions that will actually foster growth.

>> I think that the advantage of being a big country is you can have a much bigger, more diversified portfolio. So as investment managers will immediately appreciate, there are some major advantages to that, particularly if we rebalance our portfolio over time so that as we see hits, as we see a direction developing [inaudible] the Human Genome Project would be a perfect example. Human Genome Project actually was proposed first to private venture capitalists who said, not unreasonably, "Oh, nice idea, but we're not going to invest because all the benefits are going to be in general scientific spillover." So the federal government took it on and $10 billion later, we had a pretty complete mapping of the human genome. And now we have an industry that employs about 300,000 people, mostly in good paying jobs, generating, you know, a lot of value for the American economy, selling or developing drugs that are extremely valuable to the world. And of course, that's the same industry that helped deal with COVID when it came along. So I think that making big strategic investments and having the government push in as many directions as possible, to me, that's the major advantage of the United States. And there's only one or two other countries in the world that could foreseeably do that. China is, of course, one. Other potential contenders, the European Union as a whole, if they had an integrated strategy. India, maybe one day. But right now, it is the United States in a remarkably strong position with regard to our university private sector linkages, private sector commercialization, and the willingness of 100-plus communities around the United States to desire to become much more dynamic tech hubs.

>> All this begs the question, what about the increasing trend of near-shoring or friend-shoring, and how that impacts global supply chains and distribution?

>> Inevitably going to see more focus on on-shoring because the pandemic brought home to us how likely it is that we could face another case where we get a crisis, where the market system breaks down and there's allocation based on where things are produced. And the conflict in Ukraine I think has also given many of us a little bit of a wake-up call that we wanted to believe that we would never have wars again. You know, no two countries that both have a McDonald's have ever gone to war. Well, you know, that's kind of gone by the waysides now. So I think it will just be inevitable that countries think about on-shoring to anticipate what will happen when we get into one of those crisis episodes.

>> Countries such as the United States, big countries, would like to have more parts of critical supply chains, either domestically sourced or in countries that are regarded as being 100% reliable, including in big emergencies like during COVID. So I think that's an overlay on top of existing policy priorities. We haven't yet decided how to pay for that. We haven't yet decided if we want to back that up with tariffs or in some other way. I think to the extent we're able to make strategic scientific investments in the United States, there is great interest in helping local economies develop around those innovations. And if there is this idea that we gave away some big things that we invented in the recent past, flat-screen TVs, for example, would be one of the most salient and painful examples. And we didn't really need to do that. What happened there is in a nutshell, a couple of big American companies invented the technology and were really at the forefront of it. But then because of internal politics, basically, and the question of what the priorities of those companies were, they didn't develop that technology and they allowed it to go out to, in the first instance, Japan. And then, of course, a lot of that technology was developed and brought to market in South Korea. So on the one hand, the world got the technology, American invention, some American benefits, global dissemination, and you can buy cheap and good flat screen TV or other -- we're looking at each other through flat screens, obviously, these days. I think, though, in retrospect, it's unfortunate that so much of that moved offshore as quickly as it did. And there's nothing about that movement that seems -- that was inevitable or driven by some fundamental characteristics of the United States and these other countries. It was much more accident and lack of attention, I would say. Now a lot of that's with the private sector. The government needs to think about spillover effects and continuing to create and incentivizing, at least, production of particularly of new things, of highly valuable things in the United States.

>> As Paul Romer reminds us, industrial strategies and policies can have very similar goals, but lead us down very different paths and in very different directions. That may sound perilous, but we have good reason to be optimistic.

>> There is an enormous capacity for us to discover new things. This helps us understand what might be possible with medical technology, with semiconductors, with software, all these market kinds of effects. But the same principle applies even in how we carry out our collective decisions and implement them through our governments. At about the same time that humans invented powered flight, we also invented central banks. These are units of government that have some autonomy and can deal quickly with situations that often demand a very quick response to prevent a crisis. We should stay open to the possibility that there would be better ways to do things. I don't think prosecuting a company for a crime is a very effective way to try and make sure we have a rich ecosystem of lots of firms that are all competing for business, but there are other ways we could do that. And I think rather than get trapped by kind of rote repetition of some kind of message that was handed down to us by the great authorities from the past. We need to be open-minded and as clever in our thinking about policy as we are in thinking about, you know, technologies.

>> Industrial strategies in general and public-private partnerships in particular have created some of the most successful initiatives of the modern economy. Who knows what the Erie Canal of the future might look like? The challenges it might solve, and the unexpected opportunities it might present. Thanks to our experts Paul Romer, Simon Johnson, and Katharine Neiss for their insights on large-scale government industrial policy. The Outthinking Investor is a podcast from PGIM. Follow, subscribe, and if you like what you hear, go ahead and give us a review.

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