The Four Pillars Of Industrial Policy, And Why They're All Bad | Ep 8 | FED Dialogues

Notes

A father's political journey from communism to Hayek

Ajay Shah's connection to economic growth is unusually personal and intellectual rather than experiential. His father lived through the entire arc of the twentieth century, running away from boarding school in 1942 to join Gandhi's Quit India Movement, arriving ticketless in Bombay and sleeping at the railway station. Like many thinking people of that era, he then became a full-time Communist Party cadre until 1955.

What makes the story distinctive is the turn that followed. Khrushchev's 1956 speech denouncing Stalin made a deep impact, and Ajay's father began rethinking his politics while simultaneously watching India's socialist experiment unravel in real time. These were the stories Ajay absorbed in childhood: that growth is built in the private sector, in firms, and that the Indian state had become "a cancer of central planning and lack of rule of law."

This gave Ajay an unusual head start. While most Indians of his generation point to the 1991 reforms as their awakening, Ajay was reading Milton Friedman's Free to Choose, Capitalism and Freedom, Essays in Positive Economics, and Hayek's The Fatal Conceit while still in his half-pants, well before his father died in 1984, before liberalization arrived, and unfortunately before his father could see the changes he had anticipated.

The bumper sticker: too much central planning, too little rule of law

Asked for his single best summary of what ails India, Ajay offers a compact diagnosis: too much central planning and too little rule of law. Central planning means the government meddling in the economy across thousands of details. Too little rule of law means that meddling comes as personalized, arbitrary force, not bound by consistent rules or procedure.

Combined, these two forces have created a serious risk of expropriation in the eyes of the private sector, which Ajay identifies as the root cause of an investment collapse he dates to around 2011. He is careful to separate this argument from a more common one about state capability and market failure.

"When India got a great growth episode nineteen ninety-one to twenty eleven, it wasn't like there was any state capability. It wasn't like there was much rule of law. It was a pretty horrible Indian state. So we should not have rosy visions about becoming Norway and then you'll get growth."

Ajay's point is that growth had to be ignited in a poor country with a shambolic state, and the path to something resembling Norway comes later, not first. This doesn't mean state capability and addressing market failure don't matter, they do, but Ajay resists framing them as the soul of what actually drove India's twenty-year growth episode.

Rahul draws out the practical implication: what's needed isn't more state capability in the sense of a stronger, more active government, but rather removing shackles and unleashing the private sector. Ajay agrees, describing a private sector that today faces genuine fear, not just from tax authorities and enforcement agencies, but from ordinary regulatory unpredictability, where a legal instrument issued one evening can force an entire enterprise's IT systems to change by morning.

"There's been a Darwinian selection where the optimists got destroyed and you've got more quiet, stolid people manning the industry."

Rahul extends this insight further: this Darwinian selection doesn't just produce cautious firms, it selects for firms that optimize for managing government relationships rather than optimizing for price and quality, which is what determines competitiveness everywhere else in the world.

Four pillars of industrial policy, and why Ajay is skeptical of all of them

Turning to the prominent contemporary narrative around industrial policy, Ajay lays out what he sees as four distinct forms it can take, and explains why he's unenthusiastic about each.

Pillar one: subsidies. This includes explicit payments, PLI-style schemes, and tax breaks, all channeling taxpayer resources toward chosen industries. Ajay's core objection rests on the marginal cost of public funds (MCPF), the idea that a rupee of government spending costs society more than a rupee, due to economic distortion, compliance costs, and the implicit taxation of forced government borrowing. He and Vijay Kelkar estimate India's MCPF at around 3, meaning government capital is roughly three times as costly to society as private capital.

"It's better for society that things should be done by the financial system. When a venture capitalist uses one rupee, it's a cost of one rupee. When a government uses one rupee, it's a cost of three rupees."

Beyond cost, Ajay invokes public choice theory: officials lack the incentives that discipline venture capitalists, and political considerations, like who "shouts on Twitter saying pro-government things", distort allocation. Finally, he appeals to epistemic humility about technological forecasting itself.

"Will you know it well? Will I know it well? Who are we? We are pygmies. No individual knows it. It is the market economy that discovers this."

Pillar two: ethno-nationalist protection of national champions. Ajay rejects defining competitiveness by the nationality of a firm's ownership or leadership, noting the absurdity of asking whether Sundar Pichai's leadership makes Google Indian, or whether ICICI Bank (90 percent foreign-owned) counts as Indian. He argues the best Indian firms remain far behind the best global firms, and that genuine learning happens when global firms operate in India, seeding local talent with knowledge, as happened when Texas Instruments built early software development facilities that trained the people who built India's IT industry.

"High productivity, high capability are in global firms... The best knowledge is in the advanced economies. So let's not lose sight of the development journey."

On national security specifically, Ajay argues for a clean separation: defense should worry about genuine risks, like backdoors in Chinese-sourced chips, without using national security as a justification to contaminate the broader economy with ethno-nationalism. His formulation: "the best foreign policy is eight percent GDP growth."

Pillar three: government-dictated technical standards. Ajay treats it as near-dogma that firms, not governments, possess the tacit, sophisticated knowledge of production. He draws a military analogy: tanks appeared in World War One, but it took a decade of work by strategists like Guderian, Tukhachevsky, and Rommel to develop the doctrine, the management and organizational choreography, that made tanks actually effective in war.

"High productivity firms are not just a creature of the technology in a scientific, in a hard science sense. High productivity firms are management. They are the genius of that choreography of the dance of people and how they work with the machines."

As an example of this pillar in practice, Ajay points to UIDAI, UPI, Bharat Bill Pay, and the Unified Lending Interface, cases where a designed technology gets imposed on the entire country, with coercive backing and foreign competitors blocked from entry.

Pillar four: government-built monopolies, exemplified by entities like NPCI or Air India. Ajay connects this back to his broader philosophy that growth is a process of discovery, not design, invoking Jane Jacobs' observation that great cities look messy because the human mind is messy, contrasting organically-grown Gurgaon with top-down planned Chandigarh.

A more sympathetic look at PLI and the tax system underneath it

Pressed further on subsidies, Ajay offers a more textured take on India's Production Linked Incentive scheme. He argues there's real wit behind PLI: much of what's being refunded to firms like Apple compensates for mistakes in India's indirect tax system, taxes that shouldn't have been levied in the first place.

"There is more wit in PLI than meets the eye. The argument is, the Indian tax system is broken. There is plenty of stupidity in the Indian tax system, and we're just refunding the monies to Apple that should never have been taken from them in any reasonable indirect tax system."

Ajay credits economist Ila Patnaik with opening his eyes to just how deeply these tax mistakes are "first order" problems, not minor technicalities, that fundamentally frustrate globalized manufacturing in India. He had previously assumed that GST's zero-rating of exports mostly solved this, but has shifted his view after working with Patnaik on a forthcoming paper.

His objection to PLI isn't the mechanism itself but its permanence. He'd have been comfortable with it as a six-week stopgap while a proper committee report and legislative fix were pushed through, especially given a government with an overwhelming parliamentary majority. Instead, it has become normalized indefinitely.

Rahul adds a further concern: PLI-style deals favor firms wealthy and resourced enough to navigate Indian policy processes, like Apple, while leaving out the much larger universe of smaller global entrepreneurs who lack that access.

"There are tens of thousands of important, capable global firms who don't have that ability to work with the Indian state and solve their problem... this big-firms-centric view of creating policy environments that work for the largest firms is also limiting in terms of the scale of its impact."

Ajay also notes that policy ideas like GST take a very long incubation period, tracing its intellectual origins to a late-1990s NIPFP report, through a 2003 FRBM implementation task force he worked on with Kelkar and Arbind Modi, to actual implementation in 2016-17, a reminder that fixing tax structure properly is a decade-plus project, not a quick fix.

The China problem: subsidies, IP theft, and a self-inflicted collapse

Asked how to compete with a country subsidizing industry as aggressively as China, Ajay separates the issue into several distinct threads rather than treating "China" as one undifferentiated phenomenon.

The first is outright IP theft and cybercrime, which he considers to simply cross a line no civilized country should accept, citing an example of Cisco router firmware allegedly stolen and repackaged by Chinese firms with government support. Related to this is a pattern where factories built by global companies in China are secretly replicated nearby using stolen engineering designs, producing counterfeit competitors under different brand names.

The third thread is subsidies proper: cheap energy, land, and finance propping up "zombie firms" that stay operational despite negative operating profits, a dynamic Ajay says was seen before in Japan's evergreened bank loans. He describes the competitive agony this creates for legitimate producers.

"It is a unique agony for you and me to be running a sophisticated high productivity firm and to watch our profits being destroyed... because some loser who doesn't know how to run a factory is competing with us in the market, charging low prices while running a negative operating profit for several years, propped up by the government."

The fourth and most significant thread is what Ajay calls a "very unique moment" in Chinese economic history: a present-day macroeconomic collapse. He traces its cause directly to Xi Jinping's rise, which reversed Deng Xiaoping's trajectory toward political and economic liberalization. Power was concentrated, rule of law declined, dissent was suppressed, and Xi combined this with an increasingly hostile nationalist posture toward the West, including support for Russia's invasion of Ukraine and threats against Taiwan.

"My five-minute narration sounds like a script out of hell for how to mismanage an economy. It is like everything wrong all at once."

The result, in Ajay's account, is zombie firms, zombie banks, entire unsold cities of real estate, and deflation, falling aggregate prices signaling a severe supply-demand imbalance. Because Xi is unwilling to accept the roughly 30 percent decline in per capita GDP needed to correct this imbalance, the government instead subsidizes firms to keep exporting at bare operating cost, flooding global markets with artificially cheap goods.

Given this specific, time-bound crisis, Ajay and Ila Patnaik have co-authored an argument, unusual for Ajay, for limited and carefully targeted non-tariff barriers against Chinese exports. But he's explicit that this applies only to sectors where India has genuine institutional capability worth protecting.

"If there is no such industry, there's no meaningful industry, then you should just be saying thank you to the Chinese and buying up this stuff and sticking it in a warehouse... because this will not last indefinitely."

He acknowledges the implementation risk is severe, noting that his own article shows how difficult it is to design such measures without falling into the same state capability and political economy traps he criticizes elsewhere.

Ajay also pushes back on cherry-picking China's electric vehicle success as vindication of industrial policy, pointing out that the same philosophy produced catastrophic overbuilding in China's real estate and construction sector.

"You should not cherry-pick that Chinese EV has done rather well and that is the achievement of Chinese industrial policy. The Chinese industrial policy has played in many fields, and I would argue that in fact this kind of approach represents the destruction of the successful China model."

Drawing on economist Ricardo Hausmann's framework, Ajay explains China's earlier, more successful approach: since China's institutions and rule of law were never going to match the West's, the country instead pursued a "sterile engagement with globalization", giving foreign firms land and logistics without requiring the complex contracts, accounting, or institutional depth of a mature market economy. This explains, in Ajay's telling, why China's stock market has performed poorly for so long despite decades of growth: institutions like modern accounting are difficult to rebuild after the Cultural Revolution, whereas India's accounting traditions stretch back to the seventeenth century.

Japan's MITI and the limits of industrial policy's early wins

Turning to Japan, Ajay acknowledges the historical record shows real success in the early decades of Japan's industry ministry, MITI, across steel, electronics, and automobiles in the 1950s, 60s, and 70s. But he insists on situating this within Japan's unique starting conditions.

Japan was not a developing country by the time MITI operated. Its capability-building began at the Meiji Restoration in 1869, when young people were sent abroad to absorb Western scientific and institutional knowledge, deliberately choosing, for instance, German-style law as the most advanced model available. By 1905, Japan had built enough indigenous capability to defeat Tsarist Russia's navy, a semi-Western power, in a war fought with a homemade fleet.

After World War Two, Ajay highlights a distinctive national psychology: a genuine process of truth and reconciliation, and a humble acceptance of wartime guilt, that channeled into a determined effort to rebuild well, rather than into nationalist resentment against American occupation. This context, high pre-existing state capability plus intense post-war national morale, is what Ajay says shaped MITI's operating environment.

Rahul raises a counterpoint: Soichiro Honda was reportedly a critic of MITI, and Sony was initially blocked from acquiring transistor technology, suggesting MITI's early record is more contested than a simple success story. Ajay clarifies that his praise applies mainly to the 1950s-60s-70s window, and that by the 1980s, MITI was already fumbling.

He cites MITI's failed push into semiconductors as a clear counterexample, recalling a forty-page Scientific American advertisement recruiting engineering talent to Japan's chip ambitions, an effort that came to nothing because CPU development happened in America instead.

Zooming out, Ajay's overall verdict is measured: averaging Japan's growth from 1945 to today produces a record that is "good, but not great." He raises the possibility, without claiming certainty, that a pure market economy counterfactual from 1945 might have produced steadier long-run results than a policy-driven spurt followed by decades of stagnation and lost institutional memory.

South Korea's export discipline and the value of clearing obstacles, not offering subsidies

Discussing South Korea, Ajay relays a framework from economist Lant Pritchett: a small number of business houses, the chaebols, around fourteen in total, combined with a dictator who fixed on one clear objective, exporting. The dictator, per this account, ran meetings with the chaebols nearly every day, insisting on export performance.

Crucially, Ajay stresses what this arrangement did not include: subsidies or exchange rate manipulation. The government's role was to clear obstacles, not to cushion firms from the discipline of competing internationally.

"We're not going to give you subsidies... We want you to perform. So performance is defined as exports."

This connects to arguments from Anne Krueger, T.N. Srinivasan, and Jagdish Bhagwati (as referenced by Ajay) that export orientation creates a healthier domestic political economy: firms align around building genuine competitiveness for global markets rather than fighting each other for domestic favor.

Ajay also credits South Korea's democratic transition, cemented around the 1988 Seoul Olympics, with sustaining growth afterward by delivering the "full package" of economic and political freedom, something China notably did not do under Xi Jinping.

Rahul draws the contrast forward to India's scale: South Korea's model depended on the span of control being small enough for a handful of personal relationships between business leaders and the state to function. Ajay agrees this doesn't translate to India, where tens of thousands of firms are spread across the country, and reliance on personal deals risks recreating the old pattern where "managing Delhi" became central to business success, forcing firms to fly in and plead with bureaucrats rather than compete on merit.

Why exports remain the truest test, and the final case for fixing rules over doing deals

Closing the conversation, Ajay articulates why exporting occupies a special place in his thinking about growth. Competing in the global market eliminates the possibility of domestic political gaming, one firm cannot simply out-regulate another through the political process, because the discipline of the export market forces genuine performance.

"The only way to succeed in exporting is to become a host to multinationals."

He notes that roughly fifty percent of world trade happens intra-firm, within multinationals rather than between arms-length firms, meaning export success is deeply tied to attracting both foreign and Indian multinational supply chains. Indian multinationals themselves are, in Ajay's view, one of the underappreciated success stories of recent decades, hundreds of large Indian firms now operate genuinely globally.

He pairs this endorsement of exporting with a firm caveat: it must not be gamed. He and Ila Patnaik coined the term "fake exports" to describe exports manufactured through distorted exchange rates or subsidies rather than genuine competitiveness, something the South Korean dictator explicitly refused to offer his chaebols.

Rahul closes by reframing the practical policy implication: rather than businesses pleading with individual bureaucrats to solve their specific problems, the broader intellectual and business community should focus on identifying which rules are broken and fixing them systematically, making both Indian and multinational firms in India naturally competitive enough to export.

"For a country the size of India, we are far better off going toward rules, because there are tens of thousands of firms spread all over India."

Ajay agrees this is the way to growth, closing the conversation on the same throughline that opened it: the case against ad hoc deals and central planning, and for building an economic environment where competition, not government favor, decides who succeeds.

Supplementary Resources

• Many roads lead to a sound GST by Vijay Kelkar and Ajay Shah (Resource)
• Why firms in the country need to prioritise Japanese engagement more by Ajay Shah (Resource)
• The China Model is Broken by Ajay Shah and Amit Varma (Resource)
• Graduating to Globalisation by Ajay Shah and Amit Varma (Resource)
• In Service of the Republic: The Art and Science of Economic Policy by Vijay Kelkar and Ajay Shah (Book)
• Beware of Industrial Policy by Ajay Shah and Amit Varma (Resource)

The complete transcript file is available to download below.