A Balancing Act Between Market Forces and Government Intervention
Opinion
State intervention is increasingly shaping Europe’s industrial policy. ZEW President Professor Achim Wambach, PhD takes a look at market-conforming measures and the challenges they present.
Industrial policy is en vogue. The way was paved last year by Enrico Letta’s report on behalf of the European Parliament, advocating a “dynamic and effective European industrial policy”, and by Mario Draghi’s report on behalf of the European Commission, laying out “a new industrial strategy for Europe”. In late January, the Commission explained in its “Competitive Compass” how it plans to implement the proposals. On 5 March 2025 the strategy plan for the “Clean Industrial Deal” was published. The agenda also includes the "Net-Zero Industry Act” of 2023, which aims to scale up manufacturing of clean technologies in Europe.
The Act sets a goal for net-zero manufacturing capacity to meet at least 40 per cent of the EU’s annual deployment needs by 2030. The existing state aid regulations, which define the subsidies that national governments are allowed to give out, are to be adjusted for this purpose. There are also discussions about amending the merger rules in order to make it easier for companies to merge, e.g. by invoking innovation activities or sustainability aspects.
While in 2019 the proposal of a “National Industry Strategy 2030” made by the then German economics minister, Peter Altmeier, was still viewed critically by many, using instruments of industrial policy has in the meantime become the norm in Germany. In 2024, financial aid and tax benefits to the tune of 67.1 billion euros were given to companies. In 2021, the figure was 37.9 billion euros. Much attention was paid to the multi-billion euro funding programmes for battery producer Northvolt, chip manufacturer Intel and Meyer Werft, a German shipyard building cruise ships. Compared to the other European countries, Germany leads in awarding subsidies, also in relation to gross domestic product.
A number of studies on industrial policy exist in the domain of economic sciences. They include research on economic history, e.g. an analysis of the impact of the Continental System, a blockade imposed by France in the early 19th century to ban trade with Britain. Under the temporary protection provided by the Continental Blockade, young domestic industries thrived and became internationally competitive in the long term. There are also studies examining more recent phenomena like the development of the Chinese shipbuilding industry, which was subsidised by the government in the early 2000s and greatly expanded its market share. As the studies emphasise, untargeted subsidies tend to be economically inefficient. In contrast, if subsidies benefit companies that are particularly efficient, they are more likely to achieve their objective. The Verein für Socialpolitik, an association of German-speaking economists, chose “Revival of Industrial Policy” as the topic of its annual meeting this year.
“We turned a blind eye when it came to industrial policy”
For many years, industrial policy has been treated as a marginal topic by academia because it was a marginal topic in politics. Industrial policy measures were frowned upon, and for a good reason. There are many examples of how the government overstretched its remit when choosing which companies to subsidise, as well as of distortions to competition between subsidised and non-subsidised companies, inefficient rent-seeking by companies hoping for funding and unproductive races for subsidies. The EU deliberately put a stop to extensive subsidy policy by implementing state aid control. The World Trade Organization (WTO), too, believes it is legitimate to call for protective tariffs for imports by companies subsidised in their country of origin or production in order to prevent distortions to competition. However, the maxim we often heard in Sunday sermons that the state should only ensure the framework conditions and simply let the economy take care of itself, was just that: a Sunday sermon. Or, as an older colleague once put it: “Regulatory policy is averse to industrial policy interventions, but we turned a blind eye from time to time.”
Wilhelm Röpke, one of the fathers of the social market economy was more explicit. He declared that “in addition to the framework [...] of market economy, certain well-regulated and well-considered interventions by the state” were required. But it was also clear to him that “there is a Rubicon for interventionist economic policy” and if it was crossed, a situation would arise in which “collectivism would altogether replace” the market economy. The goals and means of market intervention should therefore be decided very carefully and they should be restricted.
The goals of industrial policy intervention: Transformation and security
In its Competitive Compass, the European Commission adopts three fields of action that Mario Draghi put forward in his report: 1. Closing the innovation gap in relation to the US and China; 2. A joint roadmap for decarbonisation and competitiveness; 3. Reducing dependencies and increasing security.
There have always been good reasons for public innovation funding because of the externalities of innovation activities: Companies are unable to fully translate the economic benefits of their innovations into profits. That is why they tend to invest too little in research and development. The “if” of state funding for research and development is therefore undisputed, the “how” is more difficult. The fact that economic growth in the US was 50 per cent higher than in the EU countries over the last 20 years points to fundamental weaknesses in the European single market. But inadequate research funding is only partly responsible for this: A lack of financing options and excessive regulation are major impediments to the growth of new firms.
The transition to climate neutrality was not part of the script in the post-war years. And a market failure, e.g. inadequate prices for harmful emissions, justifies intervention in the market. In 2027, when the second European emissions trading scheme comes into force, close to 90 per cent of all emissions in Europe will carry a price. Additional industrial policy interventions for climate policy reasons will become increasingly unnecessary since the set number of emission certificates is such that the EU climate targets are met through emissions trading. The areas with a particular need for action are those without CO2 prices.
The level of ambition applied in Europe is currently not shared by countries worldwide. As a result, European companies are at a disadvantage in international competition. Within Europe, the Carbon Border Adjustment Mechanism (CBAM) is designed to level the playing field: For certain product groups, imports from countries that pursue a less stringent climate policy are subject to a tariff. While this is a first step, CBAM is incomplete and does not help ensure that European companies do not suffer competitive disadvantages on world markets outside the EU.
It is worthwhile stressing this point: With the EU emissions trading scheme, the objective of industrial policy for climate protection reasons is shifting. It is now less about taking measures to achieve EU climate targets (emissions trading ensures this) and more about ensuring a fair competitive environment for domestic companies to prevent them from relocating their production abroad. This would not help Europe as a business location and would not address the issue of harmful emissions (keyword: carbon leakage).
The second new reason for pursuing an industrial policy is that security issues have arisen following the pandemic experience and especially the outbreak of the war in Ukraine. Ensuring security of supply and building robust supply chains is essentially the responsibility of each individual company. Companies have responded by increasing the diversification of their supplier base and relying more on regional production: in China for China, in Europe for Europe. However, individual hedging is not enough in all circumstances. There are systemic risks that the market alone cannot control. Often it is still unclear where exactly these risks lie – this, too, is an area that has only in recent years attracted more attention from scientists.
Added to this are the new demands for a stronger defence industry. The planned increase in military spending and the need for closer European cooperation will transform the defence sector. This transformation can be an opportunity. While the US spends 16 per cent of its defence budget, which is about three times higher than that of the EU, on research and development, the figure for the EU is only 4.5 per cent. Strengthening R&D would have benefits beyond defence: Innovations in the military sector are often later found in the civil sector. Conversely, many innovations, particularly in the form of technical innovations, are used in the defence sector that have their origin in the civil sector.
Röpke mentioned two basic principles that should guide “liberal interventionism”. This term, adopted by Röpke, was coined by Alexander Rüstow, another father of the social market economy. The first principle is based on the intervention’s objective: If the objective is an “adjustment intervention” to “alleviate the hardships and frictions of changes and disruptions in economic life”, the measure is more likely justified. In contrast, “maintenance intervention” measures should be rejected as “reactionary, dangerous and irrational”. Measures that would probably fall under the category of adjustment intervention are, for example, transformation as a reorganisation of economic life, efforts to ensure protection in the event of disruptions in economic life and the expansion of the defence industry. Subsidising cruise ship builders tends to belong to the second category. Following the objective, the intervention itself also has to be considered. This is where Röpke’s second principle comes into play.
Market-conforming interventions
Röpke distinguishes “conforming and non-conforming interventions”. Interventions are considered market-conforming if they “[are] in accordance with the principles of our market economy system and can be digested by it”. These principles include e.g. the functioning of the price system and the prevention of market power.
According to this conceptual category, the EU has chosen a market-conforming instrument with its two certificate trading systems. The price mechanism can work. Companies thus compete for the best positions in the market on the basis of their expertise and technologies, not on the basis of their access to politics. However, the subsidies awarded to steel companies for the production of green steel are assessed more critically. With their focus on production rather than research and development, they are inadequate as an instrument for promoting innovation, because climate protection requires the transformation of the entire industry, not the transformation of each single company. Tenders that aim to promote only those companies that are best at managing the transformation would at least have stimulated competition for the best solutions. A more market-conforming and therefore even better idea, which the Commission is pursuing, is to establish green lead markets for steel. Requirements to use a certain amount of green steel create markets for green steel and stimulate investment.
A market perspective of this kind should also be adopted for resilience measures. A well-known example of this is the capacity market in the electricity sector. The electricity market alone cannot ensure security of supply, additional instruments are needed. This opinion is now shared widely – but ten years ago, policymakers took a different view and wasted valuable time. One market-conforming way of achieving security of supply is to create a market for it: either through capacity markets, as in the UK or France, or through a mandatory system of futures markets where suppliers have to hedge their future demand. A similar approach applies to other markets: To ensure the supply of vaccines, the German government created a system of pandemic preparedness contracts. Vaccine manufacturers receive payments to provide production capacity in Germany in the event of a supply shortage. The design of such markets is currently in the focus of market design research.
These instruments are necessarily sector-specific and require a precise understanding of the market situation and the systemic risks in the respective sector. To develop this understanding, the Scientific Advisory Board of the Federal Ministry for Economic Affairs and Climate Action has recommended setting up a “European Supply Security Office” to provide data on supply chains, develop stress tests in vulnerable sectors and draw up proposals for market-conforming security measures.
Industrial policy in the social market economy
The guiding principle for the EU’s economic policy is the concept of social market economy (Article 3 of the EU Treaty). The pillar of the latter is free competition, safeguarded by a strong competition policy. The economic model of the social market economy has proven to be crucial for innovation, productivity increases and sustained growth in prosperity. Now industrial policy has entered the arena. The goals of industrial policy and competition policy are in conflict: While industrial policy intervenes in markets and aims to achieve certain results, such as strengthening a sector or developing specific technologies, competition policy by contrast safeguards open markets and is neutral with regard to market outcomes. When politicians demand that certain goals be achieved, free competition is often seen as an impediment. According to Röpke, interventions that are not “market-conforming” should be “kept in the poison cabinet of our economic policy pharmacy”. The undermining of the price system by creating monopolies, commonly referred to as European champions, is one such intervention.
It is often argued that awarding subsidies is necessary because others, notably the US and China, also do so. On the one hand, this argument was weakened by the election of Donald Trump, who stopped the Inflation Reduction Act. On the other hand, the line of reasoning is of a more fundamental nature: How to maintain competitiveness in a systemic competition with an economic area that is characterised by state control and subsidies? Even if Chinese subsidies often benefit European consumers, competition problems are increasingly arising, especially when European companies are crowded out of the market. In such cases, protective instruments must take effect.
Tariffs can be imposed on imports from subsidised companies, as is currently the case with Chinese electric vehicles. In 2023, the EU also passed a law to sanction companies subsidised by third countries that produce, buy companies or participate in public tenders in the EU.
However, there is a gap in protection when it comes to competition outside Europe. As with the border adjustment mechanism mentioned above, European companies are also at a disadvantage when they encounter subsidised companies in markets outside Europe. This could pose a problem for Germany's export-oriented firms in particular.
Industrial policy is not new, but sustainability and resilience are new motives for embracing it. There is still a risk of pursuing a “policy of interventionism that has taken the wrong turn down the road to collectivism” (Röpke). A narrow definition of the objectives and market-conforming interventions help to avoid taking the wrong direction.
This essay is an abridged version of the Wilhelm Röpke lecture held by Achim Wambach in Erfurt on 13 February 2025.
