How State Capacity Drives Industrialization

Ant Rozetsky/Steel factory

In 1961, Park Chung-hee and his Supreme Council for National Reconstruction (SCNR) took power in South Korea after a military coup. Park, who had trained at military academies in Imperial Japan and later the United States before fighting in the Korean War, believed industrialization and political unity were the only way to prevent Korea from being a “victim of foreign aggression” and a “battleground for foreign powers.”

Almost immediately after his rise, South Korea began implementing his industrial policy. While some of South Korea’s new industry was managed directly by the state, much of it was run by the chaebol, large conglomerates of private industry. The chaebol, however, were far from independent, and the state exerted substantial control over their actions. As Hyung-A Kim writes in his 2003 book, Korea’s Development Under Park Chung Hee:

Nothing would illustrate the effectiveness of the “administrative controls” on the business community more than the SCNR’s arrest of fifty-one prominent businessmen on the charge of “illicit profiteering,” and thus the confiscation of their property…These leading businessmen were released on 30 June, only after they had signed an agreement stating: “I will donate all my property when the government requires it for national construction.”

After establishing who was in charge, the Park regime was not shy about telling the businessmen how, exactly, to use their property for “national construction:”

Ku Inhoe, the founder of Lucky-Goldstar and one of the “illicit profiteers,” was ordered to build a cable factory. He would have preferred to build a textile factory…But in April 1962, exactly four years before the completion of Lucky-Goldstar’s Han’guk Cable Company, Ku was summoned by Colonel Yu Wonsik…Although details of this episode are not documented, which is not surprising, Ku, like many industrial proprietors at that time, seems to have received much more than “verbal” lessons. It took around just ten days for Ku’s company, Lucky-Goldstar, to complete a loan contract of US$2.95 million with Fuhrmeister, a West German company, which had clearly taken extraordinary steps to help address Ku’s needs…After this incident, no business leaders, including Ku, dared to resist directly the directives that emanated from the SCNR’s industrial planning committees.

Once Ku shaped up and came on board with Chung-hee’s program, he was treated very well. His company, Lucky-Goldstar, is known today as LG. Instead of cable or textiles, LG has a sterling reputation for manufacturing advanced electronics such as cell phones. The company is still run by Ku’s descendants.

Under the direction of the SCNR and its successors, chaebol such as LG built up South Korea’s basic industries like agriculture and concrete, then progressed through steadily more advanced industries in record time. This required the construction of factories, and by the mid-70s, South Korean industry had grown large enough that they needed to import machine tools for these factories in large quantities.

Machine tools are tools for cutting and shaping metal more precisely and efficiently than hand tools ever could, originally controlled by manual levers and wheels or rigid metal pattern jigs, but nowadays mostly via computer control.

A machine tool in action

These “tools that make the tools” are a crucial piece of modern supply chains, and most advanced manufacturing would be impossible without them. The ability to produce machine tools domestically is one of the foundations of a deep industrial base. Recognizing this, the South Korean state encouraged Hyundai, a chaebol which built the first all-Korean automobile in 1975, to begin making machine tools for the growing domestic market. Since then, the South Korean machine tool industry has grown steadily alongside the Korean economy as a whole. Production today is slightly larger than the machine tool industry of the United States, a country more than six times as populous.

This was just one element of South Korea’s “Miracle on the Han River,” which catapulted the country into the ranks of the world’s most developed nations, even as the government transitioned from an authoritarian dictatorship to a liberal democracy. By now, the South Korean industrial base has not only raised tens of millions out of poverty, but also lifted the nation from a backwater of little geopolitical significance into an important regional player and a crucial part of global supply chains.

Korea’s story may be more extreme than most, but this type of state-led economic development is how every wealthy country on Earth has industrialized. The sole exception is Britain during the original Industrial Revolution. In spite of the Crown’s active economic policy in many other areas, the earliest industry was built with very little government support, and that only tangential and undirected. Examples of state involvement in industrialization abound. America’s government-funded railroad boom of the late 19th century made possible the burgeoning Pacific cities and the agricultural boomtowns of the Wild West, while the demand for rails provided a market to fuel the explosion of steel mills using the groundbreaking Bessemer process. The Five-Year Plans of the Soviet Union developed the heavy industry that would launch Sputnik and kick off the Space Race. In China today, hundreds of millions have been lifted out of poverty by state-directed economic development.

Such transformations require high-level guidance from a competent state coordinating the key industries and establishing crucial infrastructure for the new economic system. Building a single industry in isolation does not transform a society, and frequently cannot be done at all without the other industries that support it. The right industries must be built in the right order, and often in parallel, as in the case of Korea’s automobile and machine tool industries. In the presence of existing industry available in international trade, the coordinated investment in localizing industrial capability is beyond the ability of undirected markets, no matter how good they are at hill-climbing. Radical change has enough different steps, moving parts that must be coordinated, and short-term investment for long-term gain, that it must be planned by a human mind. The great strength of capitalist societies is that industrialists like Henry Ford or Jeff Bezos can transform single industries within an existing economic framework, but the economic framework itself is too large to be remade with the resources of any individual or corporation. Only the state can coordinate many different industries to produce a transformation at the scale of industrialization. Some attempts at this have been more competent than others, of course, but whether the state accomplishes its industrial policy via purchases and subsidies on a relatively free market, or by more directly coercive methods, the economic effects are similar.

The industrial capacity of a nation can often be predicted by its ability to produce machine tools at high quality and quantity, as seen with South Korea as its industrial capacity developed. Machine tools are not only vital to industrial supply chains and an unfakeable indicator of real industrial capacity, but they also provide a lens to examine broader industrial and development policy. Machine tools, like the industrial economy as a whole, require a well-educated workforce, substantial and well-coordinated capital investment, and a robust consumer base—none of which can be produced by a single machine tool manufacturer. Creating the context in which machine tool production can develop and flourish requires coordination between government, business, and finance elites; much of this is captured by the term “industrial policy,” but factors ranging from the nature of the financial and legal systems to culture and positioning within global trade systems are also critical. Substantial state capacity is required to plan and execute the process of industrialization. In a recent report published by Bismarck Analysis, we described the involvement of the state and other elite institutions in the machine tool industry of every major producer, as well as some failed attempts to build this industry. What follows is based on that research.

Britain Sparks the Industrial Revolution

The first machine tools were invented in Britain to support the metalworking needs of early industrialists. Watt’s steam engine, which began production in 1776, was made with a boring machine that had been invented only two years earlier to make cannons. The Crown paid little attention to this nascent industry, although it was quick to buy machine tools to manufacture guns and ships, and many historians believe Britain’s relatively new patent system was a necessary precondition of the period’s rapid technological progress. Nevertheless, there was no state effort to support machine tool production as such, since there was no way of knowing how important such tools would become.

Once the British realized what they had, Crown and Parliament stepped in to support advanced manufacturing. British technology was kept from foreign competitors by a succession of bans on export, starting in the late 18th century. However, as demand rose in the early 19th century, makers of products such as machine tools would routinely circumvent these bans and risk the heavy fines in order to sell to markets in the U.S., Prussia, and beyond. By 1841, under pressure from machine tool makers, these export bans were lifted in favor of a free trade policy. This increased profits but allowed foreign powers to accelerate their coordinated attempts to replicate British technology.

However, foreign powers did not respect British patents, and there was minimal support to protect domestic manufacturers from foreign competition backed by industrial policy. British machine tool makers at first blazed trails beyond what anyone even imagined, but the extreme cost efficiency and technological superiority of British manufacturing relative to foreign competitors, which had propelled the massive boom of the early Victorian era, waned over time. British manufacturing supremacy gradually eroded and ended up facing inwards to the captive markets of the empire. In the years after the Second World War, as Britain’s ability to protect what remained of its once-formidable industrial output slipped away, so too did Britain’s ability to maintain its overseas empire and stand on its own against the new superpowers. Today, the United Kingdom produces a mere 1% of the world’s machine tools.

The American Juggernaut

The first countries to surpass Britain industrially were Germany and the United States, whose policymakers were the first and best at aggressively supporting machine tool production in their own home markets. In America, an early two-prong strategy protected American companies with the series of trade barriers kicked off with the 1828 tariff act, while avoiding recognition of patents protecting English inventions. The federal government also purchased mass-produced rifles, creating a government-supported market for machine tools, much like that which supported Hyundai in Korea. American firms were actually exporting back to England by the 1850s. This was followed by a century of meteoric rise in industrial output. By the end of the Second World War, in the afterglow of extraordinary investment in arms manufacturing, America was fully dominant in the global production of machine tools and almost everything else.

However, in the post-war years, U.S. policymakers were more interested in rebuilding and supporting their Cold War allies than protecting domestic manufacturing. The domestic market remained colossal, but first German and then Japanese firms made massive inroads, and today, the majority of American machine tools are foreign-made. A common thread can be drawn between postwar trade policy and the late British Empire, where the growth of foreign competitors, in conjunction with lack of political support for domestic machine tool production, also led to a substantial fall in output. In a sense, both stopped engaging in deliberate industrial policy for manufacturing, while operating in the global market where other countries were still very much pursuing deliberate policy.

Bismarck’s German Industry

In contrast to the great English-speaking countries, Germany is a perfect example of what continued support for manufacturing can look like. With the Unification of Germany, orchestrated by Otto von Bismarck in 1871, high-level industrial policy became possible. Bismarck met with leading industrialists and coordinated a complex economic policy including targeted tariffs, while German industrialists sought to acquire British technology. By the eve of the First World War, German machine tool production was second only to the United States.

The situation in Germany from the dawn of the First World War until the end of the Second was turbulent. By 1945, the occupied and partitioned German state was devastated. However, after the war, West Germany engaged in massive reconstruction. West Germany supplemented American aid with massive domestic investment and planning focusing on supporting key industries and rebuilding a stable export-oriented manufacturing economy. In contrast, France used American aid for non-infrastructure projects such as the war in Vietnam and continued a pattern of importing machine tools from elsewhere. German programs such as the 1952 “Investment Aid Law” forced hundreds of thousands of firms to contribute funds for investment in bottleneck sectors of the quickly growing post-war economy, while substantial tax breaks, loans, and grants supported machine tools and other heavy industries. By the 1960s, West German industry had largely recovered to pre-war levels and after the rise of newer technologies West German manufacturers became competitive in the U.S. home market, and rose to being one of the top producers in the world.

State intervention in the German economy has long been understated by the German government. When direct U.S. aid played a substantial role, Cold War ideology made it politically untenable to speak of central economic planning and interference with private enterprise. In the modern era, with the proliferation of free trade agreements and zones, the best way to ensure access to foreign markets is to sing the praises of the free market. The modern German state, however, is more subtle rather than less active in promoting specific modes of economic activity: from structuring financial institutions to encouraging domestic investment and supply chains, to vast subsidized research institutes for manufacturing technologies, to the German role in shaping the European Union, the German state has supported high-value manufacturing since Bismarck.

Japan’s Rise

Japan’s path to a domestic machine tool industry and robust domestic manufacturing base has a lot in common with Germany’s, but started from a less developed point. Japan was a largely agrarian and feudal society, but beginning in 1868 under Emperor Meiji, Japan catapulted into vastly more modern forms of government and economy. Careful Japanese observers traveled around the Western world, especially Germany, to determine what worked best. In 1889, Emperor Meiji put in place the new Meiji constitution, based on that of the newly unified German Empire, and Japanese policymakers brought in foreign machinery and advisors to reproduce the capabilities of foreign industry. The largest focus was on bringing military technology and heavy industry to a level that allowed Japan to compete with Western powers, culminating with the Japanese annexation of much of East Asia. By the Second World War, Japan was advanced enough to produce a vast navy and support the invasion of mainland China, but their infrastructure was still behind that of Western Europe and the United States. It was in the post-war years under U.S. occupation and then as a U.S. protectorate that Japanese policymakers worked with their large business conglomerates—the keiretsu—that Japanese manufacturing finally caught up. With a strong focus on exports, Japan overtook first the U.S. and then West Germany in machine tool production, and since 1990, has remained at a similar level of production to now-unified Germany. Japan maintains relatively closed markets and deeply interlinked companies and financial institutions, which combines with substantial ongoing state investment to maintain leading-edge manufacturing for export. South Korea and Taiwan’s later industrialization relied upon a style of industrial policy heavily inspired by Japan, and on the same preferential access to U.S. markets.

In fact, the ability to buy from and sell to American companies and consumers enormously helped all of the great success stories within market economies: Germany, Japan, Korea, Taiwan, and several other Western European countries. These countries dominated production capacity through the end of the Cold War, while many trying to operate outside the U.S.-led global order failed to fully develop a domestic manufacturing base.

Failures in the Periphery

Much of the world has never developed substantial industrial production. In countries such as Brazil and India, industrial policy has had mixed results. Efforts in Brazil began in the 1930s, but were largely decentralized and contradictory. Import restrictions subsidized low-end domestic production, even as imports of higher quality machinery continued; as a result, domestic firms had no natural path to more sophisticated manufacturing, and have mostly stagnated. India has also had largely contradictory and poorly coordinated industrial policy, and despite substantial demand for machine tools in low-end manufacturing, India has limited domestic production. Many countries in the position of India or Brazil rely on global trade systems both for raw materials and for end markets, but do not have the leverage to gain access without taking down their own tariffs and protection of domestic industry. Accumulation of the capital needed to invest in advanced manufacturing is also a challenge; foreign capital investment is difficult to direct to strategic industries, but without foreign assistance or very strong domestic coordination, domestic capital accumulation is almost never achieved.

Russia’s Collapse and China’s Success

Russia and China, however, have a different story to tell.

Soviet policymakers well understood the necessity of machine tools, but did not operate within the market framework that led to American or German success. Instead they centrally planned production via the famous Five-Year Plans. By the time of the Second World War, the Soviets were able, through massive proliferation of low-end machine tools and vast factories across the country, to produce overwhelming numbers of tanks and planes to support the war effort. They still relied on imports from the even more formidable American military machine, but the contrast from 1890 to 1940 is staggering.

Almost as staggering is the fall that came later. Soviet machine tool production continued to rise after the war, and by the 1970s overtook the United States, which by then was sourcing many machine tools from other NATO countries. Soviet industry was often thought to be an unstoppable juggernaut. However, in the 1970s and especially the 80s, the Soviet system began to fray at the edges, and after the collapse of the Soviet Union in 1991, machine tool production dropped precipitously. Soviet industry had always been inefficient, but with the protection of the Iron Curtain, better and cheaper machine tools from the West could not drive Soviet producers out of business. The 1990s brought sudden withdrawal of state subsidies, introduction of free trade, and elimination of price and exchange controls, collectively termed “shock therapy.” This, along with the breaking up of supply chains distributed across many different regions of the now fractured Eastern Bloc, destroyed much of the region’s productive capacity. To this day, Russia tries to rebuild machine tool production capacity to support its relatively modest military needs but fails even at that. Many attempted policies fall flat due to corruption, lack of state capacity, limitations of global trade rules, and the sheer weakness of both consumers and producers of machine tools in Russia. The implications for sovereignty are made starkly evident when American sanctions can restrict Russian access to high-end German or Japanese machine tools vital to maintaining their dilapidated navy.

China comes out of a sister tradition to that of the Soviet Union. After the communist forces won the civil war in 1949, Soviet support for the revolutionary cause became direct aid to the fledgling state to build a bulwark against American influence in East Asia. The early years of Maoist China had uncountable failures—more so even than the early years of communism in the Soviet Union—but one of the more successful programs was a massive transfer of industrial technology spanning 1949 to 1966. While Sino-Soviet relations broke down by the end of this period, early on there were enormous strides as Soviet advisors came in and built entire factories with copied over workflows across dozens of Chinese cities. By the time of the Sino-Soviet split, Chinese machine tool production was self-sufficient, although quality and efficiency were poor.

Liberalization reforms under Deng Xiaoping allowed the Chinese machine tool sector to become far more efficient, along with the rest of Chinese industry. Later efforts to bring in foreign technology through control of lucrative direct investment deals and state-financed acquisition of foreign companies catapulted some leading Chinese machine tool producers to a technological level far beyond what the Soviets had achieved. Chinese machine tool production expanded exponentially from 1990 to 2015 to outfit massive factories built across the country, serving export-focused manufacturing directives driven by Chinese planners. Today, China produces more machine tools than any other country but still relies heavily on imports from Germany, Japan, Taiwan, and Korea for more high-end needs. China has not yet solved the problem of self-sufficiency; its supply chains still rely on essential partners within the U.S. alliance. However, through implementing a market system yet keeping in place massive state-owned enterprises, state-controlled investment banks, import and export restrictions, strong requirements for any foreign investors, currency manipulation, and many other policies, China has to this point managed to build an extraordinary industrial base.

Industrial Policy

Chinese policymakers understand industrial policy. Li Keqiang, for example, spearheaded the Made in China 2025 initiative to develop Chinese high-tech manufacturing. This includes subsidies and intellectual property transfer requirements intended to promote domestic production of equipment such as machine tools. China has used such policies to substantial effect for decades. For a modern economy, machine tools are just as essential as roads, and the state has a necessary role in building both types of infrastructure.

Savvy states often support such foundational industries via manipulating the structure of the market. Targeted tariffs, for example, raise the price on foreign imports within certain categories, thus helping domestic “infant industries” compete where they otherwise couldn’t; in theory, the tariffs are then phased out as the industry matures. This can be part of a broader import substitution strategy wherein trade barriers are put in place while the currency value is kept high, helping producers acquire capital goods necessary to build factories, and controls are placed on certain types of financial transactions. The goal is to allow a product that has been typically imported to instead be made by domestic producers, thus reducing dependence on foreign nations.

Another type of industrial policy is export discipline, wherein government policy supports industries on the basis of their ability to export to global markets (often the U.S. market). This can take the form of direct subsidies, access to loans, or other incentives tied explicitly or implicitly to export volume. This forces domestic producers to make products that are up to world standards, but allows them to do so less efficiently while the industry is being established.

A more direct approach is for the government to simply purchase a favored industry’s products, as the U.S. did for military hardware during and after the Second World War. These massive investments in American industry helped propel the country to staggering heights of production, and launched industries including space travel, the internet, and solar energy.

Industrial policy can also include broader things like education and public research. Germany invests a great deal in education and research for manufacturing. Since the Second World War, German policymakers have tailored their workforce to support advanced manufacturing.

Intellectual property rights are a piece of industrial policy so ubiquitous they are often taken for granted. The United States has long maintained a patent system inspired by the English, but during critical parts of the American industrial revolution English patents were not respected, allowing American manufacturers (with the aid of tariffs) to dominate foreign competitors. Now, American intellectual property law and strong enforcement is an essential part of ensuring investment in research and development, and American negotiators seek to entrench respect for U.S. patents in any country seeking free trade with the U.S. Britain’s history suggests American negotiators will eventually fail in this goal.

Financial systems are another way that states can support favored industries. In countries like Germany and Japan, heavily regulated banks act in part as arms of the state, ensuring easy investment and access to capital for key industries. In contrast, the American system is much more laissez-faire, and relatively low-return investments like machine tool production simply do not do well.

A reality of industrial policy is that every economic situation is unique. The toolbox extends far beyond the few policies discussed here. The reconstruction of post-war West Germany, where an industrial titan was reborn from the ashes, requires different policies from the 1950s reforms that jump started Taiwan’s growth from a nation of poor farmers to a major global exporter of manufactured goods. These are both very different from the problem of reversing industrial decline which now confronts much of the English-speaking world. Countries from the United States to Canada to the United Kingdom have at least begun to de-industrialize, importing a much larger fraction of their manufactured goods.

Decline and Revival

The United Kingdom’s decline prefigured that in the United States. Early signs included the German supersession of British production output before the First World War and the reliance of the British state on imports to support the war effort. As per The Collapse of British Power Vol. 1 by Correlli Barnett:

The shortcomings of the British iron and steel industry alone were proof enough that the Motherland, no less than the empire, was not the great independent power it seemed, for as The History of the Ministry of Munitions states: ‘It was only the ability of the Allies to import shell and shell steel from neutral America…that averted the decisive victory of the enemy’

In the years after the Second World War, the collapse became acute. As the United Kingdom transformed from a hub of manufacturing for its empire and the world to a mere part of the European and Atlantic economic ecosystems, occupying niches such as finance and high-tech, the British state became unable to act independently of nations such as the United States, as demonstrated during the Suez Crisis in 1956. Like the Russians or the Chinese, who cannot operate their essential industries without relying on advanced machine tool imports, the United Kingdom is also dependent in a multitude of ways that it was not before the decline of domestic manufacturing.

The decline in American machine tool production has not progressed nearly as far. The relative power of America in the world may not be at its apex, but there has been no great, obvious collapse—no loss of overseas possessions, no supplicant position with regards to foreign economies like the European Union—and overall American manufacturing output is still strong for now. It was confidence in American power that allowed domestic industries to be replaced by imports from Cold War allies. Policymakers in the 1990s, at the end of history, believed that the victorious American global alliance would flourish into an eternal system of free countries spanning the entire world. If U.S. supremacy would never end, then there was no need for domestic manufacturing capacity to support sovereignty, with the distortions to efficient markets that that entails.

However, even a global superpower with no real peers like the U.S. cannot import critical technologies from competitors without consequences. Reliance on China for cheap steel is one thing—5G infrastructure is quite another. Even stalwart allies like Germany and Japan, which supply the overwhelming majority of advanced machine tools to the remaining American heavy manufacturers, cannot be seen as just protectorates without their own interests. Looking at the history of machine tools, and what happens to countries that have to rely on foreign powers to get them, makes clear that what remains of industry in the former powerhouse of global manufacturing is worth reviving.

The state has a role to play in running an advanced economy. In the United States, many institutions of government are too dysfunctional to do the part required of them, and finance is too used to free rein to take kindly to the reassertion of their responsibilities. The exact path forward is unclear, but coordination among the economic power centers of American society must be reestablished to rebuild the engine of creation.

Ben Landau-Taylor studies industrial economics. He works at Bismarck Analysis, a consulting firm that investigates the political and institutional landscape of society. You can follow him on Twitter @benlandautaylor.

Oberon Dixon-Luinenburg is a systems engineer and sociology researcher. His work includes analytical instrument design for advanced manufacturing and political, economic, and historical analysis with a focus on technology. He can be found on Twitter @oberondl.