Below is the second part of my exchange with Joe Studwell, whose book, as I said in the intro to part 1, has tested some assumptions about economic development I've been carrying around with me for a long time.

SR: Asia is home to some of the great cautionary tales of industry policy: Malaysia’s national car brand, Proton, and Indonesia’s aircraft manufacturer IPTN come to mind. So what is it that distinguishes those failed efforts from success stories such as Hyundai?

And how do you get around the argument that, even where state-backed companies succeed in the long term, they still represent a misallocation of resources and an attempt to pick winners? Why wouldn’t these governments have been better off creating favourable tax and regulatory conditions for industry to flourish, rather than backing specific industries themselves?

JS: This is a number of different questions.

First, what makes industrial policy cost-effective? The answer to this in east Asia has been what I term 'export discipline', or the conditioning of subsidy (in all its myriad forms) on a significant level of exports at the firm level. In essence, export discipline solves an information problem. If you give subsidy to entrepreneurs they are amazingly good at taking the money and pretending to do what you want in terms of developing globally competitive firms that carry an economy forward, but not actually doing so.

Most obviously they tend to concentrate on services, which employ and 'upgrade' relatively few people, avoid adding value through manufacturing by importing components of manufactured goods or even finished manufactured goods, and they tend to limit the competition they face by sticking to the domestic market. They then take the cash flows from subsidised domestic activity and invest it on a portfolio basis in more advanced and competitive economies.

This is the story of what my last book dubbed 'godfathers' — the oligarchs who dominate economies from south-east Asia, to Russia, to Latin America (KS Li, Ambramovich, Carlos Slim, if you want three examples). In essence these entrepreneurs outplay the state in its efforts to foster economic development based on technological learning and broad-based improvement of human capital.

When you have export discipline, the game changes. First, export discipline is almost inevitably bound up with a focus on manufacturing because manufactures are way more freely traded in the world than services (services are only 19% of world trade and have been stuck at that level for a quarter century). So entrepreneurs manufacture because manufactures are readily exportable.

Then comes the information bit. The capacity to export tells the state whether firms it subsidises and otherwise supports are globally competitive. Domestic financial institutions benefit from the same information feedback. Of course you can sell at a loss for a while, but not long if you have to export, say, 30% of your output, because it will bankrupt your firm. As a result, the capacity of the entrepreneur to deceive the state is undermined. He or she faces the horrible reality that in order to feed their insatiable desire for wealth and recognition (those 'animal spirits') they have to knuckle down, actually make stuff, and sell it in the viciously competitive world market.

Hyundai is a good example because founder Chung Ju Yung was himself a godfather, bribing his way to construction contracts under Syngman Rhee in the 1950s. Then came Park Chung Hee's coup in May 1961. Park brought in so much export discipline that firms had to file their export returns to the government on a monthly basis. Suddenly Chung became a big fan of manufacturing for export and had to get rich that way.

In Southeast Asia, industrialisation programs like Proton and IPTN did not face export discipline. As a result the state's return on industrial policy was very poor. Was it zero, however? I think not. There has been some industrial learning in Malaysia and, to a lesser extent, in Indonesia. So I doubt they would have been better off without Mahathir or Habibie, the main people who drove those programs. However, the performance was lousy by the standards of Japan, ROK, Taiwan and China and I talk in a lot more detail in the book about exactly why. After the Asian financial crisis, when the IMF went in to Indonesia and dismantled/emasculated its industrialisation strategy, it made things worse. If you look at IPTN, on which the Indonesians spent billions training engineers, designers and so on, many of the key people went off in the late 90s and 2000s to work in places like the US or Germany. Indonesia's learning-oriented subsidy ended up going to the world's richest nations (that's why we have black humour).

On the inevitability of misallocation of resources in industrial policy, the answer is 'yes'. There is a lot of waste in industrial policy. But the waste is at an acceptable level when you are far behind the technological frontier because you can see where you need to go. Steel, chemicals, plastics, construction materials, etc — you have to learn to make this stuff just like everybody before you. You have to fill your society with tacit, value-adding knowledge. Critically, manufacturing is the way to learn because people learn on the job, in factories, generating the capital to pay for their education. It is affordable in the way that more schooling for everybody would not be because school is just a sunk cost until you leave and get a job. (Indians — don't get me started — only think about learning through investment in formal education and have no real manufacturing strategy, which is why they are relatively so much poorer than the Chinese.)

On 'picking winners', this is a term of abuse coined by neo-liberal economists in Europe in the 1970s (I have never managed to identify first use of the term) when they were beginning to criticise the industrial policies that made a country like Italy grow 5-6% for a quarter century after World War II. It is a term of abuse because, as far as I can see, successful industrial policy has never been about picking winners. It is about culling losers, which is very different. Culling losers means cutting off state support to subsidised firms that are failing to make the grade, judged by profit & loss and export performance. There is a period of culling losers going on in China right now, so you can watch live!

On 'favourable tax and regulatory environments', development requires these, but the objective remains that of learning, as I have said, not efficiency expressed in terms of short-run returns. That comes later. I think that perhaps the answer you want to this question is the following statement: if you can show me a country, other than anomalous offshore financial centres/trading entrepots, which has developed to the first rank through policies of free trade from the get-go, then tell me which country it is. (Certainly not yours or mine...)

Reading through the first part of this answer, I realise that I simplified and exaggerated considerably to make a point. Perhaps too much so. But people need to read the book!

Can we talk about the cricket rugby now?