The only winners in a subsidy war are the battery manufacturers – on both sides of the border

If I could make just one change to the way in which we are governed, it would be to add to cabinet the post of Minister of Opportunity Costs, whose sole responsibility would be to explain the concept to other ministers at critical moments.

I can think of no single change that would do more to improve the making of economic policy, since virtually all bad policy stems from a failure to understand – or a determination to ignore – this very simple idea. It is difficult enough to bend the average politician’s mind around the concept of cost, period: the notion that resources are not limitless, but finite; that in a world of scarce resources, it is not enough to consider only the benefits of a given expenditure, but also the costs.

But that the cost of a thing consists, not just in the explicit cost to the treasury, but the opportunity cost – broadly speaking, the idea that producing or consuming more of x means producing or consuming less of y, or in other words that more of one thing means less of another – seems to defeat them altogether.

How else to explain the enduring popularity of industrial policy, in particular: the notion that government should subsidize this or that industry, firm or technology, and not others. The argument against this is not the one commonly offered, that governments are not good at “picking winners” – though that is true enough.

The argument, rather, is that when opportunity costs are taken into account, subsidy is at best a zero-sum game. That is, it does not add to output and employment over all, but merely shifts it about. The expansion that occurs in the target industry is simply the expansion that does not occur in another industry – the expansion it might have enjoyed had it been the subsidy’s beneficiaries, and not its actual recipient. The subsidy to one industry is underwritten by every other, not just in the taxes they pay, but in the diversion of productive resources from the unsubsidized to the subsidized, which is to say from the economic to the uneconomic.

Once you grasp this point, it becomes clear that the case for or against subsidy does not depend on whether the lucky recipient is or is not a “winner.” Either the investment is economic, that is, or it isn’t. If it is, it doesn’t need the subsidy. If it isn’t, all the more reason it shouldn’t get it. Selling a thing for less than it costs to produce makes little sense for an individual business, but it makes even less sense as policy for the economy as a whole.

At this the industrial policy enthusiast will smile indulgently – “ah, but you see, other countries subsidize their industry” – as if it were some sort of revelation. “We can’t afford to be the world’s Boy Scouts. We have to match their subsidies, to keep our players in the game.”

This is how you get headlines like the one that appeared on the CBC News website recently. “Ottawa preparing to go toe-to-toe with U.S.,” it said, “to subsidize EV battery production in Canada.” In what it called “a game-changer for Canadian industrial policy,” the story reported that the federal government plans to offset the “billions of dollars in new subsidies” for battery production contained in the recent Inflation Reduction Act with hefty subsidies of its own.

That “game-changer”? Where before the policy had been to subsidize “non-recurring” capital investments, now the government would be prepared to subsidize companies’ operating expenses. Subsidies that had previously been one-time and finite are now to be perpetual and open-ended – because, as the Industry Minister, François-Philippe Champagne, explained, “we intend to remain competitive with what the Americans have put forward.”

To see what’s wrong with this, consider an argument for subsidy that actually makes some sense. It’s known in the literature as “strategic trade theory.” Suppose, first, there were a product with massive economies of scale, of a kind that required a global market to realize.

Suppose, second, it were possible to identify this product, with certainty, in advance – not only that it could realize these sorts of economies of scale in theory, but that these would in fact be realized.

Suppose the government were to use this intelligence to give Canadian producers a head start, by subsidizing their production costs. And suppose, crucially, no other country thought to do the same.

Then our producers, exploiting the cost advantage the subsidy granted them, would jump to an early sales lead over their competitors, their advantage widening as those economies of scale kicked in, enabling them to add more sales and cut costs even further, until eventually they acquired a worldwide monopoly in the product in question. The profits from such a monopoly would be so enormous as to outweigh any conceivable opportunity costs; the zero-sum game of most subsidies would become a positive-sum game.

But here’s the thing. If any of those assumptions do not hold – if the product does not possess such economies of scale, if we are unable to identify it in advance, or if other countries, with deeper pockets than our own, subsidize their own producers – then the whole theoretical construct collapses. It’s just another subsidy, and fails for the same reason other subsidies do.

The assumptions needed to make strategic trade theory work, in short, make the case for why it is unlikely ever to apply. In the “real world” that industrial policy advocates are so fond of invoking, the willingness of other countries to subsidize their industries makes the case against us doing the same, rather than for it. The only thing we win from subsidy in such circumstances is the right to go on subsidizing. The only “game” it keeps our guys in is a losing game.

(The idea of subsidizing our industry just to “level the playing field” with theirs sounds a little like the old joke about the Southern judge, who summed up a particularly hard-fought case as follows: “Now counsel for the plaintiff, you’ve offered me $10,000 to find for your client. And counsel for the defendant, you’ve offered me $15,000 to find for your client. What do you say we make it an even $20,000 apiece and decide this on the merits?”)

I can see why the EV battery industry would be keen on the idea. In a subsidy war, no matter which side of the border they’re on, they get the subsidy; maintain operations on both sides, they might even get subsidized twice. So long as governments are so eager to compete in this way, moreover, the companies don’t have to. Keep building batteries, and you keep collecting subsidy, whether your market share is expanding or contracting, whether you make money or lose it. Or in other words, the aerospace model, from which the hapless Bombardier profited so handsomely over the years.

It’s just hard to see why anyone else would want to get in on this madness – except that EV batteries have been declared an industry that Canada “must be” in. Why “must” it? Because batteries are “the future.” Or because they are high-tech. Or because everyone else is. Or any number of other purported justifications, having little to do with economics and everything to do with what the economist David Henderson has called the “techno-aesthetic intuition” of their advocates.

Well, no. There is no law that says Canada has to be in the business of making batteries for electric vehicles. It may be frustrating to the ambitions of Canadian battery producers that the United States is willing to subsidize theirs so heavily, it may be injurious to national pride, but it is a fact that cannot be wished away. We are not going to out-subsidize the Americans, and if we can’t there’s no point in trying.