REMEMBER "competitiveness"? How about "industrial policy?" Two ideas that went nowhere, right?

Well, consider the following:

Michigan has brought to life an entirely new financial sector designed to provide "innovation capital" to small manufacturers. The state did so by making start-up investments in private banks called Business and Industrial Development Corporations.

Pennsylvania spends $25-30 million a year to seed technological innovation throughout its economy. The program, known as the Ben Franklin Partnership and Industrial Resource Centers, matches private investments in applied research, seed capital, management assistance, work force training and industrial modernization.

North Carolina has spent well over $200 million on a world-class Microelectronics Center and a multi-faceted grant program for biotech research and development. In 1988 it authorized up to $20 million in start-up capital plus a 25 percent tax credit for private investors in a privately owned Enterprise Corporation, designed to pump new capital into businesses in rural North Carolina.

Indiana, Massachusetts, Ohio and at least four other states are helping regional industries organize networks to manage their collective needs for training, marketing and new production technologies.

This is competitiveness policy with a vengeance. While Washington remains gridlocked in a sterile debate about taxing and spending, state governments have moved into a new era. Their leaders have developed not only a new economic policy agenda, but the radically new methods of governance necessary to bring it to life. Their journey has taught them lessons of enormous import here in the nation's capital.

Until 1980, economic development in most states meant chasing smokestacks -- recruiting manufacturing plants from other states with the lure of cheap labor and low taxes. Mississippi pioneered this "First Wave" strategy back in 1936, when it invented tax-exempt industrial bonds to recruit Northern plants.

As American companies began moving low-cost production into the Third World, smokestack-chasing yielded diminishing returns. Mississippi might be cheap, compared to Massachusetts, but when the competition was Mexico and Malaysia, Mississippi was expensive.

By 1980, America found itself fully immersed in the chilly new waters of the global marketplace. For states with advanced economies, like California and Massachusetts, the competition was bracing; they found themselves winning. Those with more traditional economies almost drowned.

With unemployment hovering near 15 percent in states like Mississippi and Michigan, leaders of both parties began to search desperately for new strategies. Many turned first to Washington, where they found a raging ideological debate but few answers.

The Reagan administration counseled laissez faire: "Get government out of the way and let the free market do its work." But in Michigan and Mississippi, the market was doing its work. It was shifting unskilled jobs to developing nations and more advanced production to sophisticated competitors like Japan and Germany. When they looked to the national Democrats, state leaders found little more solace. Most liberal Democrats called for trade barriers to protect America's sunset industries and subsidies for sunrise industries. While more traditional advocates of industrial policy gagged, an influential study group chaired by AFL-CIO chief Lane Kirkland argued for a $5 billion Reconstruction Finance Corp. to do the job. Quality Inputs: The Governors Mobilize

Governors in both parties quietly concluded that left and right were equally wrong turns. As they consulted with business leaders, they began to hear that foreign firms were beating us not because we tampered with the free market but because traditional federal policy dealt with quantities -- interest rates, tax rates, fiscal policies and so on. But in a global market, the question was no longer just how much we produced, but of what quality. It was no longer just how much capital we had available and at what interest rates, but what kind of capital. Did we have enough risk capital? Enough patient capital? It was no longer just how much research we did, but how fast we brought the results to market. And it was no longer just how many workers we had and at what wages, but how well prepared they were and how well they worked together.

Pushed forward by the relentless logic of this new economy, state leaders in both parties began designing a new set of competitiveness policies. This "Second Wave" of economic development {see box} embraced a "market-strengthening" approach, in which government made sure that U.S. businesses had access to the highest quality inputs available.

State governments organize their markets to win. Laissez faire and picking winners have given way to market-strengthening. In just one decade, this Second Wave strategy has become the norm. Every year the Corporation for Enterprise Development publishes a Development Report Card for the States. The 1990 edition showed that:

44 states now fund applied-research centers and/or grants;

45 states help businesses commercialize new technologies or apply state-of-the-art technologies to their manufacturing processes;

35 states offer innovation capital of some kind -- seed capital, venture capital or product development grants;

44 states use their leverage to strengthen their capital markets by stimulating more private venture capital investments, small business loans and the like;

47 states have passed education reform measures to provide the skilled work forces necessary to compete in a global economy;

and 47 states have created new training programs to improve the skills of those already in the work force.

Most states launched their Second Wave strategies using a very traditional method; the bureaucratic government program with its annual appropriations, its coterie of civil servants and its monopoly status as the sole supplier of some standardized service. To their surprise, however, the results were usually marginal.

Scale was inadequate, for one thing. In a private market, demand brings forth its own supply: When people are willing to buy something, entrepreneurs waste no time in producing it. But in government, politicians create programs in response to organized constituencies, not consumer demand. Capital comes from taxpayers, not investors. Unsuccessful programs are not shut down for lack of demand, and successful programs are not expanded to satisfy demand.

Quality fell short as well. While business and worker needs were shifting rapidly as markets changed, government programs provided standardized, "one size fits all" services. Schools operated as if every child learned in the same fashion. Training programs made the same assumption about adults. Services were also fragmented. While businesses and workers had multiple needs, public programs were usually set up to provide one service -- a particular kind of training, a small-business loan, a research grant.

Finally, providers were not responsive to customers. Since most government programs were monopolies, they took their customers for granted, responding to change at a glacial pace. To make matters worse, funds were usually appropriated according to "input" formulas (how many children enrolled, how many businesses served), not according to "outcomes" (how much the children learned, how the businesses rated the service provided). Performance was almost irrelevant.

The entrepreneurs within state government quickly set about reinventing their public technologies. The Michigan Strategic Fund (MSF) provides but one example of this new "Third Wave."

"In a state economy that suffered from capital gaps of hundreds of millions of dollars, the $20 million a year available from our own finance authority was a drop in the bucket," reasoned MSF President Peter Plastrik. "So we decided to try a totally different approach.

"Instead of making direct investments in businesses, we used our limited public resources to provide incentives to entrepreneurs to create new privately-owned seed and 'mezzanine' capital firms. We became minority investors in the new banks. So instead of a small, shaky loan portfolio -- what we had under the old program -- we are looking at the birth of a financial sector that promises a billion dollars in privately-managed investments in Michigan firms by the mid-1990s."

A host of other efforts have also moved beyond the traditional program technology: Pennsylvania's Ben Franklin Partnership, North Carolina's rural development strategies, Indiana's Industrial Network project, Minnesota's education choice program, Michigan's Opportunity Card, West Virginia's management assistance voucher for small businesses.Though each is different, together they embody a set of principles that begin to define a new model for public action.

They use incentives to leverage both public and private resources in the entire community, thus producing the scale necessary to have a significant impact.

They replace monopolies with competition, creating a constant force for innovation and quality.

They put decisions in customers' rather than bureaucrats' hands, so public money flows to service providers whose performance is satisfactory to customers, rather than to those who best manipulate the political process.

They use incentives and information, rather than coordination, to achieve a holistic approach. In Pennsylvania's Ben Franklin Partnership, for instance, public dollars cannot be tapped until a center or provider and a business customer have agreed on a course of action and the business has committed its own resources as a match. No government agencies need to "coordinate" or "integrate."

All of these principles shaping Third Wave governance -- leverage, competition, customer orientation, performance funding, incentives and information -- are qualities of functioning markets. Indeed, Third Wave approaches have in common one fundamental characteristic: They provide some resource in short supply by strengthening or creating markets.

Not surprisingly, these efforts are forcing state agencies to restructure themselves. Instead of operating as direct suppliers of standardized services, they are operating more as facilitators in existing or potential markets. Traditional command-style bureaucracies -- public or private -- find this more entrepreneurial role very difficult. Hence experiments to reinvent government along more decentralized, less bureaucratic lines are popping up in state capitals all across the country.

This process is occurring in both state and local governments and in both Democratic and Republican administrations. Social democratic Minnesota, home of Walter Mondale, was the first state to embrace choice for students and competition between public schools districts. Rock-ribbed Republican Indiana, home of Dan Quayle, created the first public-private council to guide state economic policy, a notion straight out of early industrial policy debates. Come Aboard, Uncle Sam

Does all this have any implications for the federal government? Washington has yet to embrace the Second Wave agenda, much less the Third. In some cases, that is fine: State and local governments can handle things on their own. But states are powerless to solve problems involving trade, financial markets, national industries, basic research funding, the legal framework guiding labor-management relations. If we are to bring "market strengthening" to bear on our national and international markets, the federal government must act.

Washington is of course home to dozens of economic "programs," from the Commerce Department (a huge but ineffective service organization for business), to the Labor Department (which funds many training and skills programs), to the National Science Foundation (which finances basic and applied research). In some efforts, the feds have moved tentatively into the Second and Third Waves. The 1982 Job Training Partnership Act combined First, Second and Third Wave techniques, for instance. President Bush's advocacy of choice and restructuring in education shows classic Third Wave thinking. But too often, the machinery of the federal government remains locked in first gear.

If America is to be competitive in the 21st century, leaders in Washington need to listen to their counterparts in Harrisburg and Lansing. If they do, they will hear a simple but profound message: The strategies and methods of the industrial era no longer work. It is time to ride a new wave.

Doug Ross, president of the Washington-based Corporation for Enterprise Development, is the former director of the Michigan Commerce Department. David Osborne, author of "Laboratories of Democracy" (Harvard Business School Press), is writing a new book titled "Reinventing Government."