Industrial policy reconsidered

Andres Velasco

SANTIAGO, Chile - First, the World Bank became a tireless advocate of women’s and gay rights. Then the International Monetary Fund backed the use of capital controls and voiced concern over income inequality. Next in line for ideological modernization is the Inter-American Development Bank (IADB): in a forthcoming report, the bank calls for industrial policies in Latin America.

This is a welcome development. To be sure, the IADB - never as stodgy as the Bretton Woods twins, but still a traditional international financial bureaucracy - does not speak of industrial policies; it uses the politically correct phrase “productive development policies” (PDPs). Yet the message is clear: in Latin America, the state and public policy should have a role in deciding what gets produced. A generation ago, this message would have been heretical. Today, it is a matter of common sense.

Last week, economists from the IADB brought their gospel to a conference in Santiago, Chile. The country, for decades the region’s poster-child for good economic management, is also an example of the risks that all Latin American economies face. With commodity prices falling and dollar interest rates on the rise, Chilean growth is slowing sharply. Productivity gains have been sluggish for nearly 15 years, and the country’s export basket is the same as it was in the 1980s.

Chile’s growth problems are among the least severe in the region. It is one of only four countries (along with Brazil, Panama and the Dominican Republic) that have managed to reduce the per capita income gap with the United States since 1960. As the IADB has pointed out in several earlier reports, productivity has been stagnant in most of Latin America for a half-century or more.

What is to be done? The conventional prescription includes improving education (especially the technical kind), modernizing labor markets, reducing bureaucratic red tape, and facilitating foreign investment and technology transfer. To this standard tool kit the IADB now adds PDPs, which can be “horizontal” or “vertical.”

Horizontal PDPs provide the inputs that a broad range of firms, across different sectors, need for their growth and development. Simple examples include transport infrastructure, trained engineers and a labor force proficient in English. More sophisticated examples can involve systems for health and safety inspection, product-quality certification or intellectual-property protection.

The problem is that some of these publicly provided inputs can be sector- or product-specific. Roads to remote and beautiful mountains foster eco-tourism but do not help carry merchandise to the nearest port. A lab built to certify that beef does not have foot-and-mouth disease is of little use in verifying that fruit and vegetable exports are similarly disease-free.

That is where vertical policies - those that favor a particular sector - come in. Horizontal PDPs are relatively uncontroversial, but vertical PDPs can unleash severe criticism, with skeptics claiming that they involve “picking winners.” But, as the examples given above suggest, the line between horizontal and vertical policies is inevitably fuzzy.

In other words, when a government provides money to train a particular kind of engineer, lay out a particular road or build a particular lab, it is favoring one sector over others, and hence de facto picking winners. The IADB argues that it is better to do this consciously, transparently, and with the appropriate checks and balances.

Vertical policies are also useful in solving coordination failures. Consider the tourism industry, which has great potential in the beautiful Patagonia region of southern Argentina and Chile. But no private firm will build a hotel in this remote, under-populated region if no road leads there. By the same token, no government official will build a road if there are no hotels or lodges, for the road would lead nowhere. Without deliberate private-public coordination focused on tourism, the sector may never take off.

Skeptics also point out that Latin America already went through a round of industrial policy in the 1960s and 1970s, with results that were mediocre at best. The IADB report provides a balanced assessment of that episode. Though import substitution and subsidies were initially successful in igniting industrialization, lack of scale soon hindered efforts (a country of a few million cannot hope to have an auto industry aimed only at the domestic market).

Worse, government help was handed out to strong and weak performers alike. In Asia, many firms that initially received help sooner or later became world-class competitors. In Latin America, with little market and policy discipline and chronically overvalued exchange rates, that transition seldom happened.

To be sure, those problems had to be corrected. But in doing so, claims the IADB, Latin American governments may have gone too far: “There is now a growing consensus among policy makers and analysts alike that by putting all industrial policy out of bounds, the region may have thrown out the baby with the bathwater. More and more, the question is not put in terms of whether to do active productive development policies but rather how to do them.” Unlike 1960s-vintage industrial policy, modern PDPs aim to correct market failures, not do away with market incentives.

Market failure is not the only issue. The emerging new approach to PDPs is also fearful of state failure. State agencies can be captured and aid can be used for private or political gain.

To prevent this, the report again usefully deviates from reigning orthodoxy, which tells countries to identify and copy “best practices” from abroad. This approach cannot succeed if such practices require what local government cannot deliver. Hence, “the focus ought to be not on policy best practices but on policy best matches with institutional capabilities.”

Latin America will need a great deal of fresh thinking and many policy innovations if it is to keep growing in a post-commodity-boom era. No policy is failure-proof. But the approach advocated in the forthcoming IADB report is the region’s best hope today.

Copyright: Project Syndicate, 2014.

* The author, a former finance minister of Chile, is a visiting professor at Columbia University.

BY Andres Velasco