How to get industrial policy right

At a time of lackluster global economic growth, developing countries are dusting off some old strategies – particularly the use of industrial policy to drive the development of particular sectors and turn them into engines of growth and employment. But the history of such policies, particularly in Latin America and the Caribbean, is filled with failure and cautionary tales.

In the 1950s and 1960s, many Latin American and Caribbean countries embraced industrial policy enthusiastically. By substituting imports with domestic production, relying on government planning to target priority sectors, and implementing selective trade protection (for example, by imposing tariffs, quotas, and import licensing), they attempted to accelerate their transitions from raw-materials suppliers to manufacturing-based economies.

While East Asian countries like South Korea used such policies to enable selected industries to compete on a global scale, Latin American and Caribbean countries rarely got it right. Despite some notable successes, such as the aircraft manufacturer Embraer in Brazil and salmon farming in Chile, governments largely picked losers – not least because political pressure, not firms’ competitive potential, drove the selection process.

In the 1980s and 1990s, Latin America abandoned such policies in favor of a more cautious approach. Rather than backing individual sectors, some countries promoted innovation with across-the-board subsidies and tax breaks, while opening their economies to foreign competition and embracing market-oriented reforms. But these changes, though necessary, were insufficient to deliver growth in productivity and output.

Almost two decades later, with Latin American governments again exploring the potential of activist industrial policy, avoiding the mistakes of the past will require a thorough understanding of why previous attempts failed – and a concrete strategy to guide future efforts. A recent report by the Inter-American Development Bank (of which I am President) does precisely that.

Beyond assessing what went wrong previously, the report identifies three fundamental questions that policymakers in any emerging economy should answer before pursuing industrial policy:

· Is there a clear market failure that justifies government intervention?
· Will the proposed policy be effective in remedying the market failure?
· Does the country have the institutions necessary to execute the policy?

Consider sectoral policies in Costa Rica and Argentina. In Costa Rica, the rice industry took the traditional route of lobbying for protection. Though there was no market failure to remedy, the government obliged, introducing high import tariffs and subsidies for powerful local growers; as a result, productivity declined.

By contrast, farmers in the Argentine province of Entre Ríos requested that the National Institute of Agricultural Technology (INTA) ramp up research into new rice varieties, even agreeing to pay a tax to augment INTA’s research budget (thereby overcoming what economists call private-sector coordination problems). When a new rice variety was introduced, productivity soared.

Unsurprisingly, the intervention in Argentina passed all three tests: the market suffered a coordination failure that was addressed effectively through public policy carried out by appropriate institutions. Instead of coddling an entire industry with subsidies or import restrictions, the provincial government and INTA provided a public good that bolstered production in a specific sector. Other successful examples of this approach include sanitary certifications of agricultural products and training programs for the software industry.

Once governments identify an opportunity that passes these three tests, they are in a much better position to use measures like temporary subsidies or targeted incentives effectively. In Mexico’s Mayan Riviera, for example, public support for investments in lodging and transportation helped create a world-class tourist destination.

Costa Rica, despite its rice-industry failure, has also had some success with such policies. When the medical-device industry was blocked from producing lucrative products like heart valves, owing to the lack of specialized firms to provide sterilization services, the government used incentives to attract such companies. As a result, exports of more sophisticated, higher-value-added medical devices soared.

Ensuring adequate institutional capacity is essential to prevent private and political interests from shaping policy, as occurred in the 1950s and 1960s. Ireland, often praised for its success in picking winners, relied on the technical competence of its renowned Industrial Development Agency to safeguard the integrity and effectiveness of the selection process. Chile, despite possessing reasonably strong institutions, turned to a third party, the Boston Consulting Group, to ensure that the most promising sectors were selected objectively.

Fostering industrial development is a complex challenge. Policymakers must periodically reassess their efforts and promptly abandon failures. There will be hits and misses, but, if officials consistently ask the right three questions, their chances of success will be much higher.

This article is published in collaboration with Project Syndicate. Publication does not imply endorsement of views by the World Economic Forum.

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Author: Luis Alberto Moreno is President of the Inter-American Development Bank.

Image: People pass the Bank of England in the City of London January 16, 2014. REUTERS/Luke MacGregor.