Industrial Policy for the 21 st Century

1. Industrial Policy for the 21st Century Sergio M. Marxuach Director – Policy Development Center for the New Economy 12 March 2008 San Juan, PR

2. Traditional Case for Industrial Policy • World is full of market failures. • Strong government intervention is necessary to overcome poverty traps. • Two principal forms of market failure: • Coordination failures – Return on one investment depends on whether some other investment is made: • Building a hotel near a beautiful beach may be profitable if somebody builds an airport. • Information spillovers – The process of finding out the cost structure for the production of new goods is fraught with uncertainty: • First mover will find out whether something is profitable or not, if it is he is copied by other entrants, but if he fails he bears the whole loss. • Thus, private returns are lower than the social benefits and the market incentives for these activities are inefficiently low.

3. Traditional Critique of Industrial Policy • Government failure is worse than market failure. • Governments are not good at picking winners: • Market imperfections are rarely observed directly; • Policies are implemented by bureaucrats that have little capacity to identify where the imperfection are or how large they may be; and • Bureaucrats are supervised by politicians who are susceptible to corruption and rent-seeking by powerful groups and lobbies. • Governments should limit themselves to: • Ensuring property rights; • Contract enforcement; and • Macroeconomic stability.

4. Industrial Policy Today • Reality has not been kind to either set of expectations: • Import substitution, planning and state ownership did produce some successes, but where they got entrenched and ossified over time they led to colossal failures and crises. • Economic liberalization, deregulation, and opening up benefited export activities, financial interests, and skilled workers but produced growth rates far short of what was expected and has spurred income inequality.

5. Industrial Policy Today • Critical to get institutions “right” before thinking of specific policies: • A first-best policy in the wrong institutional setting will do considerably less good than a second-best policy in an appropriate institutional setting. • Challenge is to find middle ground between full autonomy and full embeddedness: • Too much autonomy for the bureaucrats and you minimize corruption but fail to provide what private sector really needs; • Too much embeddedness and bureaucrats end up in the pocket of business interests.

6. Industrial Policy in Puerto Rico • Anachronistic: • Top-down, Soviet-era process; • Focus on traditional manufacturing; and • Institutions have become entrenched and ossified over time. • Backwards: • Emphasis is on: • Specific policies (i.e. tax breaks) not on getting the institutions right; and • Specific sectors not on activities. • Policy process: • lacks transparency/openness; and • is controlled by a small unrepresentative group.

7. Some Principles for Industrial Policy • Incentives should be provided only to new activities; • Clear criteria for success/failure; • Built-in sunset clause; • Target activities not sectors; and • Need to establish open, permanent, transparent channels of communication with the private sector.