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Openness and diversification can be beneficial for economic growth (Brainard and Cooper, 1968; Frankel and Romer, 1999).1 Openness to trade can foster growth by making it easier to import goods that embody new technology, by reaping economies of scale, and by facilitating the process commonly known as learning by doing through exporting, among other channels (Harrison and Rodriguez-Clare, 2010). Export diversification, in turn, reduces sensitivity to sector-specific shocks. Furthermore, deeper participation in global value chains (GVCs) facilitates access to international flows of knowledge and technology, and thus increases the potential for learning and productivity improvements in local firms.

Productivity and financial development go hand in hand. Unfortunately, credit is scarce, volatile, and expensive in Latin America and the Caribbean (IDB, 2004). Average credit to the private sector in the region, at about 40 percent of GDP, is much lower than the averages for the advanced economies (112 percent of GDP) and for East Asian developing countries (64 percent of GDP) (Figure 6.1).1 A GDP-weighted average presents an even bleaker picture, with credit to the private sector at 33 percent of GDP in Latin America, compared to 156 percent for the advanced economies and 98 percent of GDP for developing East Asia. Given this lack of financial development, it is not surprising that productivity in the Latin American and Caribbean region is low.

Chapter 1 made the case that the relevant question is not whether productive development policies (PDPs) should be pursued; rather, the question is how. What types of policies can help address the many market failures that beset the process of productive development—without repeating the errors of the past—and pave the way for a better future? In this regard, the oft-cited image of a pendulum, by which past industrial policies have swung out of vogue and are now back in fashion, is simply not appropriate. It would be more accurate to say that certain well-designed policy interventions may be worthwhile; they have stood the test of time, or can be crafted to meet new challenges. Other types, however, may lack proper conceptual justification or may be too risky to implement effectively. What types of policies should be favored? Which ones should be set aside? There is a need to rethink PDPs, to screen them in order to separate the wheat from the chaff. Rethinking these policies starts with a proper conceptual framework.

This book argues that productive development policies (PDPs) are an important component of a successful development strategy. But designing and implementing successful PDPs is not easy. To begin with, the process requires a well-oiled learning mechanism to diagnose market failures amenable to policy intervention, and design sound policy initiatives. Furthermore, it is not enough to get the policy design right; the public sector as a whole and the agencies in charge of specific policies (which we will call productive development agencies or PDAs) must also have the right capabilities to implement them.1

Economies grow when workers and other factors of production move into projects that have higher productivity. Many higher-productivity projects arise in existing firms. These firms can leverage internal capabilities, including internal sources of capital, to help jump-start these new undertakings. But sometimes, these new, higher-productivity projects originate in new firms. Such firms could offer advantages, such as greater flexibility or closer supervision, compared to existing firms that may be especially useful when generating products or services or using processes that are more innovative. Yet these new endeavors by new firms could have a harder time getting started because entrepreneurs cannot rely on existing firm capabilities, including the ability to borrow cash and collateral from other projects, to attract the right talent, or to secure the required complementary assets for the project to take off.1

The process of economic development does not just center on the ability of countries and their firms to make more of the same goods and services they already produce. Most of the successful cases of development around the world have been associated with the capacity of countries to produce new and better-quality goods and services—that is, to engage in processes of productive transformation that stimulate economic development. As important as it is, focusing on increasing the efficiency with which production is carried out—characteristic of a static approach to economics of “doing more with less”—is not enough; catching up with advanced countries may require a dynamic process of productive transformation.1

Few subjects have been more studied in the social sciences than the role of human capital in economic development. The consensus is that education—broadly understood as the continuous process of acquiring skills and/or capacities—determines the productivity of workers, their income levels, and, ultimately, the overall welfare of society. In turn, a better-educated population boosts the innovative capacity of an economy, speeds up the development of new technologies and products, and facilitates the dissemination of knowledge and adoption of new technologies developed by third parties. Through these diverse channels, higher individual levels of human capital result in higher levels of economic growth and development (Hanushek and Woessmann, 2008).

In the traditional view of productive development policies (PDPs), the roles of government and the private sector are completely separated. Market forces are powerful, and largely lead to desirable outcomes. When a market failure does arise that requires government intervention, a public sector entity identifies the problem and designs a solution. Government sets the rules and conditions, pursuing some collective goals, and firms act within those rules and conditions, attempting to maximize profits. If the rules are well designed, the individual and profit-seeking behavior of the firms leads to good results. In that context, with very well-informed governments, there is limited room for public-private interaction in productive development policy. Each side can do its part independently of the other.

Since the pioneering work of Solow (1957), technological change has been credited with explaining a substantial share of economic growth. Indeed, recent evidence for the United States shows that investments in R&D—a proxy for the innovation effort of a nation—made up 40 percent of the productivity growth observed during the postwar era (Reikard, 2011). Based on these findings, several Latin American and Caribbean countries have established and implemented public policies aimed at enhancing innovation. In practice, the first explicit interventions to encourage innovation by the private sector emerged even earlier, toward the end of World War II. Although many of these policies were either abandoned or dramatically downsized under the structural reforms inspired by the Washington Consensus, the disappointing results in terms of productivity growth have led several countries in the region to reintroduce policies to stimulate innovation and encourage technology adoption.

In a market economy, firms constantly interact in a variety of market transactions with other firms and organizations. They buy and sell goods and services as well as production factors in markets where prices convey essential information. In the course of doing business, they forge linkages that may yield important benefits to themselves, other firms, the economy, and even society at large.1 These benefits may include reducing information asymmetries, generating knowledge spillovers, strengthening economies of scale, and facilitating the generation of public goods. However, these linkages do not occur at random; firms located in a given geographic area or within a specific value chain or cluster are more likely to interact. And even within these geographic and production neighborhoods, linkages are not automatic and may lack the depth to reap all the benefits.