Politics, Business & Culture in the Americas
Inequality

Industrial Policy Can Rescue Latin America from its Commodities Trap

Policymakers can reduce inequality by moving beyond past failed attempts at diversifying national economies.
A man harvests bananas on an estate in Ecuador on Feb 22.David Diaz/picture alliance via Getty Images

With record turbulence in sections of the global commodity market and prices for many raw materials pushed higher, some see opportunity for commodity-exporting Latin American countries—while others see a mixed blessing. But regardless of whether the region’s economies benefit from the latest commodity price spike, the region’s high inequality and the profound limits of past commodities booms should encourage policymakers to look beyond commodities as the source of future economic growth.

The solution could come in the form of industrial policy. Countries must learn from the mistakes of failed experiments with industrial policy in past decades. But if a carefully coordinated, sophisticated industrial policy can be combined with innovation, education and social inclusion, the results could move Latin America past its race to the bottom of unskilled labor and raw material exports.

Why redistribution isn’t enough

In Latin America, the richest 10% bring in 54% of all income, making the region one of the most unequal in the world. Persistent income inequality has undermined socio-economic progress and resulted in social unrest, aggravating political and economic instability across the region. The COVID-19 crisis has made things even worse for the poorest segments of the population. In the future, redistribution through taxation may not be enough to sustainably reduce income inequality in the region. Redistribution leaves greater obstacles untouched—conspicuously, limited competitive advantage in high value-added sectors, high commodity dependence, and a scarcity of jobs that pay above subsistence levels.

In most Latin American countries, the initial income distribution is so uneven that even a major redistributive reform won’t be enough. Redistributive tax reforms—though badly needed—are unlikely to lower inequality rates to OECD levels on their own, since this would require a rate high enough to have adverse effects on economic growth and arouse strong elite resistance.

Long-term inequality reduction in Latin America is also constrained by the region’s high degree of commodity dependence. What a country produces and exports matters for improving the distribution of income. Most of the inequality reduction achieved in the 2000s was the result of commodity-financed social spending, cash transfers and improvements in education but did not address the region’s trade structure, which remains concentrated around commodities. The inevitable result was that these interventions could not be sustained after the fall in commodity prices from 2014 onward, which has led to the reversal of the progress achieved in the previous decade.

Without economic diversification, there are clear limits to how far inequality can be reduced.

Economic diversification has a central, yet often overlooked impact on inequality: It contributes to stabilizing and increasing tax revenues without increasing the tax rate, which can in turn finance poverty reduction programs and social transfers. It also expands job opportunities for low-income groups who otherwise have limited options, potentially magnifying the positive impacts of policies such as conditional cash transfers.

The benefits of industrial policy

Improving the income distribution requires coherent industrial policy to generate demand for workers and their newly acquired skills. Market forces won’t do the job alone, and a growing body of evidence suggests that successful economic diversification is often underwritten by government intervention.

Governments play a key role in overcoming market obstacles to the emergence of new industries by catalyzing targeted human capital accumulation, solving collective action problems in knowledge creation through research and development (R&D) support, facilitating domestic firms’ access to foreign markets through trade support and quality control, and sending market signals through price control mechanisms and public investments. Those market signals could be tax breaks, subsidized credits, patient capital, as well as targeted infrastructure and skills development programs to promote investment in high-potential areas (with large socio-economic spillovers) where investment has been suboptimal.

In contrast to the widespread narrative of a free-market miracle, Chile employed industrial policy to promote its own diversification in past decades. The emergence of the high-value-added salmon and berries industries can be traced to public policies and the role of Fundación Chile, a semi-public agency that diffused knowledge acquired through R&D as a public good to promote investments in promising industries that would not develop through market forces alone. In Brazil, public support for R&D and technology transfers were critical to the development of the internationally competitive aeronautics sectors.

Of course, government interventions also present risks and challenges, and Latin America’s own experience with industrial policy in the 1970s and ’80s was marked by notable failures. But there’s no reason why the next wave of industrial policy in Latin America must repeat the errors of the past, on a few conditions. Institutional capacity to implement industrial policies must be improved, with a focus on mechanisms to adequately incentivize, monitor and evaluate firms that receive public support. Stronger links must be constructed between firms, universities and public agencies. This kind of implementation capacity is the main difference between East Asia’s successful experience with industrial policy and Latin America’s so far less successful one.

Reducing inequality with a two-level industrial policy

The stakes are high to get industrial policy right. A non-strategically designed policy could have adverse effects and actually increase inequality if it focuses exclusively on sophisticated activities that only create better jobs for a few high-skilled people, as in Costa Rica. Focusing exclusively on labor-intensive activities, on the other hand, would help reduce income inequality by offering job opportunities with higher wages than in the informal or rural sectors to unskilled workers—but it would not contribute to the long-term upgrading of the national economy (the maquiladora model in Mexico is one example).

The best option is a two-level industrial policy, promoting both upgrading and skilled employment in high value-added activities, as well as unskilled employment through an initial expansion of labor-intensive activities. But such a strategy hinges on deploying an appropriate education policy to avoid skills mismatch. It also requires ensuring that low-income groups can benefit not only from unskilled but also skilled job opportunities in value-added activities.

Latin American governments’ historical inability to reduce inequality is closely related to the strong relationship between wealth and political power. But even Latin American business elites should by now perceive that lowering inequality by diversifying the economy through industrial policy is in their own interest. The increasing cost of inequality in the region is damaging economic progress, illustrated by a wave of social unrest since 2018 that has led to political instability and a loss of revenue and investment. The logic is simple: If the bottom of the social pyramid is too unstable and the top too heavy, the whole structure will soon crumble.

Lebdioui is a lecturer at SOAS, University of London, and leads the Canning House research program at the London School of Economics.


Tags: Commodities, industrial policy, inequality, redistribution
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