LatinFinance - January/February 2015 - 72

PARTING
SHOT
Industrial policy for the modern era should focus on
creating private-sector screening and support for
business innovation. By Ernesto Stein

Picking winners
Politicians, and many economists, have often pushed for programs
that support small and medium enterprises. One justification is that
SMEs employ a large portion of the labor force, so policies that help
them should generate more jobs.
But evidence from the US and Latin America suggests that it is
new firms, not small firms, which have a disproportionate impact on
net employment. Moreover, new firms, rather than established firms
that remain small, are a natural conduit for introducing innovative,
high productivity ideas to the marketplace.
The process of converting good ideas into good new businesses,
however, is rife with market failures. A new firm that introduces a
novel idea could be imitated. If so, the entrepreneur - who took all
the risks - may not appropriate all the benefits of introducing her
idea, thus discouraging entrepreneurship.
Entrepreneurs may have a great ideas but not have the
complementary skills - such as managerial capacity or marketing
knowledge - to start and grow a viable organization, or to attract
those who do. Furthermore, new innovative firms typically lack
access to finance, since even good ideas are hard to collateralize.
Not all new firms have the same potential impact on job creation
or innovation. In fact, the majority of new business owners -
such as construction contractors, auto mechanics, dentists or
insurance brokers - do not plan for their firms to innovate or
grow substantially. But market failures tend to be more severe for
innovative firms.
Efforts to encourage the creation of new firms should not,
therefore, consist of blanket policies favoring entrepreneurship.
Rather, they should focus on dynamic entrepreneurship, that is, on
encouraging the creation of innovative new firms with high growth
potential.
But if policies need to target the most promising new firms, how
can countries identify the "right" ones? Indeed, there is no need to
pick them beforehand. Rather, countries need to adopt policies that
attract high productivity firms, or implement policies that leverage
private sector capabilities to screen and identify the most promising
ones.
Supporting business incubators and accelerators may have an
impact on a relatively small number of firms, but at least may be
targeting the right ones. Incubators provide entrepreneurs with
access to networks of mentors and financing, and may help promising
firms emerge and grow. But for incubators to select the right firms and

72 L ATINFINA NCE.COM - January/February 2015

provide valuable services,
incentives have to be right.
Incubators should be
rewarded according to firm
performance, not just based
on the number of incubated
firms, as often done in the
region.
Encouraging the
development of a venture
capital industry is another
complementary way
to stimulate dynamic
entrepreneurship. Unlike
banks, VC funds can accept
innovative ideas as collateral
because they participate
in the financial upside
of firms. While VC is not
possible everywhere (it
requires a critical mass of
good projects), it was the
cornerstone of the recent
development strategy in
countries like Taiwan and
Israel. But, with the possible
exception of Brazil, the VC
industry is underdeveloped in Latin America.
Encouraging dynamic start-ups, however, is not enough. To make
a dent, high productivity start-ups need to scale up and absorb
workers and other factors employed in less productive activities. But
high productivity firms in Latin America do not scale-up well, and
tend to remain too small. The reasons range from distortions in labor
markets and tax codes favoring small firms, to family ownership.
Understanding the constraints that prevent firms scaling up - and
addressing them - is a key. Without it, policies encouraging start-ups
will not deliver on their promise. LF

"EFFORTS SHOULD
FOCUS ON THE
CREATION OF INNOVATIVE NEW FIRMS
WITH HIGH GROWTH
POTENTIAL"

Ernesto Stein is principal economist at the research department of
the Inter-American Development Bank, and co-author of Rethinking
Productive Development, published by the bank in September
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