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Brazilian Lessons for Industrial Policy

By Tarun Khanna and Santiago Mingo

Project Syndicate | May 10, 2010

CREDIT: UK DEC (CC).

Few economic ideas are more lauded and reviled than that of industrial policy. Proponents, such as those who studied the rise of the East Asian economies, swear by it. Opponents see red at its very mention. The former point to economic development; the latter maintain that tens, even hundreds, of billions of dollars have been squandered.

One recent theatre of (dis)content is that of renewable fuels. Worldwide, $184 billion is being allocated in public stimulus investments to promote clean energy, led by the United States ($67 billion) and China ($47 billion). Of course, there is some progress—wind power meets 20 percent of the electricity demand in Denmark and about 15 percent in Spain and Portugal, for example—but the recipe for success remains elusive.

In this vein, Brazil's experience at promoting renewable fuels, beginning in the 1970s, is directly relevant to today's polarized views of industrial policy. A 10-year industrial policy program called Pro-álcool was crucial in the development of the industry. Today, Brazil is the world's most competitive producer of renewable fuels, based primarily on bioethanol. Ethanol accounts for more than 50 percent of current light-vehicle fuel demand in the country, and Petrobras—Brazil's energy giant and one of the largest companies in Latin America—expects this share to increase to more than 80 percent by 2020.

Our research shows that industrial policy was successful in promoting a competitive bioethanol industry in Brazil. A massive stimulus package, prompted by the 1970s rise in oil prices, gave rise to an entirely new industry. But it would not have worked without the crucial role played by competition.

Brazil was attempting to become energy self-sufficient in a manner similar to modern efforts by other countries. But, as opponents of industrial policy are right to remind us, freebies never lead to a good outcome. The aftermath was the key. As world energy prices collapsed, Brazil fortuitously turned off its subsidy tap, whereupon a brutal Darwinian free-for-all ensued. This competitive rationalization was the key to the policy's success.

The details of Pro-álcool involved providing incentives to several parties to participate, without which they would have sat on the sidelines. The Brazilian state offered low-interest loans and credit guarantees for the construction of distilleries, as well as tax incentives for the purchase of ethanol-powered vehicles. Ethanol prices were manipulated to make it an attractive alternative to gasoline. In addition, the government induced Petrobras to distribute the renewable fuel. Gas stations installed ethanol pumps. The government signed agreements with the major automobile companies to provide incentives to make vehicles that could run on 100 percent ethanol.

A visitor to Brazil today will see these flex-fuel cars everywhere. The experience of filling these vehicles' tanks is curious. Just before entering a gas station, Brazilian drivers calculate whether conventional gasoline or ethanol is cheaper (bioethanol has 30 percent less energy content than traditional gasoline), then choose between a gasoline and an ethanol pump.

At the outset, Brazil's policies attracted entrepreneurs of all sorts. Some were talented and believed that the new subsidies and incentives rendered long-term investments in the industry highly attractive. Entrepreneurs of dubious quality no doubt entered as well, thanks to the generosity of the state. Fortunately, the government did not attempt the impossible task of trying to separate winners from losers.

By the 1990s, the major subsidies and policies were abolished, and the industry was deregulated. Our statistical analysis of the entry and exit patterns of entrepreneurs in the Brazilian ethanol industry shows that the more efficient acquired the less efficient. Most underperforming ethanol companies went bankrupt or were taken over by entrepreneurs who had successful track records in running efficient operations.

The government did not bail out the underperformers, allowing market forces to restructure the industry during the post-subsidy phase. Certainly, the beneficiaries of Pro-álcool's subsidies lobbied the state to continue the protective policies even after their usefulness—inducing the development of the industry—had expired. Fortunately, the government was not persuaded.

Brazil's experience offers three important lessons for nations implementing renewable energy initiatives: (1) government policies must be consistent, simple, and long-lasting, providing assurance to would-be entrepreneurs that they can invest for the long haul; (2) picking winners, the familiar weakness of overenthusiastic bureaucrats, must be kept to a minimum; and (3) the state must have the discipline to dismantle subsidies when the need for them has passed.

If these lessons are implemented, market forces can pick up where industrial policy leaves off. As industrial policy returns to the scene in countries around the world, that is a goal that advocates and opponents alike should be happy to embrace.

Read More: Agriculture, Business, Economy, Energy, Environment, Finance, Governance, Technology, Brazil, Americas

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