When is a risky bet still a good bet?
When it comes to the use of public finances for local economic growth, how can we know what is a good bet? And should governments be betting at all?
When it comes to the use of public finances for local economic growth, how can we know what is a good bet? And should governments be betting at all?
Humans often demonstrate an appetite for risky bets: whether investing in Bitcoin, migrating across the Mediterranean, or going to the moon. But when it comes to the use of public finances for local economic growth, how can we know what is a good bet? And should governments be betting at all?
Local council offices might seem very different from Las Vegas or Newmarket, but each time an economic strategy is adopted or a public investment is decided, a bet is taking place. Some recent vivid examples, from the large to the small:
All these bets are about the best way to support entrepreneurs and investors to generate economic growth. Clearly they are risky bets. Are they good bets?
In this blogpost I’ll share a few stories from my work with local economic policymakers through the World Bank. I highlight three techniques for local economic strategies to be distinctive, logical, and equipped to manage risk. These themes can resonate in many countries including the UK, where new funds for Community Renewal, Levelling Up and Towns investments will require good local strategies for economic development.
Imagine going to the horse races and betting on the same horse as everyone else in the stadium. Even if your horse wins, the odds will be low and your returns will be poor. As a mayor of a Combined Authority or in a Local Enterprise Partnership, how will you place your bets? If you help your local firms produce buttons, barley, or bolts, the likelihood is you’ll lead them to the slaughter if those markets are already highly competitive. Success requires being distinct in some way: cheaper, faster, or better. So think about which race your firms are in, and how that race will evolve in the future.
During my work with municipalities in Europe, I’ve noticed distinctiveness is scarce. Tourism projects focus on promotion and marketing, but rarely find a unique proposition or package of products to be marketed. Cultural heritage projects focus on renovating old buildings, but less often on the ‘experiences’ that make the buildings seductive and memorable for visitors. Business incubators are ubiquitous but often provide generic services and are sparsely occupied. One small region of eastern Croatia has 10 incubators for its 750,000 people, with 8 more incubators under development. Most of the incubators are struggling to find start-ups, which isn’t a surprise since a region of the same size in the UK or Sweden could expect only two or three incubators. Across Europe, strategies for economic growth tend to be loosely connected with the intrinsic conditions of each region; they mostly imitate what other areas are doing. This is a problem because evidence shows that various types of regions have various pathways to success: there isn’t a single growth model.
So local policymakers need to help firms to discover the bets that others have missed. The transformation strategy of the Basque Country succeeded by focusing on unique assets and resources of the region. Culinary training centers focused on bringing Basque restaurants up to Michelin star standards, far beyond basic training, and tourism promotion included the region’s unique culinary heritage. The Basque electronics, computing and telecommunication cluster during its period of transformation focused on highly specific initiatives: a ‘center of excellence in Java technologies’, a registration body for electronic signatures, and the development of an ISO 14001 standard. Likewise in Germany, industry support initiatives for automotive and mechatronics around Munich have focused on materials engineering, robotics, and big data; while around Dusseldorf they have focused on communications technologies, networks, media and creative industries. We need to think about how firms and regions can be distinctive and excellent.
But…is every bold idea a good one? A vision of cowboy tourism or digital skyscrapers may or may not work. We need a filter.
Primarily, all projects need to have a clear logic: the opportunity, the constraint, and the choice of intervention to solve the problem. This information is easy to collate because the private sector is usually candid about its pain points. However, doing a focus group or a survey doesn’t always yield the best long-term insights. Partly because the wrong people are often in the room: the friends of local governments rather than a full range of firms and potential investors. But more importantly because businesses are more emphatic about their short-term pains (“lower taxes; less red tape”) than about their longer-term options for strategy and innovation. So we need to underpin consultations with analysis.
What types of analysis are available? Economic appraisals are based on forecasts and probabilities, and depend on assumptions about future payoffs which are uncertain. The degree of uncertainty is especially high when it comes to local industrial strategies and transformative projects. So we need specialized analysis to increase our knowledge of local economic opportunities and constraints. Many methodologies exist, with ‘Smart Specialisation’ being amongst the most comprehensive. The core idea is to understand what kind of business local firms can be involved in, and whether it will be viable over time.
A British example of this analysis in action: when Grimsby’s fish market received funding for upgrades in 2012, there were loud calls from some businesses for an emphasis on infrastructure for frozen fish as well as fresh fish. But analysis revealed that frozen fish infrastructure could be counter-productive: it would gift an opportunity to frozen fish importers to underprice Grimsby’s fishermen with fish from anywhere around the globe. By contrast, a focus on fresh fish brought higher-value opportunities: fresh fish is perishable and therefore isn’t vulnerable to competitors from afar, while also earning a premium price. That meant infrastructure should focus on temperature control and fast logistics, not larger docks and huge warehouses. Now in 2021 with the advent of Brexit and frictions for trade in fresh fish to Europe, a further pivot in the fish industry may be required. Understanding the market forces in each industry is a precursor to good strategy, and public investments must be based on a clear understanding of alternatives.
Logically the analysis must include a rationale for public investment. Strategies need to be selective about where public investment can best make a difference, not try to solve every problem. Ideally, private investors can provide most solutions, and the public sector can focus on setting the right incentives and filling in the remaining gaps. So, in our work in Georgia, Armenia, Moldova, Belarus and Ukraine, we worked with the European Commission to train development officers from 146 local authorities on how to appraise public investments, especially with regard to the needs of local firms and industries. In practice the task of local officials is fiendishly difficult: to balance their technical role with demands by mayors or elected officials who have little patience for analysis.
One of the oldest chestnuts for World Bank staff working on local economic initiatives is the question of whether it is appropriate to support specific industries. This question arouses strong views. Some argue the public sector should stick to its knitting and focus on the fundamental conditions for growth (business and labour regulations, tax systems, basic infrastructure like roads, education systems, and healthcare). Those are ‘no regret’ investments since they are broadly useful whatever economic trajectories are taken. Others argue these fundamental conditions are useful but insufficient; major gaps in industry competitiveness are often too expensive or complicated for the local private sector to fill alone. So a paradigm of ‘no regret’ may turn out to be ‘no win’.
Some combination of both paradigms seems sensible. For example, North Macedonia enacted fundamental reforms to jump up the World Bank’s Doing Business ranking from 92nd in 2006 to 22nd in 2012, and invested specifically in agribusiness, manufacturing, and tourism. Chile similarly performed well on regulatory reforms, but its explosive growth in salmon exports amongst other sectors (from 10% to 35% of world production in 12 years) was prompted by industrial policy to support innovation and improve commercial viability. Similar reasons exist for Mendoza’s growth in high value wine exports compared to the neighbouring Argentinian region of San Juan. According to Ricardo Hausmann and Dani Rodrik, there is a simple reason why public investments must consider industry strategy: it is impossible to be agnostic. Governments are ‘doomed to choose’ because even roads, water pipes or schools will advantage some sectors and economic activities more than others.
The critical step is to institute a risk management mechanism. Even the best bets are not always successful, so feedback mechanisms are needed to help detect and solve problems. Look at the UK’s approach to vaccine development for COVID-19, which shows risky bets can be good bets if the portfolio is well managed. This portfolio approach is customary for organizations that manage innovative investments. For example, the world’s most successful innovation funds—like the United States’ Defense Advanced Research Projects Agency (DARPA) whose most successful projects have seeded fibre optic technologies and the Internet—are based on the expectation that many projects will fail but a few will succeed spectacularly. Similar expectations inform venture capital funds. During implementation, there are clear objectives for results, and project managers actively help solve problems. So this is a risk management mechanism for a portfolio of investments. These techniques could be more widely adopted in local policymaking, as they have been in some cities and countries.
So here are three ways to increase the quality of bets: distinctiveness, logic, and risk management. Can local economic strategies be improved with these techniques? We should bet on it.
Austin Kilroy is a Senior Economist at the World Bank
This blog is published as part of an occasional series by guest experts to provide a platform for new ideas in urban policy. While they do not always reflect our views, we consider them an important contribution to the debate.
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