This post is  a follow up to yesterday's about an article in this week's Economist that discusses the work of one of my professors, Ricardo Hausmann.  Though there are important caveats I think people need to understand (see my post), the work has tremendous value in helping us understand how the structure of economies evolve.  The real problem comes when Hausmann partners with Dani Rodrik and Charles Sable to translate his findings into policy prescriptions.  Somehow, something has gone terribly wrong.

The Economist article concludes: "In work with Dani Rodrik of Harvard and Charles Sabel of Columbia University, Mr Hausmann argues that governments should emulate venture funds, backing new enterprises in the hope that one will make the leap into a more densely forested area. They should spread their bets widely, monitor progress closely, and cut losses promptly."

Well first, the Economist gets it wrong in that Rodrik and Hasumann don't advocate a one size fits all, start a public VC approach.  But they've advocated it before, and I think this suggestion is a horrible idea, for two reasons.  One, because  it's probably impossible to operationalize and two, because it violates Rodrik's own first principles for industrial policy, which guide how I think about these types of government-market interactions.

Operationalizing a public venture capital fund is likely to be infeasible for a number of reasons, here I will only note the most obvious.  It would be very difficult to design and enforce an structure that protects against the incentive issues outlined above. Equally critical are the political challenges that arise from failed investments (in their papers Rodrik and Hasumann argue that if you're not failing, you're not doing it right).  Low tolerance for failure would be even greater in developing countries with limited fiscal resources.  Pressure against failure would both exacerbate the incentive issues as well as skew the fund towards less risky investments.   The government is also bound to be much worse at allocating capital than the market due to capability deficiencies.  Staffing a public fund would be extremely challenging, as the skills necessary for venture capital operation is scarce in developing countries.  In the rare instances where it does exist, it will be difficult for the public sector to provide attractive compensation.

More problematic, a public venture fund violates Rodrik's own first principles for industrial policy.  The crux of Rodrik’s approach is that 1) markets fail, 2) governments should intervene where markets fail, and 3) policies should target the failures.  Rodrik and Hausmann never address what the failure is that justifies government intervention in the financial market.  Surely failures do exist in the venture capital market, but it's unclear why the government  should go so far as provide venture capital directly, versus providing incentives to venture capital firms.  Equally central to Rodrik’s approach to industrial policy is the need to define institutional processes that balance the need to interact with the private sector for information to formulate policy with the risk of corruption and rent-seeking.  The partial ownership of firms that results from the provision of venture capital fails in this.  Huge incentive problems are created when the government becomes investor, policy maker, and regulator.

For these reasons I believe public venture funds are infeasible at best and harmful at worse.  A better understanding of failures in the venture capital market is necessary to formulate policy incorporating the insights from Hausmann and HIldago's work.