Banking and Capital Markets

Government procurement: arsenic, or gold?

Ricardo Hausmann
Founder and Director, Growth Lab, Harvard University
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Gold is rare. More than 99.9% of the Earth’s crust is composed of oxides of silicon, aluminum, calcium, magnesium, sodium, iron, potassium, titanium and phosphorus. So, for most of human history, people have become quite excited when they have discovered gold. Despite the serious environmental consequences of gold mining, including mercury and cyanide pollution and the devastation of landscapes, humanity has not given up the search – and seems unlikely to do so any time soon.

But there is a figurative goldmine – safer and potentially at least as lucrative as the real thing – that most countries possess, but few choose to exploit fully: government procurement.

The potential adverse consequences of government procurement are well known. It can enable companies to charge excessive prices for low-quality goods and unreliable services, while facilitating corruption, abuses of power, and waste.

To mitigate these risks, most countries have implemented requirements for open bidding processes and strict transparency rules for government purchases. Indeed, most recent free-trade agreements require signatories to open up government procurement to one another’s firms, and the World Bank publishes the names of firms barred for fraud or corruption from bidding on Bank-financed projects. Countries that forego open bidding processes end up with the kind of large-scale theft that has been documented in Venezuela and almost certainly occurred in Ukraine under deposed President Viktor Yanukovych.

But beneath all of this arsenic is gold. Most modern production involves not just the cost of doing things, but also the cost of figuring out how to do them. Before aircraft manufacturers can produce and sell a new airplane model, they must spend billions of dollars over a decade or more of development – costs that must later be recouped. If they were not sure whether there would be a market for the new model, few would assume these costs. That is where government procurement comes in.

For example, in 1946, the United States government issued a contract for Boeing to develop the B-52. The government obviously did not want the company to deliver more of the same; it wanted the first fast jet-powered strategic bomber. After all, the second-best army in a war is the loser. The contract thus had to reflect the risks inherent in finding out how to design and produce the most advanced aircraft of its time.

But the benefits of the government purchase extended beyond its specific goal, when Boeing used the knowhow it acquired developing the B-52 to create its commercial B-707 aircraft. Though the government never purposely promoted the development of commercial airplanes, its procurement of high-quality, technologically advanced military aircraft was essential to the emergence of America’s globally dominant commercial aircraft industry.

Simply put, figuring out how to do one thing often makes it easier to do other things. In this way, a government that is exacting about the quality of its purchases can have a powerful impact on the evolution of its country’s comparative advantage.

Israel’s government has had a similar impact through its effort to manage its limited water resources. Let’s say that the country incurs a cost of 100 of some unit because of its water shortages. The innovations that the government encourages, such as drip irrigation or desalination, not only reduce the domestic cost of such shortages to, say, 70, but also underpin an industry that, by selling its wares in the most demanding markets, accrues a global value of more than 1,000. In this sense, Israel’s water scarcity has made the country wealthier than it otherwise would have been.

Likewise, Israel’s military investments have generated a set of solutions that, with some extra effort, have had useful – and lucrative – civilian applications. This helps to explain why private investment in research and development constitutes a larger share of GDP in Israel than anywhere else in the world.

The lessons from army purchases can be applied elsewhere. Governments are in the business of procuring solutions to their particular society’s most pressing challenges. Given that a country’s problems are rarely unique, innovative solutions can spawn globally competitive – even dominant – industries. And solutions for one problem may have applications in other areas.

This should serve as a model for Latin America as it works to improve the quality of its educational systems. As it stands, the eight Latin American countries that take the OECD’s standardized PISA exam are among the 15 worst-performing countries of the 65 that participate in the program.

Instead of sinking massive amounts of money into poorly performing school systems, Latin American governments would undoubtedly be interested in innovative solutions, such as tablet-based textbooks, that can help teachers provide effective lessons, monitor their students’ progress, and identify remediation strategies. Beyond improving their own children’s performance, such efforts could spawn a globally competitive industry in state-of-the-art teaching tools.

These are just a few examples of the value that can be extracted from the government-procurement goldmine. By committing to purchase large amounts of high-quality products that address major national challenges, governments can encourage private, public, or mixed organizations to incur the fixed costs of finding solutions. In many cases, the benefits of those solutions will extend far beyond their original purpose.

But, in pursuing such a path, governments must remember that mining is a potentially dangerous industry that must be approached with care. To this end, they could begin by applying, say, 5% of their procurement budgets to nurture urgently needed solutions in areas with potentially large global markets. After all, anything that is worth doing is worth doing better.

Published in collaboration with Project Syndicate

Author: Ricardo Hausmann, a former minister of planning of Venezuela and former Chief Economist of the Inter-American Development Bank, is Professor of the Practice of Economic Development at Harvard University, where he is also Director of the Center for International Development.

Image: A general view of the city of Chicago, March 23, 2014. REUTERS/Jim Young


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