The Political and Financial Economics of Innovation

1. The Political and Financial Economics of Innovation Dr. William H. Janeway Institute for New Economic Thinking Third Plenary Conference Berlin: April 12, 2012

2. Schumpeter: The Process of Creative Destruction “The essential point to grasp is that in dealing with capitalism we are dealing with an evolutionary process…. “…The fundamental impulse that sets and keeps the capitalist process engine in motion comes from the new consumer goods, the new methods of production and transportation, the new markets, the new forms of industrial organization that capitalist enterprise creates. “…This process of Creative Destruction is the essential fact about capitalism. It is what capitalism consists in and what every capitalist concern has got to live with….” -- Schumpeter, Capitalism, Socialism and Democracy, pp. 82-3.

3. Technology Paradigms and New Economies “A full evolutionary account of economic growth would also take into account that the historical time path of growth tends to be punctuated by “eras” characterized by the development and diffusion of specific constellations of “general-purpose” technologies, that is broad techno-economic paradigms…. During a particular economic era , much of the economic growth is accounted for by innovation and productivity growth in the industries that produce the goods that directly incorporate the driving technological paradigms and also in the downstream industries that are able to use these goods as inputs (historically this was the case of steam power, later electricity and the internal combustion engine today it is the case of ICT technologies.)” --Dosi and Nelson, “Technical Change and Industrial Dynamics as Evolutionary Processes,” p. 113.

4. Figure 5.2 Approximate dates of the installation and deployment periodsof each great surge of development GREATSURGE Technological Revolution Core country Turning Point INSTALLATION DEPLOYMENT IRRUPTION FRENZY SYNERGY MATURITY 1st The Industrial Revolution Britain 1771 1770s and early 1780s late 1780s early 1790s 1793–97 1798–1812 1813–1829 2nd Age of Steamand Railways Britain (spreading to continent and US) 1829 1830s 1840s 1850–1857 1857–1873 1848–50 3rd Age of Steel, Electricityand Heavy Engineering USA and Germany overtaking Britain 1875–1884 1875 1884–1893 1895–1907 1908–1918* 1893–95 4th 1929–33 Europe 1929–43 USA Age of Oil, Automobiles and MassProduction USA (spreading to Europe) 1908–1920* 1908 1920–1929 1943–1959 1960–1974* 5th Age of Informationand Telecomunications USA (spreading to Europe and Asia) 1971–1987* 1987–2001 20?? 2001–?? 1971 Crash Institutional recomposition big-bang Source: Perez, Technological revolutions and Financial Capitalism

5. The Players in the Innovation Game “I have come to read the history of the Innovation Economy as driven by three sets of continuous, reciprocal, interdependent games played between the state, the market economy and financial capitalism. “Through the centuries, the state and the market economy have variously collaborated and competed in the allocation of resources and the distribution of income and wealth. “Financial capitalism has emerged to exploit discontinuities in the evolution of market and political processes, while itself inevitably dependent upon those same processes for its prosperity and even at times for its survival.” -- Janeway, Doing Capitalism, Introduction

6. Financing the Innovation Economy “The Innovation Economy begins with discovery and culminates in speculation. Over some 250 years, economic growth has been driven by successive processes of trial and error and error and error: upstream exercises in research and invention, and downstream experiments in exploiting the new economic space opened by innovation. Each of these activities necessarily generates much waste along the way: dead-end research programs, useless inventions and failed commercial ventures. In between, the innovations that have repeatedly transformed the architecture of the market economy, from canals to the internet, have required massive investments to construct networks whose value in use could not be imagined at the outset of deployment. And so at each stage, the Innovation Economy depends on sources of funding that are decoupled from concern for economic return.” --Janeway, Doing Capitalism, Introduction

7. Schumpeter and the State “What we know from experience is not the working of capitalism as such, but of a distorted capitalism which is covered with the scars of past injuries inflicted on its organism…. Everywhere we find industries which would not exist at all but for protection, subsidies and other political stimuli….Such industries are assets of doubtful value, in any case a source of weakness and often the immediate cause of breakdowns or depressive symptoms. This type of economic waste and maladjustment may well be more important than any other.” -- Schumpeter, Business Cycles, vol. I, p. 13.

8. Schumpeter and Finance “[R]isk bearing is no part of the entrepreneurial function. It is the capitalist who bears the risk. The entrepreneur does so only to the extent to which, besides being an entrepreneur, he is also a capitalist but qua entrepreneur, he loses other people’s money…. “Entrepreneurs borrow all the ‘funds’ they need both for creating and operating their plants….No one else borrows…. “…[S]ince [financial] failure primarily shows in dealing with novel propositions – where judgment is most difficult and temptation strongest – an association has developed between financing innovation and miscarriage or misconduct.” -- Schumpeter, Business Cycles, vol. I, pp. 104, 110, 116.

9. Neoclassical Theory versus History “Modern endogenous growth theory has postulated that innovation is ‘produced’ within the system, subject to economic incentives and should be regarded as an output, resulting from inputs, where physical capital, human capital, R&D, and economies of scale all play major roles….The greatest technological sea change in history…supposedly constitutes a ringing affirmation of this view….Yet the neoclassical view of technological progress needs to cope with the historical parameters of technological progress, which govern a phenomenon unlike anything else in history. “…Technology, like all forms of knowledge is non-rivalrous…, so that the social marginal cost of sharing it is zero. Since the social marginal product is positive, the optimal static solution is one in which it is made accessible freely to all able and willing to use it. Yet under these conditions no one has much of an incentive to engage in the costly and risky R&D in the first place….” --Mokyr, “The Contribution of Economic History to the Study of Innovation and Technical Change,” in The Handbook of the Economics of Innovation, vol. I, p. 13

10. Market Failure and R&D:Arrow’s Summary “To sum up, we expect a free enterprise economy to underinvest in invention and research (as compared with an ideal) because it is risky, because the product can be appropriated only to a limited extent, and because of increasing returns in use. This underinvestment will be greater for more basic research. Further, to the extent that a firm succeeds in engrossing the economic value of its inventive activity, there will be an underutilization of that information as compared with an ideal allocation.” --Arrow, “Economic Welfare and the Allocation of Resources to R&D,” p. 156

11. Mission R&D versus Market failure “Defense-related R&D is an example of “mission R&D,” that is, R&D funded by public agencies to support their activities. Despite its significance…, this class of R&D is largely overlooked by the welfare economics of R&D…. “Although the market failure rationale retains great rhetorical influence in justifying public investments in R&D programs, casual empiricism suggests that it influence over such public investments is modest…. ‘Market failure’ underpins less than 50% of public R&D spending in most [OECD] economies. “…Rather than ‘scientists’ choosing the fields in which large investments of public R&D funds were made, allocation decisions were based on assessments by policymakers of the research needs of specific agency missions ranging from national defense to agriculture….To a surprising extent, scholarly analysis of the ‘new context’ of science and technology policy fails to acknowledge the prominence of mission-oriented R&D programs that have few of the hallmarks of the idealized ‘Bush Social Contract.’” --Mowery, “Military R&D” in The Handbook of the Economics of Innovation, vol II, pp. 1121-3

12. List: The National System of Political Economy “Had the English left everything to itself—laissé faire and laissé aller—the merchants of the Steelyard would be still carrying on their trade in London, the Belgians would be still manufacturing cloth for the English, England would still have been the sheepyard for the Hansards.” --List, The National System of Political Economy, trans. Sampson S. Lloyd, 1885 ed., (New York: Augustus M. Kelly, 1966 [1841]), p. 25.

13. National Development andState Support of Science “…[I]t was generally recognized during the early twentieth century that British industry was lagging behind German and American practice in the exploitation of new technologies and scientific knowledge and in the developments of new institutional mechanisms to encourage such exploitation. “ --Mowery and Rosenberg, Technology and the Pursuit of Economic Growth, p. 113 “…In subsidizing research…, the economies of the Continent faced more activist governments [than in Britain], which subsidized what they believed to be important research, from agricultural research stations in Saxony and Polytechnics in Prussia to the Kaiser Wilhelm Society for the promotion of sciences to the Grandes Ecoles in France and the Pasteur Institute in Paris.” --Mokyr, p. 45

14. The Central Research Laboratory “…[T]he mergers and corporate reorganizations of the late nineteenth and early twentieth centuries hastened the growth of industrial research. The firms emerging from the numerous horizontal mergers of the period were among the largest in the American economy. Many of these giant enterprises reorganized and rationalized their internal structure following their creation and developed a strong central staff to coordinate the activities of their many component parts….In firms such as American Telephone and Telegraph, General Electric, U.S. Steel or Du Pont, the development of a strong central office was closely associated with the establishment or significant expansion of a central research facility….[T]he lack of comparable changes during this period in the ownership and structure of many British firms was associated with lower levels of R&D employment and investment within industry.” --Mowery and Rosenberg, pp. 71-2

16. National Security and State Support of Science “…National Security would prove to be a potent justification for investments in science and technology and much else besides. The Office of Naval Research in the late 1940s was a premonition of what was to come. ONR’s renowned generosity and flexibility with respect to academic scientists bore little relation to the navy’s apparent needs. When defense management was loose enough, national security provided a convenient pretext to move ahead with policies designed primarily to serve other ends. NSF, too, benefitted from the belief that it would help to win future wars….” --Hart, Forged Consensus: Science, Technology and Economic Policy in the United States, 1921-1953, p. 174 “The IT sector, which scarcely existed in 1945, was a key focus of federal R&D and defense-related procurement spending for much of the postwar period. Moreover, the structure of these federal R&D and procurement programs exerted a powerful influence on the pace of development of the underlying technologies and the structure of the industries that developed these technologies for defense and civilian applications.” --Fabrizio and Mowery, “The Federal Role in Financing Major Innovations,” in Financing Innovation in the United States, 1870 to the Present, p. 283

17. The Other Legitimizing Mission: NIH and State Support of Science “Simply described, the goal of NIH research is to acquire new knowledge to help prevent, detect, diagnose, and treat disease and disability, from the rarest genetic disorder to the common cold. The NIH mission is to uncover new knowledge that will lead to better health for everyone. NIH works toward that mission by: conducting research in its own laboratories; supporting the research of non-Federal scientists in universities, medical schools, hospitals, and research institutions throughout the country and abroad; helping in the training of research investigators; and fostering communication of medical and health sciences information.” (http://www.nih.gov/about/FAQ.htm#NIH) “As long as members of Congress and their constituents keep getting sick and pray that science can provides cures, it seems likely that the NIH budget juggernaut will continue to roll on….” --Hart, p. 232

18. Financing the British Railways “…In 1846-8 railway investment was absorbing 5-7 per cent of the national income (about half total investment and very much the largest single slice). This was equivalent to two-thirds the value of all domestic exports, and entailed a £16 million wage bill for a 250,000 labour force….[S]wings in railway investment created at their peak almost as much employment as the entire cotton industry, while the income raising flows were greater than all the fluctuations in foreign trade in these years. “Financial consolidation pyramided capital into the main companies in a very wasteful way. Competitive lines went on being built—stupid, petty railways….yet another main line was built to London in 1899…, giving London its thirteenth main-line terminus….The total network of the United Kingdom in 1900 was 22,000 miles….£1,300 million was in the system in 1914—the most expensive heritage of Victorian success. But there were no more manias after 1846….” --Mathias, The First Industrial Nation, pp. 283, 286-7

19. Financing the American Railroads “The demands of the railroads during the 1850s on American financial intermediaries and on construction contractors were unprecedented. Railroads required far larger amounts of capital to build than did canals. The total expenditures for canals between 1815 and 1860 reached $188 million, of which 73 percent was supplied by state and local governments….By 1859 the investment in the securities of private railroad corporations had passed the $1,100 million mark, and of this amount close to $700 million had been raised in the previous ten years…. “As soon as the American capital market became centralized and institutionalized in New York City, all the present-day instruments of finance were perfected; so too were nearly all the techniques of modern securities marketing and speculation…. “By the outbreak of the Civil War, the New York financial district, by responding to the needs of railroad financing, had become one of the largest and most sophisticated capital markets in the world…” --Chandler, The Visible Hand, pp. 90-2

20. Speculators and the U.S. Railroad “Systems” “System-building proved costly to individual roads and to some extent to the national economy as well. The great growth of the individual enterprises often led to a redundancy of facilities. During the 1880s more miles of track [75,000]were built than in any other decade in American history, and in the 1890s more mileage [>40,000] was in bankruptcy than in any other decade before or since…. “In the interplay between the three types of businessmen who determined railroad strategy, the investors played a passive role and the managers and speculators an active one… “It was…the speculators who shattered the old strategies. They were the first to disrupt the existing alliances. They undermined the viability of the regional railroad cartels since they often had more to gain from violating than from maintaining rate agreements….It was the speculators, then, who precipitated system-building in American transportation.” --Chandler, pp. 147-8)

21. National Interstate and Defense Highways Act (1956) “It is hereby declared to be essential to the national interest to provide for the early completion of the "National System of Interstate Highways", as authorized and designated in accordance with section 7 of the Federal-Aid Highway Act of 1944 (58 Stat. 838). It is the intent of the Congress that the Interstate System be completed as nearly as practicable over a thirteen-year period and that the entire System in all the States be brought to simultaneous completion. Because of its primary importance to the national defense, the name of such system is hereby changed to the "National System of Interstate and Defense Highways". Such National System of Interstate and Defense Highways is hereinafter in this Act referred to as the "Interstate System.”

22. From ARPAnet to Internet: The Importance of TCP/IP “…[T]he explosive adoption and commercial exploitation of the Internet during the 1990s built on a foundation of computer-networking R&D and investment, much of which was from federal sources…. “…ARPAnet is widely recognized as the earliest forerunner of the Internet…. “In 1874, two DARPA-funded engineers…published the first version of the TCP/IP protocol suite. The new…protocol allowed physically distinct networks to interconnect with each other as ‘peers’ and exchange packets through special hardware…’gateways.’… “TCP/IP’s origins in a federally funded research project…were crucial to the eventual victory of this open, nonproprietary standard….The weak intellectual property protection for TCP/IP…reflected the network’s academic origins, the DOD’s support for placing research in the public domain, and the inability of proprietary standards to compete with the open TCP/IP standard. The resulting widespread diffusion of the Internet’s core technological innovations lowered barriers to the entry by networking forms in hardware, software and services.” (Fabrizio and Mowery, pp. 305-6)

23. Exploring New Economic Space:The “Killer App” of the Railroads “[A] curious thing happened as railroad bankruptcies and price wars put steady downward pressure pm shipping prices and slashed rail freight and passenger rates across the country: New industries sprang up. “Consider…the old Montgomery Ward and Sears Roebuck catalogs….Mail a catalog to every household in the country. Offer the big-city goods at near big-city discounts. Rake in the money from satisfied customers. For two generations this business model—call it the ‘railroad services’ business model—was a license to print money, made possible only by the gross overbuilding of railroads, the resulting collapse of freight rates, and the fact that railroad investors had had to kiss nearly all their money good-bye…. “The same thing will happen with the froth that the bubble put on our 1990s boom. Investors lost their money. We now get to use all their stuff….” (DeLong, pp. 1-2)

25. Venture Fund Performance Relative to the NASDAQ Fund Multiple and IRR measures of performance are estimated for a hypothetical set of funds that are created assuming that each terminated fund in the database made an equivalent investment in the NASDAQ. The Public Market Equivalent (PME) is a measure of the total disbursements to a fund expressed relative to the total distributions to the hypothetical fund. This data is also summarised excluding the top decile and quintile of funds. 25 25

26. Venture Fund Performance (IRR) Relative to the IPO Market The performance of the sample of venture funds, as measured by the IRR, is summarised by market and exit conditions indicators. 26 26

27. Decline of the IPO Market: 1991-2011

28. Table VIII: VC Fund-raising 1980-2010 # of Funds$B raised$B managed 1980 52 2.0 2.1 1985 118 3.8 11.4 1990 86 3.2 22.1 1995 165 9.5 32.4 2000 649 105.0 182.2 2005 234 30.8 234.4 2010 157 13.8 164.7 2011 169 18.2 n/a Source: National Venture Capital Association 28

29. Profiles of Two BubblesNew York: 1929 and 1999

30. The Necessity of Bubbles:Financial Valuation and Real Investment “By conveying a positive signal about profitability, higher aggregate investment . . . increases asset prices, which in turn raises the incentives to invest. This two-way feedback between real and financial activity makes economic decisions sensitive to higher-order expectations and amplifies the impact of noise on equilibrium outcomes. As a result, economic agents may behave as if they were engaged in a Keynesian “beauty contest” and the economy may exhibit fluctuations that may appear in the eyes of an external observer as if they were the product of “irrational exuberance.” Importantly, these effects are symptoms of inefficiency, are driven purely by the dispersion of information, and obtain in an otherwise conventional neoclassical setting.” --Angelotos, Lorenzoni and Pavan, “Beauty Contests and Irrational Exuberance: A Neoclassical Approach,” pp. 31–2; emphasis in original

31. The Necessity of Bubbles:Financing Risks and Waves of Innovation “Our model also implies that some extremely novel but NPV positive technologies or projects may in fact need `hot' financial markets to get through the initial period of discovery or diffusion, because otherwise the financing risk for them is too extreme. This provides a more positive interpretation to peaks of financial activity and may also explain the historical link between the initial diffusion of many novel technologies (e.g. canals, railways, telephones, motor cars, internet, clean technology) being associated with heated financial market activity (Perez (2002)). This implies that regulators should not always be concerned with popping `bubbles', and furthermore, that those wishing to stimulate innovation should look for ways to concentrate investment in a sector or time or location in order to help create the coordination among investors that creates or magnifies innovation.” --Nanda and Rhodes-Kropf, “Financing Risk and Innovation,” p. 6

32. The R&D Boom of the Late 1990sSource: Brown, Fazzari and Peterson, “Financing Innovation and Growth: External Equity and the 1990s R&D Boom”

33. Schumpeter Meeting Keynes:Policy Implications “One of the main insights…is a vindication of a strong complementarity between Schumpeterian policies addressing innovative activities and Keynesian demand management policies. Both types of policies seem to be necessary to put the economy into a long-run sustained growth path. Schumpeterian policies potentially foster economic growth, but they do not appear to be able alone to yield sustained long-run growth. In a broad parameter region, ‘fundamental’ (indeed, endogenously generated) changes in technology are unable to fully propagate in terms of demand generation and ultimately output growth. By the same token, demand shocks (in the simplest case, induced by government fiscal policies) bear persistent effects upon output levels, rates of growth, and rates of innovations….Keynesian policies not only have a strong impact on output volatility and unemployment but seem to be also a necessary condition for long-run economic growth.” --Dosi et. al., “Schumpeter Meeting Keynes: A Policy-Friendly Model of Endogenous Growth and Business Cycles,” p. 1750

34. Keynes’ Provocation “If the Treasury were to fill old bottles with bank-notes, bury them at suitable depths in disused coalmines which are then filled up to the surface with town rubbish, and leave it to private enterprise on well-tried principles of laissez-faire to dig the notes up again, . . . there need be no more unemployment and, with the help of the repercussions, the real income of the community, and its capital wealth also, would probably become a good deal greater than it actually is. It would, indeed, be more sensible to build houses and the like; but if there are political and practical difficulties in the way of this, the above would be better than nothing.” --Keynes, General Theory, p. 129

35. DeLong and Summers:“Fiscal Policy in a Depressed Economy” “The analysis demonstrates that, as a matter of arithmetic, if the short run multiplier is even moderate and if there are even modest hysteresis effects, then temporary expansionary fiscal policy will not impose future fiscal burdens. Our subsequent analysis has made the strong case that shortrun fiscal multipliers are likely to be substantial enough and that hysteresis effects are likely to be present in an environment like the present one in the United States, where the economy is operating well short of potential and where interest rates are constrained by zero lower bound. “It is crucial to stress that this result does not speak to the question of the long run sustainability of fiscal policy, or to the importance of addressing unsustainable fiscal policies. If committed spending and committed revenue plans are inconsistent, then as a matter of arithmetic adjustments will be necessary. Nothing in our analysis calls into question the widely held proposition that it is desirable for those adjustments to be committed sooner rather than later. “Our analysis simply demonstrates that additional fiscal stimulus, maintained during a period when economic circumstances are such that multiplier and hysteresis effects are significant and then removed, will ease rather than exacerbate the government’s long run budget constraint.”

36. Henderson’s Response:“The Argument from Confidence” “If you launch a . . . ₤200 million two year’s programme . . . there are solid grounds at once for believing that that means that taxation is likely to be increased ever higher, year by year . . . I should say that the alarm might quite easily serve to counter-act finally the employment benefits of the programme, and you would then be in a vicious circle of requiring a still bigger programme, still more unremunerative in character, with an increasing hole in the Budget, and increasing apprehension, until you were faced with either abandoning the whole policy or facing a real panic-flight from the pound. --Henderson to Keynes, May 30, 1930) “The scope and scale of the programme as a whole must be such as to commend itself as reasonable and sensible to public opinion . . . While . . . we do not believe that employment created by public works need involve a diminution of resources devoted to private investment, it might easily do so, if it took a form which aroused apprehension as to the stability of the public credit.” --Report of Economic Advisory Council, October 1930

37. The Pursuit of Economic Efficiency:A Two-edged Sword “The same appeal to economic efficiency serves both to rationalize the toleration of Keynesian waste and to limit the toleration of Schumpeterian waste, and the double-edged impact is compounded by the interaction between the two effects. When Keynesian waste is at a minimum—that is, in a high-growth, fully employed economy—the consequences of Schumpeterian waste are likely to be more creative and less destructive. More innovations will be profitably exploited, and the people and capital stranded in legacy occupations will be more rapidly redeployed. And very much vice versa.” --Janeway, Doing Capitalism, Coda

38. The Innovation Economy andThe First Global Crisis of Big-State Capitalism “The political economies of the Western, industrial world have all reached positions of stasis: the recovery of the market economy remains incomplete, the overhang of financial excess persists, and the space for political initiatives to address each is constrained. “Closest to my intellectual and professional home, in the developed economies of the world the forward movement of the Innovation Economy is stalled. Having managed to convince themselves they are out of Cash, their leaders have jointly and severally lost Control over their technological and economic future. In a frustrating and needless echo of Britain eighty years, when the scale of small-state capitalism institutionally constrained the scope for activist response, paralysis is the political consequence of the first crisis of big-state capitalism.” (Janeway, Doing Capitalism)

39. Economic Growth and Public debt “Britain in 1815 offers signal support for the proposition that even an astonishingly high level of public debt is most productively addressed by the acceleration of economic growth through leadership in the Innovation Economy. Britain exited the Napoleonic Wars with a national debt no less than 250 percent of its estimated national income. Far from suffering default, Britain saw its gilts (government bonds) come to represent the highest-quality risk-free asset in the world as British leadership of the First Industrial Revolution generated economic growth at unprecedented rates. Decade after decade, as the economy expanded, the public debt fell on a relative basis, though it declined in absolute terms only after 1860. By 1890 it was less than 50 percent of gross national product. Sixty years later, the United States emerged from World War II as the unquestioned leader both in current production of goods and services and in technological innovation, and with public debt equal to almost 120 percent of GDP. In this instance, the pace of economic growth was markedly more rapid. By 1965, only twenty years later, even though it had grown by 20 percent in absolute terms, the US national debt had likewise fallen to less than 50 percent of GDP.” --Janeway, Doing Capitalism