Innovation and the Investor State

The lagging growth of productivity despite enormous advances in information technology remains the great conundrum of economic life in the West during the past 20 years. This is the most urgent issue of our time. Disappointing productivity growth translates into substandard growth in household income and the marginalization of once-prosperous parts of the American population. It also leaves the West losing ground to China, with potentially dire economic and strategic consequences.

Philippe Aghion, Céline Antonin, and Simon Bunel have performed an important service by assembling a corpus of research on economic growth in a single volume, The Power of Creative Destruction. This dense, chart-filled tome will be heavy going for the average reader, but it belongs on the bookshelf of every public policy analyst and every member of Congress concerned with economic policy. It summarizes the key data and relevant research on a wide range of issues with clarity and common sense, without tripping over ideological stumbling-blocks. Even readers who disagree with the authors’ recommendations will find problems framed in a helpful fashion.

America has a long if limited tradition of state intervention into public life. Alexander Hamilton, the father of American economic policy, advocated “internal improvements” (what we now call infrastructure) as well as protection for infant industries and inducements for entrepreneurs to adopt new technologies. In the modern era, World War II and the Cold War elicited an enormous government commitment to military and space R&D and, in some cases, production. “Limited” is the key word: By focusing government spending on infrastructure and basic R&D, the United States avoided many of the traps of government interventionism. We still haven’t gotten the formula quite right.

The authors argue that the solution to stagnation, if there is one, will require more government intervention, but of a highly selective kind, including subsidies for key industries and anti-trust measures against the dominant technological monopolies. Their capitalist credentials are impeccable. (Prof. Aghion is a member of The Center on Capitalism and Society at Columbia University, headed by Edmund Phelps, the 2006 Nobel Laureate in Economics.) But they observe that capitalism requires government action under special circumstances.

The Schumpeterian Contradiction

Creative destruction, of course, was the watchword of the Austrian economist Joseph Schumpeter (1883-1950). The authors distill Schumpeter’s complex thinking into three simple statements. The first is that “innovation and the diffusion of knowledge are at the heart of the growth process.” The second is that “innovation relies on incentives and protection of intellectual property.” The third is that “new innovations render former innovations obsolete . . . growth by creative destruction sets the stage for a permanent conflict between the old and the new.” They mean by this that “creative destruction thus creates a dilemma or a contradiction at the very heart of the growth process. On the one hand, rents are necessary to reward innovation and thereby motivate innovators; on the other hand, yesterday’s innovators must not use their rents to impede new innovations.”

Schumpeter’s limitation, as Edmund Phelps observes in his book Mass Flourishing, proceeded from the view of the German Historical School that “all material advances in a country [are] driven by the force of science.” He “added just one new wrinkle to the school’s model: the need for an entrepreneur to develop the new method or good made possible by the new scientific knowledge.” What Phelps calls “mass flourishing” emerges when people all across society are prepared to innovate. Under such conditions, the “contradiction” cited by Aghion may disappear.

For example, American venture capitalists include successful innovators who have an interest in protecting the rents from their previous innovations, but who nonetheless invest in new businesses that might replace their earlier, successful enterprises. In fact, Aghion et al. include an excellent chapter on the importance of venture capitalists which emphasizes the decisive role of economic culture.

In the United States, the typical venture capitalist started out as an innovative entrepreneur who received venture capital funding. The royal road is for the entrepreneur to sell her firm by means of an IPO. She uses the proceeds of the IPO to become a venture capitalist herself. Her personal experience as an entrepreneur has provided her with the expertise and know-how necessary to select the most promising projects and to advise newer entrepreneurs pursuing those projects.

One might add that the vast majority of venture capital returns accrue to a small proportion of VC investors. According to one survey, half of all venture capital funds lose money, an additional 35 percent of funds return 1 to 2 times investors’ money, and 15 percent return double or more. This lopsided distribution of outcomes underscores the importance of entrepreneurial expertise.

US patent applications fell following China’s admission into the World Trade Organization in 2001. Instead of a virtuous cycle arising from Ricardian comparative advantage, as free-trade dogma predicted, the US entered a vicious cycle of falling incomes and lower innovation.

The authors add, “In contrast, In France, venture capitalists are most often finance professionals whose career has been in banking or insurance and who, therefore, have neither the practical entrepreneurial experience nor the technological knowledge to advise a startup. This explains in part why, in 2009, French venture capitalists invested only 353 million euros in young innovative firms, compared to 4.5 billion euros in the United States.”

What Phelps calls economic dynamism avoids the so-called Schumpeterian contradiction because the owners of rents created by previous innovation invest the proceeds in future innovations. That is a cultural and political matter; France lacks the venture capital culture that predominates in the United States and Israel, for example.

Schumpeterian antagonism between owners of past rents and would-be challengers has reappeared with a vengeance in the Information Technology sector. Aghion and his coauthors cite studies that blame the “decline in dynamism of the American economy since the beginning of the 2000s” on “an increase in industrial concentration and in markups.” The dominant firms, “having already accumulated the most patents, are the ones that continue to file the most patents. These same firms purchase the greatest number of patents for defensive purposes, that is, to discourage new innovation by potential entrants in their respective sectors.” That makes it harder over time for the laggards to catch up with the leaders.” Thus, “production ends up being more concentrated in the hands of the leaders, whose rents consequently increase.”

They conclude, “It is thus imperative to rethink competition policy, in particular antitrust policy regulating mergers and acquisitions, so that technological revolutions, such as IT and artificial intelligence, increase growth in both the short run and the long run.”

An October 2020 report by the House Subcommittee on Antitrust, Commercial and Administrative Law saw the same problem:

To put it simply, companies that once were scrappy, underdog startups that challenged the status quo have become the kinds of monopolies we last saw in the era of oil barons and railroad tycoons. Although these firms have delivered clear benefits to society, the dominance of Amazon, Apple, Facebook, and Google has come at a price. These firms typically run the marketplace while also competing in it—a position that enables them to write one set of rules for others, while they play by another, or to engage in a form of their own private quasi regulation that is unaccountable to anyone but themselves. The effects of this significant and durable market power are costly. The Subcommittee’s series of hearings produced significant evidence that these firms wield their dominance in ways that erode entrepreneurship, degrade Americans’ privacy online, and undermine the vibrancy of the free and diverse press. The result is less innovation, fewer choices for consumers, and a weakened democracy.

The modern equivalent of starvation in the midst of plenty is stagnant productivity in the presence of fundamental technology change driven by the IT sector.

Targeted Intervention

Public policy can help, and not just in the form of anti-trust measures against monopolistic and predatory Big Tech. An important case in point is the China import shock, which hit hardest during the George W. Bush Administration. Republican dogma at the time held that cheap imports from China benefited Americans by reducing the cost of consumer goods. That simply isn’t the case, according to studies cited by the authors. The higher the penetration of Chinese imports in any given region of the United States, the more industrial jobs were lost. Nor was the loss of industrial jobs the inevitable result of labor-saving investments. More than a fifth of manufacturing job loss can be attributed to the China shock. And worst of all, “The loss of industrial jobs was not the only consequence of the Chinese import shock. Wages also fell. Hence the negative effect of Chinese imports on regional economies was even worse, because the fall in wages decreased the demand for local services while increasing the supply of labor available for service-sector jobs.”

Innovation also suffered: US patent applications fell when Chinese imports to the US accelerated following China’s admission into the World Trade Organization in 2001. Instead of a virtuous cycle arising from Ricardian comparative advantage, as free-trade dogma predicted, the US entered a vicious cycle of falling incomes and lower innovation.

America’s tech industry has largely abandoned manufacturing in favor of software, which has inherently higher profit margins, conceding the hardware to Asian producers. That has given Americans cheap means of entertainment but fewer industrial jobs.

The question, then, is how to respond to trade shocks. “There are two ways to deal with foreign competition: one is to increase import duties (tariffs): the other is to incentivize domestic firms to innovate more, especially by subsidizing investments in R&D,” the authors observe. Tariffs attempt to defend existing industries against changes in the world economy, while support for R&D encourages domestic firms to leapfrog the competition and gain global market share. Citing studies by Marc Melitz and others, the authors note that tariffs suppress innovation by removing the incentive for domestic firms to raise productivity in order to deal with foreign competition. Subsidies for research and development, though, help domestic firms to compete against imports, and also help “expansionary innovation” on the part of firms that want to export more.

This general rule “does not imply that protectionist policies must always be rejected,” the authors allow. But “tools such as public investment in the knowledge economy, infrastructure, and industrial policy are more likely to yield productivity gains and long-term prosperity than a drastic increase in import duties.”

Asia subsidizes capital-intensive industry, and the United States subsidizes sports stadiums. America’s high-tech industry is one of the beneficiaries of such subsidies; it has largely abandoned manufacturing in favor of software, which has inherently higher profit margins, conceding the hardware to Asian producers. That has given Americans cheap means of entertainment but fewer industrial jobs. R&D subsidies encourage innovation, as Aghion et al. observe, but it is also the case that Asian capital subsidies suck manufacturing jobs out of the United States. The obvious solution is a change in the tax structure to favor capital-intensive investment (as opposed to equity buybacks, which in 2019 exceeded total capital investment among the S&P 500).

Immigration policy is also important, as qualified immigrants contribute disproportionately to American innovation. One study of the period 1976-2012 “shows that foreign-born individuals who arrived in the United States after the age of twenty were responsible for 23 percent of total [innovation] output, which was more than their demographic weight of innovators (16 percent).” Immigration between 1995 and 2008 “accounted for a 29 percent increase in the proportion of the US working population with a college degree,” especially in STEM fields.

The authors draw a bright line between the “investor state,” which supports innovation, and the “insurer state,” which uses state resources to preserve the status quo. European welfare state and industrial policy is a baleful example of the insurer state. As an exemplar of the investor state, Aghion and his coauthors cite the Defense Advanced Research Projects Agency (DARPA), which “demonstrates that a well-managed industrial policy can successfully foster rather than inhibit innovation.”

DARPA was born in the Sputnik Moment of 1957, when Russia beat the United States into space. “The DARPA model, they observe, is especially interesting because it “combines a top-down approach with a bottom-up approach. On the top-down side, the Department of Defense funds the programs, selects the program heads, and hires them for a three-to-five-year period. On the bottom-up side, the program heads, who come from the private sector . . . have full latitude to define and manage their programs.” They note that “DARPA has played a decisive role in the development of high-risk projects with high social value, such as the internet . . . and GPS.”

That is exactly correct, but does not quite capture what DARPA accomplished. Two things characterized every one of the signature inventions of the digital age, from integrated circuits to the Internet to optical networks. The first is that they all began as a DARPA project, and the second is that they all stumbled on game-changing technologies while looking for something else. DARPA not only provided funding for what the authors call “exploration” (as opposed to “exploitation”) R&D; it also allowed engineers and scientists from a wide variety of corporate, national, and academic laboratories the latitude to pursue the unknown unknowns.

The semiconductor laser that powers optical networks and a vast number of other applications began with a Signal Corp project to illuminate battlefields at night. CMOS chip manufacturing (mass production of fast, light, and energy-efficient custom chips) began with a DARPA request to allow fighter pilots to run weather forecasts in the cockpit but ended up powering lookdown radar. Famously, the internet began as a way to secure communications in wartime and became the universal medium of interchange.

The authors express the hope that peaceful economic rivalry rather than war will motivate competition among nations, and in doing so they miss a critical point about DARPA’s efficacy. The United States had to contend with Soviet breakthroughs, starting with Sputnik but including surface-to-air missiles that displayed devastating effectiveness during the 1973 Arab-Israeli war. By supporting research at the frontiers of physics and computer science, DARPA motivated scores of corporate laboratories and many thousands of scientists to push the envelope of science.

Sadly, peacetime industrial policy is subject to the whims of political constituencies who want to secure jobs and profits for existing industries. Defense R&D requires researchers to tackle problems with no known solutions and create technologies whose peacetime applications cannot be predicted. But the drive to win wars has produced virtually all the technologies that transformed civilian life during the past generation. Our great bursts of innovation occurred not only because the right number of dollars came out of Washington or the right number of graduates came out of universities, but because presidents like Eisenhower, Kennedy, and Reagan set great challenges before us, such as the Apollo Program and the Strategic Defense Initiative. Political leadership provided not only the resources, but the motivation and dynamism to do things that no-one had imagined before.