Author: Mazzucato, Mariana
Date published: December 1, 2011
The current debaie, in the UK and abroad, on the need to cut back the state in order to unleash the power of entrepreneurship and innovation in the private sector, builds upon a stark contrast that is repeatedly drawn by the media, business and libertarian politicians: a dynamic, creative competitive private sector versus a sluggish, bureaucratic, inert, 'meddling' public sector. Company heads complain about the state stifling innovation; in the US, Tea Party politicians call for the state not to meddle in areas like Healthcare that are more efficiently run by the market; David Cameron calls civil sector workers the 'enemies of enterprise', and editorials in the Economist call for the public sector to be reduced to open up opportunities for innovation and competition.
In painting this contrast, it is assumed that the private sector is inherently more innovative, more able to think out of the 'box' and to lead a country towards long-run innovation-led growth. In this view, the retrenchment of the public sector will inherently make the economy more productive and achieve higher growth. But many examples in the history of innovation, entrepreneurship and competition, in different sectors and across different countries, paint a very different picture - of a risk taking innovative state - especially in the most uncertain phases of technological development and/or in the most risky sectors - versus a more inert private sector, which only invests (in innovation, in new startups, in networks) once the state has absorbed most of the uncertainty.
There are plenty of examples. In the pharmaceutical industry it is the staterun labs that have been responsible for the discovery of the most radical new important drugs, with private pharma focused on the less risky slight variations of existing, 'me too', drugs (such as Viagra in different colours and dosages). In the USA and Europe, state funding has been responsible for most, if not all, general purpose technologies, i.e. those technologies that help achieve economywide growth (aviation, computers, electricity, internet, nanotechnology). The biotech revolution owes its success not to venture capital (as is commonly assumed) but to major inventions within the UKs Medical Research Council and the US's National Institute of Health, as well as pro-innovation regulations that have made it easier for these inventions to be commercialised. This has not been just a question of 'research', but of the state having the courage to think about completely new areas of development, invest its resources into uncertain territory, open multiple windows of exploration, fund early-stage risky research, create organisations dedicated to funding and supporting new start-ups, and formulate dynamic 'networks' between science, business and finance.
In most cases of the development of general purpose technology it has been the state that has gone against the grain, thought Out of the box', risked large amounts of money; while the private sector has more often been wedded to the status quo, where short-run returns are inevitably more secure. Similar examples can be found in the creative sector, where, for example, innovative first-time directors can 'enter' the industry only through risky state-backed funds or stateowned broadcasters. In this sense, the state has played a role that goes beyond the Keynesian emphasis on taxation, subsidies, spending and regulation, and the Schumpeterian emphasis on creating the 'right conditions' for innovation and growth. It has played an active entrepreneurial role - envisioning new technological opportunities in high-growth areas; undertaking the very early risky investments that lay the groundwork for future exploration of these areas; funding new start-ups that commercialize the innovations; and in some cases even bringing the product to market. It has in fact not only solved 'market failure' (of which there are many instances); more importantly, it has solved 'network' or Opportunity' failures. It has not only 'fixed' markets; it has actively led the creation of new ones.
Beyond market failures
The view of the current UK government regarding its role in stimulating innovation is to create an environment where the private sector can flourish. Indeed, a recent growth review by the Department for Business, Innovation and Skills and HM Treasury stated that its role is to 'provide the conditions for private sector growth and investment'.1 This is the view that sees government as having a role only for the purpose of correcting market failures - for example through investment in basic science, education and infrastructure. The arguments in favour of limiting the role of the state and relying on the market for innovation are not new, but they would benefit from a greater understanding of the academic literature on the role of innovation in creating economic growth.
Entrepreneurship, like growth, is one of the least understood topics in economics. Entrepreneurship involves taking risk.2 It is not just a question of setting up a new business (the more common definition), but of doing so in a way that produces a new product, or a new process, or a new market for an existing product or process. According to Schumpeter, regarded by some as a key theorist of entrepreneurialism, an entrepreneur is a person, or group of people, who is willing and able to convert a new idea or invention into a successful innovation. Entrepreneurship employs 'the gale of creative destruction' to replace inferior innovations across markets and industries, simultaneously creating new products, including new business models, and in so doing destroying the lead of the incumbents.1 In this way, creative destruction is largely responsible for the dynamism of industries and long-run economic growth. Each major new technology leads to creative destruction: the steam engine, the railway, electricity, electronics, the car, the computer, the internet have all destroyed as much as they have created, but have also led to increased wealth overall.
In fact, entrepreneurial risk-taking, like technological change, is not just risky; it is highly 'uncertain'. Frank Knight distinguished risk from uncertainty in the following way:
The practical difference between the two categories, risk and uncertainty, is that in the former the distribution of the outcome in a group of instances is known . . . While in the case of uncertainty that is not true, the reason being in general that it is impossible to form a group of instances, because the situation dealt with is in a high degree unique.4
Technological change is a good example of the truly unique situation, since not only do R&rD investments take years to materialise into new products, but most investments lead to failure. In the pharmaceutical sector, for example, innovation takes up to seventeen years from the beginning of an R&D project to the end. It costs about $403 million per drug and the failure rate is extremely high. Only one in 10,000 compounds reaches market approval phase - a success rate of 0.01 per cent. When successful, the search for one product often leads to the discovery of a completely different one. The process is characterised by serendipity.5 This of course does not mean that innovation is based on luck. Far from it. It is based on long-term strategies and targeted investments. But the returns from those investments are highly uncertain and thus cannot be understood through rational economic theory (this is one of the critiques that modern-day Schumpeterians make of endogenous growth theory, which models R&D as a game-theoretic choice).
The high risk and serendipitous nature of the innovation process is one oí the main reasons why profit-maximising companies invest less in basic research and more in applied research - there are greater and more immediate returns from the latter. Investment in basic research is a typical example of 'market failure': the market alone does not produce enough basic research, which means that government must step in. This is why there are few people, on all sides of the political spectrum, who would disagree that it should be (and is) the state that in general funds most basic research. In the US economy, for example, while government spending on R&D makes up only 26 per cent of total R&rD, with the private sector making up 67 per cent, the proportion is much higher when basic research is considered in isolation. Indeed public spending accounts for 57 per cent of basic research in the USA, with the private sector taking on only 18 per cent.
The concept of market failure is inadequate as a way of understanding the role of government in the innovation process because it ignores a fundamental fact about the history of innovation. Not only has government funded the most risky research, whether applied or basic, but it has also frequently been the source of the most radical, path-breaking types of innovation. To this extent it has actively created markets, rather than simply fixing them.
Large-scale and long-term government investment has been the engine behind almost every general purpose technology. In analysing the development of six different technology complexes (the US 'mass production' system, aviation technologies, space technologies, information technology, internet technologies and nuclear power), Ruttan reached the conclusion that government investments have been of some importance in bringing these new technologies into being - and that nuclear power would probably not have been developed at all without large government investments in development." In each case he looked at, support for the development of technology involved not only the funding of innovation and creating the right conditions, but also the envisioning of opportunity space, an engagement in the most risky and uncertain early research, and the overseeing of the commercialisation process. This is also the case for the current development of nanotechnology, which many believe is the next general purpose technology.
At a more micro level, Fred Block and Matthew Keller found that between 1971 and 2006, seventy-seven out of the most important eighty-eight innovations in the USA (rated by RcyD Magazine's annual awards) were found to have been fully dependent on federal support, especially, but not only, in the early phases.7
Across a number of different sectors, it has often been the state that has funded the most radical innovations, while the private sector has focused on the less risky, more profitable innovations. Venture capital itself has often entered the field too late (when the core risk has been absorbed by the state sector), and with the sole interest of making a buck from the initial public offering process, rather than of following through to make sure that the companies it invests in actually produce anything (for example the majority of venture capita! backed biotech companies remain product-less8).
Ironically, the state has played this innovatory role most strongly in the USA, which is usually described in European policy circles and in the media as one in which the economy is mainly driven by the market, with many European politicians pitching the need to learn from the market-driven Silicon Valley experiment. Silicon Valley was in fact built upon decades of state-led vision about the power of the internet, decades of investment in the riskiest research, and decades of nurturing regional innovation systems and new company start-ups - a lesson that is, ironically, now being ignored by the UK but followed by China. Block and Keller describe how, because of political pressure, the state's work in this area has operated in a 'hidden' way, through a decentralised network of state agencies such as the Defense Advanced Research Projects Agency and Small Business Innovation Research.9
Lessons for green technologies
In the pages of the Economist it was recently claimed that the 'government has a terrible record at picking winners' (28.4.11) - and this was applied to all governments, as an economic entity. But a look at the massive impact of the state's targeted large investments in industries such as steel, railroads, air travel, silicon microchip manufacturing, automotive manufacturing, computers, biotechnology, the internet and nanotechnology shows that this is simply untrue. Without the government pursuing a targeted investment strategy, none of these industries would have come into being.
Today there is a global race to be the leader in green technologies. Britain has a potential to do well in this race, but is in danger of being left behind if it adheres to this myth about the state's limited role in economic policy. Innovation policy needs to focus on creating the conditions that allow innovation to flourish, but also, and perhaps especially, on directly commissioning and procuring innovative solutions. History tells us that these will not happen without a strong push by the state.
In the LJSAs stimulus packages, 11.5 per cent of the budget was for green investment, while in the UK the figure is only 6.9 per cent, far lower than China (34.3 per cent), France (21 per cent) or South Korea (80.5 per cent).10 In fact, in July 2010 the South Korean government announced that it would double its spending on green research to the equivalent of £1.9 billion by 2013 (almost 2 per cent of its annual GDP), which means that between 2009 and 2013 it will have spent £59 billion on this type of research.
This lack of public investment is not a new problem. Data for 2007 shows the UK near the bottom of the league when comparing government investment in energy R&D, spending less than US and Asian competitors and some other European countries. The problem is that, contrary to the prevailing orthodoxy, the private sector is not coming in to fill the gap. This means that, overall, the UK's investment of 12.6 billion in 2009-2010 is less than 1 per cent of GDP - half of what South Korea currently invests in green technologies annually, and less than the UK presently spends on furniture in a year.11
Lessons from previous developments of major technologies teach us that innovation is about having the right networks in the economy and then commissioning specific technologies; and it could be argued that scaling back direct subsidies and grants, regardless of the purpose, would not be troublesome as long as innovative forces were coming from elsewhere. However, a look at recent data seems to imply that this is not the case. In fact, the UK is at risk of falling behind in this area, in spite of having been seen as a country that was catching up in the last decade.
Since green technology is still in its very early stage, when Knightian uncertainty is highest, capital funding - as might be expected - is focused on some of the safer bets, rather than on the radical innovation that is so needed if the sector is to reach the 20-20-20 targets. 12 This is highly problematic since the early stage of development of the sector means that by definition many of the needed developments are both risky and capital intensive; this means that if the government does not make its mark, these important areas will remain underdeveloped. Venture capitalists are increasingly targeting incremental innovations in established technologies to improve energy efficiency, moving away from more radical forms of innovation for energy production. And these preferences for familiar technology and quick payback add to fears that a renewed 'dash for gas' may turn out to be the most likely route for the UK to try to meet its emissions reduction commitments, even though this will add to the dangers of energy insecurity and of sharply rising costs when gas reserves begin to deplete.
The conclusion that might follow from this lack of private investment is that the government needs to be commissioning the development of the riskiest technologies. But this is not happening. The main initiative of the Coalition government is to establish a green investment bank to provide seedcorn funding for green technologies. In accordance with its general approach, this is based on the notion that the green revolution can be led privately, simply 'incentivised' by the state. This is wrong (no other tech revolution has occurred this way); and the current amounts being discussed are in any case too insignificant to make any difference. The green investment bank initiative has not learned from previous revolutions that have shown the importance of active state-led investments, which have allowed these states to 'be first' and hence reap future increasing returns. China is building one power station a week and Britain is fiddling with play money.
Improving the UK's aging energy infrastructure will require massive investments. The proposed green investment bank could help to get important projects off the drawing board. However, as the cash for it is dependent on selling off strategic assets in difficult market conditions, it will take many months or even years before the fund is able to make a meaningful difference. And the current figures are of negligible significance. However, if it was expanded and broadened, the green investment bank could grow into a strategic investment bank, like the European Investment Bank or Germany's Kreditanstalt für Wiederaufbau. These have a proven track record of promoting infrastructure development and returning a profit for the taxpayer; while the UK has always lacked a comparable source of long-term finance, and would gain from developing one. If such a government-run investment bank took more of an innovation focus than the European Investment Bank and Kreditanstalt für Wiederaufbau, it could become a new type of public-sector strategic finance institution. This would be particularly helpful in getting largescale projects off the ground. But even so, it would not necessarily be capable of providing the incentive for the high risk innovative breakthroughs to occur in the first place.
Risk and return: smart and inclusive growth
In finance, it is commonly accepted that there is a relationship between risk and return. However, in the innovation game this has not been the case. Risk taking has been a collective endeavour, while the returns have been much less collectively distributed. The only return that the state usually gets for its risky investments are the indirect benefits of higher tax receipts that result from the growth that is generated by those investments. Is that enough?
There is indeed lots of talk of partnership between the government and private sector, but while the efforts are collective, the returns remain private. Is it right that the National Science Foundation did not reap any financial return from funding the grant that produced the algorithm that led to Google's search engine? Can an innovation system based on government support be sustainable with such a system of rewards? The lack of knowledge in the public domain about the central entrepreneurial role that government plays in the growth of economies worldwide is currently putting a successful model in major danger.
The socialised generation but privatised commercialisation of biopharmaceutical - and other - technologies could be followed by withdrawal of the state, if private companies were to use their profits to reinvest in research and further product development. The states role would then be limited to that of initially underwriting radical new discoveries, until they are generating profits that can fund on-going discovery. But private-sector behaviour suggests that public institutions cannot pass on the R&D baton in this way. This means that the states role cannot be limited to that of planting seeds that can be subsequently relied on to grow without further intervention.
A fairer and more dynamic relationship between risk and return requires a more informed understanding of the state's leading role in taking on risk. When SlTRA, the Finnish governments public innovation fund, provided the early stage funding for Nokia, it later reaped a significant return on this investment - a fact accepted by the Finnish business community and politicians. The reason why the US government has not reaped a return from its early stage investments in companies like Google (which benefited from a state-funded grant for its early algorithm), and other such success stories, including Apple and Compaq (which both received public funding), is due to the lack of understanding in the USA of state-led growth-inducing investments. And this allows conservative forces to portray the state as only ever a menace in the economy. But as governments all over the world are fighting hard to put their finances in order, while simultaneously needing to find the funds and opportunities to make necessary growth-inducing investments (in education, research, infrastructure, etc), finding ways to reap a return from such investments is more important than ever. Such returns could help provide funds that can be re-plugged back into the economy, helping to assure a virtuous cycle, rather than the current vicious one. Conclusion
The state has been fundamentally involved in generating radically new products and processes that have changed the way that businesses operate and citizens live - transforming economies forever, from the internet revolution to the biotech revolution to what (it is hoped) will be the green-tech revolution. A key way to tackle together smart and inclusive growth is to ensure that the gains from innovation are as collective as the risk-taking underlying it.
In seeking innovation-led growth, it is fundamental to understand the important roles that both the public and private sector can play. This requires not only understanding the different ecologies between the public and private sector, but, especially, rethinking what it is that the public is bringing to that ecology. The claim that the public sector can at best incentivise private sector led innovation (through subsidies, tax reductions, carbon pricing, green investment banks and so on) is currently being propagated heavily in the UK, especially but not only in the face of the recent crisis and ensuing deficits. But this fails to account for the many examples in which the leading entrepreneurial force came from the state rather than from the private sector.
1. Department for Business, Innovation and Skills and HM Treasury, The Plan for Growth, March 201 1, http://ccln.hm-treasury.gov.uk/201 lbudget_ growlh.pdf.
2. E Knight, Risfe, Uncertainty and Profit, Augustus M. Kelley, 1921; P. Drucker, Technology, Management and Society, Butterworth-Heinemann 1970.
3. J. Schumpeter, Capitalism, Socialism and Democracy, Harper, 1975 ; and 'Economic theory and entrepreneurial history' , in R. Clémence (ed), Essays on Entrepreneurs, innovations, Business Cycles, and the Evolution of Capitalism, Transaction Publishers 1989.
4. Risk, Uncertainty and Profit.
5. In numerous historical instances scientific theory and explanations have emerged after the technologies they are seeking to explain. For example the Wright brothers flew before aerodynamics was developed, and the steam engine was operational before thermodynamics was understood.
6. V. Ruttan, is War Necessary for Economic Growth?: Military procurement and technology development, Oxford University Press 2006.
7. E Block and M. Keller, 'Where do innovations come from?' in E Block and M. Keller (eds), State of Innovation: The US government's role in technology development, Paradigm, 2010.
8. W. Lazonick and O. Tulum, 'US biopharmaceutical finance and the sustainability of the biotech business model', Research Policy 201 1 (forthcoming).
9. A full account of this story, and its implications for understanding the economics of growth and innovation, can be found in my recent pamphlet, The Enterpreneuriai State, Demos 201 1.
10. PlRC, The Green Investment Gap: An audit of green investment in the UK, Public Interest Research Centre, March 2011.
11. The Green Investment Gap. The figure of £12.6 billion of UK green investment in 2009-10 was made up of total public investment to the amount of £6.7 billion (public subsidy, government loans and levies) and total private investment to the amount of £5.9 billion (asset finance, public markets, venture capital and private equity).
12. See S. Ghosh and R. Nanda, 'Venture capital investment in the cleantech sector', Harvard Business School Working Paper 1 1-020, 2010. The 20-20-20
strategy seeks a 20 per cent cut in emissions of greenhouse gases between 1990 to 2020, as well as a 20 per cent increase in the share of renewables in the energy mix, and a 20 per cent cut in energy consumption. See European Commission Climate Action, The EU climate and energy package', hup:// ec. europa. eu/clima/policies/package/index_en. h tm).
Mariana Mazzucato is RM Professor of Science and Technology Policy at the University of Sussex, and Professor in the Economics of Innovation at the Open University. She is Economics Director of the ESRC Centre for SocioEconomie Study of the Genomics (INNOGEN www.genomicsnetwork.ac.uk/ innogen/) and Coordinator of a European Commission FP7 funded project on Finance, Innovation and Growth (FlNNOV www.finnov-fp7.eu). Her most recent publication is The Entrepreneurial State, Demos 2011: www.demos.co.uk/ publications/theentrepreneurialstate.