“Bill Janeway, a key creator of modern venture capital, tells the amazing story of the intersection of economics and innovation. This book is essential to anyone who wants to understand technology and how its creation will be financed for decades to come.”
— Marc Andreessen, co-creator of the Internet browser, co-founder of Netscape and Andreesen Horowitz
This post contains mostly my highlights from William H. Janeway’s Doing Capitalism in the Innovation Economy. This book changed the way I viewed bubbles, the government’s role in innovation, investing, and technological innovation in general.
The following text is quoted from the book, my notes are in brackets, and the quotes are Janeway quoting others.
Cash & Control mitigate crises
I have learned that the ability of any player in the game to hedge against what cannot be anticipated — to hedge against crisis — is a join function of assured access to cash and sufficient control of circumstances. Cash buys time to find out what is going on; control permits the player to use that time to shift the parameters of the problem. (pg 6)
Big Data doesn’t get rid of need for judgment
I learned to pursue parallel but methodologically independent approaches. First, one would project forward estimates of future cash flows, discounting them back at a rate judged to reflect an appropriate level of idiosyncratic risk specific to the perceived stability of the business and its competitive position, as well as to market rates of interest. In the language of the new finance theory just being propagated, this defined the “fundamental,” as if only one such number could be generated and as if all interested parties would agree on it. In practice, alternative approaches were invoked. One would identify more or less comparable public companies, then introduce market metrics such as price/earnings and market/book value ratios, making appropriate adjustments to reflect the particulars of each company in question. Finally, one would estimate the likely net realization from a hypothetical sale of the business, having due regard for “what a willing buyer would pay a willing seller, neither under any compulsion to transact.”
The layers of judgment in each of these methodologies for valuating companies were as evident then as they are now. In a financial universe transformed institutionally beyond imagining from that of the early 1970s, the same techniques remain central to the discipline, and they are just as dependent on judgment as ever, regardless of the reservoirs of data and massive computing power brought to bear.
US Defense Department had a crucial role in creating Silicone Valley
The National Science Foundation was endowed with a broad mandate across both the natural and the social sciences, but the Office of Naval Research’s initiative pointed the way. National funding of the basic research that enabled the IT revolution emerged largely from the Defense Department. The Soviet threat, crystallized in the years following 1945 and amplified by the Korean War in 1950 and the launch of Sputnik in 1957, was the context for the US military’s massive commitment to renewing its wartime role as the principal financier of IT research and the principal customer of the products generated therefrom. Indeed, the fact that various arms of the Defense establishment had become sophisticated purchasers of advanced digital technology may have been more significant than the government’s direct funding of research, for it both enabled substantial investments in productive capacity and know-how by the industrial side of the military-industrial complex and encouraged the sharing of expertise by requiring second sources of supply and cross-licensing of patents.
Kira Fabrizio and David Bowery summarize the essential elements of federal policy:
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.
And the scale was substantial: for twenty-five years through 1978, federal sources accounted for more than 50 percent of national R&D expenditures and exceeded the R&D expenditures of all other OECD governments combined. As Henry Kressel, my partner and collaborator at Warburg Pincus, would write in retrospect, drawing on his own entry into the digital research enterprise at RCA’s Sarnoff Laboratory around 1960: “The real visionaries in the early days were to be found in U.S. defense organizations.”
Early computer companies were vertically integrated
All the computer companies were vertically integrated: that is, the core processing engines were built according to proprietary designs that ran proprietary operating systems often bundled with their own application software and peripheral devices. The goal was to manage complexity for the customer — an important need given the novelty of the technology and the scarcity of trained personnel. The cost was laggardly innovation and customer lock-in. The resultant profit margins were too good to last.
“There is no such thing as a fixed cost…”
Fred was able to reduce headcount by some 20 percent while maintaining operational continuity of the business and without needing any additional capital. More broadly, he showed me how to implement his dictum, “There is no such thing as a fixed cost; what matters is how much time and money it takes to turn what appears to be a fixed cost into variable one.” (pg 63)
Venture capitalists have no use for modern finance theory
The lessons I learned from collaborating with Fred Adler to generate positive returns from start-up ventures that had seemed destined to go bankrupt cut against the grain of how modern finance theory instructs investors to manage risk — namely, by diversifying. For the ventral capital investor, a fund portfolio typically consists of no more than twenty-five positions, usually in no more than two or three industrial sectors and often concentrated in only one; this is hardly an opportunity for substantial diversification. Moreover, each position is definitionally immature as a business and is subject to failure along any of several dimensions, including managerial competence, technological efficacy, and market acceptance. In a venture capital portfolio, that is to say, idiosyncratic risk is both very great and quite homogeneous. And, as in the case of BRL, it cannot be hedged through any sort of transactions in markets that either do not or cannot exist. Thus, the counterpart of learning the game of venture capital in the trenches was learning that modern finance theory is largely irrelevant to its practice.
“Whose problem are you proposing to solve?”
In the premodern, preindustrial era that is Braudel’s subject, “the capitalist game only concerned the unusual, the very special, or the very long distance connection.” It was in the long-distance trade that Braider’s capitalist flourished:
Long-distance trade certainly made super profits; it was after all based on the price difference between two markets very far apart, with supply and demand in complete ignorance of each other and brought into contact only by the activity of middlemen … If in the fullness of time competition did appear, if super-profits vanished from one line, it was always possible to find them again on another route with different commodities.
Unlimited flexibility to arbitrage across vast geographical space: this is Braider’s defining attribute of the premodern capitalist. The notion of arbitrage as the essence of the capitalist transaction has powerful resonance. For the modern venture capitalist, the arbitrage is typically between a technological innovation and the commercial product or service that can be derived from it. My own experience suggests that too much weight is often given to management of the process of technical transformation — “research and development” — and too little to the selection of the target market and the establishment of a channel to that market. For Braudel’s capitalist the question asked of the sea captain would be: Why are you setting your course there? For the modern venture capitalist interrogating the entrepreneur, the corresponding question would be: Whose problem are you proposing to solve? It took me twenty years to absorb this principle fully. (pg 75)
The notion of arbitrage as the essence of the capitalist transaction has powerful resonance. For the modern venture capitalist, the arbitrage is typically between a technological innovation and the commercial product or service that can be derived from it. My own experience suggests that too much weight is often given to management of the process of technical transformation — “research and development” — and too little to the selection of the target market and the establishment of a channel to that market.
Yet the impact of the bubble and its aftermath on the profile of venture capital returns is enormous. From the incipient emergence of a venture capital industry in 1981 through funds launches in 1994, the aggregate distributions of venture capital firms to limited partners (net of fees and carried interest) amounted to 3.24 times the capital they had committed to the funds. For the 1995 vintage, the multiple reached 6.19 times, and it was 4.97 for the 1996 vintage. However, the 1998 vintage, at 1.38 times, was the last to generate a positive cash-on-cash return to limited partners. The ten-year return on the US Venture Capital Index turned negative as of the end of 2009 and declined at a compound annual rate of 2 percent through December 31, 2010, before turning modestly positive (2.6 percent) through the third quarter of 2011. (pg 83)
VCs scale back: focus on cheap bets
A growing number of venture capitalists have reckoned that in the prolonged absence of an active IPO market accessible by emergent companies prior to their reaching sufficient scale to launch a $100 million issue, the rational strategy is to scale back both resources and commitments in order to focus on funding distributed research and development for large companies, with the explicit intent to hold an auction as soon as a venture has proven its concept and to forgo the risk and the opportunity entailed by trying to build a sustainable, independent business. Yet other firms have scaled back even further, backing consumer-oriented web start-ups whose odds of sustainable success may be very low but whose capital requirements for launch are also minimal, given the availability of free open-source software, clouds of rentable computing resources, and the web itself as the channel for marketing and distribution. (pg 83)
Nanotech & bigger projects
As I learned from Ed Giles at Eberstadt, it took DuPont and General Electric each at least twenty years and more than $1 billion of then-current dollars to commercialize the new generation of engineered plastics. That history is in the process of repeating itself in the domain of nanoscience and nanotechnology: again, it will require the ability to mobilize very large financial resources over decades to identify what potential applications serve economic needs and to work down the learning curve to reliable and efficient production — both tasks appropriate for established businesses and simply not available for start-ups. And the premature efforts by venture capitalists to promote clean tech and green tech ahead of the required public investment in the enabling science and technologies have failed to ignite the desired speculative response from the financial markets.
“Don’t expect what you don’t inspect.”
One of the lessons of life as a venture capitalist was drilled into me by Tom Connors, a remarkable operating executive turned independent consultant and director, with whom we at Warburg Pincus built a close and collaborative relationship: “Don’t expect what you don’t inspect,” Tom used to say. (pg 106)
VC management: Shared Rewards →Collaboration
As is common among venture capital firms, but vanishingly rare among private equity firms, all Warburg Pincus partners eat off the same plate. That is to say, each partner’s interest in the firm applies to all of the investments the firm makes: a 1 percent partner based in New York and investing in health care, for example, has the same 1 percent interest in IT deals in Silicon Valley and energy deals in Texas. This structure motivates and rewards a culture of collaboration; it also provides a powerful incentive across the partnership to monitor the portfolio. In the case of OpenVision, strict scrutiny would be exercised at the time of each additional funding decision and not less often than quarterly. (pg 112)
[W]ithin 12 months, Geoff had reduced head count by one-third and doubled revenues. He did it by determining which products were actually being bough, closing down those that were not, and concentrating all resources behind those that were. (pg 113)
The story of BEA [Systems] dramatizes the complex dynamics of the Innovation Economy. The engine of its initial growth was research funded by a state-sanctioned monopoly that, when liberate to compete commercially, had no idea how to do so. Its phenomenal growth was also a function of the maturation of the internet, offspring of the Defense Advanced Research Projects Agency, as an environment for commerce. Its competitive success was conditioned on the inability of IBM, the dominant force in computing, to cannibalize its own proprietary products and the profits they generated. And the extraordinary investment returns that it delivered were due in good measure to the speculative excess of equity investors who had recognized the emergence of a new, digital economy. BEA, that is to say, represented the apotheosis of the Three-Player Game’s fostering of the Innovation Economy.
At the mundane level where the practitioner labors, BEA’s success both as a venture investment and as an operating business did not emerge in a vacuum. On the contrary, to identify and realize the opportunity it represented was the combined and contingent consequence of multiple strands of education: in the alternative architectures of the computer industry, in the evolving technologies of computer systems, in the different business models available to start-up companies, and in the recurrent inefficiency of the stock market’s manner of valuing enterprise under the recurrent pressures of speculation. From my perspective, BEA emerged from a context thirty years in the making.
Shape of a Bubble: Original Investors Win
A dozen years later, Alexander Siemens pronounced the epitaph on the Brush Brook, offering a homily on the problematic relationship between financial speculation and innovative enterprise:
However much other causes may have contributed to delay the development of electrical engineering, it is clear that the principal one must be looked for in the exaggerated expectations that were raised, either by ignorance or by design, when the general public first seriously thought of regarding electricity as a commodity for everyday use.
At that time the promoters of electric companies preached to the public that electricity was in its infancy, that the laws of science were totally unknown, and that wonders could be confidently expected from it. There was a short time of excitement to the public and of profit to the promoters; then the confidence of the public in electricity was almost destroyed and could only be regained by years of patient work.
Again and again, it has been the opportunity for financial investors to sell shares into a rising market that has motivated investment by entrepreneurs in real assets that embody frontier technology. If Schumpeter’s entrepreneur in principle loses other people’s money, historically financiers have been able to win from speculation even when the projected the fund ultimately fail, and it is the entrepreneur and the purchasers of the original investor’s shares who lose. (pg 146)
Carret [Wall Street legend who published The Art of Speculation in 1927] is most compelling when he describes the challenge to the studious speculator represented by the “ripples and waves” of price movements driven by mere gamblers:
To attempt to trade on such movements is mere gambling with the odds against the trader by a considerable margin. It is astounding that thousands of otherwise intelligent persons persist in trying to make money in this way. Commonly accepted figures of somewhat dubious origin are frequently cited to show that 90% to 95% of all margin players lose money in the stock market. The deep-seated gambling instinct, the well-founded belief that in widely fluctuating markets there must be opportunities for profit nevertheless bring fresh recruits to the brokerage offices in constant streams.
Carret’s gamblers were rediscovered two generations later by theorists who have attributed the emergence of bubbles to the activity of mindless “noise traders.” Writing as the bull market that would peak in October 1929 gathered force, Carret had truly seen nothing yet. (pg 153)
For when economic growth over time is driven by unpredictable bursts of technological innovation that is speculatively financed, the allocation of resources to research and development at any moment in time is bound to appear inefficient in static economic terms. (pg 168)
- Long life’d funds allow investing against current mood.
- “…at any point in time there is more technology available than anyone knows what to do with.”
- “… “In our model world, an imitative strategy may, if supported by luck early in the industry’s evolution, be a runaway winner. And certainly imitators will have good luck at least some of the time.””
- “Buy what you can, build what you must.” Mainstream VC’s focus on building best product tech-wise, leaving space for others to compete by focusing on channels to market, marketing, customer service, etc.
- If you can participate without a startup, do that.
Throughout, the firm remained true to its core strategy: bringing active but patient equity capital to back exceptional operating executives in order to build or rebuild significant and sustainable businesses. With this broad investment mandate, Warburg…
a start-up. In direct contrast to the classic venture capital model, from my perspective doing a start-up is a last resort. But now in such a project, as in all others, I would be aligned with a firm that possessed the resources to assure access to cash and maintenance of control at the outset and throughout the life of any investment.
Government & Investing
- Only go with the top funds: “…while the mean return to the 136 actual venture funds was 1.59 times what would have been realized by investment in the index, when the top decile was excluded, that figure dropped to 1.02 times.”
- IT and biomedicine have done so well for venture capital returns because “… the federal government funded construction of a platform on which entrepreneurs and venture capitalists could dance.”
- If you don’t have access to the best VC firms, invest elsewhere.
Risk bearing is not for entrepreneurs
Innovation — “any ‘doing things differently’ in the realm of economic life — drives the course of economic evolution. And innovations, in turn, are embodied in new plants, new firms and, above all, new people, the entrepreneurs who carry out innovations:
The entrepreneur may, but need not, be the person who furnishes the capital … In the institutional pattern of capitalism there is machinery, the presence of which forms an essential characteristic of it, which makes it possible for people to function as entrepreneurs without having previously acquired the necessary means. It is leadership rather than ownership that matters.
The capitalist, in the prime role of owner of surplus cash available for investment, is relegated in remarkable fashion:
Risk 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.
[Quotes from Carlota Perez. pg 77]
Some things are unknowable to everyone
William Goldman, novelist and screenwriter, legendarily defined the law of Hollywood to be: “No one knows anything.” The law of the equity markets is both softer and more complex: “No one knows enough, and everyone at some level knows that about herself and everyone else.” Models of equity bubbles that privilege some set of investors as knowing more than any investor can know must be flawed.
Uncertainty for everybody (no such thing as perfect information, for anybody)
From John Maynard Kaynes’ General Theory:
Professional investment may be likened to those newspaper competitions in which the competitors have to pick out the six prettiest faces from a hundred photographs, the prize being awarded to the competitor whose choice most nearly corresponds to the average preferences of the competitors as a whole; so that each competitor has to pick, not those faces which he himself finds prettiest, but those which he thinks likeliest to catch the fancy of the other competitors, all of whom are looking at the problem from the same point of view. It is not a case of choosing those which, to the best of one’s judgment, are really the prettiest, nor even those which average opinion genuinely thinks the prettiest. We have reached the third degree where we devote our intelligences to anticipating what average opinion expects the average opinion to be.
In the same spirit, Andreas Park and Hamid Sabourian have shown how informed investors may be led by their observation of market action to abandon their own beliefs and choose to follow the herd or act against the crowd. As they do, they alternatively add to momentum or help market prices revert to the mean. In either case, their behavior is “rational” in that it is based on a calculus of expected value in the relevant short run, as they weigh their own “private information” against the evidence generated by the market.
Finally and fundamentally, in this term rational and its antithesis there is a nexus of confusion that infects both academic and popular discussion of how economic and financial agents think and act. Much of this originated with the hijacking of the term by the theorists of REH. For, as Roman Frydman and Michael Goldberg have written:
A rational, profit-seeking individual understands that the world around her will change in non-routine ways. She simply cannot afford to believe that, contrary to her experience, she has found a “true” over-arching forecasting strategy, let alone that everyone else has found it as well.
Trying in the face of the impossible, unknowable
In this context, attributing market inefficiency to the irrationality of investors is fundamentally misfocused. Rather, let us say that by and large they — we — do the best we can. We deploy the heuristics that evolved from our survival in such a universe to evaluate the more or less misleading patterns discernible in history’s unfolding tapestry as more or less inadequate guides to our behavior.
There is a certain heroic quality to the struggle of the new finance theorists to model the behavior of market participants who know that they cannot know enough and that they have only a limited time during which they will be allowed to be wrong, to stand out against the crowd. I am convinced that Keynes would honor their efforts, even while pushing them to go further in accepting the ontological uncertainty inherent in the universe:
We should not conclude… that everything depends on waves of irrational psychology. On the contrary, the state of long-term expectation is often steady, and, even when it is not, the other factors exert their compensating effects. We are merely reminding ourselves that human decisions affecting the future, whether personal or political or economic, cannot depend on strict mathematical expectation, since the basis for making such calculations do not exist; and that it is our innate urge to activity which makes the wheels go round, our rational selves choosing between the alternatives as best we are able, calculating where we can, but often falling back for our motive on whim or sentiment or chance.
the ratio between two valuations of the same physical asset. One, the numerator, is the market valuation: the going price in the market for exchanging existing assets. The other, the denominator, is the replacement or reproduction cost: the price in the market for newly produced commodities.
Tobin’s q, as it has come to be known, quantifies the apparent arbitrage opportunity created by a disparity between the valuation of corporate assets in the financial markets and the cost of investing in new ones. [pg 181]
The missing information is in future action
…the missing information is not “dispersed”; its bits and pieces are not scattered out there, available to be assembled and thereby render the market efficient. That information can be discovered only in retrospect, as a consequence of the decisions made in its absence by entrepreneurs and traders doing the best they can. [pg 184]
The use of bubbles: reduce rationality
very radically new technologies, such as railways, motor cars, internet or clean energy technologies…may in fact need “hot” financial markets, where financing risk is extremely low and many investors are in the market, to help with the initial diffusion of such technologies.
John Eatwell has neatly summarized the useful role bubbles can play in the equity markets. Considering how rational investors may be inhibited from funding major innovations by the challenge of scale, by their inability to capture positive externalities and by the very long-term nature of the potential returns, Eatwell writes:
The usefulness of bubbles derives from their effect in alleviating social inefficiencies that derive from rational individual actions. In other words, I suggest that, in the absence of bubbles, rational individual actions result in a socially irrational outcome, and that the bubble, by inducing irrational acts in individuals, may (and only, may) shift the economy toward a more socially rational position.
That Eatwell plays with the loaded term rational should not obscure the positive, if messy, conclusion: bubbles can overcome a potential coordination failure to generate a new and more productive economy. The seemingly perverse opportunity to make money by speculating in risky financial assets regardless of the fate of the real investments so funded is — precisely — the vehicle of economic progress. [pg 185]
Changing uses for telephones
… by the first years of the 1890’s, the Electrophone Company in London was offering concerts, opera, music hall variety and even church services by subscription; the entertainments were delivered to homes, hospitals and other venues via telephone. [pg 188]
General Purpose Technologies
The commercial development of electricity presages that of information and communications technology. Each of these is a general purpose technology (GPT) whose development and deployment demonstrates the nonlinear nature of the innovation process. Timothy Breshnehan offers a basic definition:
A GPT (1) is widely used, (2) is capable of ongoing technical improvement, and (3) enables innovation in application sectors (AS). The combination of assumptions (2) and (3) is called “innovation complementarities” (IC).
More precisely, IC means that innovations in the GPT raise the returns to innovation in each AS and vice versa.
$20k revenue → $5 billion valuation in 1.5 years
The only cash investment Warburg Pincus ever made in Covad was $6 million to lead its first round. The goal was to prove the technology and the market demand in the San Francisco Bay Area and then, stepwise, to expand geographically, securing funding at progressively lower cost as the model was proved out in emulation of the successful deployment of cable television and wireless telephony. The initial application was supposed to be telecommuting so employees in the new knowledge economy could work from home.
But any such mundane consideration of what economic activity the new technology would support swiftly became irrelevant. Less than nine months after our investment, Bear Stearns approached us with a proposal to sell $300 million of junk bonds to enable full-bore acceleration of the plan — this for a company that in 1997 recorded just $26,000 (that is correct: twenty-six thousand dollars) of revenue. All that was required was a promise by Warburg Pincus to inject additional equity in twelve months if the company had not raised it way from us. Together with the common stock warrants that we received as payment for the promise, Warburg Pincus owned about 20 percent of Covad when it went public in January 1999. In a year and a half, this raw start-up raised half a billion dollars of financial capital and had a market value of some $5 billion. Of course, this was one small component of the estimated $4 trillion of equity and debt raised and invested in broadband networks — backbone and local access — by start-ups and incumbents before the bubble burst.
Bubbles: “Investors lost their money. We will now get to use their stuff.”
Even as Amazon and eBay were demonstrating their post-bubble momentum and even before Google’s IPO, DeLong correctly anticipated the rhyming of history: “The same thing will happen with the froth that the bubble put on our 1990s boom. Investors lost their money. We will now get to use their stuff.” [pg 198]
“Irrational” investment in railroads allowed for tons of more rational investments (benefits far beyond lowering cost of transport)
DeLong caricatures and Chandler documents in detail the economic transformation that the railroads engendered in the United States, transcending their direct macroeconomic effect. They drove the westward movement of population and property development, the re-architecting of industrial organization, the evolution of accounting practice and principles, the emergence of nationally branded goods, and the creation of liquid exchanges for securities — in short, they transformed the core commercial and industrial and financial structures of the nation. To focus only on the marginal cost of transporting commodities as the measure of the railroad’s economic significance does not trivialize Fogel’s heroic efforts at data collection and analysis. Rather, it exposes the irrelevance of the framing neoclassical economic theory that specifies the problem Fogel addresses. Of the new and expanded industries that accompanied the build-out and consolidation of the railroads, none required capital on the scale of the railroads or was as dependent on financial speculation. The telegraph system largely followed and was partly funded by the railroads, and local capital did the rest, as it did for the host of local telephone companies that sprang up in the last two decades of the nineteenth century. The Boston railroad financiers who funded the organization of the American Bell Company in 1880 eventually did have to turn to J.P. Morgan and Wall Street for capital, obtaining $100 million even as the financial crisis of 1907 pushed the banking system almost to collapse, hardly a time of speculative excess. The iconic manufacturing and distribution companies of the new economy that emerged from the Second Industrial Revolution, in turn, relied on local businesspeople and commercial banks for both short-term and long-term loans. None, however, needed to go to the capital markets to finance the expansion that so quickly placed them among the largest business enterprises in the world. [pg 199]
Wall Street frenzies enabling industries
Two additional new industries were midwived by the stock market in the 1920s. Charles Lindbergh’s flight in May 1927 ignited a speculative frenzy for aviation-related shares. Wright Aeronautical was the only publicly traded aviation company at the time. Its shares traded from 25 in April 1927 to 94 3/4 by the end of 1927. From mid-1928 through mid 1930, no fewer than 124 public issues raised $300 million, of which more than half had been raised prior to the Crash of 1929. [pg 202]
Intro to Carlota Perez and her Technological Revolutions
[Carlota] Perez applies her schema to five successive technological revolutions, as laid out in Table 9.1 In each case, the technological revolution begins with an “installation” period that climaxes in a frenzy of speculation, which is followed by a crash and an extended turning point, as that which was once innovative — even revolutionary — and not amenable to rational calculus becomes recognized as routine. Finally, the technology’s deployment constitutes the construction of a previously unimaginable new economy.
More people incentivized to innovate→more innovation
In direct and conscious contrast with the prevalent European patent systems, characterized by extremely high fees and subject to pervasive political influence, the American system was open and accessible, dedicated to
providing broad access to a well-specified and enforceable property right to new technology [which] would stimulate technical progress and nearly all of the innovations they made in the design of the patent institutions aimed to strengthen and extend inventive activities to a much broader range of the population than would have enjoyed them under traditional intellectual property institutions.
America incentivized for creation instead of destruction
The economic consequences of wars so financed could be substantial — and certainly had been during the Napoleonic Wars — both in the state’s exceptional demand for resources and in the inflation regularly generated by military consumption of scarce commodities and disruption of their supply, but these were unintended consequences. The American System, by contrast, was explicitly statist, emulating the French tradition of mobilizing public credit in pursuit of economic development for its own sake, thereby triangulating the relationships between the state, the market economy and financial capitalism for positive gain, not for reciprocal destruction. Although the implementation of the American System was limited at the national level, at the state level it produced the salient success of the Erie Canal, and it attracted capital from abroad to fund an extensive array of other canals and turnpikes and then the railroads. But consistent with state engagements in support of the emerging market economies that followed, it also produced rampant corruption that fed the Jacksonian assault on financial interests. [pg 218]
Science is a necessity to industry
The relevance of science to industry had been discovered by that most entrepreneurial of capitalists, Andrew Carnegie, who reflected on the economic benefits of systematic assays of iron ore by a trained chemist:
What fools we had been! But then there was this consolation: we were not as great fools as our competitors.. Years after we had taken chemistry to guide us [they] said they could not afford to employ a chemist. Had they known the truth then, they would have known they could not afford to be without one.
Arguments for an innovative market
Jewett’s fear that government bureaucrats would distort research priorities exemplified a more general rejection of state intervention in the market economy. In Business Cycles, published in 1939, Schumpeter stated the case in the most comprehensive terms:
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… The very fundaments of the industrial organisms of all nations have been politically shaped. Everywhere we find industries which would not exist at all but for protection, subsidies and other political stimuli, and others which are overgrown or otherwise in an unhealthy state because of them… Such industries and assets are 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.
It was strictly to the private sector and increasingly to the large-scale firm that Schumpeter looked for innovation. In the “perennial gale of creative destruction,” the restrictive practices and price-setting power of monopolists and oligopolists were “incidents of a long-run process of expansionism which they protect rather than impede.” As specific evidence, anticipating Mowery and Rosenberg’s research, Schumpeter remarked:
The first thing a modern concern does as soon as it feels that it can afford it is to establish a research department every member of which knows that his bread and butter depends on his success in devising improvements. This practice does not obviously suggest aversion to technological progress.
By the time that Schumpeter wrote these sentences in 1943, the dynamics of the Innovation Economy had been transformed by the advent of the Second World War. The profit-seeking monopolistic enterprise that funded applied research for immediate economic reward, as characterized by Schumpeter, was supplanted by the national security state funding research that extended all the way back upstream to quantum physics in its struggle for survival. [pg 225]
Corporate R&D requires ROI
Upstream, however, Kay correctly notes that “markets don’t do the basic research, or the training that isn’t job-specific, on which the innovative capacity of economic systems depends.” [pg 233]
Keynes on nonconformity and the negative productivity of unemployed resources
In the General Theory, Keynes wrote of the “long-term investor”:
It is… he who most promotes the public interest, who will in practice come in for most criticism…For it is in the essence of his behavior that he should be eccentric, unconventional and rash in the eyes of average opinion. If he is successful, that will only confirm the general belief in his rashness; and if in the short run he is unsuccessful, he will not receive much mercy. Worldly wisdom teaches that it is better for reputation to fail conventionally than to succeed unconventionally.
In addition to writing a summary prospectus for the aspiring venture capitalist — this passage has hung on the wall of my office since I entered Wall Street — Keynes might also have been writing of his own standing in the world of 1929–1931.
As Keynes struggled to escape from a mode of thinking that implicitly assumed that all resources are always fully employed, he proposed an abstraction of the state’s activities in terms of a generalized investment function: debt-financed expenditure that would fill the gap in aggregate demand when private-sector investment fails. In the General Theory, he dramatized the point with characteristic panache:
If the Treasury were to fill old bottles with bank-notes, bury the 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.
What Keynes understood even before he could formulate a comprehensive theoretical explanation was that unemployed resources, human and capital, possess negative productivity. Skills atrophy and become obsolete; machines rust and likewise become obsolete. Putting them to work on whatever projects, even of zero economic return, will augment the flow of income and expenditure that, by definition, have become inadequate. And, incidentally, whatever goods and services those newly reemployed choose to spend their incomes on can be expected to be as economically “efficient” as what those still employed are spending money on. The positive effect will be all the greater if the new income and expenditure are funded by borrowing: as Richard Kahn demonstrated at the time, loan-financed expenditures would finance themselves out of savings from the increased stream of income. [pg 237]
Keynesian stimulus needs scale: better if we can have it without war
In July 1940, Keynes took rueful note in an article published in the New Republic: “It is, it seems, politically impossible for a capitalist democracy to organize expenditure on the scale necessary to make the grand experiment which would prove my case — except in war conditions.
From the perspective of today’s Great Recession, the authors of the most comprehensive analysis of the economic effect of transnational fiscal and monetary policies during the Great Depression broadly concur:
Fiscal policy made little difference during the 1930s because it was not deployed on the requisite scale, not because it was ineffective..The real Keynesian stimulus, when it came, would be associated with military expenditure during World War II, producing very rapid growth in countries like the United States. In our view, peacetime stimulus packages, which could have halted the rise in unemployment that ultimately led to the election of Adolf Hitler…would have been preferable to the stimulus of the war.
The challenge remains: to construct integrated models of a financial economy whose participants both are aware of the limits and fragility of their own knowledge and condition their behavior on that of others similarly aware. [pg 267]
In the context of the Three-Player Game [the “dynamic and unstable configuration of political, economic and financial forces…”], the consequences of explicitly invoking the financial markets as the judges and disciplinarians of state behavior can be anticipated, and they are dangerous. The most general lesson to be learned from observing the centuries of financial history summarized by Carmen Reinhart and Kenneth Rogoff is that, given the opportunity, financial markets will go to extremes. Some twenty years ago, my wife’s doctor responded to her inquiry as to whether our cat could accompany her during an extended hospital stay by asking, “Can you guarantee his behavior?” “Yes,” she responded, “it will be bad.” [pg 270]
Wars set up Britain & US as leaders
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 the Second World War 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. [pg 272]
Joseph Schumpeter expressed the view that large firms ahve an inherent advantage in innovation relative to smaller enterprises. But, as Josh Lerner summarizes the experience of the biotech and internet revolutions: “The enabling technologies were developed with government funds at academic institutions and research laboratories. It was the small entrants…who first seized upon the commercial opportunities.” [pg 275]
How the government should participate: create competition
It is worth emphasizing once again the role of the US defense agencies a generation ago as imaginative and generous customers for innovative digital technologies. By setting specifications open for any supplier to meet, the Defense Department sponsored competition at the frontier that its funding of research continued to advance. By contrast, today’s program of loan guarantees by the Department of Energy is fundamentally misconceived: targeting such high-risk candidates as Solyndra and Tesla with capital subsidies is the opposite of the successful programs that induced the digital electronic revolution.
Call to arms!
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 ago, 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.