19 October 2010
The spending cuts, soon to be unveiled in the Spending Review, are being made in the name of making the economy more competitive, innovative and entrepreneurial. The reasoning is that by drawing back the state and bringing in the private sector to run public services they will become more dynamic, more competitive, with the resulting growth and tax receipts, plus the fact that the public purse will no longer be funding them, delivering the necessary deficit reduction.
The assumption is that, while government is needed to provide the basics, it is the private sector that is the most entrepreneurial and the most willing to engage in the risk taking necessary to kick start the innovation engine that will stimulate economic growth. It is this same assumption that is used to justify the excessive earnings and bonuses in the private sector; those who take the most risk should take the most return. However, evidence shows that this is a flawed premise, based on a misunderstanding of where real risk taking and innovation often come from.
Innovation is one of the most risky activities in modern capitalism. It is risky and uncertain for many reasons, including the length of time it takes and the very high failure rates which can be subject to many random factors. When successful, often the search for one product leads to the discovery of a completely different one.
So, who is it that usually takes on this extreme form of risk—especially in the early, most crucial phase of a new product’s development? In fact, in many advanced economies, it has often been the State that’s been the entrepreneurial agent in a wide variety of sectors from aerospace to the internet (which traces its origin to the US Department of Defence). Most new medicines trace their research to public laboratories, not private ones, which tend to focus on less risky ‘me too’ drugs rather than new molecular entities. In the UK, the State has played a leading role in innovation around computers, packet switching, optical fibre in telecoms, antibiotics, radar, and pyrethrins (insecticides). Molecular antibodies were discovered in UK Medical Research Council labs in the 1970s—a foundation for the UK’s current leadership in biotech.
Of course the private sector also plays an important role but early stage and radical innovation are areas in which the State has had a far reaching effect, risking all the money invested, with the private sector often shying away.
Venture capital, which is widely thought to be behind the biotech revolution, actually entered very late after 20 years of government spending in the related sectors (enzymology, genomics, chemistry, IT ). And venture capital often leads to PLIPOs: product-less initial public offerings, allowing VCs to make millions, with the economy not benefiting in terms of new products and job growth.
The stock market, which is often heralded as a bastion of the innovation process, allowing companies to raise capital to take risks, is often scared off by the uncertainty of innovation. When Microsoft announced that it would start to compete with Google by investing billions in a new search engine, its stock price dropped 11%, reducing its capitalisation by 30%. This reaction to a smaller company’s plans would kill it off.
In fact, the shareholder revolution has in many ways damaged companies’ ability to focus on structural change and innovation. Data indicates that the practice of stock buybacks, aimed solely at boosting share prices, skyrocketed in the 90s right up to the period before the 2007-2008 financial crisis--at the expense of R&D spending.
So it’s just wrong to think that more private and less state intervention will deliver the new products and markets that will restore economic prosperity. It is also wrong to think that the returns from periods of high growth should be so concentrated in the hands of a few private actors as though they were the risk taking entrepreneurs. Risk is shared widely with the State playing the vital role.
Yes, fiscal tightening is essential to reduce the deficit but arguing that a leaner government will lead to a more innovative economy ignores the lessons of history. Growth will depend on an entrepreneurial state, one that does not shy away from risk, one that is brave enough to make the strategic investment necessary to lay the groundwork for future waves of growth from dot.com to green tech.
If the UK wants a leading place in the international race around green technology, which is still in its early, uncertain phase, with the private sector all over Europe waiting for governments to make their mark, UK industrial policy will have to prioritise research in this area and make that crucial investment.
A gentle ‘nudge’ just won’t do for this type of radical innovation. A strong push is needed. And it is this type of risk taking behaviour that might give ‘risk’ a good name again and lead to a more resilient, sustainable economy.