Capitalism

Economic Myth: Private Sector Works Well and the Public Sector Just Gets in the Way

Is it time for the state to be entrepreneurial?

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By Mariana Mazzucato

When you argue that the role of the state in the economy is more than a ‘facilitator’, a ‘de-risker’, a regulator, a spender or an administrator–you will get a big reaction. After all, these assumptions have been at the heart of economic policy in countries around the world for the last half-century or more. We like to pretend that the state is at best useful for fixing different types of market failures – an idea that justifies the need for the state to fund basic science, a classic ‘public good’.

But the reality, as I explain in my work on The Entrepreneurial State: debunking public vs private sector myths, the state has actively shaped and created markets, not just fixed them. It has done so by being an active investor along the whole innovation chain: not only in basic research but also even in downstream areas like applied research and early stage financing of companies. Ignoring this key market shaping and market creating role (not only market fixing) is having today two effects: (1) it is hurting future innovation possibilities (making some countries think they can simply use public money to indirectly incentivize private sector investment), and (2) it is contributing to the increase in inequality.

Why inequality?

Because, by not admitting the public side of the value creation process (the public money behind many innovations), we have ended up socializing risks while privatizing rewards — giving the largest proportion of profits to the 1%. This is a different way to see the connection between innovation and inequality from the usual emphasis on those without the necessary skills being left behind.

In a great article in the New York Times, Eduardo Porter included a brilliant summary of some of the key points in my work – his earlier piece on the current shaky foundations of US innovation, citing some insightful new research on the dangers of falling investments in innovation by both public and private actors. Inevitably, however, there’s only so much room in print, so I wanted to set out some of the background logic from my work in more detail, especially my points on the relationship between risks and rewards, which is shared by some, like Professor Dani Rodrik from the Institute of Advanced Studies in Princeton, and not by others.

Understanding the state as market maker not just fixer means understanding that in the few areas of the world which have achieved innovation led ‘smart’ growth—what so many countries say they want after too much short-run, speculation-led growth—the state has played the role of strategic investor, not only spender; catalyzer not only de-risker.

Where?

Places, such as Silicon Valley (usually sold to us as a result of venture capital and a bunch of individual entrepreneurs), which have benefited from investments by visionary ‘mission-oriented’ public sector organizations that have created and shaped markets not only ‘fixed’ them—before the private sector was willing to enter. Organizations such as Darpa in the Department of Defense, the National Institutes of Health in the Department of Health, ARPA-E n the Department of Energy and others such as the National Science Foundation (NSF), the Small Business Innovation Research program, NASA, and even CIA venture capital funds. And of course not just in the USA, also in many other countries including Tekes and Sitra in Finland; Yozma in Israel; and increasingly also public banks like KfW in Germany or CDB in China. I will not go into the story of these organizations as I have done so already in both my book (focusing on the Silicon Valley experience) as well as in recent papers linked to a new project on Mission Oriented Finance for Innovation. I’ll focus here on key points that relate to Porter’s piece on the NYT.

What has characterized public investments in innovation?

Investments in innovation by public organizations have had five often ignored characteristics, and only by understanding these can we begin to understand why the risk-reward problem is an issue to be reckoned with instead of being shoved aside easily:

  1. They have been massive, with the NIH spending in just 2011 a total of $31 billion on the knowledge base that feeds the US (and indeed global) biotech and pharmaceutical industry, while the private companies concentrate more on D and less on R.
  2. They have been focused not only on basic research (the classic ‘public good’) but also on downstream areas in the innovation chain: on applied research, and on early stage seed finance to innovative companies, with programs like SBIR investing more in early stage high risk finance than private VC (see Figure 1 below).
  3. The investments have often been “mission oriented“, framing the challenges of the organizations in ‘big thinking’—such as going to the moon or fighting climate change; and
  4. Precisely because they are creating new markets not only fixing existing ones, such public investments have had to make difficult choices on the types of technologies, sectors and even firms to fund—yes, “picking” directions of change (not just leveling the playing field for the market to choose the direction), and
  5.  in doing so have taken massive risks, because many such investments will fail.

Figure 1

figure1
Keller, Matthew R., and Fred Block. “Explaining the transformation in the US innovation system: the impact of a small government program.” Socio-Economic Review (2012)

This last point is critical. Failure is inevitable and part of the innovation game, whether we are talking about blue sky research or financing of companies. When DARPA invested in Arpanet, which later became the Internet, that was a massive success. But for each such success there were many failures. More recently, when the US government invested $465 million in Tesla S (through a guaranteed loan), it was a remarkable success (with Elon Musk lauded as the new hero of Silicon Valley after Steve Jobs), a similar investment ($500 million guaranteed loan) to Solyndra, failed. This is normal when investing along the innovation chain: for every success there are many failures.

When the state fails we blame it for being stupid. Look at Concorde! Look at Solyndra! But if and when the state is a key player in the innovation process, investing along the entire chain, of course it will fail—as that is part of the highly uncertain process. Indeed, talk to any VC investor and they will tell you that failures are their way to success, as brilliantly explained in Janeway’s Doing Capitalism. But, what the venture capitalists have benefitted from and the state has not, is a revolving fund–earning profits from the upside to cover the downside risk. By not admitting that the state has played an active, entrepreneurial, investor role, we have socialized only the risks, while privatizing the rewards. In other words, exactly what many have argued of the financial sector, is just as true of the ‘real economy’!

Sharing risks and rewards

Economists will argue that the return to the state occurs through taxation. But this is naïve. Firstly, the same companies that have benefitted so much from state investments, whether Apple (which benefits from government-funded technologies like internet, touchscreen, gps, and siri to make its iPhone smart and not stupid – see Figure 2 below) or Google (whose algorithm was funded by the NSF)—don’t pay much tax –compared at least to their record level profits (which are of course related to their key innovations, results of the collective efforts discussed above). But even if they did, let’s look at what happened to the tax rates themselves, even if taxes were not dodged.

Figure 2

figure2

Source: Mazzucato, M. (2013) The Entrepreneurial State: debunking public vs. private sector myths p. 109, Fig. 13

The lobbying efforts to reduce tax have been constructed around specific stories about the ‘innovation economy’, hyping up the role of some private actors, while hyping down (ignoring or badly theorizing) the role of public actors. As Bill Lazonick and I argued, it is not a coincidence that it was the National Venture Capital Association that, by presenting itself as the key provider of risk capital to innovators, was able to lobby for a 50% fall in capital gains at the end of the 70s. Yet VC has always entered sectors like biotech, nanotech and greentech after the greatest risk and uncertainty was absorbed by the pubic sector, through the kinds of funding discussed above. Warren Buffett clearly states that the fall in capital gains tax at the end of the 1970s increased inequality while having no effect on investment and jobs. And of course this is even more true of the constant chipping away at corporate income taxes (to ‘spur growth’), and new loopholes appearing every year—all in the name of releasing ‘investment’.

And again in the name of increasing innovation, pharmaceutical and IT companies have managed to convince governments to introduce massive tax reductions not only through R&D tax credits, which tend to have little ‘additionality’ (making R&D happen that would not have happened anyway), but also through ‘patent box’ type tax reductions which while reducing government tax revenue, have little to no effect on companies’ investments on innovation. (See here for a great critique by the IFS of such policies.). All this means that the ability of government to earn tax revenue from innovation has been greatly damaged over the years.

Of course the public benefits from investments in basic research through spillovers to the entire economy, whether through new knowledge benefitting a wide set of people, businesses and entire sectors. That is the whole point of the ‘public good’ argument. This creates new skills, new jobs, and, sometimes, higher tax receipts. But, if we go back to the point above that the state has been critical not only in funding the upstream basic science (the public good) but also the downstream applied research and early stage financing of companies, it is essential to get a bit more ‘real’ about risks and rewards.

So what to do? As I’ve been arguing since 2011, admitting that the state is a lead risk taker, and market maker must be accompanied by an admission that it will sometimes fail. So we need a more concrete way to make sure that it is not only the risks of innovation that are socialized, but also the rewards. Of course this should not be done in a way that makes the state become profit maximizing like the private sector. It must remain mission-oriented (thinking big and out of the box), but when successes happen, there could be concrete ways in which some of the upside is shared, to reflect this contribution. This could happen through various measures, which I have also discussed in a piece for Project Syndicate:

  1. Equity. When specific companies receive funding by government, equity or royalties could be reserved for the taxpayer. This would allow the losses from the Solyndra type investment to be at least partially recouped by the equivalent successful ones like Tesla.
  1. IPR golden share. For those products, like many drugs, whose research was nearly all publicly funded, public organizations that funded the research (like NIH in the case of medicines) should be able to retain a golden share of the IPR;
  1. Prices. The prices of the products could also be capped to reflect this investment. As I argue in my book, the taxpayer ends up paying twice for many drugs. While the Bayh Dole act in the US gives the government the right to cap the prices of such drugs, it has never exercised this right;
  1. Reinvestment. A key problem in today’s modern economy is the financialization of companies, with many spending more on areas like share buybacks than on R&D. Bill Lazonick has written a great piece on this in Harvard Business Review (Profits Without Prosperity), and our joint work on the problem of risks and rewards and the relationship with share buy backs can be found here. This is a massive issue that is only now beginning to be more widely understood. (I recently had a long discussion with Jim O’Neill, ex chief economist of Goldman Sachs, on this point, which he picked up in a recent Project Syndicate article.) It is also a key problem today given the record level hoarding rates by companies. Indeed, the skills problem is getting worse as skills themselves are suffering from the falling private investments in long run areas like human capital formation. In my New Statesman article I argue that this is part of the skills problem often ignored;
  1. Deals reflecting a mutualistic (not parasitic) partnership. Bell Labs, one of the most important R&D laboratories in history (along with Xerox Parc), emerged from a deal between AT&T and government. Government asked that AT&T return the favor for its government granted monopoly status by reinvesting its profits into important innovations, to be co-financed publicly. It did, and Bell Labs was born by that healthy tension. It is precisely this kind of pressure on companies that benefit from public subsidies and/or investments that we are in desperate need of today, radically changing the nature of our current innovation ‘eco-systems’.

While some argue that tax revenue, spillovers, and ‘consumer surplus’ are enough to ensure the public gets back a reward for its risk taking, I continue to think this is not only naïve but is putting future innovation at risk. Perhaps the tide is turning. Project Syndicate pieces have advanced similar proposals to the ones I’ve been trying to advance on risks and rewards, such as those by Dani Rodrik and Kemal Dervis who argue for a public innovation fund to be replenished through private contributions which recognize the public investment role. Porter’s piece is a great summary of the key issues at hand.

Personally my key concern is not to give the exact recipe for how returns might be better socialized—as the exact method will depend on local conditions—but to open a new conversation about how the way we talk about the state, and the wider public sector organizations that constitute it, affects the kind of growth that we achieve. In the end, if we want growth that is not only smarter but also more inclusive we need something that goes beyond taxing wealth, as Piketty argues for. What we need is a more complete understanding of where wealth comes from in the first place, so that the returns can be shared by all the contributors—rather than being siphoned off to the 1%.

Originally published here.

11 November 2015


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  • John Edward Malin

    Brilliant! Need I say more. I should know. I am the Father of the Silicon Bayou [1984-2016] in Southwestern Louisiana.

  • Why do we want the government making equity investments? There is no reason to believe that government officials are better at this that private investors and many reasons (susceptibility to cronyism, no market check, elections being a poor feedback mechanism, inability to structure compensation to hire the best people) to believe that the government is worse. These problems only become worse if the government is actually able to exert control over entities in which it might invest.

    • David

      What’s wrong with you? Don’t you know that government officials are altruists and private investors are greedy capitalist pigs? 😉

    • Jacob Basson

      because there are early stage risks the private sector won’t take on

      • Which risks are those? And why do you think that is?

        • Jacob Basson

          early stage R&D risks, those where the route to commercialization is far from clear. paying to sequence the human genome, say. very likely in the grand scheme of things to prove worthwhile, but no particular company wants to single handedly foot the bill with some specific disease/condition/drug in mind because the development/commercialization is too far off. worth it for society as a whole, not worth if for any particular company: right where the government should step in .

          • In theory that’s possible for narrow case basic research. I suspect that you would have better results allowing a consortium of firms to do such research simply because of the hefty risk politcization in government funded research (and the other factors I cite above). But this is ultimately an empirical question.

  • David

    In other words, this author believes in crony capitalism.

  • Hudson

    Evonomics: “combining fancy words with logical gymnastics in order to justify socialism everywhere and always.” Every so often I like to go here to see what the top socialist minds have to say…and then feel comfortable that I’m not missing anything terribly enlightening if I don’t check every day.