Does The Entrepreneurial State Need a Return on Investment?

By Dan Kervick

Joshua Gans raises some doubts at about Mariana Mazzucato’s argument in Slate and New Scientist that it is time for the state to get something back for its investments. Gans’s brief argument isn’t very thorough, but he makes an interesting point. Let’s first establish the context. Mazzucato’s article recapitulates some of the central points from her book The Entrepreneurial State about the sizable role governments have played in driving innovation:

Images of tech entrepreneurs such as Mark Zuckerberg and Steve Jobs are continually thrown at us by politicians, economists, and the media. The message is that innovation is best left in the hands of these individuals and the wider private sector, and that the state—bureaucratic and sluggish—should keep out. A telling 2012 article in the Economist claimed that, to be innovative, governments must “stick to the basics” such as spending on infrastructure, education, and skills, leaving the rest to the revolutionary garage tinkerers.

Yet it is ideology, not evidence, that fuels this image. A quick look at the pioneering technologies of the past century points to the state, not the private sector, as the most decisive player in the game.

Whether an innovation will be a success is uncertain, and it can take longer than traditional banks or venture capitalists are willing to wait. In countries such as the United States, China, Singapore, and Denmark, the state has provided the kind of patient and long-term finance new technologies need to get off the ground. Investments of this kind have often been driven by big missions, from putting a human on the moon to solving climate change. This has required not only funding basic research—the typical “public good” that most economists admit needs state help—but applied research and seed funding too.

Mazzucato cites two key examples to support her case, one from the tech area and one from the area of pharmaceuticals:

Apple is a perfect example. In its early stages, the company received government cash support via a $500,000 small-business investment company grant. And every technology that makes the iPhone a smartphone owes its vision and funding to the state: the Internet, GPS, touch-screen displays, and even the voice-activated smartphone assistant Siri all received state cash. The U.S. Defense Advanced Research Projects Agency bankrolled the Internet, and the CIA and the military funded GPS. So, although the United States is sold to us as the model example of progress through private enterprise, innovation there has benefited from a very interventionist state.

The examples don’t just come from the military arena, either. The U.S. National Institutes of Health spends about $30 billion every year on pharmaceutical and biotechnology research and is responsible for 75 percent of the most innovative new drugs annually. Even the algorithm behind Google benefited from U.S. National Science Foundation.

These are very compelling examples, and they can be extensively multiplied.  But turning now from the important role of government investment in spearheading progress and innovation, questions can be raised about how the returns from public investment should be distributed, and here is where Mazzucato’s argument takes a turn that Gans singles out for attention:

It is time for the state to get something back for its investments. How? First, this requires an admission that the state does more than just fix market failures—the usual way economists justify state spending. The state has shaped and created markets and, in doing so, taken on great risks. Second, we must ask where the reward is for such risk-taking and admit that it is no longer coming from the tax systems. Third, we must think creatively about how that reward can come back.

So Mazzucato thinks the government should reap a reward for its investments, especially when it had to take substantial long-term risks to generate the added value the investments have yielded.  She then touches on a few possible mechanisms for collecting that reward:

There are many ways for this to happen. The repayment of some loans for students depends on income, so why not do this for companies? When Google’s future owners received a grant from the NSF, the contract should have said: If and when the beneficiaries of the grant make $X billion, a contribution will be made back to the NSF.

Other ways include giving the state bank or agency that invested a stake in the company. A good example is Finland, where the government-backed innovation fund SITRA retained equity when it invested in Nokia. There is also the possibility of keeping a share of the intellectual property rights, which are almost totally given away in the current system.

Recognizing the state as a lead risk-taker, and enabling it to reap a reward, will not only make the innovation system stronger, it will also spread the profits of growth more fairly. This will ensure that education, health, and transportation can benefit from state investments in innovation, instead of just the small number of people who see themselves as wealth creators, while relying increasingly on the courageous, entrepreneurial state.

Here is where Gans’s criticism comes in.  He thinks there is some tension between Mazzucato’s argument that the state should reap a return on its long-term investment, and her previous argument that what makes the state so successful in funding innovation is the fact that the state doesn’t need to profit financially from the investment.

Now as I understand it, her argument is that what the state needs is to appropriate more of the returns from innovation it funds on its books. However, this is at the same time, that she argued that state success in funding and seeding innovation was precisely because it didn’t have to worry about getting the returns from innovation on its books. In other words, the problem with state-funded innovation is apparently it is not sufficiently like private funded innovation in its return calculus.

I think Gans has raised a fairly good point here. But it is also a limited one. For one thing, Mazzucato doesn’t say that the state needs to reap all of the return from its investments, only some of it.  Also Gans doesn’t address the central points Mazzucato makes about the possibility of the public retaining ownership stakes in some of the new capital produced by the state investment, including intellectual property rights.  Retaining public ownership need not add at all to the total economic cost for society of a project; it is only a decision about how the capital products of that project will be distributed.  In fact, retaining public ownership could decrease the net economic cost.

Let’s suppose the government invests in a major transportation “moon shot” program that leads to the development of a nationwide hovercraft network which includes a substantial infrastructure: a variety of hubs, transfer stations, repair facilities, electromagnetic conduits, traffic towers, power stations, etc.  The craft themselves are manufactured and operated by privately owned companies.  What about the infrastructure?  Who owns it?  And how are the costs and benefits of the investment in that infrastructure allotted? We can imagine at least five options:

1. The infrastructure is privately owned by a small number of oligopolists.  The oligopolists charge fees for use sufficient both to cover the costs of ongoing maintenance, and add to their profit.  The government receives no return for its initial investment.

2. The infrastructure is privately owned by a small number of oligopolists.  The oligopolists charge fees for use sufficient both to cover the costs of ongoing maintenance and add to their profit, and to return some money to the government to cover the costs of its investment in developing the network.

3. The infrastructure is publicly owned. The government charges fees for use sufficient both to cover the costs of ongoing maintenance and return money to the government to cover the costs of its investment in developing the network.

4. The infrastructure is publicly owned. The government charges fees for use sufficient both to cover the costs of ongoing maintenance but not to cover the costs of its investment in developing the network.

5. The infrastructure is publicly owned. The government charges no fees for its use whatsoever.

We could imagine other options with mixes of fees and disbursements of the fees.  But one approach represented partly by option 4, and even more by option 5, is let the public keep their user fees. The state is a set of institutions that exist to serve the public interest, and so it is supposed to be working for the public. If the state succeeds in creating value for its constituents greater than the cost of its investment, then that added value is itself a return on public investment. It has been delivered to the public in the form of new services and conveniences that didn’t exist before.

Note also that in options 3, 4,  and 5 part of the compensation that the public has received for its investment comes from the public ownership of the infrastructure, which means that the public can operate that part of the system at cost, without the need to collect and distribute profits to a small number of private shareholders or other owners. In some industries, of course, private ownership plays a useful and important role. The large number of competitors in the potato chip industry, for example, need to compete aggressively for market share, which drives down profit margins, promotes efficiencies and improvements, and eliminates shoddy performers from the system.  But in the case of a large network with an integrated national infrastructure, competition is impractical and wasteful, and so private ownership means oligopolistic ownership. The oligopolists are able to extract large profits without fear of competitors who can enter the market and undersell them. There is no public purpose served by this.  Instead of distributing the full value created by the new service evenly, the users of the system receive less value, since they have to pay more of it back in fees, and that value is then redistributed to owners.

There are several other issues raised by the Gans and Mazzucato pieces, issues having to do with the benefits and costs of monetary flows to the government in the form of fees and taxes, when that government controls its own floating fixed rate currency. There is also a political dimension to these flows that shows up in the interminable wrangling and confusions about deficits, taxation and debt issuance.  But these questions will be left to another time.

Cross-posted from Rugged Egalitarianism

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