By Mariana Mazzucato | 25 June 2013

Those who take the risks reap the rewards. Or do they? The truth is that from Silicon Valley to Singapore, innovation relies heavily on state funding. It’s time for the private sector to give something back, says Mariana Mazzucato

Policy makers have been asking themselves a burning question for a long time – well before the recent global economic crisis. That question is: where are the ­European Googles – the innovators, the risk takers?

The answer we have heard to this question is that the US economic model is more ‘entrepreneurial’ than that in many parts of the globe. This is supposedly due to the prevalence of economic actors such as ‘venture capitalists’, who provide high-risk funding to genius ‘garage tinkerers’ in their endless pursuit of innovation.  

We are even told that Americans somehow have a greater entrepreneurial spirit, which makes them more tolerant of the occasional failures that go hand in hand with the occasional successes – like the internet – that result from an endless experimentation process.   

In general, there seems to be a consensus that the US model is more successful because it is more market-driven. The heavy hand of the state in Europe has made it slower, less efficient, less innovative – putting its growth, even before the crisis, under threat.

And inside the US, the current battle in Congress over how large the state should be often resorts to claims that a larger state would wipe out the innovative drive of the economy.

Of course, economists understand that the market sometimes fails – with ‘big-time’ failures most recently. But in the end the state is still viewed, even by progressive economists, as a backseat player. Important for ‘fixing’ market failures but not for ­creating or shaping markets actively; guiding the ­capitalist engine.  

But what if the image we are constantly fed – of a dynamic business sector contrasted with a necessary but sluggish bureaucratic, often ‘meddling’, state – is completely wrong?

What if the revolutionary, most radical, changes in capitalism came not from the invisible hand of the market but the very visible hand of the state?

Indeed, the real story behind Silicon Valley is not the story of the state getting out of the way so that risk-taking venture capitalists – and garage tinkerers – could do their thing.  From the internet to nanotech, most of the fundamental advances – in both basic research but also downstream commercialisation – were funded by government, with businesses moving into the game only once the returns were in clear sight.  Indeed, all the radical technologies behind the iPhone were funded by government: the internet, GPS, touchscreen display, and even the new voice-activated Siri ­personal assistant.

These investments were not just about the ­government providing the ‘basics’ – like funding upstream research. The state funded both the basic and applied research and, in some cases, went as far downstream as to provide early stage risk finance to companies themselves that were deemed too risky for private finance. Apple initially received $500,000 from the Small Business Investment Corporation, a public financing arm of the government. Likewise, Compaq and Intel received early stage grants not from venture capital but via public capital through the Small Business Innovation Research Program. As venture capital has become increasingly short-termist, SBIR loans and grants have had to increase their role in early stage seed finance.

While many of the examples sound as if they are related to the military, they are actually everywhere, including in the US’s Department of Health and the Department of Energy. Indeed, it turns out that 75% of the most innovative drugs owe their funding not to Big Pharma or to venture capital but to that of the National Institutes of Health. The NIH has over the past decade invested $600bn in the biotech-pharma knowledge base, $32bn in 2012 alone.

Although venture capital entered the biotech ­industry in the late 1980s and early 1990s, all the heavy investments in this sector occurred in the 1950s, 1960s and 1970s. Venture capitalists entered 20 years after the state funded the most high-risk and capital-intensive parts of the industry. And their desire to reap back returns within 3-5 years has also done quite a bit of damage to the industry. Today it is filled with product-less companies that produce little for the economy beyond the returns earned by private equity in the exit stage.

We are seeing the same pattern being repeated in clean technology. In countries including the US, China, Singapore, Germany, Finland, and Denmark, the state funds the difficult areas that are characterised by high-capital intensity and technological and market uncertainty. Business is waiting for future returns to become more certain.

These examples are important for three reasons. First, they tell a very different story about the drivers of capitalism in areas like Silicon Valley – and hence also offer very different recipes for countries that are failing. Is Greece having problems because its state is too large, or because its state is not doing enough? Are Germany and Denmark among the stronger countries in Europe because they have ‘tightened their belts’ or because their governments have spent more than most EU governments on areas such as R&D, and have the type of ‘patient’, long-term committed public finance that China also has.

Is Europe’s problem the lack of risk capital, or the lack of a wave of state funding for that risk capital to surf on? Evidence points to the latter. And no matter how much venture capital and private equity we try to muster up, it is the wave that is missing.  

Second, they teach us why so many policies aimed at unleashing entrepreneurship are ineffective. Here it is interesting to go to economist John Maynard Keynes, who actually did not talk about innovation. He talked about government and was an expert on what drives private investment. He used the phrase ‘animal spirits’ to talk about the volatility of investment, driven more by gut instincts and herd behaviour than by rationality. And he used this to justify why you need government investment to stabilise growth.

However, in a private letter to President Roosevelt in the 1930s, Keynes also talked about businesses as ‘domesticated animals’. And indeed, this distinction, which he did not really delve into, is vital. Are we talking about businesses as lions in cages, who simply need barriers to be taken away for them to roar; or are we talking about pussy cats who need to be groomed into lions? So much of policy today assumes the former. Different types of tax cuts – whether they are capital gains tax cuts, or taxes aimed at reducing the cost of R&D – assume that business is willing and able to spend.

In fact, the stories above show us that they are only willing after the state leads the way and takes the risk. Did Pfizer recently move out of Kent in the UK to Boston in the US due to the lower taxes and regulation in Boston? Or due to the $31bn a year that taxpayers in the US fund through the National Institutes of Health? Many businesses talk the talk about tax but walk to where the government spending is. Yet the two contradict each other since lower taxes are de-funding the public purse.

This brings me to the third point and the biggest problem. By not admitting to the role of the state as lead risk taker and entrepreneur, what we are increasingly witnessing is a dysfunctional capitalism – where the risk for innovation is increasingly socialised yet the profits are privatised. And this is putting the innovation machine at risk.

If we acknowledge that the state does not only fix markets but creates them through active risk-taking, we need to have a more direct mechanism that brings something back into a public ‘innovation fund’ that can be used to fund the next round. Had only 1% of the direct financial profits from the internet come back to the state to compensate for its seed funding, there would be much more today to spend on Green-tech, which is being starved – and only gently ‘nudged’ rather than pushed as previous revolutions were.

While many argue that this return-generating ­mechanism is the tax system itself, we live in an era in which major global corporations, whose products descend directly or indirectly from state-funded research, use legal loopholes to pay hardly any tax.

In the end, it is about not hyping up myths about innovation ‘eco-systems’ but admitting who does what in them – and allowing the rewards to be as social as the risks taken. Otherwise, growth might be ‘smart’, but surely not ‘inclusive’. This will hurt not only future innovation (starving the state of funds, despite it being one of the lead innovators) but also the wellbeing of future generations. Not a good result.

Mariana Mazzucato is an economist and professor of science and technology policy at the University of Sussex. Her new book The Entrepreneurial State: debunking private vs public sector myths was published on June 10. She tweets on @MazzucatoM  (www.marianamazzucato.com).

She will be speaking at the CIPFA conference being held in London on July 9-11

This article will appear in the July/August edition of Public Finance