The State and the Innovation Economy

The face of libertarianism in America today may be the Tea Party, but some of its most influential adherents are Silicon Valley venture capitalists who pride themselves on discovering and developing the greatest new technologies and companies free from public-sector support — or in spite of its interference.

Peter Thiel has become the leading voice of these technology-focused libertarians. He laments a great slowdown in technological innovation — “we wanted flying cars, instead we got 140 characters,” states the manifesto of his venture capital group, Founders Fund. As a solution he urges a greater retreat from government and backs utopian anti-state projects.

“In our time, the great task for libertarians is to find an escape from politics in all its forms — from the totalitarian and fundamentalist catastrophes to the unthinking demos that guides so-called ‘social democracy,’” Thiel wrote in a 2009 essay for the Cato Institute, articulating his philosophy behind investing in “new technologies that may create a new space for freedom.”

“Unlike the world of politics,” he continues, “in the world of technology the choices of individuals may still be paramount. The fate of our world may depend on the effort of a single person who builds or propagates the machinery of freedom that makes the world safe for capitalism.”

Thiel’s first investment priority is cyberspace: with PayPal, which made his first fortune, he sought to create a world currency, “free from all government control and dilution.” Backing Facebook was a way of supporting communities “not bounded by historical nation-states.”

Thiel admirably urges new frontiers for technology and radical visions for the future. But he fails to acknowledge the deep irony his libertarianism presents for his complaint about technological slowdown: namely the fact that the government created the Internet, as well as many other transformative general purpose technologies, and it is arguably the result of the post-1960s antigovernment Right that has driven the public sector’s declining prominence in advancing innovation. Even more broadly, the public’s loss of trust in government and antipathy toward its ability to secure a better future, whether by technological innovation or other means, has much to do with the same libertarian forces.

The pervasive antigovernment bias among VCs is one of the reasons why William Janeway’s recent book, Doing Capitalism in the Innovation Economy, is so refreshing. Janeway, a venture capitalist at Warburg Pincus and an economist, articulates a deep and nuanced vision of how innovation happens, one that acknowledges the important roles played by the public sector as well as private actors.

He is quick to remind his fellow tech investors, for example, that “the Department of Defense developed the platform we all danced on.”

Janeway recently spoke with the Breakthrough Institute about “Schumpeterian waste,” the irrelevance of neoclassical economics, and the role of the state in technological innovation.

It is the state’s responsibility, Janeway said, to make transformative investments in innovation, subsidize the creation of new networks, and use its purchasing power to create markets for new products. “Revolutionary innovations are non-linear processes requiring enormous investments over decades,” he said, pointing to the example of electricity:

It took 80 years — from 1850 to 1930 — to build out and deploy electricity. It took 20 years to do street lighting. It took another 20 years to electrify mass transit. It was only in the 1920s that you finally had it for manufacturing. It was only in the 1950s that you had it for consumer products like washing machines.

One of the reasons why public sector investments have been underappreciated is because economic theories fail to measure the value of major publicly funded projects like the Interstate Highway System, which are justified more often on the basis of political vision or military necessity than economic value. “Economy depends on sources of funding that are decoupled from concern for economic return,” he writes.

“What I worry about is the delegitimation of the state as an economic actor,” Janeway said. “The 2008 crisis reminded people of the role of the state, but it also tightened the grip market fundamentalists have over the Republican Party. It's not just the Tea Party people. It's the deficit doomsayers.”

Janeway’s book was named last year by the Financial Times as one of the “best books of 2012” and by Foreign Affairs as one of the “Best Books on Economic, Social, and Environmental Subjects.”

Read the Breakthrough's interview with Janeway below.

It's unusual to hear a venture capitalist extol the virtues of government investment.

Younger VCs don't have the same institutional memory that I and other VCs my age have. The Department of Defense developed the platform we all danced on. Some younger VCs are starting to get it. [Netscape founder and VC] Marc Andresson hosted a book party for me.

You criticize neoclassical economists for ignoring the critical role played by states in creating the foundations for economic growth.

I think the most underrated economist of the last 200 years was Friedrich List. His 1850 book, The National System of Political Economy, was a study of how Britain got to its leadership role, and what other countries would have to do to catch up. It's all about state power.

List has this wonderful line about how if the English had practiced laissez-faire economics, then England would still have been the sheep yard of the Hanseatic League selling wool to Flanders in return for manufacturing textiles. In other words, had Britain not had a national strategy for economic development there would never have been an industrial revolution.

Is it true your dad advised both President Franklin Roosevelt and President Lyndon Johnson?

My parents never lived in Washington and my father, who was business editor at Time, never had a government job. But my parents were the most junior members of the circle of intellectuals around the second New Deal, which included Bill Douglas, the Supreme Court Justice, and a bunch of the policy architects of the New Deal, like Tim Cohen and many others whose names have faded. Lyndon Johnson was very engaged with this group even though he came from the other end of the earth. My parents knew Lyndon and Lady Bird and were close until Vietnam produced a split that was truly universal around Washington D.C. at the time.

How did this influence you?

I always knew it was only worth talking about political economy, not the economy per se. I always knew there were two powers in the world. The first is where power is distributed according to one dollar one vote. The second is where power is distributed, at least nominally, between one person and one vote.

The players who were losers in the market economy — whether unemployed workers or businessmen suffering from competition they couldn't handle — would invent a political process for redress. Political losers would seek economic power by, for example, forming unions. And those who had economic power would be expected to use it to extract rents through buying political power. I grew up with an understanding of this two-sided game.

Later, after I read [French historian of capitalism Fernand] Braudel, I realized there was a third, opportunistic player — finance, the possessor of liquid capital who can invest it seeking discontinuities, seeking disruption. That's the case whether it's my friend George Soros betting against the pound or me investing in the distributing computing revolution of the 1980s.

How has your venture capital work influenced how you think about the economy?

It's important to understand the high uncertainty with investments in technology. My last hurrah as a VC is Nuance Communications, which is speech recognition company moving into natural language understanding. The goal is to understand the intent of the speaker, not just what she's saying. The economic consequences of this are totally unknown.

Are bubbles inevitable?

Bubbles are endogenous and inevitable. They are built into the logic of liquid markets. The problem is made worse by the fact of so many investors managing other people's money. This has mostly not been productive. But in some circumstances, like the dot-com bubble, it can be. But it can also shut down the market economy, as we saw in 2007 and 2008.

You offer a defense of the dot-com bubble as productive.

Not all bubbles are! But when it's liquid securities for instruments that are clearly productivity enhancing, as in the dot-com bubble, then let it run!

When are bubbles a problem?

When speculation infects the banking system. Remember the gambler in Guys and Dolls? He was introduced as a guy who would bet on anything — including which sugar cube a fly would land on. That kind of finance is the model of insanity.

When the funding has no potential to increase productivity — think gold and silver mines, real estate, tulip bulbs — the bubble is destructive not productive. That's when the regulators have a positive mandate to take the punch bowl away.

What is the role of the state in that environment — is it to create what you call the "Schumpeterian waste" that drives innovation?

The state needs to make investments in innovation that can transform the market economy. The state needs to be involved in supporting and subsidizing the deployment of new networks. In particular, the state needs to be a creative customer for new products.

How so?

The role the state plays in procurement has been the one most neglected. Of course, the state might not be productive. It can also encourage rent seeking. Is it corruption when we gave away 9 percent of the land mass of the western part of the of the United States to the railroads?

I don't know, was it?

When Robert Fogel [the economic historian] tried to precisely quantify the economic benefit of the railroads in the 1960s, he did so in a manner that demonstrates the utter irrelevance of neoclassical economics. He assumed a counterfactual example where the resources spent on the railroad would instead by spent on other modes of transportation, like expanding roads and canals. He ignored the revolutionary economic impacts of the railroads. He thus massively underestimated the value of the railroads.

This railroad example is a classic example of trying to understand something that is essentially dynamic — innovation — in a static model focused on calculating the optimal or the most efficient allocation of resources.

So economic analyses can't measure the impact of state investments?

Economics misses the point. We didn't do a cost benefit analysis of the Interstate Highway System.

What drives economic growth and these massive public investments is always a transcendent political vision. A theory of market failure can get you $4 billion a year for the National Science Foundation's basic research. But that theory doesn't get you the Interstate Highway System.

In other words, it takes big visions to get big drivers of growth, like railroads and highways and the Internet.

It's not just this way in the United States. The highways model came from Hitler's autobahn to move troops from the eastern to the western fronts. That was for war, not economic development.

After it had been introduced, the Interstate Highway Act was renamed the Interstate Highways and Defense Act. Every bridge had to be high enough so that a missile carrier could pass underneath it. But building to those specs across the wastelands had damn to do with deterring the soviets. It was a rationalization of economic investment.

Same with the railroads?

The states had been making local road building grants, sure. But with the Pacific Railway Act, the mission was to tie California to the Union. It had nothing to do with economics per se. The effort to confine the legitimate scope for the debate to a cost-benefit analysis, and to quantified financial terms. It profoundly misses the historical point.

You argue that economists used OPEC's price hikes to discredit Keynesianism. How so?

OPEC's price shocks of the early seventies can be understood as the greatest excise tax increase in history, raising the cost of production and shifting cash flows from supporting high consumption in the developed world to low consumption by OPEC nations. This resulted in both an increase in inflation and a reduction in aggregate demand — hence stagflation. The problem was that all the econometric models associated with Keynesianism management broke down because the critical variables — inflation rates, exchange rates, unemployment rates — moved into areas not experienced since WWII. That resulted in the discrediting of Keynesian economics. In fact, the episode demonstrated the limits of a particular set of tools. Ironically, Keynes himself warned against constructing econometric models with static values.

The economist Robert Gordon says that the IT revolution is played out, and its impact pales in comparison to indoor plumbing and electricity.

Gordon doesn't compare apples to apples in time scales. He lets his first two industrial revolutions — steam and electricity — run for 100 to 150 years. But he then truncates the IT revolution.

If you applied the short time period to the steam-railroad revolution, you would cut it at when the B&O was built in 1828. If you cut it at 1873 you are only few years after Sears and Montgomery Ward — the killer commercial apps, if you will, of the railroad era — started up.

If you truncate electrification after Pearl St, the first electrified neighborhood in 1882, you would still be forty years from the 1920s, when electricity was just starting to influence manufacturing, and there were still no electrical household appliances to speak of.

Technological revolutions don't happen overnight.

Revolutionary innovations are non-linear processes requiring enormous investments over decades. It took eighty years — from 1850 to 1930 — to build out and deploy electricity. It took 20 years to do street lighting. It took another 20 years to electrify mass transit. It was only in the 1920s that you finally had it for manufacturing. It was only in the fifties that you had it for consumer products like washing machines.

What should the government do to encourage these kinds of innovations?

Providing loan guarantees to start ups [as DOE did with solar panel company, Solyndra] is a really bad idea. Start-ups shouldn’t have debt to anyone. It would be better if the government issued proposals and calls for orders of better batteries and solar cells than if it guaranteed loans. The defense department pulled companies down the learning curve as a customer, not as a bank. Government agencies should act as customers, not as lending agencies.

You note that transformative innovations inspire bubbles. Was there a transformative innovation behind the real estate bubble that popped in 2008?

There were three innovations behind it. The first was big government. In 1930s the public sector was just seven percent of the U.S. economy, and just two percent was the federal government. The massive expansion of the public sector was legitimated by World War II and eventually became 35 percent of the national economy. That larger public sector allowed for financial bubbles and crises — whether the crash of Long-Term Capital Management, the Asian flu, the dot-com — to be absorbed. The public sector was the source of aggregating demand and liquidity for the banking system, and a system offering safe securities for investors who wanted to hold something.

The second was the innovation in financial derivatives. It was an intellectual breakthrough that did not require new technology.

The third was IT. Information technologies allowed for a grotesquely over-leveraged financial system. The banks have an insatiable demand for assets. When they ran out of real assets they manufacturing fake assets to buy and sell to each other.

Wasn't the rise of China a big part of it?

China tried to compress in 30 years what US and Britain did in 120. Stealing patents. Adverse terms of trade. Protectionism. Driving growth with substantial trade surpluses. With such large surpluses you have to invest internationally, which the Chinese wanted to do to protect themselves against the Washington Consensus.

But I don't think there is anything inevitable about productivity increases forcing asset bubbles. The money that went to speculation could have been invested in clean tech or highways and some other carbon-friendly way, for example.

What is so frustrating now is that this should be the discussion around climate change. There are a lot of investments that could be productivity enhancing, including a smart grid. Including the electrification of cars. Including next generation energy sources.

Are Americans losing our willingness to tolerate the public spending on innovation — what you call "Schumpeterian waste" — that's needed for innovation?

What I worry about is the delegitimation of the state as an economic actor. The 2008 crisis reminded people of the role of the state, but it also tightened the grip the market fundamentalists have over the Republican Party. It's not just the Tea Party people. It's the deficit doomsayers, the Pete Petersons, the business confidence fairies. What's happened to the Republican Party will presumably be self-correcting, but it will have caused an enormous amount of destruction by then.