My subject here is innovation: how important is it? And how do we get more of it? In the conventional thinking, our economic strength depends on an environment in which entrepreneurs develop new commercial products in hopes of achieving innovation. The higher the rate of innovation, the higher the average level of employment, and the higher the economy’s rate of growth. That is why Washington economists are yearning for a return of such booming economic activity.

For me, this thinking does not go far enough. Innovation is even more important from the (radically different) perspective of what a “good” economy is about. A “good” economy—and even the not-so-good economy of the United States these days—is all about the creation and application of new ideas: Business people, as economist and philosopher David Hume would have understood, imagining new concepts and novel departures. Technical personnel, in the spirit of early scientist Francis Bacon, are experimenting with ways of producing the new product. Bankers, as founding father Alexander Hamilton envisioned, are backing new business proposals they judge to be promising. Entrepreneurs, as economist Friedrich Hayek conceived, are attempting the development of a new product embodying the new idea, on the hope that sufficient consumers or managers will adopt it. Managers, as Nelson-Phelps modeled them, are using their education to assess the possible value of adopting novel products coming on to the market. Consumers, as economist Amar Bhidé has described, are venturesome enough to take home some of the latest things seen at the mall. Thus, this economy is shot through with the exercise and the expression of the participants’ creativity, their curiosity, their appetite for change, their ambition, and their personality. Of course, in nations that are badly missing some of the institutions that would enable and encourage such innovation, the economy is not going to be “good.”

I can imagine you might say, “Fine, but with so many good causes to support, why should the government put enough value on your ‘good’ economy to want to give support to innovation?” I would say that without a “good” economy, the participants cannot have the prospect of a good life: For a good life, people need to be stimulated by new developments, to be engaged by new problems, to be enlisted to meet new challenges, to find personal growth in the process, and to have a chance—which is all anyone can ask for—to make a difference, to achieve something. (We have witnessed outcries of precisely these needs in the Arab world in recent months.) As I have been arguing for several years now, a high-income country is not doing justice to the potentialities of its population for self-actualization, self-discovery, and inclusion if it allows its economy to lack the institutions and attitudes necessary for high economic dynamism.

I can also imagine people asking whether there is really any link between the dynamism of a nation’s economy—the capabilities and the tendencies to innovate—and the human satisfaction and sense of fulfillment in the country. I have spent a lot of time attempting to understand intercountry differences in job engagement and job satisfaction among the high-income countries. To be brief: According to data from the 1990s, among the G7 nations, Canada ranked highest and next came the United States and the United Kingdom, with Japan ranking fourth. France was at the bottom and Germany next to it. Italy was, in both respects, in the middle. Data from 2000, which do not include job engagement, shows job satisfaction was highest in the United Kingdom, followed by the United States, then Germany and France, with Italy having sunk to the bottom. These results are consistent with my thesis that where we see high-income countries with high levels of boredom and a deficiency of engagement and satisfaction in the workplace, the explanation is usually a deficiency of innovation. Job satisfaction in the United States, for example, plummeted in 2004. At the same time, there was an increase in overseas competition and a decline in innovation, which caused many companies to prune themselves of employees in fun jobs doing forward-looking work, such as product development, strategic planning, and so forth. In line with my thesis, the United States developed a deficiency in job engagement and job satisfaction because of a deficiency in economic dynamism, making it a prime candidate for boosts to innovation.

Two points are of critical importance in the present discussion. Many neo-Schumpeterians are telling us that, although the great navigators of the 16th century and the scientists of the Enlightenment are no longer with us, the central government of the nation can—and should—recreate the days of Queen Isabella and the more recent days of the space agency NASA by instituting government-sponsored research projects in green technologies, alternative fuels, and pharmaceutical research. One drawback of this approach is that in a company placed under a government contract to do research or a research agency of government, radically new ideas—ideas that are “out of the box” —are unlikely to get the ears of the government overseers. And the directions decided on by these well-funded organizations may crowd out competing visions. Perhaps the true genius of the modern economies that emerged in the 19th century was that they achieved mass innovation, by encouraging diverse business people to come up with new ideas, by requiring that these new ideas “make it” with the public, not the government, and by allowing these ideas to compete for the support of entrepreneurs and financiers possessing a pluralism of beliefs, so that ideas that were suspect because of their great novelty would have a chance.
I have to add that I was surprised to see the reference in President Obama’s 2011 State of the Union Address to the “Sputnik moment” in 1957. He asserted that the outpouring of US government money for research, both basic and applied, that continued throughout the 1960s led, with time, to heightened innovation in the business sector. The fact is that, by 1973, the US economy was in the grip of a massive productivity slowdown, which still has not completely loosened its grip.

The second point is that the Washington economists are nevertheless likely to be right in supposing that fewer business people are going to take the plunge of developing their new idea and, if getting that far, bringing the product to the market when the prospect for prosperity in the future has dimmed with the structural problems that have beset so many western economies. So it makes sense to me that the US government should voice support for innovation and throw its financial support into efforts to boost innovation in the economy. The symbolic significance of such a movement could help lift entrepreneurial spirits.

For two years now, I have been suggesting that the state could give a more substantial boost to business innovation by introducing into the financial sector new “banks” or other bodies dedicated to financing company projects in the business sector, including the formation of start-up companies of a demonstrably innovative character.

I have been moving toward a proposal to establish banks of a new kind. It is not uncommon to see financial entities in a country that are dedicated to residential construction or to agriculture or to exports, and so forth. This is curious and disturbing because little or no economic dynamism comes from that. There is no awareness among the general public and its legislatures that most of the economic dynamism inherent in the structure of a country’s economy comes from the innovative inclinations of ordinary people making their careers in the business sector! To right the balance, I suggest to every country that its government establish a corps of banks that are dedicated to lending to—or investing in—companies in the business sector. I like to remind audiences that Germany, with its famous Deutsche Bank, had just such a financial institution serving its business sector during its brilliant economic development in the 1880s and 1890s, when the bank backed the new electrical engineering industries.¹

I stand by this proposal. It will not be a panacea. But I believe it will be one of several moves in the right direction and have detectable benefits.

A concrete version of the idea emerged in subsequent discussions with strategist and author Leo Tilman. In the blueprint we developed, the state would make an initial capital contribution to a government sponsored enterprise (GSE) and the latter would create a system of new “banks” or other bodies under its umbrella. We came to realize that this financial “system”—the Innovation Finance System—could be loosely modeled after the mission and structure of the US Farm Credit System. Every one of the members of the system would be engaged in relationship-based investing in, or lending for, entrepreneurial ventures of various industries and regions. These entities would be properly chartered and capitalized to reflect risk/return characteristics of investing and lending to the targeted category of entrepreneurs. Through a dedicated funding arm, akin to the Federal Farm Credit Banks Funding Corporation (FFCB), our system would raise funds in the global capital markets at the relatively attractive rates owing to its status as a government-sponsored enterprise and economies of scale. These funds would be passed onto entrepreneurs at rates commensurate with risks of their projects, as judged by experienced investment and loan officers. Finally, the “joint and several liability” of our system’s members, a separate insurance fund that protects debt holders, and proper oversight and transparency can all foster well-judged business decisions, rigorous risk management, and properly aligned incentives.²

Another version of the basic idea would make available equity financing as well as lending, and the finance extended by the new institution would be concentrated on equity stakes rather than loans. The “bank,” in that case, might better be called a fund for innovation.

I have come to see that it is better to invest in new ventures than to lend. A lender is apt to find that there is no interest rate high enough to cover the losses from the loans that do not work out in view of the other lending opportunities. And even in the case where the entrepreneur and the financier could agree on the terms of a loan, the entrepreneur’s preference to spread the risk might be strong enough to induce the financier to become a partner rather than a creditor.³

I would like now to address some of the questions raised by this proposal. One question is what could justify committing the resources of the state for this initiative or other similarly aimed initiatives when there are so many other worthy causes. My answer, as I have already said, is that the government owes its citizens, both young and old, the dignity of work, the pride of being self-supporting, and the opportunity for realization of talents and discovery of one’s capabilities—and to have these primary goods in one’s own country rather than having to go abroad to get them.
Another question is whether this is not a time for the government to spend less, rather than more. My answer is that most of the annual outlay of the new financial initiative is an investment that will bring back cash returns. Furthermore, cutting back on government expenditures is not a reliable way to increase employment; it might or might not do any good while costing something in other social dimensions. (I do believe that many initiatives of the welfare state are counterproductive: they sap incentives to work and to take business risks.)

A worry among many economists is whether any investment-type expenditure by the government crowds out other kinds of investment expenditure—more or less dollar for dollar—so that the benefit, if any, is significantly offset by the loss of the benefits of some other government investments. My answer is that actions to enhance the attractiveness and financing of innovative projects does not significantly take away from the value placed on the other investment projects or add to the cost of undertaking them. Think of the business investment boom of the 1990s—the Internet boom. It may have dented alternative investments (housing, etc.), but it did not crowd out such investment enough to block the huge rise of employment.

Many financial people question whether it is a good idea to inject into the financial sector an investment fund for innovation that will do a poor job, as compared to the “good” job that venture capitalists and other private investors do. My answer is, first, that it is not at all clear that venture capitalists do a very good job: they demand towering interest rates, so the most uncertain projects—even if they are visionary—have little chance. Second, the VC industry makes up only a tiny bit of the financial sector, so it is preposterous to suggest that the VC industry should be depended upon to do the whole job of supporting a nation’s innovation. Third, we must not cling to the highest standards for financing innovative investments when the more important objective is to get a larger volume of innovative investment projects underway by boosting the availability of their finance and reducing their cost of capital. Finally, we should welcome a new investor to the financial sector that, owing to its size, is willing to take risks that are unknown and quite possibly large for the sake of a comparably large payoff. We would welcome a Mickey Mantle to our baseball team in order to have his home runs even if he strikes out a lot.

¹ Edmund Phelps, The justice of a well-functioning capitalism and the reforms that will realize it, not kill it, New World, New Capitalism Sarkozy-Blair Symposium, Paris, January 8–9, 2009. The same proposal was advanced in the Center on Capitalism and Society’s Letter to the G20, sent on March 24, 2009, following the Center’s February 20 conference on the crisis.

² Edmund Phelps and Leo Tilman, “Wanted: A first national bank for innovation,” Harvard Business Review, January–February 2010, Volume 88, No. 1/2, pp. 101-103.

³ My colleague Richard Robb adds, that in the not unlikely event of a default on the loan, the lender might become the owner of the business and, to run it, need to employ the entrepreneur who started it. Since that outcome would have costs, a more orderly arrangement, in which the financier begins with an ownership stake, could be preferable for both parties.

Back to top