E-Notes

Innovation and the World Economy

The Second Annual Rocco Martino Lecture on Innovation

By Robert E. Litan

December 2009

Robert Litan is Vice President for Research at the Ewing Marion Kauffman Foundation and a Senior Fellow of Economic Studies at the Brookings Institution. An economist and lawyer who has served in a variety of federal agencies and White House posts, he is an expert on antitrust, banking, Internet policy, and other financial and regulatory issues. He received his Ph.D., J.D., and M.Phil. at Yale University, and his B.S. from Wharton School of Finance, University of Pennsylvania. This essay is based on his September 23, 2009 lecture.

Why it is that we consider entrepreneurship so important? It’s because, when you look through history, entrepreneurs are the source of the most radical, disruptive innovations that have made modern life what it is. Just think about it—the car, the airplane, computers, computer software, air conditioning have changed the world. All of these break-through radical innovations were developed by individuals—by entrepreneurs — and not by large, existing enterprises. (Of course, there are some exceptions, like the transistor, created at Bell Labs, but these are far and few between.)

It’s the entrepreneur who commercializes the innovation and makes it real, and brings its benefits to the rest of society. That’s the reason Ewing Marion Kauffman founded his Foundation, where I now have the privilege to work. He (and now we) want more high-growth or “scale” entrepreneurs doing more radical innovations that lead to economic growth, because ultimately, it is through innovation and growth that our living standards advance.

Consider the fact that growth is actually a relatively recent phenomenon. Economists have tried to reconstruct what the average income of people would have been through time. By the way, this is not easy. Obviously we didn’t have price indexes and statistical agencies, and so on, until the twentieth century. But using a kind of “economic archaeology”, economists have estimated that between the time of Christ and 1800, the average world income was flat. Just think about that. Although incomes in some parts of the world were higher than others, on average, people throughout the world were no better off in 1800 than they were 1,800 years earlier. That’s remarkable! And yet, in the last 200 years, U.S. income per capita has increased by a factor of 30 or 40. If you were to look at any chart of per capita income in the world— or by country—you would see an almost vertical leap starting from the Industrial Revolution and continuing on thereafter.

Adam Smith was probably the first “economist” to write about and try to explain this — even before the growth takeoff actually happened. As you know, he singled out trade and specialization — or the division of labor — as crucial elements in powering any economy. Later economists, like David Ricardo, refined these ideas. But gradually in the 19th century, interest among intellectuals in the subject of growth waned. Interest in growth resumed, not surprisingly, during the Depression. But then the focus was on what modern economists call “aggregate demand”, or how to get people and businesses purchasing things again so that employment would increase. It wasn’t really until after World War II, that economists — led by Nobel Laureate Robert Solow of MIT — began to think seriously about the so-called “supply side” of the economy, and how to sustain growth over the long run, once the economy’s labor force was roughly fully employed. Solow’s great contribution was estimating that roughly 85% of that long-run growth was attributable to innovation, not the accumulation of physical equipment and capital equipment.

More recent research has marked the contribution of innovation down to something like 60%, while demonstrating that other factors — notably education (human capital) and legal institutions — are also important growth drivers, at least in the United States. Elsewhere around the world, saving and investment are more important than they are here. These countries have had the advantage of being able to import technology developed in the West, and then to apply their capital and increasingly educated labor to it to climb onto and then steadily up the ladder of economic progress. This process helps explains the remarkable rise of the Asian “Tigers” for example, and economies like China and India.

Nonetheless, economists still continue to wrestle with the vexing challenge of explaining the difference in growth rates between countries. Apart from the simple facts mentioned— innovation driving growth in the United States but saving and investment driving growth in other parts of the world— is there more to it? This was that question that motivated Kauffman’s president, Carl Schramm, William Baumol (a distinguished economist at New York University) and me to write a book a couple of years ago entitled Good Capitalism, Bad Capitalism. That book’s thesis was that there was more to explaining growth than just talking about differences between countries in their investment and innovation records. One also has to take account of the kind of economic system — specifically in a post-communist world the kind of capitalism — that countries have.

Just look around the world. There over 190 different countries and in all but two of them (Cuba and North Korea), people or at least some of them, can own and profit from private property — what we mean by the word “capitalism.” But the nature of capitalism in different parts of the world is clearly different. Europe has a different form than the United States. Obviously, China, which has been morphing from a state-controlled economy into something resembling a quasi-capitalist society, has its own brand. So does India. And so on. In short, capitalism is not monolithic.

We could have written our book then about roughly 190 different forms of capitalism, but that wouldn’t have been very illuminating or interesting. After much thought we realized, and I will argue here, that there really are only four basic kinds of capitalism. No county falls entirely into one bucket or another, rather there are mixes of the types in different countries. At the same time, however, countries tend to have one or two dominant types. And so it is now important to tell you what we think they are.

Oligarchic Capitalism

We start with what we call oligarchic capitalism. In these countries, all the power and the money are concentrated in the hands of a few. This is true in most Latin American countries, Russia, and in many African countries. Oligarchic capitalism is really bad capitalism. Why? Because in societies with both huge inequalities in income and major concentrations of power at the top, it is not surprising that growth is paltry. Simply, the oligarchs at the top don’t really care how rapidly incomes advance for the vast majority of their populations; of course, they don’t want people to starve, but beyond some low level of growth, the elites only care about what they can take home for themselves. Some oligarchic societies are lucky: they have a valuable natural resource such as oil. But that’s it, and the money from it flows right to the top and is not widely shared. Such societies have great difficulties diversifying into other sectors, especially those that depend on entrepreneurs. In addition, when wealth and power are highly concentrated, the elites at the top don’t want to share. No wonder then that in such societies you tend to see a high degree of “informality” — people living extra-legally — because the elites deliberately don’t want to let them into the formal system. They don’t want the competition.

State-Guided Capitalism

Our second category consists of state-guided capitalist economies. These are not communist societies because communism, by definition, means that the state owns all the means of production. In contrast, the defining feature of a capitalist society is one where production is still in private or group hands (as in China).

State-guidance has been practiced in economies where governments have thought that the best way for their economies to catch up to those on the “technological frontier” is to enlist the helping hand of the state, guiding resources to industries and firms that are believed to have the best chance of copying and out-competing firms on the bottom rungs of the economic ladders elsewhere (and then climbing up those ladders over time). Various tools are used in the process: state ownership of banks, tariffs, regulatory and zoning policy, to name just the most obvious. The Southeast Asian Tigers are probably the leading exemplars of successful state guidance (though other factors, such as high rates of saving and investment and vast improvements in education almost certainly have been more important). But state guidance does not work forever. Once you’re at or close to the technological frontier, you can’t rely on government bureaucrats to figure out what the next “great big thing” is. You eventually run out of creativity — and thus rapid growth — if your economy is going to be dominated by state guidance.

Big-Firm or Managerial Capitalism

Our third form of capitalism is big-firm or managerial capitalism. If you look around the world, this form is best found in Japan and Western Europe—economies that are overwhelmingly dominated by large firms, with “mom and pop” smaller firms operating at the margins. It is important to note that the so-called “small and medium size enterprises” or “SMEs” so celebrated in these economies are not necessarily “entrepreneurial” — because they largely replicate existing technologies rather than commercialize new products and services. For truly innovative companies, one has to look elsewhere: the United States, parts of India, Israel and Taiwan for example.

Managerial capitalism has its advantages, which is one reason why Europe and Japan were able to recover rapidly after World War II. Large enterprises can exploit economies of scale and have the capital to routinize research and development, and thus innovation. But the innovation that emerges from large companies generally is more incremental than radical, and this defines the limitations of managerial capitalism. There’s a reason why IBM, for example, did not birth Microsoft (although it was able to avoid extinction by successfully morphing from manufacturing into services). There are some exceptions to the big firm pattern — the Toyotas of the world, or Nokia (which turned itself into a cell phone company after being in the lumber business). But the exceptions prove the rule. If an economy is solely managerial, its growth inevitably will slow.

Entrepreneurial Capitalism

And so we come to entrepreneurial capitalism where fast-growing companies drive the economy. That’s us, or at least the way we were coming into the recession. But we were not always an entrepreneurial economy. Today we’re celebrated for having Silicon Valley and many other “hot spots” around the country with high tech. Yet this was not true in the 1950s coming out of World War II. In our book, we call the 1950s economy a “Galbraithan economy.” It’s an economy that was celebrated for big labor, big unions, big government and big firms. We don’t have that economy any more, a change we celebrate in our book. We owe the resurgence of rapid productivity growth in the United States in the 1990s and for much of this decade (until the recession) to the transformation of our economy into one characterized more by entrepreneurial capitalism than by managerial capitalism. We will need to sustain and strengthen that transformation if we are to keep our economy going after the current stimulus measures wind down and are eventually withdrawn.

Kauffman’s Studies on New Firm Formation

Entrepreneurs are vital to the economy not only because of the innovations they bring to the market, but also for the jobs they create. The Kauffman Foundation sponsored a study recently to look at the source of job growth in the United States since 1980. The conclusion is remarkable, or at least I believe it to be. Since 1980 until the recession, all net new jobs—net meaning gross jobs minus layoffs — have been created by firms under five years old. Think about that. That means all existing firms as of 1980 have not increased their employment since that year. In fact, if anything, the firms that existed in 1980, as a group, have lost employees. Using these data, we have made a rough estimate that at least 1/3 percent of our employment and a somewhat smaller fraction of our GDP since 1980 is due to young new firms that have since grown. These are amazing facts.

In the wake of the current financial crisis, one of the questions we hear is: Have we now turned from a good capitalist society to a bad one? Unfortunately, the United States now finds itself uncomfortably straddled among the entrepreneurial, the big-firm and the state-guided categories. We weren’t state-guided until about a year or 18 months ago, when our banks were forced to take government funds. And now, regrettably, our banking system bears an uncanny resemblance to the Chinese system of five years ago, before the Chinese privatized their banks at our behest to get into the World Trade Organization.

The ironies here are huge. And the changes are so sudden and so important that Carl Schramm and I are now in the middle of a writing a sequel to Good Capitalism, Bad Capitalism, one that will, among other things, reinvent the theory of growth going back to where Solow began, but seeing if maybe we can improve upon it.

To oversimplify, when economists model and think about economic growth, they do so in “aggregates.” The Solow growth model, for example, makes economic growth a function of an aggregate called capital, an aggregate called labor, and an aggregate called innovation. The policy prescription from all this is that, in order to get more growth, you treat the economy as if it were like baking a cake. If you want a bigger cake, then you add more ingredients: more investment, more people (or actually better trained people), and more R&D so you get more innovation, and then presto! Somehow, you get faster growth.

With all due respect, the founder of our foundation, being a very practical man, would have wanted more. He would have asked, “Where are the entrepreneurs in this economy and in these aggregates?” And Mr. Kauffman would have been right to ask this question because, as I said earlier, it’s the entrepreneurs who drive the aggregate variable we loosely label “innovation.”

So, to get at this point, Carl and I are now wrestling with this two-by-two matrix which we think helps illuminate thinking about growth. On one axis, companies are either high-growth or no or low-growth. On the other axis, we have young and mature firms.

GrowthNo/Low-Growth
MatureA few: IBM, Nokia, etcMost big firms; rent-seeking; bailout risk
YoungSweet spotMicro-Entrpreneurs

Now take a look especially at the bottom left box, which is our “sweet spot”: here we have the young, high-growth companies that drive the economy. They are the future Microsofts and Intels, and so forth. In the top left, we have the mature companies that are also still growing, but there are probably only a few of them. In the upper right-hand corner, you see low-growth mature firms, which are basically the Fortune 500. And then, finally, in the right-hand corner at the bottom, we have the micro entrepreneurs. These are your lifestyle businesses. For example, 10 percent of the American population is self-employed. Probably 98 percent of those people have what we call “lifestyle businesses.” These micro entrepreneurs don’t intend to grow, they’re not going to be the next Microsoft and thus drivers of economy-wide growth, but they are still important.

The next graphic scales the four boxes we have just illustrated by the number of firms that are in each box. So if you took all the firms in the economy, approximately 15 million firms, and you spread them out, you would find that most are on the right-hand side. They are in the low or the no-growth side. They’re old big firms or they’re micro entrepreneurs. Relatively speaking, there are few young high-growing firms and few mature growing firms.

Yet if we scaled those boxes by their impact on economic growth, we believe you get something like the third chart. To simplify, that chart illustrates that the job of our policymakers—and those in other countries as well — is to get more firms on the left-hand side, where the high growth firms are. I will candidly admit that I don’t have a good handle on what public policies will get us more mature, rapidly-growing firms. But if you want the answer, then I suggest you go to any of the top business schools which are trying to teach their students how to be disruptive intrapraneurs within larger companies.

At Kauffman, we believe that very few business schools, however, are teaching students how to start the young, high growth firms on the bottom left hand side sweet spot. Indeed, this may be something that business schools can’t teach. Among the things we’ve learned in our grant-making is that entrepreneurship on campuses is frequently best found outside formal classrooms, especially those outside business schools. One reason is that most successful entrepreneurs have liberal arts or engineering or science training, not majors in business. A second thing we’ve learned is that schools that connect would-be entrepreneurs to mentors, colleagues and sources of capital through formal or informal means outside the classroom seem to be having the most success nurturing future high-growth entrepreneurs.

One especially intriguing program, Launchpad at the University of Miami, was kicked off this year by one of its provosts, Bill Green. He had a novel, if obvious idea: He and others opened an “entrepreneur’s door” at the university’s career counseling office, and invited any undergraduate or graduate student to come in — for advice, mentoring, and connections. He enlisted the university’s alumni entrepreneurs and other experts in the region to help. The result? Magic. More than 700 kids have gone through the office and by end of the first year, more than 20 new businesses had been started. Many others are currently in gestation. The entrepreneur’s door has become a major new campus force. Launchpad’s success raises an obvious question: why isn’t there a similar program on every campus in America, at 4 and 2-year community colleges?

An Entrepreneur’s Visa

Policy makers can boost the numbers of high growth entrepreneurs with another obvious idea. Change our immigration laws to make it far easier for high-skilled immigrants to stay here and do what they disproportionately do best: create new high-growth companies that employ even more Americans. We know this from a major study we have commissioned — by Vivek Wadwha of Duke and Harvard — and from the extensive research of Berkeley’s Annalee Saxenian. Roughly 25% of successful high-tech start-ups over the last decade were founded or co-founded by immigrants, according to Wadwha. The immigrant share in California is even higher, finds Saxenian. So, despite the current political headwinds, it’s clearly time to begin handing out green cards to immigrants who receive undergraduate or graduate degrees from our universities in the so-called  
“STEM” fields — science, technology, engineering and math — since knowledge of these subjects is key to breeding more high-growth, innovative companies.

But suppose this sensible idea is not currently politically possible. Then here’s a good fallback: why not create an “entrepreneurs” — or more accurately, a “job creators” — visa? This renewable visa would go to immigrants who can show that they are employing at least one other individual.

Whatever we do on immigration, we need to move beyond the stale debate over the H1-B visa program, which lets in a limited number of technologically trained immigrants for short-term periods to work for American companies. This program has been highly controversial because software programmers and other IT professionals here in the United States complain that the H1-B immigrants take their jobs or force down their wages. That’s not the real issue. The H1-B program needs to be changed or abandoned in favor of a permanent high-skill or job-creators visa of the type I’ve just described because bringing over people here to do our IT work for just a short time wastes the chances that these individuals — who are more likely to start high-growth businesses than native Americans — will in fact be able to do that. It makes no sense to send these people home, when new high growth businesses are just what we need and they are disproportionately likely to start them.

The Federal Budget Deficit: A Major Fly in the Ointment

There is one major problem that further innovation is not likely to solve, however. And that is the long-term budget outlook of our federal government. The next chart, which I frequently call the “scary chart,” comes from the Congressional Budget Office. Although this version is two years’ old, a chart like it has been available for several years now, and with the recent stimulus package and the recession, an updated chart would look even worse.

The chart shows federal spending as a share of our gross domestic product of government spending for each of our major “entitlement” programs — Social Security, Medicare and Medicaid. The chart is depressing, to say the least. It shows that these three programs, as currently structured, eventually will wreak havoc with our national finances. The greatest problems are in the health care programs, Medicare and Medicaid, where costs continue to outpace inflation by 2-3 percentage points per year.

To put it bluntly, this chart shows policies that are unsustainable. We cannot expect foreign investors to continue doing what they have been doing — financing our large deficits — forever, especially as the deficits soar ever higher.

Of course, if by some magic, future health care innovations really “bend the cost curve” for medical care, the entitlement-driven budget problem would look less forbidding. But none of us can count on that magic bullet to bail us out of our budget predicament any time soon.

We need some common sense in Washington to bring these long-term deficits under control. Given their size, we cannot and should not rely on higher taxes to do the job — that would kill the innovation goose that lays the golden eggs for growth. Eventually, and I hope sooner than later, we will need to restructure the benefits under these entitlement programs. Realistically, those now receiving benefits or about to receive them will be untouched — because they vote in large numbers, and also as a matter of fairness, they developed their life plans under the expectations that the current benefits would be there.

But our kids, who will be richer than we are, still have time to plan their lives under a different, more affordable benefit regime. It’s a shame that our generation has left them this legacy. But the sooner we get to putting these entitlement programs on a sustainable footing for our kids and their kids, the stronger our economy will be, and the less prone it will be to the kinds of financial crisis that we have just lived through.

Conclusion

But let me conclude on a semi-optimistic note. Regardless of what policies Washington officials or our state and local leaders adopt, America will continue to need innovation — new ideas, new processes, and new products. And we will need the entrepreneurs who will bring these innovations to market and make them part of our everyday economic fabric. The genius of America has been that we have been successful in both these activities: thinking up and then applying new ideas to meet real world needs and problems. We will need all that genius and more in the years ahead.

Audio and video of lecture.

Of Related Interest

For essays, lesson plans, and other materials drawn from FPRI’s Project on Teaching the History of Innovation, visit www.fpri.org/education/innovation/

For the 1st Annual Rocco Martino Lecture on Innovation, featuring Paul Bracken on Technological and National Security, visit http://www.fpri.org/enotes/200806.bracken.innovationnationalsecurity.html

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