This post will cover chapters 8 and 9 of the Entrepreneurial State.
The first point the chapters make is that there is a disconnection between risk and return, contrary to what one would expect in a market. The chapter also rails against companies making huge profits, inequality, that disconnecting rewards from risk generates inequality, Apple not generating enough jobs, Apple generating not good enough jobs, and Apple’s executies earning too much relative to Asian workers who manufacture the iPhones, corporations evading taxes via loopholes, etc. This isn’t directly used in the argument, it seems, but generates the view that the actual system unfairly distributes rewards. (My saying this does not imply that it is totally fair). Given that this posts deals with ethics, I will be making ethical judgements. I assume no particular moral theory, and I’ll argue in the basis of thought experiments, analogies, and relatively common sense moral beliefs.
As usual in this post series, both for efficiency (that is, I’m lazy), and because I want you to see what is actually said in the book, verbatim, here are some extracts from the relevant chapters:
While in finance it is commonly argued that there is a relationship between risk and return, in the innovation game this has not been the case. Risk taking has been a collective endeavour while the returns have been much less collectively distributed. Often, the only return that the State gets for its risky investments are the indirect benefits of higher tax receipts that result from the growth that is generated by those investments. But given the presence of different types of tax loopholes and the fact that tax receipts often do not accurately reflect the source of earnings (e.g. income vs. capital gains), taxes have proved a difficult way for the State to get back its return for innovation investments. And indeed, even if taxes derived from Statebacked innovations were collected properly, it is not clear whether the amount would be enough to fund the innovation investments that characterized Silicon Valley, which will always imply colossal failures for every big hit, like the Internet – that is simply the nature of the truly uncertain innovation process.
There is indeed lots of talk of partnership between the government and private sector, yet while the efforts are collective, the returns remain private. Is it right that the National Science Foundation did not reap any financial return from funding the grant that produced the algorithm that led to Google’s search engine (Block 2011, 23)? Can an innovation system based on government support be sustainable without a system of rewards? […]
In theory, the socialized generation and privatized commercialization of biopharmaceutical – and other – technologies could be followed by a withdrawal of the State if private companies used their profits to reinvest in research and further product development. The State’s role would then be limited to that of initially underwriting radical new discoveries, until they are generating profits that can fund ongoing discovery. But private sector behaviour suggests that public institutions cannot pass the R&D baton in this way. […]
they do not realize that corporations are making money from innovation that has been supported by their taxes. Meanwhile, these taxpayer-propped corporations are neither returning a significant portion of the profits back to the government nor investing in new innovation (Mazzucato 2010).
It will be argued that industrial and innovation policy must include redistributive tools in order to justify the ‘entrepreneurial’ investments required by the State – tools able to cover the inevitable losses (as failures are part of the trial and error process), but also to replenish the innovation fund which is necessary for the next round of innovation. […]
What is uniquely apparent in the case of Apple, however, is that the company’s executives and shareholders are not the sole (nor largest) bearers of the risk that was part of developing innovative products such as the iPod, iPhone and iPad. Rather – as told in detail in Chapter 5 – the success of these technologies is overwhelmingly due to the foresight of the US government in envisioning radical innovation in the electronics and communication fields going back to the 1960s and 1970s. It was not Apple executives nor its shareholders who rose to the challenges associated with the risks involved in basic science and technology investment. When no one else stepped up to the plate to take on the challenge, it was the US government, mainly the military, that dared to risk striking out and in the end, hit the home runs. Apple incrementally incorporated in each new generation of iPods, iPhones and iPads technologies that the State sowed, cultivated and ripened. […]
While it is evident that the success of products like the iPhone and iPad has provided handsome rewards for Apple, it is difficult to determine whether the US government has managed to recuperate its investment. […]
The fact that some of the businesses that have benefitted most from large public investments are the same that have lobbied for tax reductions that have significantly reduced the public purse should open eyes and lead to policy changes – the subject of Chapter 9. […]
Ignoring how such innovation depended greatly on State-funded radical components, and denying the State its reward (via taxes, and as argued in Chapter 9, in more direct ways as well) will not help future shiny apples to emerge.
Many people correctly highlighted the financial crisis and subsequent bailouts as proof that we were operating an economy that socialized risk and privatized rewards of economies in a manner that enriched elites at the expense of everyone else. The bailouts highlighted the financial sector as a potentially parasitic drain on the economy that we are forced to accept. In the financial sector, banks have sliced risk so finely, traded it, and cashed it in so many times that their share of profits far outstrips those of the ‘real economy’. Financial firms have grown to such incomprehensible sizes and embedded themselves so deeply into the global economy that they could be described as ‘too big to fail’; many fear that regardless of their recklessness, their essential survival ensures that the next time their hubris peaks they will get bailed out by the State (bankrupting the State in the process). Fairly or not, they are positioned to win on the upside, and also on the downside. The fact that interest rates are counted in GDP as a ‘service’ rendered for the sector’s intermediation of risk should be revisited now that we know who assumes the real risk. Interest in this sense is purely rent, usury. […]
What is needed is a functional risk–reward dynamic that replaces the dysfunctional ‘socialized risk’ and ‘privatized rewards’ characterizing the current economic crisis and evidenced in modern industry as well as finance. The right balance of risk and rewards can nurture – rather than undermine – future innovation and reflect its collective nature through a broader diffusion of the benefit. […]
The logic here is that shareholders are the biggest risk takers since they only earn the returns that are left over once all the other economic actors are paid (the ‘residual’ if it exists, once workers and managers are paid their salaries, loans and other expenses are paid off, and so on). Hence when there is a large residual, shareholders are the proper claimant – they could in fact have earned nothing since there is no guarantee that there will be a residual (Jensen 1986; for a critique see Lazonick 2012). Or so goes the theory.
Shareholder-value ideology is based on this notion of shareholders as the ‘residual claimants’ and thus the lead risk takers with no guaranteed rate of return (Jensen 1986). This argument has been used to justify shareholdwers’ massive returns (Lazonick 2007; Lazonick and Mazzucato 2013). Yet this framework assumes that other agents in the system (taxpayers, workers) do have a guaranteed rate of return, amongst other things ignoring the fact that some of the riskiest investments by government have no guarantee at all: for every successful investment that leads to a new technology like the Internet, there are a host of failed investments – precisely because innovation is so uncertain. But reducing the ability of the State to either collect tax, or to receive its fair share from the returns, hurts its future ability to take such risk – a matter to which I turn to in the next section.
Most importantly, identification of who bears risk cannot be achieved by simply asserting that shareholders are the only contributors to the economy who do not have a guaranteed return – a central, and fallacious, assumption of financial economics based on agency theory. Indeed insofar as public shareholders simply buy and sell shares, and are willing to do so because of the ease with which they can liquidate these portfolio investments, they may make little if any contribution to the innovation process and bear little if any risk of its success or failure. In contrast, governments may invest capital and workers may invest labour (time and effort) into the innovation process without any guarantee of a return commensurate with their investments – and without guarantee that they will be ‘bailed out’ (or not laid off) in case of failures. For the sake of innovation, we need social institutions that enable these risk bearers to reap the returns from the innovation process, if and when it is successful. […]
The critical point is the relation between those who bear risk in contributing their labour and capital to the innovation process and those who appropriate rewards from the innovation process. As a general set of propositions of the risk–reward nexus, when the appropriation of rewards outstrips the bearing of risk in the innovation process, the result is inequity; when the extent of inequity disrupts investment in the innovation process, the result is instability; and when the extent of instability increases the uncertainty of the innovation process, the result is a slowdown or even decline in economic growth. A major challenge is to put in place institutions to regulate the risk–reward nexus so that it supports equitable and stable economic growth. […]
To achieve this it is essential to understand innovation as a collective process, involving an extensive division of labour that can include many different stakeholders. As a foundation for the innovation process, the State typically makes investments in physical and human infrastructure that individual employees and business enterprises would be unable to fund on their own, both because of the high amount of fixed costs that investment in innovation requires and also because of the degree of uncertainty that such investment entails. The State also subsidizes the investments that enable individual employees and business enterprises to participate in the innovation process.
In Lazonick and Mazzucato (2013), we build a risk–reward nexus framework to study the relationship between innovation and inequality – which is nested in a theory of innovation. We ask: What types of economic actors (workers, taxpayers, shareholders) make contributions of effort and money to the innovation process for the sake of future, inherently uncertain, returns? Are these the same types of economic actors who are able to appropriate returns from the innovation process if and when they appear? That is, who takes the risks and who gets the rewards? We argue that it is the collective, cumulative and uncertain characteristics of the innovation process that make this disconnect between risks and rewards possible. […]
Given the commonly accepted relationship between risk and return in finance theory, if the State is so important to funding high-risk investments in innovation, it should follow that the State should earn back a direct return on its risky investments, Such returns can be used to fund the next round of innovations, but also help cover the inevitable losses that arise when investing in high-risk areas. So rather than worrying too much about the State’s in/ability to ‘pick winners’, more thought should be dedicated to how to reward the wins when they happen so that the returns can cover the losses from the inevitable failures, as well as funding new future wins. Put provocatively, had the State earned back just 1 per cent from the investments it made in the Internet, there would be much more today to invest in green tech. Many argue that it is inappropriate to consider direct returns to the State because the State already earns a return from its investments, indirectly via the taxation system. Such an argument assumes, however, that the taxation system already draws revenue ‘fair and square’ from multiple sources and by extension, that tax expenditures reflect the best possible configuration of support for economic growth. The reality is, however, that the tax system was not conceived to support innovation systems, which are disproportionately driven by actors who are willing to invest decades before returns appear on the horizon. […]
Then there are some of her policy proposals, but that’s not the topic for today’s post.
Attempting to derive a cogent argument from the above leads us to the following. I ignore most of the angry paragraphs about inequality, workers, and wages. Along this series, the focus is on innovation, its causes, costs, and benefits. Also, to make this even worthy of considering, I’ll asume that the State has truly played the role Mazzcato assigns to it, something I’ve criticised elsewhere.
- In markets there is, and ought to be, a relation between risk and reward
- There is no such thing in innovation: corporations reap the rewards, while most risks are taken by the State
- To bring about the correlation, the government should reap more rewards, and corporations less rewards
Suppose I try to climb the Everest naked. And succeed. Where are muh rewards?
The above absurdity, firstly, reveals why premise one of the argument is mistaken. There is nothing intrinsic to risk that makes you deserve any reward. In fact, the notion of desert itself is morally suspicious, but that’s another matter. Doing something risky does not give you the moral right to claim any reward. The reason there is a correlation, a tendency, in markets, to align risk and reward is the logic of profit maximization. If you can pick 1000 pounds now, or a 0.1% chance of 1 billion pounds, and that deal is offered to a lot of people, you’ll see the correlation. In markets, firms try to reduce their cost of capital and increase their rates of return. Sometimes, the way to do this is taking bets (risks) like the above. One example is investing in R&D. If there were a lot of riskless opportunities to make great profits, those would most probably be already taken. Sometimes opportunities arise, and people who don’t take risks at all get rich, but that’s rare. Equally, if it were not for the great rewards that risky activities give access to, there would be little profit-oriented investment towards them.
States don’t work that way, they don’t care about profits, mostly. True it is that some State actions take into account cost-benefit analysis (not the same as being subject to the logic of the market, but better than nothing). But in R&D, if Mazzucato is to be believed, the State carries out the R&D it carries out because under cost-benefit analysis it is not rational to carry it out (Yes, she does say that “This is why you have to be a bit ‘crazy’ to engage with innovation… it will often cost you more than it brings back, making traditional cost–benefit analysis stop it from the start.” (TEE) ).
Furthermore, States supposedly carry out innovation that is not privately profitable, but socially so: this is the core market failure argument (Again, with qualifications, only around 50% of State R&D spending can be justified via market failure considerations, according to the Handbook of the Economics of Innovation). If it were possible for the State to appropiate the full returns of R&D investments and use the earnings to fuel more innovation in the same way a corporation does, a private corporation could also do this in the first place. The reason the State does not appropiate its returns is that it is providing a public good. Duh! In theory, States could regain investments through taxation and economic growth, though, but Mazzucato criticises this elsewhere in the book, saying that it is not enough,
Secondly, once one understands the above, premise two is also suspect. It is true that corporations profit using innovations that come from the government. They also profit from old discoveries, analysis of competitor’s products, and academic research (the part that is not funded by the government). But those transactions are generally made via mutual consent. Researcher A agrees to sell, or donate if she wishes, technology or research B to corporation C for a price P. And done. If P is 1000 and the corporation is able to extract thousands of time more than P as profit, there is no problem there. (Remember what we said about risky bets). The researcher, after she has sold or donated her research or technology, is entitled to nothing, just because that’s the terms of the deal she agreed to. In the case of governmens, the relevant agencies decide a policy for licensing their technology, and that policy can consist of freely handing out research precisely to encourage others to profit from it and deliver products. It’s subsidising the private sector, but that’s precisely the aim of said policy. The risk-reward imbalance is a feature, not a bug, of State innovation policy as presently envisioned.
Thirdly, the conclusion doesn’t just follow. Another possibility to avoid socialising costs and privatising rewards via socialising rewards is privatising costs. That is, reducing State R&D spending, or charging corporations whenever they want to purchase technology or research from State-funded institutions. But again, this defeats the basic market failure rationale, and implicitly the Mazzucatian one. If the State can fully get its rewards, so can corporations, and the State is not necessary in the process. Plus, the State does not really need all that money to invest. Shares of R&D investment across time tend to be constant, and are just a small amount of government expenditures. Keeping R&D at 3 or 4% is perfectly possible without the State appropiating anything it does at all.
Finally is an additional problem besides flirting with an outdated Labour-like Theory of Value (Where hard work merit rewards), that she sees corporations not as groups of people literally minding their business without harming others, in general, but as part of a national economy, to be planned and designed so as to serve society. If corporations do something the public, or Mazzucato, doesn’t think benefit society, they should be forced to do so. This amounts to boss people around -corporations, as per the Soylent Green Principle, are made of people- treating them as means to an end. Surely sometimes consequences can justify doing something like this, but for that you need pretty strong evidence for your cost-benefit analysis, and we don’t quite have that to critise Apple’s large chest of profits, or their policies. There are arguments by Murphy, Nagel, Sunstein, and Holmes saying that private property is just something for the State to decide. Some even claim that the economy is really a big governmental program, and that there is no problem in it being managed as such. I won’t say much to justify this here, but curious readers can go to Huemer (2014) or Brennan (2004) for a rebuttal to these arguments.
To be totally fair to Mazzucato, let’s also review her published research on this, to see if she has stronger points to defend her position.
The first one is co-authored with William Lazonick: The risk-reward nexus in the innovation-inequality relationshp: who takes the risks? Who gets the rewards? (2013)
They argue that innovation is collective, and that there are some individuals who situate themselves at key points in the innovation process as to reap huge rewards. They also say,
By embedding our analysis in the collective, cumulative, and uncertain characteristics of the innovation process, we can ask who contributes labor and capital to the process and who reaps the financial rewards from it
Do you even TFP, bro? (How comes that only labour and capital count for productivity?
Our explanation is based on how some actors position themselves along the process of innovation to extract more value than they create, whereas others get out much less than that which they put in. The power to engage in such excessive value extraction does not occur through “exchange” relationships in which the contributions of some economic actors are “undervalued” by the market. Rather it occurs when certain economic actors gain control over the allocation of substantial business organizations that generate value, and then use product or financial markets on which the enterprise does business to extract value for themselves.
we claim that the increasingly financialized economy has created incentives for companies to not invest themselves in human capital and innovation while increasingly depending on those investments to come from elsewhere—mainly the public sector but also from niche “small” firms. State investments and subsidies that are supposed to support and encourage innovation often only serve to permit companies to get off the hook of making these risky investments themselves even as their executives deliberately make no mention of State support. Indeed, they invoke “free market” ideology to claim that, having taken all the risks, “private enterprise” needs to reap all the rewards
They then criticise the idea the it is shareholders, as owners of capital, the ones who take entrepreneurial risk, as they are the ones without a guarantee stream of income:
But even when, as in Knight’s original argument, it is admitted that business judgment is a factor in leading an entrepreneur to confront uncertainty in the business world, it is assumed that the risk of investing in a business enterprise remains in the hands of one particular type of individual—the “entrepreneur”—while it is market processes, not business organizations, that determine whether these investments yield financial returns. By ignoring the collective and cumulative—or “organizational”—character of the innovation process, Knight’s notion of entrepreneurial profits ultimately prepared the way for the Chicago School application of agency theory to corporate resource allocation in which the shareholder is substituted for the entrepreneur as the only economic actor in the corporation who makes a contribution without a guaranteed market-determined return, and is hence the only bearer of risk (Jensen and Meckling, 1976; Jensen, 1986). It then follows (as we discuss later in the text) that, of all participants in the corporation, it is only shareholders who have a claim to the “residual” (i.e. profits) if and when it occurs. For the sake of maximizing the residual, according to this highly influential view of the economic world, corporations should be run to “maximize shareholder value” because, in a market economy, it is only shareholders who take risk (for critiques, see Lazonick and O’Sullivan, 2000; O’Sullivan, 2000) Once we recognize the collective character of the innovation process, it becomes evident that it is not only, or even primarily, entrepreneurs or shareholders who bear risk. For high fixed cost investments in physical infrastructures and knowledge bases that have the character of public goods, it is generally the government (representing the collectivity of taxpayers) that must engage in this strategic confrontation with uncertainty (Mazzucato, 2011; 2013). In effect, the government assumes part of the risk that households and businesses would not be willing to bear if they had to invest in the innovation process on their own. Moreover, within business enterprises, workers, and not just financiers, bear risk when they exert effort now with a view to sharing in the future gains from innovation if and when these gains materialize. The exertion of this effort on the part of individual workers is critical to the process of organizational learning that is the essence of the innovation process. This learning generally requires the organizational integration of a complex hierarchical and functional division of labor within the firm and often across vertically or horizontally related firms. Besides being uncertain, the innovation process is therefore collective, and it is the collectivity of taxpayers, workers, and financiers who to different degrees bear the risk of innovative enterprise. […]
While I don’t agree corporations should just maximize shareholder value, and I agree that innovation is a collective process, it is totally wrong to say that the State takes risks in the same way individuals do. What risks? Barren wars and long term societal change, States won’t just disappear because they fail in their investments, investors at least lose money. They can extract taxes. If we are to use Lazonick and Mazzucato’s concept of desert, the State deserves nothing, given the origin of it funds, and the little hard work it takes for such an organisation to achieve a given end. What merit is there in taking societal wealth and plunging it into one activity or another? You could argue that it is useful, but not that it it meritorious, and therefore not a basis for desert. They do have a point when they say that workers also take risks when they expect to share future rewards. They may work extra-hard now with that expectation, and receive or not a reward. However, there is a key difference between workers in a firm and shareholders. Workers have a contractually set wage that they can expect, and all the extra effort they want to put it doesn’t take place in a market place, but inside a firm. Firms do not necessarily work internally like markets (if they fully did, they wouldn’t exist). It is an interesting topic of study the relation between workers, their effort, and their wages, overtime inside a single firm. This probably requires a highly reductionist framework, following individual workers, and studying individal firm. Shareholders, on the other hand, are not entitled to anything at all. The market does not owe them anything, that is. They can succeed or fail. Workers can choose to do just what is written on their contracts, or go beyond that, but they know that what they are entitled to is what they agreed to. Therefore, the only ones who cannot chose not to be exposed to risk are really shareholders qua shareholders (others can be exposed to risk, if so they wish). The algorithm to see who is is making risky investments is to see if there are contractual guarantees of profit, what the usual result of investments is in that sector (If every investment succeeds, there is no risk, if most fail, there is), and of course, that someone is doing investments. Taxpayers aren’t. They are just sources of money for the government, and government doesn’t do risky bets: every investment the government decides to do it will do, because it needs not fear costs being greater than benefits.
Workers who had the expectation of reaping returns through a career with a company may be laid off by profitable companies, perhaps with their jobs offshored to low wage areas of the world. What taxpayers and workers lose, financial actors (including top executives) often gain (Lazonick, 2013a). […]
And is it wrong that money that workers in poorer areas benefit instead of workers in richers areas?
Indeed, it can be argued that public shareholders generally do not risk their capital by investing in the innovation process. First, insofar as public shareholders simply buy and sell shares on the stock market, they invest in outstanding shares that have already been capitalized. They do not invest in the innovation process. Second, they are generally willing to hold shares because of the ease with which they can liquidate these portfolio investments, and as a result bear little if any risk of success or failure of an innovative investment strategy. It is only those shareholders who actually commit their capital to the innovation process, through the generation of higher quality products at lower unit costs that yields returns, who risk their capital on the success or failure of the innovation process […]
They do. If you buy a share, you have no guarantee it will keep its value. First, what a shareholder does when buying a share is taking the place of a previous investor who was in turn risking her capital. At a given moment in time, all shares must be held by someone. If you have a share, and no one wants to buy it from you, you cannot escape and regain the money you used to buy it. In the same way, I could argue (wrongly) that those who buy shares that have been newly emitted aren’t really contributing anything. How so, if they are handing their money directly to the corporation? Well, because the shares reflect the value of the corporation itself. The corporation does not create the value of the shares ex nihilo: shareholders estimate what that value is, and market mechanisms price the shares accordingly. What happens there is a trade of a liquid asset (money) for other asset (a stake in the company, a slice of its estimated value). Similarly, if I go and buy a share, I exchange a liquid good (money) for a less liquid good (a share). Shares are negotiable, but not very liquid. You can buy and sell them, but when everyone wants to sell them, you are screwed. Liquid goods are highly demanded consumption goods, and their related financing via short term commercial paper, that will remain liquid except if people suddenly stop liking the final goods en masse (and that rarely happens).
As it is explained here (in Spanish), capitalists have three main functions: deferring their consumption to finance investment, picking successful investment, and concentrating risks. That is, workers can consume all of their income (a shareholder has wealth tied to the capital, and she would require to sell it for income), they need not think about in which company to invest (they just do they assigned job), and if she is fired, she loses her job, but not her wealth. Since this services are valuable, they would arise even when beginning from a world of perfect equality, just because different risk aversion profiles, and different consumption patterns.
In contrast, it can be argued that taxpayers and workers often invest their capital and labor in the innovation process without a guaranteed return. When the State makes early high-risk investments that enable businesses to create a new industry, the State does not have a guaranteed return on that investment. When workers provide time and effort to the innovation process beyond that required to reap their current pay, they generally lack a guaranteed return on that investment. From this perspective, the agency-theory argument that shareholders are the only economic actors who invest in the economy without a guaranteed return may serve as an ideology for those who claim to be representing the interests of public shareholders to appropriate returns that, on the basis of risk-taking, should be distributed to taxpayers and workers. In a world dominated by MSV ideology, we contend that a major source of inequality is the ability of economic actors to appropriate returns from the innovation process that are not warranted by their investments of capital and/or labor in it. Indeed, we argue that by diminishing the incentives and even the abilities of certain economic actors (taxpayers and workers) to contribute to the innovation process, the inequality that derives from misappropriation in the RRN can undermine the innovation process itself. The collective character of the innovation process provides a foundation for inclusive growth; the participation of large numbers of people in the innovation process means that inherent in the innovation process is a rationale for the widespread and equitable distribution of the gains to innovation. These gains from innovation can either be reinvested in a new round of innovation or, alternatively, distributed to stakeholders as returns to labor or capital. Insofar as government agencies have used public funds to invest in innovation, the State has a claim to a share of the returns to innovation if and when they occur. As we discuss in the conclusion of this article, the exercising of these claims can take the form of special levies on those business enterprises that make the most use of, or gain the most from, government investments in innovation […]
Taxpayers do not contribute at all to the innovation process qua taxpayers. From the point of view of the State, they are pasive cattle for the State to extract rents from. Most taxpayers are totally unaware of what the government spends the money on, let alone how innovation works. Workers do play a role in that, but it is up to firms to implement incentive schemes to foster innovation within them.
The State does not have a claim to the returns of information, except to what others have agreed to give it. And the State has historically chosen not to take anything in return. Why? Partly lobbying, yes, but also because that is a way to subsidise innovation in the private sector.
Particularly, in the US stock repurchases, justified by MSV ideology, have functioned as a mode of value extraction that generally undermines investment in innovation (Lazonick, 2013a, b). […]
Here we see again the problem with their view: Shareholders are people who invest and own the company. Of course they want to extract value, and if they want to sacrifice innovation for more short term rewards, they are entitled to it. Opposing to this view is one in which companies are part of a societal scale governental program -the market- and that they have to play the role assigned to them. We already discussed this above. For data on short termism, see this.
From this perspective, so-called rent-seekers are engaged in value extraction. They insert themselves strategically in exercising control over the returns from the innovation process, extracting a share of returns from the expanding economic pie that is in excess of their contribution to the process that generated that expanding pie. In doing so, they—i.e. top executives, venture capitalists, Wall Street bankers, hedge fund managers—make the claim, explicitly or implicitly, that they are the risk-takers who were responsible for making the contributions to the innovation process that justify their high returns […]
The proponents/beneficiaries of these institutional mechanisms extol the virtues of a “free market” economy. Yet, it is organizations, not markets, that create value in the economy. Historically, well-developed markets are the result, not the cause, of economic development that is driven by organizations in the forms of supportive families, innovative enterprises, and developmental states (Lazonick, 2003, 2011). Well-developed markets in inputs and outputs can enhance the ability of the possessors of capital and labor to extract value. But markets do not create value. Any economy requires both the creation (i.e. production) and extraction (i.e. distribution) of value. For example, whenever a worker gets paid a wage he or she extracts value. […]
Duh! Organizations and markets, and States, and families are people. It is their subjective valuations that create value. It is their voluntary interactions -in a market-that generate wealth. Without markets, actually, there can be no capital, for capital is precisely the market value of a bunch of assets (normally the capitalised future rents that can be extracted from the asset). Markets have always existed, and people traded in them as tribes, or as individuals, guilds, States, corporations, etc. What drives innovation and growth are not organisations. Organisations are more of a result, and markets can’t be, beacuse they’ve always been there. The Industrial Revolution wasn’t caused by the appearence of the Corporation, it was the Corporation that appeared because it was advantageous for people to band togethar that way. It is also true that the appearece of an organisation affects the market. A market populated by corporations may behave differently than an inter-tribe market.
In effect, we will be arguing that people like Mark Zuckerberg of Facebook, one of the world’s richest people with the company’s IPO in May 2012, or John Chambers of Cisco, who as CEO had total remuneration of $12.9 million in 2011 and $662 million from 1995 through 2011, have used financial markets to extract far more value than they create. In making this argument, we are not criticizing these individuals per se but rather a set of institutions that, while enabling, and even extolling, the ability of these individuals to extract value, fails to recognize the relation between risks and rewards that creates value. […]
An IPO capitalizes value gains that have been generated collectively by all the actors in the innovation “eco-system”—and hands those gains to a tiny group who often were not the original innovators or risk-takers but who nevertheless are currently positioned to appropriate much or all the profit. […]
The problem with these holistic arguments is that, even if they were right, prove too much. I am using the English language. Suppose I earned anything from this blog. Do I therefore owe anything to past and present anglophones for keeping the language alive? Or suppose I am doing math. Do I owe money to the hypothetical descendence of Leibniz? Or if I buy a book, do I therefore owe anything to Guttenberg? Of course not. Beyond tolerance and respect, you owe others what you promise others you owe them (via contracts, for example). Suppose the some decades ago, the US Government had told Apple that if their profits increase beyond a certain amount, that amount will belong to the government. Had Jobs and Wozniak agreed, then Apple would ower the government that. But it didn’t happen that way. They argue that it should be this way, because it works better. Fine. We can argue about how well that works, but in common sense morality, debts don’t occur the way they say they occur (retroactively).
Since the early 1980s in Silicon Valley, by far the most dynamic industrial district for high-tech startups, tens of thousands of venture capitalists, founders, top executives, and early-stage employees have become multimillionaires. Although these actors no doubt played a part in the IT revolution, the rewards that they gained are disproportionate to the actual risk they took. Indeed, as already mentioned, venture capitalists in particular have been adept at entering “late” in the development of different sectors, after most of the real uncertainty and risk was absorbed by the public sector, yet making gains that could only be justified if they had been the ones that had risked the most. Instead, it appears that their real genius was when to hop on the bandwagon of investments made by others […]
Well, what do you expect venture capitalists to do if the government is churning out innovation? Why should they make riskier bets if there is an entity already taking them? You could argue that were not for the government, those risky gets would never get made in the first place. I want an argument for that.
Companies such as these are usually presented as “sui generis” private-sector success stories, whose CEOs deserve their mega-wealth because they took great personal risks in pursuit of daring visions that captured major new industries for the United States. A set of socially devised institutions related to corporate governance, stock markets, and income taxation have permitted this concentration of value extraction in a few hands. […]
They don’t deserve it (But then, almost no one deserves anything), but probably they are entitled to it. Are they rewarded according to productivity? That could be resolved by looking at the literature. Some reasoning here. Some evidence here, and here.
The risk is transferred to market makers who are backed by investment banks, which, we now know, are underwritten by government. In effect, through NASDAQ, the profits of innovation have been privatized and its risks socialized (Ellis et al, 1999). […]
As I said before, don’t socialize profits: Privatize losses!
In the United States, it has been particularly this insistence on the part of the venture capital community that they need low tax rates to induce them to make risky investments that has deprived the State of return to its investments in technology commensurate with the risks it has taken. […]
So? Are States losing revenue they could use to fund innovation and so they can’t fund more innovation? Look at statistics of State R&D spending and see that they haven’t moved that much, as a % of GDP, and that they have either stayed the same or grown in absolute terms.
I am not impressed. I do agree that there are troubles with the financial sector, but that should be cured striking directly at the root: the current monetary system. A free banking system would greatly diminish this bank subsidising, too big to fail, mess. Unfortunately, almost no one seems to be discussing that, not even to criticise it. Talk is concentrated on regulating and fixing, not overhauling the entire system.
Her other paper, co-authored with Lazonick and Tulum, Apple’s changing business model: What should the world’s richest company do with all those profits (2013), they rehash the arguments made in the book and in the already mentioned article, adding that financialisation leads to a decrease in innovation. I have not addressed not yet read information on financialisation and impact on corporate performance, but it seems implausible, given how private and publicly traded corporations behave. They predict the end of innovation for Apple, yet two years later, they have continued improving their products, packing more power into their systems, and there is already speculation of the newest product: the Apple Car. Surely this is anecdotal evidence, but other evidence, such as R&D as percentage of revenue also point in the nice direction.
In conclusion, no one owes governments anything for their research efforts, as they don’t generally ex-ante arrange it that way. The holistic arguments they try to put forward fail. But there is a more interesting question: Should future governmental efforts be rewarded with profit sharing? Or: What are the best policies to foster innovation? This will be the topic for a future post, dealing with Mariana’s policy recommendations.
NOTE: I’m no Apple fan. I’ve never bought or plan to buy an Apple product. I like tinkering with my software, and their products are overpriced given my value scale.