Oiling the Innovation Machine

President Obama was right to highlight the role that innovation plays in strong economies. Innovation and business success are closely linked. Established companies that do not innovate will lose market share to competitors that do. High-growth start-ups are built upon innovations that they want to force into the marketplace.

Yet, while everyone says they want more innovation, words are easy. The tough, practical questions remain: How do we get more innovation and how do we harness it? That is the challenge we face.

Let’s consider the broader ecosystem for innovation.

A Free-Market Innovation Machine

The economist William Baumol described a healthy, thriving system of capitalist enterprise as a kind of “free-market innovation machine.” When it is operating smoothly, it cannot help but create innovations that raise living standards over time. So it’s worth studying how the machine operates.

That machine has several components. At its center are large, thriving corporations, often multinational in scope. These big firms develop enormous markets and establish platforms for innovative devices and business practices.

Consider a company such as Wal-Mart, which used innovations in information technology and supply management techniques to revolutionize global retailing.

Or think of Minnesota-based 3M, which makes everything from Post-It Notes to digital imaging equipment. Its engineers are making advances in material and other sciences and developing new products that scale to become multi-million dollar or billion dollar businesses.

Or take Microsoft, Intel and AT&T, the software and telecommunications giants. These firms cultivate and accumulate the human and industrial capital required to satisfy rapidly advancing global demand for information services. In these cases, size really does matter.

Some critics of capitalism think big companies are not drivers of innovation. Large ­firms trend toward oligopoly or even monopoly and thus, it is alleged, are to be feared and restrained.

However, as Baumol’s research has shown, thriving markets need “oligopolistic competition among large, high-tech business ­firms, with innovation as a prime competitive weapon, ensuring continued innovative activities, and, very plausibly, their growth.”

Indeed, he notes that in some of these markets featuring large companies, “innovation has replaced price as the name of the game.” Within this competitive framework, even large companies must continue to push new innovation or else they will decline.

And large businesses are uniquely able to provide a crucial market for entrepreneurs creating new tools and innovations for the enterprise sector. As AEI economist Alan Viard has noted, “economies of scale enable large firms to purchase more sophisticated capital.” This fact helps explain how big companies drive innovation, and how this in turn prompts them to “hire more skilled workers who receive higher wages,” Viard says.

Small Fries, Big Impact

Silicon VAlley's start-up culture is justifiably famous, but start-up energy can be found elsewhere.

Turn to history for a moment. Long before Silicon Valley was something other than a sleepy bedroom community, cities like Detroit, MI, Rochester, NY, Dayton, OH, Cleveland, OH and many others were looked to by the rest of the nation as start-up hubs the way the Valley is today. And today there are thriving entrepreneurial colonies in Boulder, CO, Austin, TX, and Jacksonville, FL.

Capital Markets

America's varied capital markets also play a critical part in the innovation ecosystem. When large firms need to invest to create products or services to satisfy enormous market demand, they can turn to America's vast pools of investment capital.

Likewise, when small firms need risk capital to develop an innovative idea, they can turn to America's venture and angel investment communities, or to local banks and credit unions.

All genuine innovation results from the discovery of new knowledge. This new knowledge can come in many forms – it could be novel ways of arranging inputs that become a new technology; or it could be new ways of managing, motivating, and utilizing labor.

This process of knowledge discovery doesn't just happen by itself, however. Robust capital markets play an important role in making these discoveries possible.

Capital markets facilitate trade and mobilize resources in new ways. They enable a process of trial-and-error discovery that leads to new business practices, new industrial techniques, and innovative enterprise activities. They propel an ongoing process of dynamic knowledge discovery that is at the heart of the innovation machine.

America's capital markets are a tremendous national asset and an indispensible driver of innovation. Although they are easy to overlook when we think about innovation, they in fact provide the fuel of the innovation machine.

Entrepreneurial Culture

When we think of harnessing innovation, we must pay special attention to America’s business and entrepreneurial culture.

By its nature, culture is hard to define. We can define a big company with hard data, such as its market capitalization or total revenues; or a small firm by its number of employees; or capital markets by bank assets or the number of annual IPOs. Yet, how do we define culture?

While specific metrics are hard to come by, an innovative culture will be recognizable by several characteristics:

  • It will be open to change.

  • It will embrace risk.

  • It will be tolerant of failure (indeed, it will acknowledge that failure is a part of progress).

  • It will be at the technology frontier.

America has been fortunate to have a culture long hospitable to innovation. Among the many reasons for our culture is that our nation was founded by immigrants – and is perpetually renewed by them.

Think of the character of a person who chooses to migrate: they accept the hazards of moving to a strange new place; they risk their own private capital and resources to move a long distance; and they accept that there is no guarantee of ultimate success and comfort.

This embrace of the unknown and the untried is essential to innovation. It is hardly surprising then that a “nation of immigrants” would generate a culture that makes innovation an imperative.

The Role of Government

What is the role for government in the innovation cycle? Government can be a force for good or a net negative. It’s important that policy makers know the difference and act accordingly.

Government can be a significant force for advancing innovation in at least two key ways. First, it can support basic scientific research. This support advances the total stock of knowledge upon which new innovations are built.

For example, I recently visited a series of information and life sciences companies in Silicon Valley and the broader Bay Area. At several biotechnology firms, it was clear just how important the National

Institutes of Health and other government agencies have been in advancing life science over the last two generations. These advances, prompted over decades by government research budgets, then become critical tools used by scientists and engineers in the private sector to develop innovative new treatments, drugs, medicines, and devices for the healthcare marketplace.

Second, government must establish good rules of the road upon which the private sector operates and flourishes. These include establishing the rule of law, enforcing contracts, protecting intellectual property, maintaining peace and security, building critical infrastructure, and maintaining a sound and stable currency. These are no small tasks, and to be done well require the talents and hard work of many of those who work in the public sector.

Fostering Innovation

Given the nature of the free-market innovation machine described above, how can we foster innovation to improve the future?

The role for government is to act as a lubricant, oiling the innovation machine. That comes in the form of supporting basic research as opposed to targeted and politicized investment.

The recent episode with now-bankrupt firm Solyndra demonstrates that the government’s comparative advantage is not in picking new industrial winners and losers, but instead in fostering elementary research.

Government must stick to basic investment. Economist Michael Mandel notes that it is useful to think of the federal budget as having an investment budget. The dip in investment relative to GDP in recent years is cause for concern, and Mandel rightly argues it should certainly be higher than it was in the 1980s and 1990s.

The innovation machine’s gears are also lubricated when the government establishes and maintains a predictable system of fair rules and regulations. If the government is seen to act capriciously, or is hyperactive with respect to tax and regulatory policy, this can gum up the gears.

Here, there’s room for improvement. Economists Scott Baker, Nicholas Bloom, and Stephen Davis recently created a “policy-related economic uncertainty” index in order to “estimate its dynamic relationship to output, investment, and employment.” Their index “reinforce[s] concerns that policy-related uncertainty played a role in the slow growth and fitful recovery of recent years.”

The private sector can play its role in the innovation machine by competing fiercely. To do this companies must attract top talent, train their workers, respond quickly to changing customer demands, adopt and develop new technology that boosts efficiencies and creates wealth, deploy risk capital in the interests of shareholders, and expand into new markets.

Innovation as a National Imperative

There is a moral imperative to innovation that is worth keeping in mind. Innovations do more than raise living standards and make society wealthier, although that is certainly good. As Harvard University’s Benjamin Friedman has put it, rising living standards shape “the social, political, and ultimately moral character of a people.”

“Economic growth,” he says, “more often than not fosters greater opportunity, tolerance of diversity, social mobility, commitment to fairness, and dedication to democracy.”

In a recent e-book called “Launching the Innovation Renaissance,” Alex Tabarrok of George Mason University summarized the issue well. “The United States and the world face many challenges in this new century,” he wrote. “We do not know how to solve the challenges we face. But we need not be daunted. Tough problems are often identified before solutions and solutions identified only after problems have been solved. We faced many challenges in the 20th century and even so the world grew faster in that century than in any previous. Innovation is the universal solvent.”

In this way, innovation and subsequent economic growth are a national imperative.