The Value of Everything (UK)

by Mariana Mazzucato

  This chapter takes a critical look at the innovation economy and the stories around it. It explores how the dominant narratives about innovators and the reasons for their success fundamentally ignore the deeply collective and cumulative process behind innovation. This failure to recognize these processes has in turn led to a problematic distribution of the rewards for innovation, and to policies which, in the name of innovation, have enabled a few companies to extract value from the economy.

  Value extraction in the innovation economy occurs in various ways. First, in the way that the financial sector – in particular venture capital and the stock market – has interacted with the process of technology creation. Second, in the way that the system of intellectual property rights (IPR) has evolved: a system that now allows not just the products of research but also the tools for research to be patented and their use ring-fenced, thereby creating what the economist William J. Baumol termed ‘unproductive entrepreneurship’. Third, in the way that prices of innovative products do not reflect the collective contribution to the products concerned, in fields as diverse as health, energy or broadband. And fourth, through the network dynamics characteristic of modern technologies, where first-mover advantages in a network allow large economies to reap monopolistic advantages through economies of scale and the fact that customers using the network get locked in (finding it too cumbersome or disadvantageous to switch service). The chapter will argue that the most modern form of rent-seeking in the twenty-first-century knowledge economy is through the way in which risks in the innovation economy are socialized, while the rewards are privatized.

  WHERE DOES INNOVATION COME FROM?

  Before looking at these four areas of value extraction, I want to consider three key characteristics of innovation processes. Innovation rarely occurs in isolation. Rather it is by nature deeply cumulative: innovation today is often the result of pre-existing investment. Innovation is, moreover, collective, with long lead-times: what might appear as a radical discovery today is actually the fruit of decades of hard work by different researchers. It is also profoundly uncertain, in that most attempts at innovation fail and many results are unexpected. (Viagra, for instance, was initially developed for heart problems.)

  (i) Cumulative Innovation

  If there is one thing that economists agree on (and there are not many), it is that technological and organizational changes are the principal source of long-term economic growth and wealth creation. Investments in science, technology, skills and new organizational forms of production (such as Adam Smith’s emphasis on the division of labour) drive productivity and long-term increases in GDP. Building on the work of Marx, who highlighted the role of technological change in capitalism, Joseph Schumpeter (1883–1950) is probably the economist who has most emphasized the importance of innovation in capitalism. He coined the term ‘creative destruction’ to describe the way that product innovations (new products replacing old) and process innovations (new ways to organize production and distribution of goods and services) caused a dynamic process of renewal but also a process of destruction, with old ways falling aside and in the process causing many companies to go bankrupt. Schumpeter was particularly fascinated by ‘waves’ of innovations, which he believed occurred every thirty or so years. While Marx’s interest in technological change led him to look at the crises that capitalism would experience due to the effect of innovation on capital’s ability to create surplus value (or, to put it another way, if machines replace labour, how will the exploitation of labour – the source of profits – occur?), later economists focused mainly on the positive side of innovation that Schumpeter had underscored: its role in increasing the productive capacity of national economies.

  In 1987 Robert Solow, a professor at the Massachusetts Institute of Technology, won the Nobel Prize in Economics for showing that improvements in the use of technology explained over 80 per cent of economic growth. Following many before him who were readers of Schumpeter, Solow argued that economic theory had to better understand how to describe technological change.2 Practising what they preached, they explored what forces drive technological change. But where does innovation come from? Is it lone entrepreneurs working in their garages, genius scientists having a eureka moment in the laboratory, heroic small businesses and venture capitalists struggling against the commercial odds? No, they concluded that inventions are overwhelmingly the fruits of long-term investments that build on each other over years.

  To take one obvious example: innovation in personal computers, which replaced clunky mainframes, came after decades of innovation in semiconductors, in memory capacity and in the box itself (reducing the size of mainframes to much smaller units). Individual companies such as IBM were key to the introduction of personal computers in the late 1970s and 1980s. But there would have been little innovation without the contribution to that lengthy process of other actors, such as the US government’s investment in semiconductor research and its procurement power in the 1950s and 1960s. Or, later, the investments made by the US government in the Internet, or that made by companies like Xerox Parc – itself a beneficiary of large amounts of public co-funding – in the development of the graphical user interface, which Steve Jobs later made use of in Apple’s first Macintosh, Lisa.

  (ii) Uncertain Innovation

  Innovation is uncertain, in the sense that most attempts to innovate fail. It also can take a very long time: decades can pass from the conception of an idea to its realization and commercialization. The types, sources and magnitude of risks vary across technologies, sectors and innovations. Technological risks, for instance, can increase with the complexity of the target (e.g. going to the moon, solving climate change) or the paucity of knowledge within the organizations involved.3 The longer the time required to devise certain solutions, the greater the chance of a competitor reaching the market first, establishing what are known as first-mover advantages. Additional risks that militate against recouping the initial investment or the viability of the business include spillover effects (an event brought on by an apparently unrelated event elsewhere); the lack of demand for goods even if they make it to the market; investors’ exposure to labour or tax problems; and changing economic conditions. These are all reasons why an appetite for risk – in both the public and private sectors involved in innovation – is essential.

  Yet contrary to the prevailing image of fearless, risk-taking entrepreneurs, business often does not want to take on such risk. This is especially the case in areas where a lot of capital is needed and the technological and market risks are high – pharmaceuticals, for instance, and the very early stages of sectors, from the Internet to biotech and nanotech. At this point the public sector can, and does, step in where private finance fears to tread, to provide vital long-term finance.

  (iii) Collective Innovation

  Understanding both the role of the public sector in providing strategic finance, and the contribution of employees inside companies, means understanding that innovation is collective: the interactions between different people in different roles and sectors (private, public, third sectors) are a critical part of the process. Those who might otherwise be seen as lone entrepreneurs in fact benefit from such collectivity; moreover, they stand on the shoulders of both previous entrepreneurs and taxpayers who, as we will see, often contribute to the underlying infrastructure and technologies on which innovation builds.

  Such processes are evident in the technologies underpinning some of today’s most ubiquitous products: the iPhone, for instance, depends on publicly funded smartphone technology, while both the Internet and SIRI were funded by the Defense Advanced Research Projects Agency (DARPA) in the US Department of Defense; GPS by the US Navy; and touchscreen display by the CIA. In the pharmaceutical sector, research has shown that two-thirds of the most innovative drugs (new molecular entities with priority rating) trace their research back to funding by the US National Institutes of Health. Meanwhile, some of the greatest advances in energy – from nuclear to s
olar to fracking – have been funded by the US Department of Energy, including recent battery storage innovations by ARPA-E, DARPA’s sister organization. Both Bill Gates, CEO of Microsoft,4 and Eric Schmidt, Executive Chairman of Alphabet (the parent company of Google),5 have recently written about the immense benefits their companies gained from public investments: as well as the Internet and the html code behind the worldwide web written in CERN, a public lab in Europe, Google’s very algorithm was funded by a National Science Foundation grant.

  The collective role of innovation can be seen not only in the cooperation between public and private but also in the role that workers play. Countries that have a more ‘stakeholder’ approach to corporate governance, many of which are to be found in Northern Europe, tend to involve workers more directly in the innovation process and to train them through well-developed vocational programmes: worker skills are most heavily invested in; they contribute more, and thereby are more able to share in the rewards that their work generates. When trade union representatives sit on the boards of companies, they are more likely to demand that any sacrifices in wages are compensated by higher investments in areas that eventually create more and better jobs. And countries with a more stakeholder-driven economy are more likely to embrace the kinds of public and private collaborations that are required for value creation: the strength of German manufacturing, for instance, is closely related to the strong links between science and industry fostered by public-private organizations like the German Fraunhofer Institutes.6

  An understanding of the uncertain, collective and cumulative characteristics of innovation is helpful to understand both value creation, as indicated above, but also value extraction. There are four key ways in which value extraction occurs in the innovation economy. The first is to be found in the economy’s interaction with the financial markets.

  FINANCING INNOVATION

  Given the lengthy and cumulative process of innovation, understanding which actors enter the innovation process, how they do it and at what point is key. In Figure 30 we can see how financial returns to innovation evolve through the innovation process. In the early days returns are low due to the very high risks; then, if the innovation proves successful, returns increase, often exponentially, before flattening out. This cumulative process is shown through a cumulative distribution curve. But it’s also true that who is doing what changes over that time period. In the very early days it is often public R&D agencies or universities that fund the science base, and only when innovation is close to having a commercial application do private actors enter. Public R&D agencies include organizations like DARPA and ARPA-E and even public sources of early seed money for innovative firms often tend to precede private venture capital. These include public venture capital funds (like Yozma in the Israeli government); the funding of small enterprises linked to public procurement programmes (such as the Small Business Innovation Research Programme in the USA); or through innovation funds inside public banks like the European Investment Bank, the KfW in Germany or the Chinese Development Bank. Evidence shows that it is only after these high-risk patient funds have been invested that the more risk-averse private financial funds enter, for example private VC.7

  Figure 30. Cumulative returns for innovation

  In the case of venture capitalists, their real genius appears to lie in their timing: their ability to enter a sector late, after the highest development risks had already been taken, but at an optimum moment to make a killing. While many such investments fail, the few that succeed can make the investment fund in question a fortune, as exemplified by the success of the VC company Kleiner Perkins. In 1976, Kleiner Perkins invested $100,000 in the biotechnology company Genentech, which four years later, during its initial public offering on the stock market, was valued at $300 million. In 2009, Genentech was acquired by a Swiss-based healthcare company, Roche, for $47 billion, making a fortune for the investors. Similarly, Peter Theil’s $500,000 investment in Facebook back in 2004, which bought him a 10.2 per cent stake in the company, made him £1 billion when he sold the majority of his shares in 2012. These early investors are doubtless crucial to the innovation process. The critical question here is: are their rewards proportionate to the risks they take?

  You might imagine, in the instances where public funds have made the initial risky investments – the private VC only entering at the point where investment looks more of a sure bet – that these funds would receive appropriate remuneration for their boldness. But in fact, the opposite is true. In these cases, the private VC industry’s share of the rewards tends to be about 20 per cent, excluding other fees and charges; by contrast, the public sector’s direct share is close to nil. The public sector is generally deemed to reap its rewards in other, more indirect ways: through taxation or from the benefits of products with high quality and low cost. Not only is this a way of thinking that all but ignores the crucial and risky early investments made by public funds in innovation; it disproportionally privileges the later, private investors in terms of rewards.

  Let’s look at this a bit more closely.

  VC – Timing is All

  The VC industry began in the USA in 1946 when the American Research and Development Corporation (ARD) was set up to raise funds from wealthy people and college endowments to invest in entrepreneurial start-ups in technology-based manufacturing. It was soon making eye-catching investments. In 1957, ARD invested a total of $70,000 in DEC, a computer company; nine years later, this same investment was already valued at $37 million. Nevertheless, the VC industry’s growth was sedate until the 1980s, when it boomed, the role of pension funds upboosting its capital.

  From the start of the VC industry, entrepreneurs and venture capitalists had often surfed on a wave created by decades of government investment. Starting after the Second World War, government investment in high-tech ventures grew significantly in the 1950s as part of the military-industrial complex, largely due to the Cold War.8 Before becoming famous around the world as ‘Silicon Valley’, a name coined in 1971, the San Francisco Bay area was producing technology for military use or, from the 1960s, spin-offs of military technology for commercial purposes.9 The first formal VC firm in Silicon Valley – Draper, Gaither and Anderson – was headed by two former US Army generals and the author of a secret report to President Eisenhower on how the US should respond to the USSR’s launching of Sputnik.10

  Much of the work to commercialize military technology was done in the research labs of established ICT companies like General Electric, Texas Instruments, AT&T, Xerox and IBM. Employees of these companies left to found their own start-ups. The Small Business Investment Company, set up in 1958 by the government’s Small Business Administration, itself founded in 1953, helped many of the start-ups to raise capital.

  The establishment in 1971 of NASDAQ – a new stock market that did not have the stringent listing requirements of the New York Stock Exchange – complemented the government’s programmes. The creation of a highly liquid national market for more speculative corporate securities was important for attracting venture capitalists to invest in the IT industry, secure in the knowledge that there was now a feasible exit route from their investments.11 Venture capitalists typically look to exit from investments within three to five years, impatient to make a buck in one enterprise and start again elsewhere.

  In 1972, the Silicon Valley VC industry began to coalesce at 3000 Sand Hill Road in Palo Alto; a year later the National Venture Capital Association (NVCA) was formed. The NVCA quickly became an influential lobby. By the early 1980s it persuaded Congress to halve capital gains tax rates, arguing that it would be an incentive to greater VC investment. Warren Buffett became a lead critic of this policy, admitting that he and most investors don’t look at tax, they look at opportunities.12 Indeed, the VC industry, from when it began, followed the opportunities created by direct ‘mission-oriented’ government investments in areas like the Internet, biotech, nanotech and cleantech.

  As we saw in Chapter 5, another
crucial success for the NVCA came when it persuaded the US government to relax the interpretation of the ‘prudent man’ investment rule (keeping pensions funds out of high-risk investments) to allow pension fund managers to invest up to 5 per cent of pension funds in riskier investments like VC ones. It meant that, from 1979 onwards, large sums of workers’ pensions savings flowed into VC funds – funds on which venture capitalists typically received a management fee of 2 per cent of total volume, as well as 20 per cent ‘carried interest’ of profits (i.e. the share of the profits that go to those managing the funds), like private equity.13

  In 1984, during a tour of Silicon Valley by the then French President, François Mitterrand, the discrepancy between the venture capitalists’ newfound bullishness and their actual achievements was picked up in an exchange between Paul Berg, one of the winners of the Nobel Prize in Chemistry that year, and Tom Perkins (the co-founder of Kleiner-Perkins) boasting about his sector’s role in biotech. Berg said: ‘Where were you guys in the ’50s and ’60s when all the funding had to be done in the basic science? Most of the discoveries that have fuelled [the industry] were created back then.’14 For the venture capitalists, however, the prospect of astonishing profits now lay before them. Nothing summed up this new spirit of enterprise better than the upstart company that went public the same year: Apple.15