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Contents 1 Chapter 1: Entrepreneurship and Growth: A Missing Piece of the Puzzle 1.1 What Drives Economic Growth? 1.2 Plan for the Rest of the Book 1.3 Concluding Thoughts 2 Notes

[edit] Chapter 1: Entrepreneurship and Growth: A Missing Piece of the Puzzle

The most astonishing thing about the extraordinary outpouring of growth and innovation that the United States and other economies have achieved over the past two centuries is that it does not astonish us. Throughout most of human history, life expectancy was about half what it now is, or even less. We could not record voices or speech, so no one knows how Shakespeare sounded or how “to be or not to be” was pronounced. The streets of the greatest cities were dark every night. No one traveled on land faster than a horse could gallop. The battle of New Orleans took place after the peace treaty had been signed in Europe because General Andrew Jackson had no way of knowing this. In Europe, famines were expected about once a decade and the streets would be littered with corpses, and in American homes, every winter the ink in inkwells froze.

Today we can create paintings on our laptop computers, put the artwork on a Web page, and quickly receive comments about it from all over the globe. There are two toy-like vehicles driving over the terrain of Mars, analyzing its surface materials and sending back crystal clear motion pictures in color. But after the initial awe and enthusiasm, this ongoing interplanetary research merits only brief notices on the inside pages of our newspapers. For the average citizen, the most plausible explanation of how these things work is that they are acts of magic, yet we have come to take such technological innovations for granted.

Economic growth has been equally astounding. It is estimated that the purchasing power of an average American a century ago was one-tenth what it is today. A moment’s thought will make you realize what a significant change has occurred in an individual’s economic circumstances over the past few generations. Suppose you were accustomed to receiving the income of an average American today, and suddenly nine-tenths of it were confiscated. We cannot imagine what our mode of living would then be like. Similar calculations can be made for other countries that have grown remarkably fast in recent years: India, China, much of Southeast Asia during the past two decades and, of course, both Western Europe and Japan since the end of World War II.

The fact is that never before in human history has there been anything like the economic progress that citizens of these countries have been privileged to witness and enjoy. The current most critical long-term economic issue for the world is how this performance can be sustained in the wealthiest countries and how it can be transplanted to societies where much of the population lives in abject poverty. To find an answer to these questions, it is necessary to investigate what is different about the economies that have already achieved this spectacular success.

In the past couple of decades, after a long spell of inattention, there has been a resurgence of interest in this topic among economists claiming to have some of the answers. (We will express our skepticism about some of their work in a later chapter.) Of course, we certainly do not pretend to have the “silver bullet” answer to what causes differences in economic growth rates among countries and over time, but we do believe we can contribute to the inquiry by focusing on the overall structure of economies (capitalist economies in particular) that could explain some portion, perhaps a good portion, of the variation. In particular, we will pay special attention to the set of rules and institutions that provide the incentives for entrepreneurs to work unceasingly for the creation, utilization, and dissemination of new products and productive techniques. Indeed, we will argue that these incentives prevent the entrepreneurs in key sectors of different economies from resting on their laurels, forcing them to start planning their next innovative campaign even before the current one has reached its conclusion.

By “entrepreneurs” whom do we mean? The term is commonly used to refer to anyone who starts a business. This definition counts the numbers of self-employed persons and new business starts, regardless of what the business does. Throughout this book, we will use the term in a narrower and, we believe, more significant manner: as any entity, new or existing, that provides a new product or service or that develops and uses new methods to produce or deliver existing goods and services at lower cost. As management guru Peter Drucker has pointed out, “not every new small business is entrepreneurial or represents entrepreneurship” (Drucker, 1965, 21). He (and we) prefer the definition that Drucker attributed to the nineteenth-century French economist Jean-Baptiste Say, noting that the term: “was intended as a manifesto and a declaration of dissent: the entrepreneur upsets and disorganizes.” Joseph Schumpeter (the great twentieth-century economist who celebrated the role of the entrepreneur) coined the famous term “creative destruction” to describe the entrepreneurial process. As Drucker paraphrases Schumpeter’s analysis: “[the] dynamic disequilibrium brought on by the innovating entrepreneur, rather than equilibrium and optimization, is the ‘norm’ of a healthy economy and the central reality for economic theory and economic practice” (Drucker, 27). Or, Drucker puts it more bluntly: “Entrepreneurs innovate. Innovation is the specific instrument of entrepreneurship” (Drucker, 30).

By focusing narrowly on what might be called “innovative” entrepreneurs, we admittedly give short shrift to the many more “replicative” entrepreneurs—those producing or selling a good or service already available through other sources—who are found throughout capitalist economies. Eighteenth-century English writer Richard Cantillon had replicative entrepreneurs in mind (although he probably didn’t know it at the time) when he referred to “wholesalers in Wool and Corn, Bakers, Butchers, Manufacturers and Merchants of all kinds who buy country product to work them up and resell them gradually as the Inhabitants require them” (Cantillon, 1931, 51). To be sure, replicative entrepreneurship is important in most economies because it represents a route out of poverty, a means by which people with little capital, education, or experience can earn a living. But if economic growth is the object of interest, then it is the innovative entrepreneur who matters; hence our focus on that form of entrepreneurship throughout much of this book. Put differently, entrepreneurship—as we use the term—is not to be confused with “small business” or even many new businesses.

We recognize, of course, that no economy can be fully successful with entrepreneurs alone. Many such firms will be too small to realize economies of scale. And there is a long distance between what may be the germ of a radical, but useful, idea generated by an entrepreneur and a commercially useful product that is sufficiently affordable and reliable to induce many consumers to buy it. For this reason, the most successful economies are those that have a mix of innovative entrepreneurs and larger, more established firms (often two or more generations removed from their entrepreneurial founding) that refine and mass-produce the innovations that entrepreneurs (and, on occasion, the large firms themselves) bring to market. When we speak of “entrepreneurial economies” at various points in the book, we are referring to this blend of the two types of firms.

[edit] What Drives Economic Growth?

To some readers perhaps unfamiliar with much economic writing what we have presented so far may seem obvious. After all, growing economies seem to thrive on new things—new cars, new products, new services. But look through any basic economics textbook and you’ll find precious little discussion, let alone analysis, of the entrepreneurs who think up and commercialize many of these new things. In more advanced textbooks and articles, one will find extensive, usually highly mathematical discussions of what determines economic growth. But here, too, entrepreneurship, and the accompanying necessary role of larger firms, is rarely mentioned. ^[1] Nobel Laureate Ronald Coase put it well when he observed: “The entities whose decisions economists are engaged in analyzing have not been made the subject of study and in consequence lack any substance. The consumer is not a human being but a consistent set of preferences. The firm, to an economist, as Slater has said, ‘is effectively defined as a cost curve and a demand curve, and the theory is simply the logic of optimal pricing and input combination’ (Slater, 1980, ix). Exchange takes place without any specification of its institutional setting. We have consumers without humanity, firms without organization, and even exchange without markets” (Coase, 1988, 3).

Instead, economists generally focus on two main sources of growth: (1) the addition of more inputs (capital and labor), and (2) innovation, technological change, or, in technical economic terms, “total factor productivity” (the increase in productivity of both capital and labor, considered together). For simplicity, one could call these two different strategies growth by “brute force” and “smart growth.” Robert Solow of MIT won his Nobel Prize in economics for showing in the late 1950s that in the United States and a few other industrialized countries, innovation or “smart growth” was more important than brute force (more inputs) in generating additions to output over time (Solow, 1956, 1957). A number of scholars have since confirmed this basic insight and extended it to many countries around the world (see Denison, 1962, 1967; and Easterly and Levine, 2001).

But what is innovation, beyond something new? As we (and others) use the term, it is the marriage of new knowledge, embodied in an invention, with the successful introduction of that invention into the marketplace. Even the best inventions are useless unless they have been designed, marketed, and modified in ways that make them commercially viable. This requires someone who realizes the commercial opportunity presented by the innovation (or even a seemingly small element of the breakthrough), which sometimes is not the purpose the inventor had in mind, and then takes all the steps necessary to turn that opportunity into something many consumers will want to buy. These tasks are inherently entrepreneurial, an insight we will return to repeatedly throughout this book.

So what determines innovation? In Solow’s model, innovation is like manna from heaven, something that policy makers largely cannot control. Although they may modestly influence it by way of government-funded research or incentives for research and development, the pace of innovation is essentially taken as a given. A growing number of economists have been uncomfortable with that assumption, and over the past two decades they have put much effort into a better explanation of innovation’s role in economic growth. These researchers, using increasingly sophisticated statistical methods, have posited a range of other variables that influence innovation, some of which governments can control (like openness to goods and investment from abroad, spending on research and development, and training of more scientists and engineers), and others of which governments cannot control (like geographic location). We discuss these efforts in chapter 3.

We do not take the position that these factors are unimportant, because many or most of them are. Instead, we suggest that it is more useful to pare down (economize, if you will) the list of suggestions that societies should implement by thinking of economies as potential “growth machines,” which need fuel to operate but which also must have some essential primary parts or components that work in harmony if they are to promote entrepreneurship, innovation (and its dissemination), and growth most effectively. The “fuel” for an economy is the right set of macroeconomic policies: essentially, prudent fiscal and monetary policies to keep inflation low and relatively stable and to prevent economic downturns (or even worse, financial crises) from derailing progress toward growth in the long run. We realize that maintaining macroeconomic stability is far from easy. Indeed, it is the focus of much, if not most, of the attention political leaders give to economic policy. But by definition, economic growth is a longrun phenomenon, and so the much greater challenge is to design and implement policies that foster growth in the long run.

We believe that policy makers are most usefully served by having a relatively simple framework for achieving this objective. Not a ten-point list, such as the so-called Washington Consensus list of reforms, or even longer lists of policy prescriptions, which we discuss in chapter 3. The danger in long lists is that they are too easily ignored by busy policy makers, who generally operate under the intense pressure of competing interest groups and have the energy and political capital to concentrate on only a few major endeavors at a time. The other extreme, the search for a single silver bullet answer to the growth problem, is equally dangerous. Economic systems are complicated, and no single policy prescription, even if followed to the letter, is likely to be sufficient to ensure rapid, sustainable growth over the long run.

We attempt to strike a balance between these extremes in concentrating on four factors or conditions that we believe are most important in contributing to long-run growth for all capitalist economies, but especially for those at the “technological frontier,” where future progress requires continued innovation more than it does mere replication. We flesh these out in greater detail in chapter 4 but give a brief preview here so readers can keep them in mind before proceeding further. The factors should be understood as forming the bare blueprint of a well-oiled growth machine—the “big picture” that busy policy makers can keep in mind when considering more detailed initiatives or programs.

We also limit our attention to growth-enhancing conditions for capitalist economies, or those that at least to some degree allow private ownership of property and reward individuals and firms for serving consumer needs. Although we discuss in some detail in chapter 5 different models of capitalism—and elevate one of them, “entrepreneurial capitalism,” above all the rest—the various models differ sharply from the central planning that governed much of the world (the Soviet Union, Eastern Europe, and China) from the end of World War II until the fall of the Berlin Wall in 1989. History has shown that central planning cannot deliver high and rapidly improving standards of living and we therefore will not consider it (even though central planning lives on in a few dark corners of the world, notably Cuba and North Korea).

Our four elements of a well-oiled economic growth machine, the successful entrepreneurial economy, are the following:

1. First, and perhaps quite obviously, in the successful entrepreneurial economy, it must be relatively easy to form a business, without expensive and time-consuming bureaucratic red tape. As a corollary, abandoning a failed business (that is, declaring bankruptcy) must also not be too difficult because, otherwise, some would-be entrepreneurs may be deterred from starting in the first place. A reasonably well-functioning financial system must also exist, one that channels the funds of savers to the users of funds, entrepreneurs in particular. And the importance of flexible labor markets cannot be overstated: if entrepreneurs cannot attract new labor, they cannot grow, nor will they want to grow if labor rules are overly restrictive (especially if rules limit the ability of firms to fire nonperforming workers or shed workers they no longer need).
2. Second, institutions must reward socially useful entrepreneurial activity once started; otherwise individuals cannot be expected to take the risks of losing their money and their time in ill-fated ventures. Here, the rule of law—property and contract rights in particular—is especially important.
3. Third, government institutions must discourage activity that aims to divide up the economic pie rather than increase its size. Such socially unproductive (though, in a sense, entrepreneurial) activities include criminal behavior (selling of illegal drugs, for example) as well lawful “rent-seeking” behavior (i.e., political lobbying or the filing of frivolous lawsuits designed to transfer wealth from one pocket to another).
4. Finally, in the successful entrepreneurial economy, government institutions must ensure that the winning entrepreneurs and the larger established companies (which were launched at some earlier time by entrepreneurs) continue to have incentives to innovate and grow, or else economies will sink into stagnation. The ostensible importance of effective antitrust laws here comes to mind, but we place greater emphasis on openness to trade (which works automatically and without the long lead times inherent in legal antitrust enforcement).

We suspect that there will be a great temptation among some readers to ask: What about this, or what about that? Why shouldn’t some other things be on the list? For example, one obvious challenge is from those who believe, as does David Landes of Harvard, that growth is primarily about culture: that some societies have hard-working, enterprising people, and other countries do not. And that those countries with hard-working, enterprising cultures (the United States, much of Europe, Japan, much of Asia, and most recently, India) grow rapidly, while those countries without that culture (much of Africa and Latin America) grow much less rapidly or not at all (Landes, 1999).

We recognize that culture plays a role, but it is—and, indeed, cannot be—the sole factor explaining economic success. If it were, then why have so many Indians, Russians, and some other expatriates been so successful economically outside their home countries, while many others left behind struggle to support themselves and their families? It is not just “self-selection”— that is, expatriates are successful elsewhere because they are the most enterprising to begin with (as demonstrated by their willingness to risk it all by leaving their home countries). The countries they left behind have struggled because their institutions have impeded progress (even in India, the home of the “information technology outsourcing” revolution, where plenty of rules still drag down other parts of that economy).

Or what about the role of geography and the notion that in some countries near the equator the heat makes it impossible for individuals to work hard and exposes them to disease, or that countries that are landlocked have excessive transportation costs and cannot easily trade with the rest of the world? Jeffrey Sachs has placed great emphasis on these factors as determining, or inhibiting, growth (Sachs, 2005). As with culture, there may something to this line of argument. But then there are the counterexamples. If being at the equator is the economic kiss of death, how then does one explain the spectacular economic success of Singapore or the somewhat less stellar but still impressive performance of Thailand? If being landlocked condemns a country to backwardness, how does one explain the remarkable economic record of Switzerland, which is so landlocked by mountains on all sides that it has used its unique geography in the past as a symbol of its neutrality?

And what about education or, as economists antiseptically label it, “human capital”? As we will discuss in later chapters, virtually every theoretical model and empirical test of economic growth assigns a major role to the presence of an educated workforce. We do not dispute the importance of some degree of education for growth but do not single it out as having a unique role for creating an entrepreneurial society or economy, for a simple reason: context matters. Before the Berlin Wall fell (and even since), the countries belonging to the former Soviet Union and many of the Eastern European countries boasted some of the most successful primary, secondary, and even higher-level educational systems in the world. But these systems were embedded in a political and economic atmosphere—socialism or communism—that was the very antithesis of entrepreneurship (admittedly, there was innovation, particularly in military technology and space exploration in the U.S.S.R., but these were the exceptions that prove the rule).

To be sure, an educated workforce can provide a huge boost to entrepreneurship when some or all of the other factors just listed are also present, within a capitalist setting. Highly educated individuals are more likely to come up with cutting-edge entrepreneurial businesses, especially in an increasingly high-tech world. In addition, countries where basic education is widespread can be vital for supplying the human capital that entrepreneurs can draw on to grow their ventures.

Finally, what about democracy? Is it not essential for growth, or as others have claimed, is some degree of autocracy first necessary to enable countries to reach a certain level of development, after which democracy becomes more or less inevitable? These are hotly contested questions, and although the verdicts are still out, our view of the evidence, such as it is, is that democracy certainly can contribute to growth, especially in entrepreneurial economies, but is not essential for this to occur. The growth “miracles” of Southeast Asia, and more recently China, attest to the latter proposition. At the same time, the evidence does not support the view that autocracies are essential for growth; in fact, even among less developed countries, democracies grow faster than countries ruled by autocrats.

The list of “what abouts” certainly goes on, and we will not dwell on all possible permutations in this opening chapter. Suffice it to say that when we examine the various theories and empirical studies of growth in greater detail in chapter 3, we find them wanting, indeed, even crying out for something else. That “something else,” we submit, consists of the four basic elements of the successful growth machine we have identified and will later elaborate.

[edit] Plan for the Rest of the Book

We flesh out the above propositions and others in subsequent chapters. In chapter 2 we will address the threshold question: why should countries, or their populations, care about economic growth in the first place? This is a seemingly obvious and innocuous question, but as we suggest in the chapter, a number of critiques of growth have been mounted in recent years. We rebut them, and more, in chapter 2.

In chapter 3 we will tackle the key question: what determines economic growth? We don’t provide all the answers—after all, that is what the rest of the book is about, and yet neither we nor anyone else has reason to be sure of the answer. But in chapter 3, we outline what, up to now, economists interested in the growth process have theorized and tested. As we have already suggested, we believe the answer to the growth puzzle so far has hardly been fully answered.

In chapter 4, we begin to fill in what remains of the puzzle by advancing some very different views about what capitalism looks like. Since the Berlin Wall fell and communism pretty much has disappeared (except in a few countries), it is understandable that many assume that, at least with respect to economic systems, capitalism has won the ideological “war.” More important, subsumed in this view is the assumption that capitalism is monolithic— that it is defined by the private ownership of property and businesses, and little else. In chapter 4 we advance and describe in some detail four different conceptions of capitalism: state-guided, oligarchic, big-firm, and entrepreneurial. These archetypes are starkly drawn and few are prevalent in a pure form in any one country. Nonetheless, societies tend to have economic systems that at any one time are predominantly one of these forms or another. As a gross overgeneralization, developing countries tend to be state-guided or oligarchic. Developed economies tend to be characterized either exclusively by big-firm capitalism or a mix of big-firm and entrepreneurial capitalism. A key point in chapter 4 and subsequent chapters is that, at some point, if and when economies approach the technological frontier and the living standards of rich countries, the only way to ensure that they will remain there is to adopt some blend of big-firm and entrepreneurial capitalism. Furthermore, other countries that have not achieved this level of economic success could benefit from having entrepreneurial features during their transitions toward faster growth.

In chapter 5, we outline what we submit are four key ingredients for building and maintaining the mixed form of capitalism we believe is ideal. Three of those preconditions are important for promoting productive entrepreneurship; the fourth is aimed at ensuring that the winners of the entrepreneurial race keep innovating. We also address the role of the “what about” subjects just mentioned—culture, geography, finance, education, and democracy, among others—and examine whether and to what extent each is unique to either big-firm or entrepreneurial capitalism or, ideally, to a blend of the two.

What steps should developing countries, currently far from the technological frontier, take to move toward the right blend of capitalism, the one we advocate? That is the question we explore in chapter 6. It is not easy to answer because it requires the right mix of economics and politics. The answer is further complicated by the fact that the developing world encompasses many countries at different stages of development, each with its unique culture and historical circumstances.

In chapter 7, we examine two parts of the world—Japan and Western Europe—that are the exemplars of big-firm capitalism and where, only two decades ago, it looked as though per capita incomes would exceed those of the United States. Indeed, Americans were nearly panicked at the thought, although what seemed to concern the United States even more were the large trade deficits that it then had with these two parts of the world. In fact, those deficits, just like the current trade deficits, primarily reflect fundamental macroeconomic imbalances in the United States economy and have essentially nothing to do with relative living standards in different countries, or with the more important question taken up in this book: how close are the economies to the technological frontier (with per capita income being one way to measure that closeness).

In any event, as Japan and Western Europe approached the U.S. living standard, something happened. Their economies stalled (Japan’s much more than Europe’s), while productivity growth in the United States took off, jumping from an annual rate of 1.5 percent between 1973 and 1975 to 2.5 percent between 1995 and 2000, and then really kicking into high gear over the next four years, speeding at 3.5 percent. The most recent productivity growth acceleration in the United States is especially remarkable, given the 2001 recession and the productivity drag that many thought would be imposed by frictions in trade following the terrorist attacks of September 11, 2001, and the dramatic increase thereafter in private and public security spending.

The debate over why the U.S. economy sped up will undoubtedly continue, but surely one reason Europe and Japan fell by the wayside was the absence of a healthy dose of entrepreneurship in both these parts of the world. Since 2000, Western European leaders have announced that they want to introduce measures to promote entrepreneurship to address this shortcoming. Whether they are likely to succeed is one of the main topics we address in chapter 7.

Finally, even economies that already have a strong entrepreneurial sector, such as that in the United States, face the challenge of remaining that way. After all, societies change. Great Britain, after leading the world, fell back into big-firm and state-guided capitalism for much of the twentieth century, only to awaken from its slumber in the last two decades or so. The United States fell into a stage approaching big-firm capitalism after World War II, a state of affairs that was celebrated by such thinkers as John Kenneth Galbraith and even by the father of entrepreneurship economics himself, Joseph Schumpeter. But the celebration turned out to be premature. America’s postwar record of strong productivity growth came to a screeching halt with the first oil shock of 1973–74, and, as we have suggested, productivity growth languished for roughly two decades thereafter, only to bounce back more strongly than ever since the mid-1990s.

A central challenge for the United State is to keep its productivity miracle going. We believe that maintaining the right blend of big-firm and entrepreneurial capitalism is a key requirement for meeting that challenge. Yet as Mancur Olson (one of the great economists of the twentieth century who, in our opinion, still has not gotten his proper due) warned several decades ago, interest groups can ossify economies (Olson, 1982). Short of war, disruptive technological change can prevent that from happening. But such disruptions are likely to occur only in a climate where risk-taking is encouraged. In chapter 8, we identify a number of trends that worry us, trends that may discourage risk-taking if they are not reversed. It would be a tragedy, to say the least, if the leading entrepreneurial society—the United States—were to forfeit that role, not because of challenges from abroad (the current worry), but from causes made at home.

[edit] Concluding Thoughts

We want to be careful about our claims. We are not propounding a silver bullet theory of growth, one that relies on only one factor, such as entrepreneurship, to explain different levels of growth. As we will demonstrate, three of the four types of capitalism we identify have produced and will continue to produce growth. But we are contending that economies that want to advance the frontier—in any sector or many of them—must eventually embrace some mix of entrepreneurial and big-firm capitalism.

Our arguments draw from logic, history, even economic theory (although they are not mathematically modeled). We explicitly acknowledge that our claims have not yet been tested by the traditional empirical techniques used by economists, although some recent work by others is beginning to build a case that entrepreneurship matters—and possibly a lot— for economic growth (Audretsch et al., 2006; Acs and Armington, 2006). The standard statistical technique is to employ some form of multiple regression analysis, which allows investigators to sort through the causes of some phenomenon to identify which are significant, and by how much, and which are not.

But policy makers cannot and should not wait for still more formal mathematics and even more statistical work to tell them what to do. We believe that there is enough information already available that can help guide busy policy makers and the citizens who watch them and are affected by what they do. We hope that you, the reader, will agree that this is indeed so.

[edit] Notes

1. ↑ One of the present authors has given considerable thought to why this is the case. Interested readers can consult Baumol, 2002.

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