Good Capitalism, Bad Capitalism/Chapter 5
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[edit] Chapter 5: Growth at the Cutting Edge
Growth failed to respond to any of the (standard macro) formulas because the formulas failed to take heed of the basic principle of economics: people respond to incentives.
—William Easterly, The Elusive Quest for Growth, p. 143
Throughout most of recorded history and in almost all societies, accumulation of wealth has been a primary goal of enterprising individuals. In the vernacular familiar to American readers, individuals have pursued one of the two primary roads to acquire wealth: increasing the size of the pie and taking one’s fair share from the increase, or simply taking more of the pie, whether or not it grows. Until the time of the Industrial Revolution, the second of these options—redistribution of what was already there—was pursued overwhelmingly. That fact, ultimately, explains why the economic growth achieved by industrial countries in the last two centuries is unparalleled in previous history, ancient or recent.
There are straightforward reasons why redistribution rather than growth has for most of human history been the preferred method of wealth-accumulation. Perhaps the most obvious is that it looks easier simply to acquire riches by taking them away from others who are weaker. Indeed, when unrelenting dangers lurked from every side, violence was understandably deemed a manly, heroic activity. More than that, in such an environment there was little certainty that the fruits of the other avenue to wealth—contribution to production and growth of the economy—would accrue preponderantly or even in any substantial part to the individuals who endeavored to make those contributions.
So manifest are the immediate advantages of wealth-grabbing activities over activities that increase the total wealth of society that it is not easy to explain what led modern free-market economies to move toward the latter. The obvious answer is the appearance of new institutions that reined in the enterprising wealth-grabbing options and limited their benefits, while at the same time offering greater reward and certainty of payoffs to the enterprising individuals who contributed to economic growth. Put that way, it becomes clear that such a revolutionary change in incentive structure must have been a piece of great good luck for societies where the revolutions occurred; indeed, something of a miracle. This chapter will seek to describe those changes in institutions and associated incentives.
The blend of big-firm and entrepreneurial capitalism we extoll here may not be right for all economies at all times. It may be that in their initial stages, economies need or benefit more from the guiding hand of the state, or so some have argued. We will not enter that debate here. We are surer, however, that once economies approach the technological frontier—that is, once their living standards are among the highest in the world—they can remain at or become the frontier only by shedding state guidance and adopting some blend of entrepreneurial and big-firm capitalism. The nature of this blend, as well as the characteristics of entrepreneurial capitalism in particular, will differ from country to country, depending on historical circumstances and differences in culture. Simply put, all economies need some degree of entrepreneurship to generate radical innovation, yet they also need effective big firms to refine it and commercialize it on a mass scale.
This chapter is about those economies that are ready for a blend of entrepreneurial and big-firm capitalism but want to know the key ingredients for achieving and maintaining it. We do not mean to be overly prescriptive since there is no single recipe for growth, even in economies at or near the frontier. The precise rules and institutions that may work well in one country, or within a country, may not and probably will not work elsewhere. But whatever their precise form, we believe that the institutions must satisfy four key conditions, which are unique, in our view, to the blend of entrepreneurial and big-firm capitalism we have described. At the same time, we recognize that other factors—not unique to this form of capitalism or even necessary for growth—also can enhance growth. We examine those factors at the conclusion of the chapter.
[edit] Four Conditions for Maximizing Growth at the Cutting Edge
An entrepreneurial economy must have entrepreneurs—not just any entrepreneurs, but innovative entrepreneurs. We submit that three preconditions are necessary to generate them. But just as important, entrepreneurial economies must have ways to ensure that the successful entrepreneurs that grow into large firms are kept on their toes. Otherwise, as suggested in chapter 8, big-firm capitalism can become sclerotic. Our fourth condition addresses this particular danger.
[edit] Easy to Start and Grow a Business
To encourage the formation of innovative entrepreneurial enterprises, governments should lower the costs of “formality” (business and property registration and ease of hiring and firing workers); have a workable bankruptcy system in place; and facilitate the formation and growth of their formal financial sectors, which channel resources to innovative entrepreneurs. The first condition should hardly be a surprise. If entrepreneurship is about starting and growing a commercial enterprise (we ignore for this purpose so-called social entrepreneurs who might have other objectives in mind), then it must be easy and inexpensive to do so—formally, that is. In other words, licensing requirements should be few (unless the business requires some kind of special expertise, such as a medical care facility), the time and the cost required to fill out the necessary applications should be kept to a minimum, and so should time required for approval. These same elements apply to registration of property and collateral (to secure loans); these steps should be easily managed.
In an age increasingly dominated by the Internet, many or all of these activities can be conducted online, and in parts of developed economies, they already are. For developing countries that lack the infrastructure for high-speed Internet communication from remote locations, the application process can be accelerated at the appropriate registry with relatively low-cost electronic kiosks or similar equipment.
Business registration. We underscore the word “formal” in these registration requirements because, as we noted in the last chapter, in many developing economies, entrepreneurship is alive and well but in an informal way—that is, without all of the necessary formal approvals. That is because the formal processes are so time-consuming and expensive.
In his first book, The Other Path, Hernando De Soto documented how significant this problem was in Peru in the mid-1980s (De Soto, 1989). He and his colleagues at his institute in Lima started a business and tried to obtain the necessary approvals, only to discover that it took nearly three hundred days to obtain them—and that was with payments of bribes to officials along the way. Before and after this book, De Soto and his colleagues were invited to other developing countries and found similar or longer waiting periods (along with corruption).
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De Soto argued that because the cost and delay in “being formal” were so substantial, it was rational for individual homeowners and entrepreneurs simply to do business without the approvals, to opt for “informality” instead. Although informality can be rational for individuals who choose it, economies as a whole suffer when vast numbers opt out of formality.
Specifically, informal firms must operate at a small scale to avoid detection by the authorities (especially since they typically do not pay taxes). Because they are not official and any “property” that they may control is not formally registered, informal entrepreneurs cannot obtain formal bank credit, for they have no legally recognized property to pledge as collateral. As a result, they either can expand only as they generate and save income, gain support from friends and family (often meager because they, too, are likely to informal and have little means), or if they can, borrow from informal lenders (known in some countries as the “curb market”) who can charge exorbitant interest rates. To underscore the point, De Soto estimated in his second book, The Mystery of Capital (2000), that due to the absence of title registration of informally “owned” property (typically buildings), there was at that time throughout the world more than $9 trillion in “dead capital,” property that could not be used to finance investment and growth. Societies plagued by large informal sectors are like poorly oiled engines, operating at far less than their full potential, with much waste and inefficiency.
De Soto’s work has had its skeptics. Some question his statistical methods. Other dispute whether informality is as costly to economies as De Soto argued. And others object to the silver bullet implication of De Soto’s work—namely, that if businesses and property could be registered properly, poor countries suddenly would grow a lot more rapidly.
Even if exaggerated, De Soto’s argument strikes home, and indeed it is becoming somewhat the conventional wisdom (always a dangerous position to be in) in international policy circles. The United Nations formed a commission in 2004 on advancing entrepreneurship in the developing world and appointed De Soto to it, no doubt in recognition of the importance of his work.[1] More important, at least for future economic research, the World Bank has begun a major effort to compile the kind of data on time and expense in business registration and property recordation that De Soto claimed he was finding. The Bank included additional variables on its list, notably the costs of hiring and firing employees, given the importance of well-functioning labor markets in all economies.
Tables 6 through 9 provide some illustrative data on the ten best and ten worst performing countries on the costs of business registration, property registration, ease of hiring workers, and ease of firing workers, from the Bank’s second report, Doing Business in 2006 (World Bank, 2006). The costs of hiring and firing workers are included not so much because they affect the ease of business formation (though they may) but because they (presumably) affect their rate of growth once they do are formed.
The data in Tables 6 through 9 reflect reports as of early 2004 and are based on extensive analyses of local laws and regulations, coupled with surveys of more than three thousand local government officials, lawyers, consultants, and other professionals familiar with registrations in various countries. Viewed together, the results presented in the tables are not surprising: most of the best performers are in developed economies and the worst in developing countries, though there are exceptions.[2]
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Taken together, the tables demonstrate that it generally is more difficult and expensive to start and grow a business in poor countries than in rich ones. For example, the Bank concludes that on average it takes fifty-nine days and 122 percent of per capita annual income to start a business in the poorest countries, but only twenty-seven days and 8 percent of annual per capita incomes to do so on average in countries belonging to the Organization for Economic Cooperation and Development, or OECD (World Bank 2005, 18).
The results in the tables should be interpreted carefully, however. One cannot automatically infer that because developed economies tend to have the lowest costs of registration and hiring and firing that those lower costs are the reason (or a reason) for their higher level of economic development. As economists say, the causation could run in the other direction. It could be the case that in developed economies entrepreneurs have sufficient political clout to ensure that their costs of registration are low, and conversely that they lack such clout in developing countries where registration costs are high.
The Bank purports to find that the causation runs in the right way, however, from costs to growth. In particular, it cites statistical work (admittedly subject to all of the qualifications we highlight in chapter 3) that controls for the causation problem and estimates that by moving from the seventy-fifth percentile in the costs of starting a business to the twentyfifth percentile (lower costs are better), poor countries could increase their annual rate of GDP growth by anywhere from .25 to .50 percent a year (Klapper, Laeven, and Rajan, 2004). Those fractions may not sound like much until one applies them to some base number, like all GDP in developing countries. When that is done, the Bank reports that raising the growth rate by just .25 percent would enhance GDP in the developing world by $14 billion annually, an amount equal to a quarter of all development aid (World Bank, 2005, 24) and roughly the size of the foreign aid budget of the United States.
The costs of business registration (both direct and indirect) are important not just for domestic businesses but for foreign-owned ones as well. Countries can benefit hugely from “start-ups” or acquisitions of existing companies by foreign investors, or “foreign direct investment” (FDI). This is because foreign investors, often major foreign enterprises, typically bring their knowledge, technology, and experience along with their money to the countries they invest in. Yet many countries, both developed and developing, restrict foreign investment, either across the board (for populist reasons) or in particular sectors (in the United States and other countries, in communications and defense industries, for cultural and national security reasons). As discussed in the last chapter, foreign investors also appear to be highly sensitive to levels of corruption, which can act like a tax, and not simply on registration but on the regular conduct of business.
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Bankruptcy protection. It may seem paradoxical, but another important, but indirect, factor affecting the costs of the entry is the cost of exit or failing. In most societies and throughout history, bankruptcy has been a mark of shame, if not a criminal offense requiring the bankrupt to serve time in jail. The United States and some other countries have taken a more enlightened attitude toward debtors who cannot pay their debts when they come due (one of the definitions of bankruptcy): depending on the part of the law they invoke, those who “declare” bankruptcy are excused from some of their debts, provided they agree to repay the balance over some rescheduled time period.[3] Effective bankruptcy protection is critical to promoting entrepreneurship, since without it, many would-be entrepreneurs would be unwilling to take the risks of starting a business, knowing that if they fail they could lose everything, on top of facing the severe social stigma of having declared bankruptcy. Indeed, it is safe to speculate that there is a strong negative correlation between the strength of that stigma and attitudes toward entrepreneurship in any given society: the more society penalizes failure, the less entrepreneurship it will get. (This proposition has its analogue in labor protection: the more difficult it is to fire workers, the less incentive firms have to hire them.) Those social scientists who attribute differences in entrepreneurship rates between countries to differences in cultural attitudes (a subject we will soon explore) thus may be missing an important underlying policy that influences culture, namely, the policy toward bankruptcy.
Access to finance. A third essential factor in starting most businesses is access to capital. J. R. Hicks, one of the great British economists, observed that the liquidity of capital markets in eighteenth-century England helped ignite the innovation associated with the Industrial Revolution by allowing inherently illiquid long-term investments in capital equipment to be financed (Hicks, 1969, 143–45). Early in his distinguished career, Joseph Schumpeter emphasized the importance of banks in funding entrepreneurs and established businesses, spurring technological innovation and hence economic growth (Schumpeter, 1911). In recent years, with more attention paid by economists to the sources of growth, there is a growing consensus that economic growth depends to at least some degree on the maturity and soundness of economies’ financial systems (Levine, 2004). After all, the central role of financial systems—financial intermediaries and capital markets—is to channel funds of those with excess funds (savers) to those who are likely to earn the highest returns on those funds (investors). As banks, other financial intermediaries (insurance companies, pension funds), and capital markets (stock and bond markets) grow in size and sophistication, they become more efficient in performing this critical function. The more efficient they are, the more risk that savers are likely to take with their funds, which should foster more investment and entrepreneurship. As Columbia University economists Massimiliano Amarante and Edmund Phelps succinctly put it: “Financiers are the channel through which innovations can be transformed from mere ideas to a source of economic growth” (Amarante and Phelps, 2005).
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What makes the financial systems of entrepreneurial economies unique is that they are more likely to finance new, risky firms than are economies characterized by other forms of capitalism. As we suggested in chapter 4, one of the primary instruments governments use to guide their economies is ownership of the nation’s banks or at least the ability to influence their loan operations. These practices inevitably favor large, state-favored enterprises to the detriment of new and smaller businesses, even if the latter hold innovative promise. Banks in bureaucratic capitalist societies do not act much differently. As we will discuss in chapter 7, in both Japan and Western Europe, where big-firm capitalism is perhaps practiced at its best, banks have close ties, through ownership or director positions (or both), with the companies that are their borrowers. Indeed, for a long time, and even now, many of Japan’s leading companies had “main” banks as shareholders. This sort of lending behavior, coupled with “administrative guidance” as to where to place funds, works to the detriment of any entrepreneurial sector.
In contrast, the U.S. financial system has long been decentralized and much more “democratic.” After a brief flirtation with federally owned banks in the early decades of its history, the United States abandoned any notion of state ownership of banks and instead went in the opposite direction by allowing a proliferation of many smaller banks, which for most of the nineteenth and twentieth centuries were not allowed to expand across state lines. United States stock exchanges developed gradually after the nation was formed, soaring in importance after World War II, to the point where today U.S. equities and bond markets are a primary source of new capital for both established and new firms, while serving as a more important home for the holders of financial assets than banks (unlike all other countries, where banks still hold most private financial wealth).
Indeed, America’s financial system has evolved in ways that continue to underscore Hicks’s maxim about the importance of finance in funding innovation. For a long time, banks were a primary source of funding for new enterprises, but only as lenders. New companies that reached a certain size could issue stock of their own on America’s stock markets—as “initial public offerings”—but the stock markets did not provide the so-called early stage funding to help new companies get started. Entrepreneurs had to have either some wealth beforehand or access to funds from family and friends, which is still true for most replicative entrepreneurs and also for innovative companies in their early stages.
What has made America’s financial system conducive to innovative entrepreneurship is that it has developed institutions that have financed the growth of innovative enterprises. For most readers, the best-known institution of this sort is the venture capital fund, which was first developed after World War II but did not bloom until the mid-1970s, when Congress permitted pension funds and various nonprofit organizations (including universities and foundations) to invest a limited portion (up to 5 percent) of their assets in these funds. Venture funds pool the funds of these institutional investors and wealthy individuals to provide equity financing for companies in their early stages. Although only a tiny fraction of U.S. companies have received venture money, venture funds have played a very significant role in launching many of America’s high-technology firms— Intel, Sun, Amazon, Cisco, and Google, to name a few.
Venture funds could not exist without an active stock market, however, for it is through initial public offerings (or IPOs) that the venture capitalists traditionally have found a way to liquefy their original investments and thus compensate their investors for the substantially higher risks involved in innovative start-ups. Other countries have begun to copy the U.S. venture capital model, but they have found it tough going since investors must have an appetite for risk, faith that the legal system will protect their investments, and have active stock markets where the shares of IPOs can be readily traded.
Since the bursting of the Internet stock market bubble (not just in the United States but also in other developed country markets), the venture capital industry and its investors have become more risk averse, even bureaucratic, concentrating on “second” or “third” rounds of funding new companies. A new financial “industry,” loosely speaking, appears to be taking on the role of providing start-up equity for innovative entrepreneurs: “angel investors,” or wealthy individuals who alone or in groups are providing the equity, along with family and friends, to help launch what America hopes will be the innovative companies of the future.
As the U.S. experience with venture and angel investing spreads to other parts of the world, other countries should experience an increase in the number and growth of innovative firms and thus import one of the features that makes the United States the leading example of entrepreneurial capitalism. Indeed, U.S. venture firms, to the extent they are still involved in funding start-ups, increasingly are looking abroad for entrepreneurial opportunities rather than within the United States. This is not a cause for alarm but rather another illustration of how “technology”—in this case “financial technology”—eventually diffuses across national borders.
[edit] Rewards for Productive Entrepreneurial Activity
A cursory reading of history indicates that the pursuit of wealth by at least some individuals has been present in virtually every society (there are exceptions—medieval serfs, monks in monasteries, and the like—but these are the exceptions that only prove the rule). As we noted at the outset of the chapter, there are fundamentally two ways in which wealth may be acquired: by undertaking productive activities that enlarge the size of total output for any society, or by ignoring that objective and seeking instead to gain a larger share of whatever output is generated. In the vernacular, the choices are to expand the pie or to seek larger slices.
Clearly, economic growth requires activities of the first type—those that expand the pie or total output—and we will refer to this as productive entrepreneurship. In turn, we have previously identified two types of productive entrepreneurship: innovative and replicative. For entrepreneurial societies, we are interested in the former, for it is only by commercializing new products and services or by adopting new and better ways of making or delivering existing ones that the economic frontier moves out.
It is not sufficient for entrepreneurial economies to make it easy for entrepreneurs to start their businesses. Such individuals and the firms they found must be rewarded for their success. Several institutions are important are in this regard: the rule of law (effectively enforced), intellectual property protection (but not too much), taxes that are not unduly onerous, and rewards and mechanisms to facilitate imitation in certain environments.
The rule of law, property, and contract rights. Innovative entrepreneurship is a risky undertaking, and individuals who bear these risks must be appropriately compensated.[4] That is, entrepreneurs must have rights to the property—money, land, goods, or all three—they gain as a result of successfully pursuing their endeavors. In addition, entrepreneurs (and all firms) must have confidence that the contracts they enter into with other parties will be honored (and if necessary, enforced by an independent judicial system). As Professor Kenneth Dam reminds us, it is not sufficient for statutes or regulations protecting contracts and property to be on the books; both must be effectively enforced. China would appear to be an exception to these propositions, which otherwise are well established. Yet Dam argues that even in China legal protections have improved as the economy has grown (Dam, 2006).
Avoiding onerous taxation. Property rights serve as a powerful positive incentive for productive entrepreneurship, but of potential equal importance is minimizing disincentives that can discourage such activity. One obvious disincentive to productive entrepreneurship, or indeed any activity, is taxation. Clearly, no one likes paying taxes, perhaps least of all entrepreneurs, who tend to credit themselves for their success and deeply resent efforts by government to take away any part of the earnings to which they believe are fully entitled. But the reality, of course, is that taxes are essential in any free society. Some compulsory means must be found to provide for basic public goods—those whose benefits cannot be fully appropriated by any individual or group but instead are widely dispersed through society. Examples include national defense, a police force, an effective legal system, roads, sanitation facilities, and education (whose benefits accrue only in part to those who receive it, society also benefiting from having citizens learn shared values and knowledge and from advances in knowledge that education makes possible).
Entrepreneurs, along with everyone else in a society, benefit from public goods and services, and we presume that those public goods are present as a precondition for growth under any economic system and any of our different types of capitalism in particular. So the optimal level of taxation for any society—whether or not it aims to be entrepreneurial—clearly is not zero. The critical challenge for entrepreneurial societies is to fund public goods at such a level and in a fashion that least punishes entrepreneurial success.
Somewhat surprisingly, little empirical research exists on this question.[5] Common sense suggests that the more highly and directly tied taxes are to entrepreneurial success, the less entrepreneurship one can expect will take place. Thus, other things being equal, if promoting entrepreneurship and growth are the sole objectives of any tax system, taxes on sales or property are to be preferred to taxes on income, which perhaps is the most direct measure of entrepreneurial success. There is an additional reason to tax sales, or value-added: such taxes discourage consumption and reward saving, which is also essential for growth (though not as important, according to empirical studies, as innovation, which is diffused throughout economies by entrepreneurs and well-established larger firms).
We recognize, of course, that few societies eschew income taxes altogether in favor of consumption taxes. More commonly, governments tax both, on grounds of fairness and also by historical accident. Nonetheless, if additional funds are needed—as we suggest, in chapter 8, they will be in all developed economies as their populations age—then policy makers should think seriously about taxing consumption before raising additional income tax rates if they want to avoid unduly penalizing entrepreneurship and hence growth.[6]
Proper regulation (or deregulation). Regulation (or deregulation) also can be a powerful force affecting entrepreneurial incentives. For example, in the United States until quite recently, regulation of prices charged in long-distance telecommunications, freight and passenger transportation, and some forms of energy sought to prevent monopoly profits by adopting ceilings on profits, defined in terms of rate of return on investment. It is hard imagine a system that more effectively invited inefficiency and waste and minimized the incentives for innovation. The firms were not only exempted from penalties for wasteful outlays, they were rewarded for incurring such expenditures since the price ceilings typically took the form of some markup over cost. As the United States undid these forms of “antimonopoly regulation”—eventually out of the recognition that these industries were not monopolies—new entrants came in, existing inefficient firms have been forced out or shrunk, and the overall efficiency of these sectors, as measured by increases in productivity, has improved. [7] In addition, deregulation of transportation industries in particular made it possible for such important innovations as “just in time” shipping (adopted from Japan) to exist. Under the previous, highly regulated, transportation system, airlines, trucks, and railroads would not have had the flexibility to accommodate rapidly shifting shipping demands (Barone, 2005, 79).
Rewarding new ideas. Having established the importance of rewards for successful entrepreneurial behavior, an obvious question begs for an answer: where do entrepreneurs get their ideas? By definition, replicative entrepreneurs have no difficulty coming up with the ideas for their businesses: they simply copy what some others have done. Their only challenge is to pick one of countless businesses or business models already in the marketplace that they believe are best suited to their talents, experience, and interests.
The more interesting questions are where do innovative entrepreneurs get their ideas, and do incentives matter here too? In answering these questions, it is useful first to dispel the notion that innovation is something that is entirely new. Of course, innovative products and services are new, but they could not exist without many other components or ideas that already exist. As the famous scientist Isaac Newton once said, “If I have seen further than others, it is by standing upon the shoulders of giants.” So, too, with innovative entrepreneurs, or any inventor for that matter: technological breakthroughs happen only when related ideas or products, already in the marketplace, are put together in new ways (Hargadon, 2003). Successful innovative entrepreneurs are the ones who recognize and then realize the commercial opportunities that such recombinations offer.
Indeed, it is safe to say that virtually every product that has ever been sold has features that were previously developed but are now combined in new ways to yield something different. A few recent examples illustrate the idea: the airplane (piston and then jet engines; the airframe; nuts, bolts and many other parts that go into making a plane; radar and wireless forms of communication); the automobile (engines; gears; steel and aluminum castings; rubber; and now increasingly, semiconductors); and the Internet (computers; networking technologies; communications protocols; fiber optics; network servers; among other components). We are confident that readers can think of countless other examples simply by looking around their office or their home.[8]
So what does government policy have to do with all this? The answer is: plenty. Although inventors will tinker simply because they are good at it or love to do it, as with any other activity, one will get more innovation if it is actively encouraged and rewarded. European monarchs recognized this as early as 1300, providing inventors with temporary exclusive rights, or what today we call “monopoly profits,” for their innovations. The concept really took hold in England several centuries later and was formally embodied in the United States Constitution by America’s founding fathers (Jaffee and Lerner, 2004). Congress implemented the constitutional guarantee initially by providing seventeen years of monopoly protection, since extended to twenty years, both periods running from the date the Patent Office awards the patent (after determining it to be an advance of the “prior art”). Other nations have since introduced their own forms of patent protection, though it is common outside the United States for the protection to be awarded to the “first to file” the application, and to that date in particular.
Yet even with the temporary monopoly profits awarded to innovators under patents, the lion’s share of the gains from innovation still spill over to the rest of society. This is a good thing, as long as patent holders are adequately compensated, since societies benefit most from innovation when it is rapidly diffused. For example, one noted study of one hundred American firms found that “information concerning development decisions is generally in the hands of rivals within 12 to 18 months, on the average, and information containing the detailed nature and operation of a new product or process generally leaks out within about a year” (Mansfield, Schwartz, and Wagner, 1981, 911). William Nordhaus estimates that inventors capture as little as 3 percent of the total social benefits of their inventions (Nordhaus, 2004).
Still, even with spillovers of this magnitude, having a patent remains a prized possession and thus must continue to act as a powerful force for stimulating innovation. Indeed, there is a danger that this force can be too powerful. If patents are too easy to come by—that is, temporary monopolies are awarded for developments that are not truly novel but instead are “obvious” and thus unworthy of legal protection—then society will stimulate too many “temporary” monopolies. Patents that are unjustly awarded will then discourage entrepreneurship because they will prevent others with truly novel ideas that are deserving of patent protection in their own right (or at least the ability to be left alone without fear of lawsuits) from entering markets and competing against those whose patents are not deserved. This is an increasingly serious problem in the United States, which we discuss further in chapter 8.[9]
Government-supported R&D. Government can play another important, but more indirect, role in stimulating ideas that eventually are commercialized by entrepreneurs: subsidizing basic scientific research. Though it rarely finds its way soon into the marketplace, basic scientific understanding provides the building blocks for subsequent applied research that eventually leads to commercial products. The semiconductor, for example, would not have been possible without fundamental knowledge about the atom, molecular structure, and the like. Likewise, the components of the Internet would not have been possible without fundamental understanding of the way in which light and information travel over fiber optic cables. Similar statements can be made for the myriad pharmaceutical wonders that extend or save lives.
Rich countries, like the United States, can afford the resources to devote to basic research at levels and in ways that poorer countries cannot. Indeed, as a share of gross domestic product, the United States has led the world in government-funded civilian (nonmilitary) research and development expenditures for some time. Although other countries may be catching up to the United States, this is not the cause for alarm that many in the United States may think. It is foolish to believe that when entrepreneurs and innovators in other countries develop new things, they will somehow keep the innovations to themselves. To the contrary, they have strong incentives to sell their innovations to purchasers around the world. Who wouldn’t want to be “number one in the world” if it were possible?
Of course, there are benefits to being first or a global leader that should not be dismissed, but they should not be overstated either. For one thing, innovators reap profits from the intellectual property that may temporarily protect their inventions, but as we have just noted, the economic spillovers from innovation typically dwarf profits. Historically, the more important benefits from innovation are the localized networks that it can help create. Firms in industries tend to cluster in certain locations. In the United States: high-tech in Silicon Valley, autos in Detroit, furniture in North Carolina, entertainment in Los Angeles, securities and banking firms in New York, insurance companies in Hartford. In the rest of the world: software programming in Bangalore, India; consumer electronics in Taiwan and Japan; fashion in Italy, to name a few. Locations hosting vibrant economic activity and innovation develop largely by serendipity, but once one or two firms in a location in a particular industry (or industries) become successful, they attract labor and entrepreneurs, and other services and suppliers, who build thicker and thicker networks, which in turn help spawn other new firms. Those who fear the rise of scientific advance in India and China, wittingly or unwittingly, base their logic on this virtuous cycle of development: if either or both of those countries (or some other economy) somehow gets “ahead” in an existing or new sector, America’s growth rate allegedly will suffer.
Such fears cannot be dismissed, but they are overstated in our view, for at least two reasons. One consideration is that in the age of the Internet, location may not be as advantageous in the future as it has been in the past. Indeed, India owes its current and likely future high-technology success to the “death of distance” created by high-speed satellite-based communications that allow processing and programming to be performed while employees in client countries are sleeping and then zapped back to their sources at the end of the Indian work day, just when clients elsewhere are just waking up. With the Internet, networks increasingly are becoming untethered from geography, and thus so should innovation.
The second mitigating factor is that whether or not India, China, or some other country takes a lead in one or more particular sectors, living standards in America or any country, for that matter, depend as they always have on rising productivity at home. America (and all other countries) should take advantage of innovations developed elsewhere and use them then to develop something new or adapt them to the local market—just as other countries have done with our innovations for decades. Innovation is a positive-sum exercise, not a zero-sum game.
Commercializing university inventions. There is also an important interaction between government funding of basic research and patent rewards that should not overlooked. Much government support of R&D in the United States, in particular, is provided to university-based researchers. Until 1980, it was not clear what rights those universities, or the researchers themselves, had to obtain patents on discoveries that followed from this research. Under one line of thought, it could be argued that those rights belonged to the government, since it after all had provided the funding.
But this was and is a shortsighted view. The ultimate aim of government research is to benefit society, and to do that, discoveries in the lab must find their way into the marketplace, ideally as quickly as possible. In 1980, the United States Congress acknowledged, through passage of the Bayh-Dole Act, that the best way to do this was to assure that universities had the right to patent innovations developed with federal funding (in turn, universities typically share a portion of the licensing royalties they receive on these patents with the professors who come up with the innovations). Bayh- Dole marked an important watershed in innovation policy in the United States and is credited by some with encouraging more rapid diffusion of university-based discoveries. Yet, as we discuss in chapter 8, the law is not working as well it could. This is especially important given the increasing sophistication of modern technology and the likelihood that high-growth businesses of the future will be technology based.
Rewarding imitation. Not all ideas from innovative businesses need to be new but instead just new to particular environments and locations. Countries in the early stages of economic development cannot realistically be expected to grow by originating ideas for new products when it is easier and less expensive for them to adapt technologies and products already in use in other settings for use at home. Indeed, according to 1999 data published by the United Nations (the most recent year for which such data were available), just two countries—the United States and Japan— received more than 50 percent of the world’s patents (United Nations, 2003). If the rest of world is to avoid falling hopelessly behind, other countries must find ways of availing themselves of as much of this intellectual property as they can.
There are several ways to do this: by importing products that embody cutting-edge foreign technology, by attracting foreign investment from abroad, by sending residents abroad for training and hope they come back, or by just stealing the technology. We do not dwell on last option other than to note that piracy of intellectual property is a well-known problem (especially, it seems, in China) and one that continues to be at the top of the trade agendas of the rich countries that try to stop it.
Much of Asia has followed the first option—importing technology embodied primarily in capital equipment and using it with local, low-cost labor to manufacture goods for export to third markets. Of course, exportled growth has worked primarily because the United States has been so willing—at least up until now—to be the world’s consumer of last resort. Furthermore, eight successive “rounds” of international trade negotiations have brought tariff rates down to single digits in most other countries, which has allowed poorer countries to catch up through exports.
To be sure, export-led growth is not necessarily an entrepreneurial strategy. Most Asian countries that have succeeded with it have done so with a heavy dose of state guidance. India is an exception. The Indian government is notorious for having attempted to micromanage its economy, except in the fields of software development and call center operations, where the government looked the other way as entrepreneurs used firstworld communications technology and highly trained local talent to become world leaders in services exports (Srinivasan, 2005). In effect, these sectors were lucky and benefited from benign neglect. As we suggest in the next chapter, the rest of India could benefit from a similar form of “neglect.”
Many developing countries have been more resistant, primarily for reasons of national pride, to adopting the second strategy for importing ideas—welcoming foreign direct investment (FDI). China is a notable exception. Its national and provincial governments compete to land investments by foreign companies, often in joint ventures that entail the transfer of foreign technology. In 2002, China became the world’s leading destination of FDI, passing the United States. Ireland is another major FDI success story. Once the poor cousin of Europe, Ireland dropped its corporate tax rate in the 1980s to 12.5 percent and then watched as foreign multinationals poured money into the country, making it a launching pad for sending goods and services to the European Union. By 2004, Ireland’s per capita income was only 10 percent below that of the United States. Israel, too, has benefited greatly from foreign direct investment, as well as from an influx of technology “embodied in people” through the emigration of nearly two million Russians, many of them highly educated.
A number of countries have tried and are still using the third strategy— allowing, and indeed encouraging, their nationals to go abroad to be trained in universities of developed economies, returning home with firstworld skills. Japan and Korea used this approach with much success, and both have been followed by India and China. India’s expatriates are unusual in that many of them have remained abroad, especially in the United States, where they have gone on to found or work in high-technology startups. Indeed, between 1980 and 2000, Indian and Chinese immigrants accounted for an astonishing 30 percent of the successful startups in California. [10] As we noted in chapter 4, India’s “human capital bet” is now paying off now that many Indians are returning home, either part-time or fulltime, to participate in that country’s high-tech boom.
American immigration policy has become much more restrictive since the terrorist attacks of September 11, 2001, but this hasn’t stopped developing countries from sending their best and brightest abroad. Rather, some of the destinations are different: universities in Australia and Europe have been filling some of the void created by the drop in foreign students accepted by the United States. In chapter 8, we suggest that American immigration policy can safely reverse course and should actively welcome foreign students—assuming they still want to come.
[edit] Disincentives for Unproductive Activity
The evil twin of entrepreneurship is unproductive activity that detracts and even subtracts from an economy’s income and wealth. By unproductive activity, we broadly mean to include both unlawful and lawful efforts to redistribute the economic pie rather than to contribute to the growth of the pie. Examples of the former, of course, are theft or bribery (or other forms of corruption), which have had such a clearly destructive social and economic impact that virtually all societies condemn them with criminal sanctions. Lawful redistribution or “rent-seeking” can be pursued either by lobbying governments for special benefits that help narrow interests rather than society as a whole, or through litigation that shifts resources from one pocket to another without effectively deterring undesirable behavior. One particularly egregious form of such activity entails misuse of the antitrust laws to undermine competition rather than to preserve it, as intended. This happens when a firm, finding that its inferior products or its inefficiency condemn it to failure, takes its competitive battle out of the marketplace and into the courtroom, complaining (falsely or on questionable evidence) that a rival has engaged in “predatory” behavior. In the United States, lobbying and litigation are not only lawful but are protected either by the Constitution or by specific statutes.
Whether or not redistributive activity is lawful, it almost always has the effect of leaving the overall size of the economic pie not just unchanged but actually diminished in size. Where the negative effect is small, as it may be for redistributive tax systems that aren’t too onerous, it can be tolerated if society deems the improvement in equity worth the negative effect on overall growth.[11] Indeed, when income and wealth are too unequally distributed, then economies are at risk either of oligarchic elites dominating policy or of populist backlashes, both of which are inimical to growth.
But when the objective of entrepreneurial activity is narrowly redistributive— to the entrepreneur and not for large portions of society—then we can find no defense for it. Indeed, if left unchecked, the quest for this kind of redistribution, at its worst, can so reduce the size of the economic pie that the result can be grinding poverty. The corruption that has plagued a number of African economies demonstrates this. In earlier times, when military means were used to effect redistribution—with the spoils to the winning army—the results of the battle for share could be seen in ravaged land and in massive loss of life. World history, unfortunately, is littered with too many examples of this form and outcome of redistribution: when Rome and Greece ruled the world, throughout the Renaissance, and through much of the twentieth century.
Unfortunately, there are no magic recipes for minimizing unproductive entrepreneurship other than to effectively outlaw clearly destructive criminal behavior that should be stopped. A society in which theft is not punished will soon no longer be a “society” but instead a disconnected set of individuals, each fearful of the other, a true “Hobbesian” state of nature. As for lawful rent-seeking, there is no way in a democracy to halt it, though certain measures may inhibit its growth.
Lest readers come away from this discussion with too much pessimism, it is important not to overlook the good news: though lawful redistributive activities continue to take place, they are less prevalent in the world’s wealthier countries than they used to be. In the Middle Ages and the Renaissance and in China in the early twentieth century, warlords were powerful, acting essentially as robber barons who kept society in turmoil, often destroyed outputs, ravaged crops and communities, and engaged in large scale murder and mayhem in order to extract ransoms, capture properties, and garner the wealth of others in any other ways they could devise. Although the warlords may still hold sway in places such as parts of Afghanistan, in much of the world this kind of lawless activity has been effectively curbed. Similarly, once kings could be expected to reward their favorites with patents of monopoly, lands, and even marriage forced upon wealthy widows, but between the Magna Carta and the Statute of Monopolies of 1623 such practices were largely eliminated in England, with other nowwealthy societies soon following suit.
It is reasonable to infer that this narrowing of the scope for redistributive entrepreneurship played an important role in the birth of the innovative societies of the past two centuries. As the doors to the unproductive path to wealth acquisition were (partially) closed, the enterprising were driven toward more productive avenues. If it is correct, as we argue below, that wealth-enhancing institutions become stronger as societies grow richer, then there is hope that this virtuous process will continue in economies that are now rapidly growing.
[edit] Keeping the Winners on Their Toes: Playing the Red Queen Game
It is not enough to induce innovative entrepreneurs to form businesses if we want entrepreneurial economies to keep growing. Once entrepreneurs succeed, it is vital that they or, more likely, the managers who succeed them be induced to keep innovating, rather than turning to rentseeking to protect themselves from competitors, especially disruptive technologies (such as electricity or the Internet) that can quickly and radically change the competitive landscape.
This is the fourth condition for growth at the cutting edge. In Lewis Carroll’s felicitous phrase, the aim should be to ensure that the winners in the competitive race run as quickly as they can in order to stand still. Or, as one economist has put it, entrepreneurial economies must ensure that their firms are constantly engaged in a “Red Queen game,” in which every player’s success depends on his or her ability to match or exceed the current efforts or expenditures of rivals, so that each is forced by the others to bid ever higher (Khalil, 1997). Where this kind of competition does not occur, winners are likely to be content to rest on their laurels. If they do, innovation slows down or even ceases, as will growth itself.
An analogy to military arms races is instructive. In medieval times, every king seemingly was forced into an arms race in which the ante was constantly raised, with innovation relentlessly raising costs. Stone castles replaced wooden castles and were not only more costly to build but far more costly to besiege. Gunpowder and artillery in the mid-fourteenth century increased the cost of fortification. The sociopolitical innovations that led the kings to become less dependent on vassals to man their armies forced them to pay their military, often purely mercenary troops, which added significantly to royal expenses. The predictable consequence of this military Red Queen game was that the kings were almost always seriously short of funds. For whenever they did manage to scrape up enough to proceed on military enterprises with little financial hindrance, this merely invited ratcheting of the arms race up yet another notch, so by the inherent character of the “game,” any amount that seemed sufficient on one day was sure to be woefully inadequate in the next.
Thus monarchs found themselves perpetually underfinanced, heavily in debt and unable to find willing lenders, and reduced to distasteful expedients, to beg for a bit here, wheedle or extort a bit there. Indeed, much of medieval history is a story of battles—not the supposedly glorious clashes of arms, but battles between the kings and the subjects from whom the monarchs hoped to draw their funding. As some historians have put it, they were “pauper kings.”
Fortunately, there is a happy and peaceful ending to this (truthful) parable about military Red Queen games. One consequence of the unceasing chase for money was that kings desperate for funds were forced into recognizing the rights of the individual. This process began in England and spread to the United States and eventually to much of Europe. To be sure, the process was a gradual one. Rights first were granted to the magnates (the fewer than ten earls and less than one hundred barons in England at the time of the birth of parliament), and then to towns and the commons (the upper middle class, the knights, the landowners, and the wealthier town residents). Furthermore, some kings found it necessary to turn to commerce rather than funding themselves with taxes and wartime booty. This made commercial activity—indeed entrepreneurial activity—respectable for members of the English nobility.
All of this helped lay the foundations for the future free-market economy and its remarkable productivity and record of growth. Indeed, the evolution of the rule of law—which predated the evolution of democratically chosen representatives—arguably was the single most important contribution to the birth of entrepreneurial capitalism. But the rule of law by itself does not guarantee that Red Queen game scenarios will continue to play out in modern economies, especially since they could not function without having large, established companies operating alongside the new, entrepreneurial firms that are more likely to be the agents of true economic change.
How then can the winners of the competitive race be motivated to keep innovating, whether incrementally or radically? Or, at the very least, how can society prevent the winners in one round of economic competition from thwarting the next generation of entrepreneurs who threaten to topple the previous winners? We consider here two institutions that would seem essential for this task: antitrust law and enforcement and openness to international trade and investment. We will take up a third important institution referred to earlier—the law and practices surrounding the transfer of new technology out of university laboratories and into the marketplace— in chapter 8, where we look ahead to ways to keep winners on their toes in all capitalist economies.
Antitrust. Ask many microeconomists (and many plaintiffs’ lawyers) how society can best assure continuation of Red-Queen-style competitive races in markets where only a few winners are left standing, and they will utter four words: “enforce the antitrust laws.” We will not digress here to discuss these laws, which have become common throughout the developed and much of the developing world (though unevenly enforced), in great detail. For our purposes it is sufficient to highlight three common themes that run through these laws: that competitors should not be allowed to fix prices (except in rare circumstances where joint activity is necessary for products or services to exist, such as common royalties for copyrighted works); that mergers between firms already dominant in concentrated markets ought not to be allowed; and that firms with “market power” (those with the ability to set prices on their own rather to accept the impersonal verdict of the market) should not be allowed to abuse that power through exclusive arrangements and other behavior having no legitimate business purpose that cements their market position.[12]
These objectives are important, but we add our own caution from experience: it would be a mistake for nations, and for those who lead their economies, to place too much faith in antitrust laws as a way to ensure that Red Queen innovation races continue.[13] To be sure, antitrust law remains important to prevent naked price fixing among competitors and to halt mergers that would unduly concentrate certain markets. But antitrust is much less effective when it comes to keeping the true “winners”—those who earn a position of market dominance or even monopoly—in the competitive race.
In theory, of course, the antimonopolization provisions of the antitrust laws (Section 2 of the Sherman Antitrust Act in the United States) are supposed to ensure this outcome by preventing current monopolists from abusing their market power or would-be monopolists from attempting to monopolize their markets through conduct that has no efficiency justification. If the provisions work, monopolists should not be able to nip competition in the bud, though the laws cannot force monopolists to devote their extra profits to innovative activities. Indeed, if monopolists enjoy their market power because of economies of scale or because the economies of networks drive the market toward a single competitor—as long appeared to be the case with landline telephone service, for example—then they may be able to live a “fat and happy life” for many years. But eventually technology changes or consumer tastes change, and monopolists must innovate or die. That is what wireless telephone service has done and is currently doing to the local landline telephone providers. And if homegrown technology does not come along, foreign technology may be needed prod to monopolists to change their lazy habits.
Can antimonopolization antitrust enforcement do any better in the meantime? We are skeptical based on the U.S. experience with these efforts over the past several decades. During this time, the Justice Department has mounted four major antimonopolization cases: one each against AT&T and IBM and two against Microsoft. The IBM case was dropped after thirteen years of investigation and trial. The government settled the AT&T and first Microsoft case and “won” the second Microsoft case after a trial and several years of litigation over the appropriate remedy.
Academics and policy makers may debate for years the value of these cases. We each have our views on these cases but do not seek to settle scores here. Rather, we make only a simple point: that even in the cases the government won or settled, it took many years to reach that outcome— eight years for AT&T, five years for the first Microsoft case, and another six years for the second one. These are not short spans of time. In each case, administrations and lead prosecutors changed and so did their approach to pursuing the cases, and technology marched on, and that was far more likely to undo the target monopoly than any legal action. AT&T’s monopoly in long-distance telecommunications, for example, ultimately would be undercut by wireless telephone service. Microsoft’s operating systems monopoly remains intact in the personal computer market, but it is being undone by “open source” technology for servers.
Did antitrust speed up change? Probably yes, but antitrust also had its costs, and not just in time and effort spent or in attorneys’ fees on both sides. In each case, mangers of the target of the antitrust action became heavily focused on the litigation and almost certainly gave shorter shrift to their business in the meantime. The management of IBM was so diverted that by the time the case was dropped, the company looked to be deeply off track. (It was perhaps not a coincidence that during this period the company did not get an exclusive license to the personal computer operating system then being marketed by a little-noticed upstart named Microsoft.) All this is to say is that policy makers would be mistaken to count on antimonopolization enforcement alone to ensure that monopolies are forced to play Red Queen games.[14]
Welcoming trade and investment. If antimonopolization legislation and enforcement have limits in rich countries that have the resources and expertise to apply to the exercise, as well as large markets that render a limited role for “natural monopolies” (those for which, due to economies of scale or network effects, the most efficient industry structure is a monopoly), then antimonopolization efforts are likely to be less important for motivating winners in smaller, less rich countries. Fortunately there is an alternative and, we believe, ultimately more effective policy, not only for smaller, less developed economies but for larger, richer ones as well: openness toward trade and investment.
Competition from imports can prod domestic firms that may be getting lazy to actively participate in Red Queen–like innovation. For proof, just look to the American auto industry, which after World War II was dominated by three large companies (and one little one). In those days, consumers were lucky if their cars lasted more than three years because they weren’t built to last, nor were they built to economize on fuel. When the first oil crisis jolted the world in 1973–74, the American consumer was only too ready to embrace the once-looked-down-upon Japanese imports, which were far more fuel-efficient and, as it turned out, superior in many other dimensions as well. Japanese imports woke up the U.S. manufacturers, who began improving the quality and fuel efficiency of their cars.
But the U.S. auto companies also engaged in the time-honored practice of rent-seeking in response to the Japanese threat, persuading U.S. policy makers (the free-market Reagan administration no less) to put “voluntary restraints” on Japanese imports during the 1980s. If the automakers thought this would take off the competitive pressure, they were sorely disappointed. Faced with curbs on their exports, the Japanese auto companies established their own plants here. The incoming foreign direct investment, which thank goodness U.S. policy makers did not stop, kept the pressure on the domestic manufacturers to continue improving their products.
The welcome sign to FDI did even more. When the Japanese manufacturers came here they brought with them their now famous “just in time” ( JIT) production system that cut inventories of supplies and in the process shaved costs off the production of cars. The Japanese also brought their “quality circles” that encouraged line workers, and not just managers, to make productivity-enhancing improvements. American companies across the economy, not just the auto companies, took the lessons to heart. Dell Computer, for example, eventually became the country’s leading PC manufacturer, largely on the strength of its JIT production system. And General Electric’s famous “six sigma” quality campaign, endlessly promoted by the company and a bevy of management consultants ever since, essentially was borrowed from the emphasis on quality that the Japanese, ironically, had been taught by an American “quality advocate,” Edward Deming (who was a prophet without honor in his own country for a long time).
The United States’ experience, in other words, demonstrates that even economies at the so-called technological frontier can benefit significantly from open borders—to goods, ideas, and people. If the developing world needs a similar example from the ranks of its own, it need look no further than Hong Kong, a once poor city-state without any natural resources that on a per capita basis has become one of the world’s economic powerhouses (even after it was absorbed by mainland China in 1997). Hong Kong achieved its success by attracting FDI primarily in the financial sector, and in the process it has become the financial hub for Southeast Asia. Ireland has followed a similar strategy, becoming not only a financial gateway to continental Europe, but also a research and manufacturing outpost for some of America’s leading high-tech companies. The challenge that countries built on FDI face in the future is to take the next step and develop their own home-grown entrepreneurs.
Yet openness as a policy instrument has its limits too. Just as the potential losers from antimonopolization enforcement efforts tend to do all they can to resist, taking advantage of every trick in the legal book available to them to delay the outcome and outlast the prosecutors (as Microsoft essentially did), the “losers” from an open trade and investment policy do not sit back quietly either. As we will discuss in chapter 8, their efforts may be blunting the force of foreign-based competition to stimulate the Red Queen games of the future. That is why effective safety net policies for dislocated workers due to all sources are important, if not critical. This is another theme we previewed in the last chapter and will develop further in our concluding chapter.
[edit] Other Factors—or the “What Abouts?”
In addition to the four broad ingredients reviewed above, four other factors have been or might be asserted as essential for economic success at the frontier: culture, education, macroeconomic stability, and democracy. We do not dispute that each of these factors can enhance growth, but we do not include them in our list of basic factors for either or both of two reasons. First, none of these supplemental “what abouts” are essential for implementing each of the four basic ingredients. Indeed, some of them—such as culture and democracy—may be outcomes of the four basic institutions rather than their antecedents. Second, none of the four “what abouts” are unique to either big-firm or entrepreneurial capitalism, or, ideally, the right blend of the two.
[edit] Culture
In his masterful survey of all of the factors that have contributed to economic growth around the world and through history, David Landes, one of the world’s leading economic historians, eventually reaches a disarmingly simple conclusion: “If we learn anything from the history of economic development, it is that culture makes all the difference. (Here Max Weber was right on.)” In other words, some countries grow more rapidly than others because their cultures are more conducive to growth. By implication, this must mean that culture is the defining characteristic for entrepreneurial success. As Landes continues: “Witness the enterprise of expatriate minorities—the Chinese minorities in East and Southeast Asia, Indians in East Africa [Landes could have added the United States], Lebanese in West Africa, and Jews and Calvinists throughout much of Europe” (Landes, 1999, 526). In her own thoughtful book on a related topic (globalization), Amy Chua adds Korean expatriates in the United States and Jews in Russia and the United States as additional examples of how culture matters (Chua, 2003).
The “culture-is-everything” view is deeply pessimistic for policy makers because it essentially implies that there is nothing they can do in their relatively short tenure to influence long-run growth. A country’s people either work hard or they don’t. Either they are creative, inventive, and entrepreneurial, or they are not. And there essentially is not much, if anything, that government can do about it.
Fortunately, we believe history is inconsistent with this policy pessimism. There are too many examples of countries turning their economies around in a relatively short period of time, a generation or less, and certainly shorter than the cultural view would imply: China and India over the past two decades (for many, though admittedly by no means all of their populations); Ireland over roughly the same time period; and over somewhat longer periods, much of Southeast Asia. These successes cannot be squared with the cultural-is-everything view. Indeed, at various points the same culture that allegedly contributed to growth was blamed for disappointing economic performance in China (Confucianism was said to be inconsistent with entrepreneurship and hard work) or, more recently, for contributing to the Southeast Asian financial crisis of 1997–98 (apparently the “Asian values” that up to that point had been so successful also led to “crony capitalism,” which some observers blamed for the crisis).
Indeed, by pointing to the success of certain ethnic groups outside their home countries, Landes and Chua unwittingly demonstrate that culture is not everything, that the institutional environment clearly matters. Indians and Chinese were not successful in their home countries until relatively recently because governments there did not reward entrepreneurial success; to the contrary, they stifled it. When given the opportunity, Jews have left countries where they were oppressed and have migrated to places that offer them routes to economic success. And Arab Americans have significantly outperformed their brethren in their home countries. Indeed, as Moises Naim reports, Arab Americans are better educated and wealthier than average Americans (Naim, 2005a).
This isn’t to say that culture is unimportant, for clearly it can matter. We nonetheless have not added culture to our list of defining characteristics of entrepreneurial economies because cultural characteristics clearly have played a role in enhancing the growth of state-guided economies as well, such as those in Southeast Asia or China. Even the state-favored firms in these countries have been run by entrepreneurial individuals who, though they may be more replicative than innovative, clearly have a strong work ethic and an eagerness to learn from other economies. Similarly, the large firms of Japan and Europe have benefited from what seems to be a cultural commitment to quality and craftsmanship that have made their goods so prized throughout the world.
But cultures favoring craftsmanship or replication are not equivalent to those that prize risk-taking, and so it still may be true that an “entrepreneurial culture” plays a distinctive role in entrepreneurial economies. Columbia University economist Edmund Phelps, in particular, has argued that one reason for Western Europe’s sluggish economic performance over the past several decades is that its culture is not sufficiently conducive to risk-taking. As for Europe’s success after World War II, Phelps attributes this to the transfer of American technology, noting that when that process was more or less complete, European growth slowed down and has never recovered. At bottom, Phelps wonders whether the anti-entrepreneurial culture is so embedded in Western Europe that it would resist transformation by any institutional reform.[15]
Phelps may be right about Western Europe, but it may also be premature to assume that future policy changes would have so little effect. After all, there is evidence from other parts of the world where culture can be and has been heavily influenced by institutions (or, as economists would say, that culture is “endogenous”). In particular, people once thought to be lazy and ill-suited to entrepreneurial endeavors suddenly can be looked on as industrious and creative once incentives reward those virtues. Look at the turnaround in Eastern Europe or at the postwar history of the Southeast Asian economies. Or consider the somewhat remarkable shift toward entrepreneurship in Russia, a country where enterprise was thought to have been snuffed out by more than seven decades of communist rule. In a survey taken of a random sample of entrepreneurs and nonentrepreneurs in Russia over the 2003–4 period, a team of scholars found that Russian entrepreneurs were more than twice as likely to have had family members running a business (in the 40–50 percent range) than other Russians (Djankov et al., 2005). We find this a clear demonstration of how in a society where formal entrepreneurship was not allowed until 1986, entrepreneurial activities have taken root in less than two decades through the same channel—family background—as one sees in highly entrepreneurial societies like the United States.
In short, we draw a different lesson from history than Landes. Policies and institutions matter; they can have a strong impact on “culture” in a period much shorter than a full generation. Put the right institutions in place, and people from all walks of life and backgrounds will respond, though admittedly perhaps because of history (so Phelps and presumably others would argue), some more than others.
[edit] Education
It seems obvious—perhaps especially to noneconomists—that as societies become more educated, or more accurately, as their labor forces become more skilled, they should grow faster. In the Solow growth model, for example, added skills in a society are implicitly reflected in additional labor. A highly trained technician, for example, may be the equivalent of two untrained laborers. So, economies should grow more rapidly as their workers gain more skills.[16]
Early economic research on the economic role played by education quantified the financial rate of return an individual could realize by spending additional time in school. In essence, “education” was defined by an “input,” namely, the number of years spent in school, rather than as an “output,” or how much workers actually knew. In any event, these studies, on the whole, demonstrated that, at least in the United States, the rate of return on time spent in school, specifically whether individuals went on to college, was quite low in the 1960s and 1970s. But starting in the 1980s, the gap in earnings between high school- and college-educated workers began to grow, so that the returns to a college education grew markedly. The conventional explanation for the turnaround is that technological advances drove the demand for skilled workers faster than the rate at which they could be turned out.[17] Other economists have pointed out that education yields benefits to society beyond those that can be captured by individuals themselves. More educated people are not only more informed citizens, thus improving the working of democracy, but a more educated society should produce more innovation, thus enhancing growth.
Economists in the United States have not been alone in extolling the virtues of education. Various multilateral organizations—UNESCO, UNICEF, the United Nations, and the World Bank—have all pointed to the important role that education has in reducing poverty and contributing toward stable, tolerant societies. Indeed, in 1990, the World Conference on Education, convened by most of these bodies, set universal primary education as a goal for every country by the year 2000 (a goal that has been missed by many countries) (Easterly, 2001, 71–72).
There is one problem with this emphasis on education as a key explanation of different growth rates across countries. When various economists have attempted to find a statistical correlation between the amount of schooling and economic growth (controlling for other factors affecting growth) in various countries, they haven’t been able to find one (Easterly, 2001, 73–84; Bosworth and Collins, 2003). To be sure, other economists have come to a different conclusion (Mankiw, 1995), especially if skills are measured by proxies of educational quality, such as test scores (Barro and Sala-i-Martin 2004, 537). Nonetheless, our reading of the studies as a whole is that the statistical verdict on the contribution of education to growth is still out.
There is an old saw that defines an economist as someone who tries to prove that something that works in practice works in theory. Maybe the education-growth nexus is an example. Indeed, given our criticisms of crosscountry regressions in chapter 3, it may not be surprising that the statistical studies that attempt to discern a link between education and growth are so mixed. Statistical studies cannot find what would seem to be obvious: that education matters for growth, period.
But then there may be a good reason for the murky picture. There are too many examples of highly educated countries where economic performance has been miserable. The former Soviet Union and the Eastern bloc countries boasted excellent primary and secondary educational attainment for much of their populations, but as the world has come to know since the Berlin Wall fell, those economies were in much poorer economic condition than many Western analysts had thought. Those nations were producing the equivalent of excellent parts for an economic engine that itself was fatally flawed. Without contract and property rights, there could be no entrepreneurs. In the end, the socialist economies essentially wasted the resources they poured into educating their populations (with the exception of space flight and certain military applications of scientific advance, where the Soviet Union was world class).
In his thorough study of economic growth, William Easterly points to another anomaly. As of 2000, when he finished his analysis, Easterly reports that while poor countries substantially expanded their education investments over the 1960–2000 period, the median growth rate of these countries steadily declined over these years (Easterly, 2001, 74). Literacy may well have improved in many of these countries, but corruption and military violence, among other factors, can offset any growth-enhancing impact of education.
We do not want to be misinterpreted. We are not asserting that education is irrelevant to growth or to improving the workings of national societies (whether or not they are governed democratically). Education indeed may have contributed to growth in the past in some countries, but that only proves that education is a necessary but not sufficient condition for economic advance. The institutions must be right for education to work its magic, just as the most brilliant baby will not grow up to be a brilliant adult without appropriate nutrition and training. Moreover, if education has spurred growth in certain parts of the world, that does not make it a peculiar feature either of entrepreneurial or big-firm capitalism. Economies that have been guided by the state have also benefited greatly from having better educated workforces.
We have two other observations on this subject. Assuming that, under the right institutional conditions, education is an important factor for a growing economy, an open question is whether economies earn a greater return overall from concentrating their educational investments among the elite, or whether a more universal approach is better. India has followed the former model, most other Southeast Asian countries the latter one. India’s approach is responsible for its great and growing success in information- technology-related businesses, but this sector accounts for only about 2 percent of the country’s output and labor force, though some forecasts have it accounting for as much as 7 percent by 2008 (Srinivasan, 2005). Hundreds of millions of Indians remain poorly educated. In contrast, Southeast Asian countries like Korea and Taiwan put greater emphasis on providing universal primary education when they were at similar stages of economic development. This strategy equipped much larger fractions of their labor forces with skills to work in labor-intensive manufacturing facilities, which several decades later have become not only state-ofthe- art, but fountains of innovation. Clearly, the universal education strategy is more equitable than the targeted approach followed by India. It will remain an open question for some time whether the targeted approach produces greater gains in national income.[18]
Our second point is that, whatever one may believe about the contribution of economic growth under any capitalist system so far, education is likely to become even more important a factor for growth in the future, especially in economies at the frontier. Until as late as the 1970s, the proverbial inventor in a garage without an advanced education could come up with commercially useful innovations, some of them quite radical. The greatest American inventor of all, Thomas Edison, did not complete high school. Even into the 1970s it was possible for two high school graduates, Steven Jobs and Steven Wozniak, to build a personal computer quite literally in a garage.
But there is reason to believe that those days are gone. The founders of some of the leading Internet-based companies—Amazon, eBay, Google, and Yahoo—all were college graduates; some had graduate training. Looking ahead, it seems far-fetched to believe that future commercially applicable advances in biotechnology, nanotechnology, or information technology will be made by high school–trained, garage-based inventors. To the contrary, innovations in these sectors, along with others, are likely to be developed either in university settings or by individuals with advanced university training. Since, for reasons already explained, entrepreneurial economies are more likely than those guided by governments or managed by large firms to generate the radical innovations that will spawn great leaps in future living standards, it follows that the future innovative entrepreneurs, as well as those running the big enterprises that successful entrepreneurial firms eventually will become, will be highly educated. In the future, therefore, education is likely to be more critical for economic success than ever before.
[edit] Macroeconomic Stability
As we implied in our first chapter, of all the advice that many countries have received about running their economies, the Washington Consensus set of remedies has commanded the field. Yet most of the consensus suggestions are concerned with stability first, then growth. The notion is that if countries get their macroeconomic policy house in order, they will be less susceptible to seemingly periodic financial crises. And without crises, they have a much greater chance of growing.
We do not dispute these basic propositions—indeed, they are essential— but they are not unique to any particular form of capitalism. Any capitalist economy, however it is structured, should want stability and the best way to assure this is through some combination of budgetary discipline (small deficits, if any, in relation to GDP), noninflationary monetary policy, and since the Asian financial crisis, some degree of exchange rate flexibility (or, failing that, a buildup in foreign exchange reserves).
But good macroeconomic policy grades do not assure economies will grow at their maximum rate in the long run. For that, we submit that our four conditions are far more relevant. Using a distinction often made by many economists, macroeconomic stability is essential to keep aggregate demand close to or equal to a society’s maximum potential output, but the four preconditions play a larger role in determining how fast that potential output will grow.
[edit] Democracy
There has been a long bipartisan tradition in the United States favoring democracy—free election and the rule of law—as the best form of government. In the early twentieth century, President Woodrow Wilson wanted to make the world “safe for democracy.” President John F. Kennedy urged the nation to “pay any price, bear any burden” in pursuit of democracy (and in fighting its nemesis, autocratic communism). President George W. Bush justified the war in Iraq, in part, on the need to establish democracy in the Middle East. The United States has not been alone in this quest for democracy. The European Union requires new members to have functioning democracies before they integrate economically.
Yet is democracy essential for the establishment of the four key ingredients for growth at the cutting edge? That democracy can be important for growth is difficult to deny. Political freedom is likely to enhance economic freedom and, in particular, to insulate the rules favoring entrepreneurship from removal at the whim of an autocratic leader who may change his or her mind about what is best for an economy.[19] Furthermore, well-functioning democracies are likely to reject oligarchic capitalism, since leaders of oligarchic societies cannot survive if they serve larger slices of a shrinking pie to only a few. Instead, democracies are driven by the need of their leaders to remain in power to expand the pie itself—that is, to enhance economic growth.
But is democracy necessary for these rules? Experience suggests otherwise. The remarkable economic growth of China attests to the fact that entrepreneurship can and has flourished under autocratic rule. Would China grow faster under democracy? Probably yes. Indeed, one recent study argues persuasively that, on average, democratically ruled countries, even those that are less developed, tend to grow more rapidly than autocracies (Halperin et al., 2005). But even this study does not demonstrate that democracy is essential for growth (though it effectively rebuts the opposite view, expressed by a number of analysts, that autocracy is a precondition for economic development, up to a certain point).
Now, ask the question the other way around: does economic growth lead to democracy? Certainly the experience of South Korea, which for decades after World War II was essentially a benevolent autocracy but eventually became a democratic form of government, supports this view (Glaeser et al., 2004). As incomes grow, so does a country’s middle class, which is more likely and able to demand political freedom. Conversely, there is ample evidence that countries already democratic are likely to backslide from that form of government when their economies perform poorly. It is striking, for example, that three-fourths of the collapses of democracies since 1977 were preceded by stagnant growth.[20]
But skeptics remain about the inevitability of democracy following strong economic growth. China has become a flash point. To some, continued growth in China may only strengthen the hand of the state and make it easier to deny political freedom (Bueno de Mesquita and Downs, 2005). Or as China gains economic strength, it will have more resources to pursue expansionist military objectives. At this point, of course, it is impossible to know whether the optimists or pessimists will prove to be correct about China. Our own view is that the odds are with the optimists— namely, that economic growth eventually will help democratize China, as it will other countries—but there can be no guarantee of this result.
One reason for being optimistic is to look to America’s early history and especially the experiences of many of the country’s founding fathers, which demonstrate that business skills can hone the talents needed to achieve and maintain self-governance. Benjamin Franklin, one of the authors of the Declaration of Independence, left copious writings describing how he had developed his diplomatic skills in the course of establishing himself as a printer. Paul Revere, a silversmith, was a consummate networker who used business contacts to coordinate the revolutionary effort. Alexander Hamilton, who managed a clerical office while still in his teens, later applied those skills to organize the Department of the Treasury. Even Thomas Jefferson, Hamilton’s adversary, who argued that America should remain a nation of farmers, was hardly the stereotypical rustic at the plow. He managed a sizable plantation and sought more scientific ways to cultivate it. In short, he was much like the best American entrepreneurs: a striver and learner, often brimming with ego and unconventional opinions, but civic-minded and, in the end, a farsighted philanthropist. In short, the experience of economic freedom seems to breed both the skills and the inclination for political freedom.
China’s business leaders may not be able to steer their country in the same way. But does that possibility mean that other countries—the United States, in particular—should do their best to thwart economic growth in China (or in other autocratically ruled countries, for that matter)? In our view, such a course is a recipe for a much more dangerous world. Autocrats who are shunned by rich countries would thus be given easy scapegoats for their countries’ poor economic performance. The politics of “blaming foreigners” has a long and unfortunately successful history. Why give autocrats such easy ammunition?
We believe the better course is to urge autocracies at least to recognize economic rights—in particular, the ability to start a business and to be rewarded if successful. The odds, in our view, suggest that political rights eventually will follow.
[edit] Conclusion
In this chapter, we have laid out what we believe are four essential ingredients for maximizing growth by economies at or near the frontier. In other words, these conditions need to be met if an economy wants to maximize the odds that it will generate and commercialize radical innovation. In brief, governments must make it easy for entrepreneurs to form businesses; they must see to it that these entrepreneurs stand to earn handsome rewards if they are successful; they should heavily discourage unproductive “entrepreneurship”; and they should see to it that entrepreneurs or their successors are not allowed to rest on their laurels but instead are motivated by continuing Red Queen games to continue innovating and commercializing. If political leaders are able to ensure the presence of these preconditions, they are likely to generate the blend of big-firm and entrepreneurial capitalism that we believe will best enhance growth in the long run.
This isn’t to say that other factors—culture, education, macroeconomic stability, and democracy—will not also enhance economic growth. Clearly they will. But in our view, these other factors are not unique to big-firm or entrepreneurial capitalism. Governments that want to guide their economies can benefit from having each of these factors in place. Furthermore, some of these factors—culture and democracy, in particular—are just as likely to be the products of the four basic preconditions as they are to be their precursors.
We also do not mean to imply that the four preconditions apply only to big-firm and entrepreneurial capitalism. Countries whose economies are heavily guided by the state can benefit from having institutions in place that promote entrepreneurship and Red-Queen-style competitions. Indeed, we believe that state-guided economies eventually must find ways of transitioning toward a blend of big-firm and entrepreneurial capitalism for a simple reason: at some point, the opportunities for imitation, the predicate for state guidance, will have been exhausted. At some point, economies must innovate rather than simply replicate. That is when state guidance will have run its course.
[edit] Notes
- ↑ The commission’s final report is United Nations, 2004. Among other things, it recommended that developing countries improve their systems of business and property registration.
- ↑ For example, it is somewhat surprising, at least to us, that the costs of property registration are zero in Saudi Arabia and very low in Belarus, Mongolia, Azerbijan, and Estonia; that among the countries with the lowest cost of hiring new workers are a number of Arab countries, Russia, and Kazakhstan (which we claim are essentially oligarchies); and that Saudi Arabia also is among those countries where it is easier to fire employees.
- ↑ The United States recently adopted amendments to its bankruptcy code that impose greater repayment obligations on individual debtors. Although generally this is a constructive move, since it imposes more responsibility on individuals, the law unintentionally may discourage entrepreneurs whose businesses fail but who declare personal bankruptcy, having incurred debts on their credit cards. We discuss this issue in chapter 8.
- ↑ The risks of entrepreneurship are somewhat overstated by the raw figures about failure rates of new enterprises. Many entrepreneurs fail simply because they don’t know what they are doing.
- ↑ One exception is Gentry and Hubbard (2004). These two analysts address features of the income tax system that are least likely to penalize entrepreneurship. In brief, they conclude that the flatter the tax schedule, the less likely entrepreneurship is to be discouraged.
- ↑ We also discuss in chapter 8 how the income tax system can be modified to provide greater incentives for growth than is now the case.
- ↑ See generally the work of Clifford Winston documenting the benefits of “economic” deregulation (Winston, 1993).
- ↑ This is true even in the case of Thomas Edison, widely regarded as the greatest American inventor (or inventor, period) ever: As Hargadon (2005, 120) explains: “The stock ticker—[Edison’s] first profitable product—combined a telegraph system with a crude early typewriter. The incandescent light was really invented forty years earlier. Edison’s brilliance lay in combining advances in lighting with advances in generators, wiring from the telegraph industry, and business models from the gas industry to create the first viable system of electric light for the home and office.”
- ↑ Indeed, one author has persuasively argued that the central problem posed by Microsoft’s monopoly in operating systems for personal computers was not the abuse of the power by the company, which was the heart of the U.S. government’s antitrust case against it, but instead the extensive, multilayered systems of intellectual property protection that surrounded the operating system (Abramson, 2005).
- ↑ Data from http://www.ppic.org/content/pubs/R_502ASR.pdf, p. 12.
- ↑ The case for redistribution through the tax system rests largely on the notion that as individuals’ incomes grow, their “utility” or satisfaction from an extra dollar or unit of income declines. If the objective of the tax system is to assess taxes in a way that equalizes the “pain” of losing a dollar or unit of income at the margin, then a declining “marginal utility of income” implies that tax rates should be progressively higher with income. Otherwise, a flat income tax would impose greater loss of satisfaction or pain, at the margin, on those with lower incomes than those with higher incomes.
- ↑ Readers interested in the antitrust laws and their enforcement can consult a wide variety of economic or legal textbooks on the subject.
- ↑ One of us (Litan) has reluctantly come to this conclusion from direct experience, after serving in the Antitrust Division at the Justice Department in the 1990s. Another author (Baumol) has reached this conclusion after extensive experience as an expert witness in antitrust and regulatory matters.
- ↑ One recent book argues that antitrust, or more precisely a set of policies that encourage competition from both domestic and foreign sources, is not as important, and may even be detrimental, in less developed economies as in economies closer to the technological frontier (Aghion and Griffith, 2005). This is because in a global marketplace, firms in developing economies are not likely to be able to compete effectively with those from richer countries. For rich economies, however, it would be a mistake, in the authors’ view, to shield firms from competition as it will dull their incentives for innovation. We refer to this analysis again in chapter 7 when discussing the economic difficulties confronting the continental European economies.
- ↑ Based on conversations and unpublished material Phelps has provided to us.
- ↑ Furthermore, if workers have multiple skills, the easier it should be for them to find other jobs if they lose their current ones, through no fault of their own, when demand for their firms’ products declines and managers have no choice except to shrink the workforce.
- ↑ Gary Becker from the University of Chicago won his Nobel Prize, in part, based on this work documenting the economic returns to education. Another Chicago economist, Theodore Schultz, also carried out similar work. See Becker, 1976, and Schultz, 1961.
- ↑ For one discussion of this issue, see Krueger, 2005.
- ↑ One study supports a related finding that democracy enhances growth by decreasing the probability of military coups, which can destabilize rules upon which both domestic and foreign business rely in making investment decisions (Persson and Tabellini, 2006).
- ↑ Halperin et al., 2005, 72–74. The authors report that there was a 2.5 percent probability that a democracy will backtrack in any given year. This probability rises to 4.3 percent if average per capita income growth over the preceding three years is less than 1 percent.
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