The Paradox of Innovation

Over the past few weeks I've been researching different start-ups and venture capital firms.  During my adventures around the datasphere, I ran into a few ideas and notions that piqued my interest.  I will highlight two of these in this post.

The first is the basic nature of innovation.  It is both essential to the functioning of capitalism and remarkably unprofitable.  The reason innovation tends to be unprofitable is because it is much more likely for a given innovation or start-up to fail than to succeed.  This led me to consider the futility of the rational, profit-maximizing model in accounting for such a fundamental aspect of capitalism.  What then, leads people to innovate?  Is it a survival instinct?  "Animal spirits"?  Risk preferences?  This is a basic question that appears to still be largely unanswered.

The second was that venture capital is not all it is cracked up to be.  By this I mean, the image of venture capital as a supporter of innovation, start-ups, and the "small guy" does not appear to be all that true.  Maybe this was a mistaken notion I had, but my sense is that this is a broader misconception.  As this blog post indicates, after years of meagre and negative returns, venture capital now tends to avoid true start-ups and bet more on tested business models and experience.  This feels distinctly anti-innovation.  By definition, innovation is something that has not been before.  This means that the next Google or Facebook will seem like a weird/crazy/idiotic idea now; and that's the point.  It's interesting to note that both Google and Facebook were turned down in their attempts to solicit venture capital funding.  I would guess that the conservative approach to innovation in venture capital firms is likely tied to the pressure on people making the investment decisions.  For example, when the 19 year-old working out of a garage on some outlandish idea you invested in fails, that is tough to explain to the investors who trusted you with their money.  With a failed bet on a tried business model run by experienced business men, you can more easily justify your decision.  The inherent unprofitability of innovation has probably forced vc firms farther down the innovation chain, which means other sources of funding will remain important.  

EconTalk Podcast

Here is a link to an EconTalk podcast by Larry White and Russ Roberts in which they discuss business cycles, money, and Hayek. I found two sections of the podcast particularly lucid and perspicacious:

1. The central bank's role in creating bubbles

and

2. The importance of the velocity of money

In the absence of a central bank, the interest rate serves to balance the amount of savings and investment in an economy. During times of innovation, for example, entrepreneurs seeking funds for new investment opportunities will bid up the interest rate, ensuring only those new projects that are forecasted to be the most profitable get undertaken. In addition, the higher interest rate redirects savings from the least profitable, older investment opportunities to the most profitable, new opportunities. The limited nature of real resources and savings renders this reallocation essential.

When a central bank enters the picture, the automatic interest rate rise that occurs when new entrepreneurs start competing for finite savings is impeded. The central bank may be slow to raise interest rates, accommodating both the least profitable, older investment opportunities, and the most profitable, new opportunities. Larry White points out that this creates the illusion that there are more savings than there actually are, leading to overinvestment. Prices begin to rise as more and more firms financed by the cheap credit bid for scarce inputs. Leaving interest rates low accelerates this inflationary process, so the central bank will likely raise interest rates - cutting the supply of cheap funding and spelling doom for many borrowers. This kind of overinvestment bubble exaggerates a genuine innovation boom, and points to the role central banks play in perpetuating this type of bubble.

In another section of the podcast, Larry and Russ discuss the importance of the velocity of money. They begin with the equation of exchange MV=PT, which is essentially an identity between total spending and total income. The "V" in the equation is the velocity of money, or the rate at which money is changing hands. What I found interesting is how Roberts framed "V" as a measure of the general psychology in the economy, and in particular, expectations about the future. When people are unsure about future economic conditions, they tend to hold onto their money and spend less until the future becomes clearer.

We are seeing this in the economy today - there has been an enormous increase in M, but since V is so low, the increase in M has not had the predicted effect. However, the efficacy of increasing M to spark recovery is undermined by the difficulty in measuring V. If we do not have an accurate measure of V, there is no way to know how much M should be increased for the desired effect. Thus, the next best solution is to strive to stabilize V. In other words, stabilize people's expectations about the future. This includes expectations regarding inflation, tax conditions, and the regulatory environment. None of these areas are at all clear in the current climate, leading to the current difficulties jumpstarting the economy with traditional monetary and fiscal policy. For any hope of a recovery, stable policies should be put in place in order to anchor expectations about the future.

Obama's Jobs Proposal

Obama recently proposed a small business jobs and wages tax cut as part of his campaign to increase job creation, and aid the economic recovery. The proposal has three key aspects:

1. Businesses will receive $5,000 for every net employee they hire in 2010. This credit is capped at $500,000 per firm to ensure small businesses receive the majority of the credit.

2. Businesses that increase wages and hours for existing workers will be reimbursed for the Social Security payroll taxes they pay on wage increases above inflation. This credit does not apply to wage increases above $106,800.

3. Companies can claim these credits on a quarterly basis.

This is a purely supply-side stimulus proposal, meaning, these tax credits will have no affect on the underlying demand for the products of these businesses. In other words, while facing the same level of demand, and therefore revenues, firms must increase their costs in order to take advantage of this tax credit. Ergo, the firms best-placed to take advantage of these tax credits are those firms that are already recovering and already thinking about adding new workers or increasing wages. While firms on the margin deciding whether or not to add a worker or increase wages will also be impacted, firms struggling the most will be unaffected by this subsidy as they have no room for any increases in costs.

I believe this proposal is largely a political maneuver, and will prove futile in creating the amount of new jobs alluded to in the administration's rhetoric. By targeting already rebounding businesses, the administration simply piggy-backs their recovery and will probably attribute these business' recovery to this subsidy in the future. Indeed, this subsidy will create some jobs on the margins, but many of the jobs that will be attributed to this subsidy would have been created without this subsidy. In addition, when tampering with the tax code, one must always consider the skewed incentives. This subsidy is no exception. Individuals currently working for a struggling businesses will have an incentive to quit their jobs and move to companies that are positioned to take advantage of the subsidy, and thus receive higher wages. This can hardly be considered job creation. This proposal, while not overly harmful to labor markets, will ultimately prove impotent at its goal of job creation.

Better Stay in School...

Every few years, the OECD conducts an international student evaluation called the Programme for International Student Assessment (PISA). In the latest round of testing (2006), the United States scored statistically significantly below the OECD average in both math and science (the reading portion was not counted due to a printing error in the test booklet), as well as below many non-OECD countries. The results of this study, combined with the meritocracy-enhancing effects of globalization, do not bode well for the economic future of the United States.

With globalization's help, meritocracy is on the rise. With the technological and infrastructural advances in communication over the past fifteen years, the significance of geographical location has fallen. The proliferation of high-speed internet access and falling software prices have helped shape a world where many jobs can be done from anywhere. Consequently, competition for many jobs has shifted to a global scale. While these developments are encouraging for economic efficiency; for the US economy, they are less so.

A basic lesson of economics is that standard of living depends on the level of productivity. Shifting from older, less productive industries, to newer, cutting-edge industries increases productivity, and thus standard of living. Thus, the strongest economies are those with the most brainpower, on the cutting-edge of innovation and productivity. In the recent past, this has been the United States. Recent trends in globalization and the recent PISA results, indicate that US's term as the world's strongest economy could be nearing its end. Specifically, a significant threat appears to be brewing in east Asia as China, Korea, and Japan are all among the top scorers in math and science.

The new global dynamics of our world will present the US with an unprecedented level of economic competition in terms of innovation and knowledge. The US has been detrimentally complacent in coming to terms with this reality. Regrettably, real change in the form of education reform will probably only come once the consequences of this complacency become tangible.

PISA Results: OECD PISA 2006 Report.

Dubious Defense of Protectionism

I recently came across an interesting article in the French magazine Marianne by Maurice Allais, the sole French Nobel Prize winner in economics (1988). The article is titled "Contre les tabous indiscutes", which literally translates to, "Against Unmentionable Taboos". As the title would indicate, it is a defense of what he perceives to be "unmentionable taboos". One such defense, that I will discuss here, and find particularly problematic, is that of protectionism.

Allais claims that protectionism has been deemed taboo as a result of the G20's doctrinal approach to free trade. He proceeds to counter this taboo while outlining both good and bad forms of protectionism. For Allais, bad protectionism occurs between two countries with similar incomes, while good protectionism occurs between countries with disparate incomes. For Allais, good protectionism is justified by wage and production cost disparities. He doubts higher income countries' ability to compete with lower wages in developing countries. He cites the vast outsourcing he believes is causing French unemployment to rise, and what he vaguely terms "aggravated social situations". Allais argues an absence of his brand of protectionism will destroy industry in richer countries, sending unemployment skyward. In addition, Allais contends developing countries will be helped as they will not have to deal with corporations leaving as soon as wages rise.

As a Frenchman, Allais' primary concern appears to be rising unemployment in France. While his concerns are normal, his responses to and prescriptions for these concerns are misplaced. At one point in his article, Allais points out that free trade is not an end in and of itself, that it is simply a means to an end. This is true, yet Allais fails to recognize this same notion with respect to French industry. At one point, Allais writes, "To me, it's scandalous that companies close sites in France, only to open new ones in areas with lower costs." For me, this is not scandalous at all; in fact it makes sense. Allais ignores a critical aspect of capitalism: creative destruction. Capitalism in operation is never in stasis, resources are constantly shifting, and this includes industries. To think there is some normative set of industries for a certain country is to miss the quintessence of capitalism. The apt response is not to give a crutch to a specific industry, but to shift to new industries, new sources of comparative advantage. If Allais feels government action is necessary, perhaps his government can promote and expedite innovation, smooth the shift to something new.

Allais paints a picture of a future France devoid of industry, with millions of French out of work with nothing to do. This is a static view of economic reality. Are those millions unemployed not free to find work in a more competitive industry, perhaps start their own business, or learn new skills? In other words, adapt? Protecting inefficient domestic industry helps a specific industry in the short-run, at the expense of future economic competitiveness and standard of living. While this trade-off may sound abstract, future economic uncompetitiveness can manifest itself in many forms; including the unemployment Allais fears.

Krugman on Europe

Paul Krugman recently penned this article in The New York Times comparing the United States and Europe. The crux of his argument is that European-style social democracy does not sacrifice anything in terms of economic dynamism when compared to the relatively more liberal (in the classical sense) United States. As a result, he claims the United States can learn from Europe and shed its fear of the stagnancy that is commonly thought to accompany the welfare state. However, Krugman's argument is remiss and has several weaknesses.

Since 1980, per capita real G.D.P. — which is what matters for living standards — has risen at about the same rate in America and in the E.U. 15: 1.95 percent a year here; 1.83 percent there.

This is Krugman's attempt to forge a link between European-style social democracy and economic dynamism comparable to the United States. However, Krugman clumsily ignores his own words and avoids mentioning the per capita GDP values, instead opting for the more convenient growth rates. According to the IMF's 2008 PPP adjusted GDP per capita numbers, the 2008 average for the EU 15 was $38,174, and $47,440 for the US. This is not an insignificant difference. In addition, if both percentage growth rates are similar, while the actual per capita incomes are different, the larger income will gain more relative to the smaller income. This can hardly be considered equal, and seriously undermines Krugman's argument.

Taxes in major European nations range from 36 to 44 percent of G.D.P., compared with 28 in the United States. Universal health care is, well, universal. Social expenditure is vastly higher than it is here.

So if there were anything to the economic assumptions that dominate U.S. public discussion — above all, the belief that even modestly higher taxes on the rich and benefits for the less well off would drastically undermine incentives to work, invest and innovate — Europe would be the stagnant, decaying economy of legend. But it isn’t.

After Krugman's sleight of logic earlier, he takes his conclusions to the extreme by claiming taxes do not affect incentives to work, invest, and innovate. Coming from an economist, the idea that you can tax people and not impact incentives to work, invest, and innovate is cavalier. When you increase taxes, it does not affect everyone's decisions, it affects decisions at the margin. This does not mean an economy with 8-16% higher taxes morphs into a regressive, decaying economy, only that marginal investment, work, and saving decisions are impacted.

The general point he attempts to get across is that Europe is not that bad, and offers more welfare options for its citizens. Europe is not that bad, there are certainly worse places to live. But, that does not mean the US should increase taxes and welfare programs either. The US and Europe have different preferences, and one could argue that our governments reflect these preferences. Also, there is a surprising dearth of evidence that argues welfare is actually helpful for those who receive it. As an economist should know, just because a program intends to do help people, does not automatically mean it correctly aligns all relevant incentives (See "Poverty Traps" a couple posts down). At first Krugman's article appears lazy. Especially when he concludes with the vague notion that there is no trade-off between social justice and progress. These terms are far from clearly defined, and he does not even attempt to do so in his article. In the end, Krugman's article transcends its apparent laziness and reveals itself for what it is: blind promotion.

Mankiw Test Question

Every so often, Greg Mankiw, an economics professor at Harvard posts an introductory economics test question on his blog. Here's the link to one such question...

Click on the image below for my answer

I am by no means omniscient in this matter, so be sure to comment if you came up with different answers.