The Federal Role in Encouraging Innovation: The "I’s" Have It

From Volume 8 Feb 2011 Issue of the Journal

Previously published at the Innovation Policy Blog , December 17, 2010.

Last week, in a well-reported address, New York Mayor Michael Bloomberg made an impassioned argument that stimulating innovation is an essential federal economic role around which Democrats and Republicans can and should find common ground. Bloomberg called innovation “capitalism’s most powerful force” and said “Unless we innovate, we cannot hope to succeed. And if we do innovate, there is no way we can fail.”

The mayor then laid out six steps towards creating an innovation-based economy: instill confidence, promote trade, reform regulations, cut business taxes, invest in job training, and fix immigration.

I’m one with the mayor regarding the importance of innovation and the need and opportunity for bipartisan fashioning of a federal role to encourage it. While I agree in general with his six bullet points, I think the “how” of a federal effort requires several more elements. Moreover, it’s important to understand how the various elements connect with one another.

Riffing off of the key term “innovation,” each of the elements begins with the letter “I,” so I’ll call the framework the “I formation.” Here’s the framework, the explanation follows.


Institutions    Individuals

Investment    Information    Incentives

International Markets    Immigration

Intelligent Government

Let’s take them row by row. Innovation is the end—this being the ITIF weblog, we’ll take its value as understood.

Economically beneficial innovations—product and process, technical and organizational—are developed by our society’s institutions—such as large firms, startups, colleges, local governments—through the work of individuals, both inside these institutions and the self-employed.

What factors enhance the capacity of institutions and individuals to innovate? I suggest that they are investment, information, and incentives.

Adequate investment in developing individuals’ skills, abilities, and knowledge is critical. So is sufficient investment in the wide array of efforts that support or enable innovation, such as new business development, R&D programs, product commercialization, machinery and equipment, and transportation infrastructure.

The many millions of individuals and institutions in the U.S. need access to current, accurate information to make good decisions about, for example, what careers to enter, if you are an individual; what degree programs to offer, if you are a community college; and where to locate operations, if you are a company.

Individuals and institutions also need the proper incentives to be innovative, incentives provided by the marketplace (e.g., to make profits), by the organizations in which individuals work (e.g., to get a promotion and recognition), and by the government regulations and tax structure (e.g., to invest in R&D).

In the last 30 years, the boundaries of the U.S. economy have become quite porous in terms of the movement of goods, services, and people. As one result, the health of the U.S. economy is very much a function of its competitiveness in international markets and that in turn depends on its ability to innovate. Moreover, U.S. innovation increasingly relies on our capacity to build on the inventions and inputs available beyond our shores.

The nation’s remarkable attraction to immigrants presents its own opportunities and challenges. The opportunities lie in bringing technically talented individuals to our universities and firms and keeping them here. The challenges are in building the knowledge, skills, and abilities of millions of poorly educated immigrants so that the capacities of the nation’s human capital base to create and compete do not erode.

Markets are a remarkable human innovation, a powerful means for determining investments, information, and incentives in an international context. However, markets have failures—tears, holes, and bloats that misallocate resources to society’s detriment. A key federal government role is to address these failures so that markets can work better. To bring Mayor Bloomberg back to the conversation: “Government is not an innocent bystander in the marketplace, and it should not pretend to be. In the face of the current economic weakness, government must act: decisively, responsibly and immediately.”  To which I’ll add another adverb: intelligently.

Economic theory says there are four kinds of market failures for the government to address—inadequate information (buyers and sellers need full information to make good decisions), externalities (when the full costs or benefits in production or consumption of a product or service aren’t reflected in pricing, e.g., the societal benefits of innovation), public goods (e.g., information is underproduced because it stays whole after being consumed and is readily available to anyone, so it’s hard to make a profit), and monopolies (which misallocate consumer resources by setting high prices).

The federal government has five types of tools at its disposal to address market failures—money (e.g., tax rates and credits, grants), regulations (e.g., patent laws), information (e.g., data on industry, occupation, and educational attainment by county), facilitation (catalyzing relationships among potential collaborators), and procurement (stimulating market demand for socially valuable goods by taking advantage of economies of scale to reduce costs per unit).

Which leads back to the “I formation”—the government has an essential role in seeing that institutions and individuals have the investment, information, and incentives they need to be innovative in an international economy. And the government needs to be smart about how it carries out that role.

The first step in being smart is to explicitly acknowledge that significant innovation-inhibiting market failures exist. The second step is to identify the nature of these market failures and the appropriate array of policy tools to address them. For many reasons, including the current budget and deficit environment, money and regulation should be instruments of last, not first, resort—money because by definition it is expensive and regulations because they are difficult to get right and susceptible to unintended consequences. Information and facilitation, on the other hand, are incredibly cheap and offer almost infinite return on taxpayer investment. (Think for instance, about the utility of the Gross Domestic Product measure in guiding the operation of our $14 trillion economy and the consequences if that measure didn’t exist. The program that produces GDP cost $33 million in 2010, less than two years of salary that the Philadelphia Phillies just announced it will give to pitcher Cliff Lee.)

The third step is organizing federal policy tools into a thoughtful innovation-based competitiveness strategy that sets goals and determines how to apply a particular set of tools to achieve them.

That’s what an intelligent government would do. Sadly, over the past 30 years, ours hasn’t been that intelligent. Two impediments make that difficult.

The first is that we don’t have a federal structure for creating and implementing a sound competitiveness strategy. Our primary economic policy institutions—the Federal Reserve, the Treasury Department, the Council of Economic Advisers, OMB—focus on using fiscal and monetary policy to manage the business cycle. The current policy arrangement came into being with the Employment Act of 1946, which sought to ensure that the nation would not experience another Great Depression. In the hegemonic, oligopolistic, relatively isolated economy of the time, the competitive and innovative capabilities of U.S. firms were not a concern. Efforts to support innovation took place outside of economic policy, e.g., creating the National Science Foundation

While current policy structure was an appropriate, innovative approach to mid-20th century conditions, times have changed, dramatically. Since the 1970s, our economy has experienced increasing structural vulnerabilities which have led to loss of economic competitiveness and economic dislocations. However, a policy-making structure to coherently address the new realities of global competition hasn’t followed.

Rather, the government has either ignored problems—assuming no market failures and American exceptionalism—or created an idiosyncratic, ad hoc, mish mash of grant programs and regulatory efforts—in education, workforce development, technology development, economic development, and financial markets, for example—of varying effectiveness and minimal synergies. In contrast, many foreign nations and U.S. states and regions have sought to create a set of inter-related policies within a coherent strategy. But it is difficult for state and regional competitiveness strategies to be fully effective in the absence of a federal one.

The second impediment to intelligent government is an outdated view of how the world works. Federal economic policy is based on the Keynesian notion that the economy is like a machine that can be operated through the adroit use of the levers of fiscal and monetary policy and appropriate regulations. Our economic policy agencies grew up in a world that saw the value of size and scale and believed in the possibility of central control of enormous resources to address major challenges. Macroeconomic policy emerged as a form of “social engineering” consistent with the physical engineering and industrial models that made America an economic giant—think the Hoover Dam and Ford Motor Company—in the first half of the 20th century.

Once America became wealthy and stable enough in the 1960s to concern itself with economic equity, the government again used the “top down” engineering approach to design Great Society grant programs and many such programs since.  For instance, the Economic Development Administration’s Public Works Program was built on a mechanical, formulaic model—using precise criteria and equations to allocate funds to distressed regions for missing physical inputs, typically roads and industrial parks, which were expected to enable economic prosperity.

The 21st century economic world, however, cannot be managed like a machine—it is full of complexity, uncertainty, and the unseen forces behind the daily decisions of hundreds of millions of U.S. market actors in the context of billions around the globe. Innovation is a very serendipitous process; insights emerge from determination, relationships, and chance. Moreover, technological innovations now allow institutions and individuals to grow, change, move, and morph in ways never before possible. If the mid-20th century economy seemed to operate on the principles of machine-like Newtonian physics, the 21st century one looks like it runs on the principles of quantum physics.

So while the “top down” approach to macroeconomic policy is appropriate, it is inadequate for innovation-stimulating efforts—there is no machine or formula for generating creativity. Rather, to a large extent, the government’s effort needs to be “bottom up,” increasing the probabilities that successful innovations emerge by providing investments, information, and incentives that can nudge the behavior of millions of market actors in productive directions.

There are many examples of such “bottom up” policies—small grants to catalyze regional innovation cluster initiatives; capital gap-filling investments and appropriate regulations that encourage private sector financing of emerging companies; R&D tax credits; and data on occupational demand to allow informed career decisions.

An intelligent government that can design and operate such programs as part of an overall competitiveness strategy requires a capacities different than those often found in government, capacities consistent with the type of innovative firms the nation needs (as Great Society program management skills mirrored the “command and control” skills found in bureaucratic corporations). These capacities include creativity, risk-taking, patience, relationship-building, and technical assistance.

Ultimately, in an unrelentingly competitive world , an innovative U.S. economy requires intelligent government that drives the connections among the “I’s” and leads the nation to economic strength.

Mayor Bloomberg framed his speech around the idea that a thoughtful package of federal policies to stimulate innovation “can be embraced by those across the political spectrum.” The notion of a government role to improve the ability of markets to generate innovation draws on key tenets of the Republican and Democratic parties.  Politically, the opportunity exists for bipartisan recognition that the “I’s” hold the answer to the nation’s economic future. The need is for cooperative action to translate recognition into meaningful policy.

[In an exquisite bit of timing, the Senate today unanimously approved an amended version of the House-passed reauthorization of the America COMPETES Act, focusing “on three primary areas of importance to improving American innovation and competitiveness: (1) increase science and research investments, (2) strengthen STEM education, and (3) develop research infrastructure.”

Consistent with a key point of the blog, the Senate bill adds language directing the Secretary of Commerce to complete “a comprehensive study of the economic competitiveness and innovative capacity of the United States” within a year of the bill’s passage and, within a year after the study, “develop, based on the study . . . , a national 10-year strategy to strengthen the innovative and competitive capacity of the Federal Government, State and local governments, United States institutions of higher education, and the private sector of the United States.” The requirements of the study and strategy are detailed in seven pages of text. The text calling for a study and strategy came fully from a bill proposed by Senator Warner this summer.

The bill authorizes several “bottom up,” relationship-building programs, including Regional Innovation and Partnerships for Innovation.

The bill also creates a number of new organizational entities, including, within the Commerce Department, a new Under Secretary for Standards and Technology and a new Office of Innovation and Entrepreneurship; within NSF, a new Center for Science and Engineering Statistics; and within the National Science and Technology Council, subgroups to coordinate STEM education efforts, advanced manufacturing research, and policies on the dissemination and stewardship of federally-funded science research.

So here we have bipartisan approval of a restructuring and rationalization of federal innovation efforts and the creation of a competitiveness strategy. While I’ll reserve judgement on the Senate’s specifics until I look at them more closely (the bill is less ambitious than the House version), it’s an interesting experience to propose a major policy recommendation and read that a form of it was agreed on a moment later. Here is hoping the House can take up and approve the bill before adjournment. Note: House approval in in May was not nearly as bipartisan as in the Senate—all Democrats but only 17 Republicans voted in favor.


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