Edmund Phelps’s new book ignores the key role that states play in making innovation happen
Despite winning the Nobel Prize in Economics in 2006, Edmund Phelps has endeavoured to write a big and ambitious book—something like The Wealth of Nations for the 21st century. Phelps hopes to offer a bold new answer to the big question of why some nations are wealthy and others poor. While innovation is central to his story, Phelps does not understand how innovation occurs. What he intended as a learned argument for rolling back ‘big government’ ends up sounding like just another Tea Party diatribe.
Phelps is sceptical of narrowly economic explanations of the sustained prosperity that the U.S. and other Western nations experienced from the 1820s up through the 1970s. He suggests that modern values play a critical role in dynamic economic growth because they help undergird what he terms ‘indigenous innovation’. Phelps is contemptuous of accounts that explain economic dynamism as resulting from major scientific breakthroughs; he argues instead that it is the accretion of smaller, incremental innovations—carried out by many individuals—that constitute the true source of economic dynamism.
But Phelps is no student of technological history or of the innovation process, so he builds his theoretical structure on a decaying foundation. He accepts a foundational myth of modern economics—that of the heroic individual or heroic firm that persists against universal scepticism in bringing to market a new product or new process entirely through its own efforts. While correctly noting that innovation is always uncertain and a leap into the unknown, he jumps to the totally unwarranted conclusion that maximising this kind of indigenous innovation requires keeping government as far away from the innovation process as possible.
To be sure, there is some merit in Phelps’s rejection of accounts that make scientific breakthroughs the key motor of innovation and productivity growth. There is almost always a long road of trial and error and intermediate inventions required before society could, for example, take advantage of cheap and nearly universal electrical power. We have witnessed in recent years thousands of incremental innovations – both hardware and software – that have made the computer an indispensable element in our everyday lives. But Phelps’s mistake is to imagine that all of this incremental improvisation occurs in the private sector under the discipline of the market. The reality is that government plays a central role in these processes.
For one thing, Phelps ignores the documented role of warfare in accelerating the movement of new technologies into the core of the economy. Both the development of interchangeable parts that facilitated mass production and the emergence of the machine tool industry in the U.S. were the result of 19th century government initiatives linked to the production of weaponry. Airplanes and radio were greatly accelerated by WWI, jet engines and atomic energy by WWII; computers, lasers, and communication satellites emerged out of the Cold War. If heightened military spending has repeatedly accelerated innovation, then the claim that the private sector is innovating at the optimal level is obviously problematic.
For another, Phelps certainly knows that advances in agricultural productivity were critical for the dynamism of the U.S. economy after the Civil War. And that dynamism was directly linked to agricultural extension services. Scientists at laboratories at the Department of Agriculture and at the land grant universities engaged in systematic research to address the specific problems of soil, pests and irrigation that farmers faced in different parts of the country. Then agricultural extension agents, funded by the Federal Government, played a critical role in diffusing knowledge about agricultural best practices and helping farmers to adapt new technologies.
A further problem is that Phelps totally airbrushes out the enormously important role that government infrastructure spending plays in facilitating and complementing the initiatives of the private sector. Federal and state governments played a key role in the canal building boom in the first half of the 19th century. Astonishingly, Phelps attributes the building of the first cross-country railroad to Theodore Judah—a Sacramento-based engineer. But it was Abraham Lincoln’s initiative that led to the actual building of the transcontinental railroad. Phelps has no awareness that, at the beginning of the 20th century, the emerging electrical industry petitioned Congress to create a National Bureau of Standards because the private sector lacked the scientific knowledge and the standards necessary to build the first national grid. Nor does he acknowledge that government road building facilitated the rise of the automobile.
It is hardly surprising, then, that Phelps is also unaware of the dramatic changes that have occurred in the U.S. innovation system over the last three decades as big corporations have significantly cut back on their R&D spending. Innovations now come from the federal laboratories and many small and medium-sized enterprises that get direct federal support from an alphabet soup of different programmes and agencies. As documented by myself and Matthew Keller, eds, State of Innovation: The U.S. Government’s Role in Technology Development and more recently in Mariana Mazzucato’s terrific book, The Entrepreneurial State, each year these efforts produce hundreds or thousands of new commercial products ranging from cutting edge pharmaceuticals to the multiple technologies incorporated into Apple’s iPhones.
Phelps sounds like a member of the Tea Party when he denounces government efforts to influence technology development:
“It is far better to leave the directions of the economy to the competition of the market, since the state does not have the knowledge or judgment to improve the efficiency of the market’s allocation of investment. In fact, subsidies, mandates and GSE’s [Government Sponsored Enterprises] have a very sorry record of unintended consequences in agriculture, construction, energy, and finance…”
Apparently, Phelps would prefer that the Human Genome Project had never occurred, that the National Institutes of Health had not made possible gene splicing, or that the Defense Advanced Research Projects Agency had not created the first academic Departments of Computer Science, funded the key innovations found in the personal computer, or created the internet.
But Phelps’s argument about innovation sets up the second half of the book in which he contrasts his ideal model of economic organisation – ‘the modern economy’- with ‘corporatism’ – the type of economy that he sees as dominant in Europe and which he argues has increasingly infected the U.S. economy since 1970. Phelps defines corporatism by high levels of government outlays as a percentage of GDP, lots of business regulation, and tripartite systems of wage bargaining. He then tries to prove that such corporatist economies as Germany and France are less innovative and function less well than the economies of the U.S. and the U.K.
Without an effective way to operationalise or measure an economy’s capacity for innovation, Phelps’s empirical investigation involves a lot of cherry picking of data and a lot of dubious claims. He measures an economy’s capacity for innovation by the ratio of the market capitalisation of a nation’s stock market to its annual Gross Domestic Product, arguing that, since the capacity for innovation lies primarily with large firms, and since the stock market correctly evaluates the future productivity of these firms, the market cap to GDP ratio should indicate which nations are ahead in this category. It’s difficult to know where to begin with all of this.
Most large, publicly traded corporations in the U.S. have become increasingly less involved in innovation; many of the scientists and engineers have moved to smaller firms. Furthermore, firms can enjoy exalted levels of market capitalisation because they have market power like the big oil companies. But the stock market plays a much more central role in the U.S. than in the Continental European economies that have historically relied on bank lending to finance investments by private firms. So he has simply stacked the deck to make the U.S. and U.K. look better than France and Germany.
Phelps does not recognise that Germany remains a manufacturing powerhouse that is able to dominate global markets for its continually improving automobiles and machinery. He also ignores the fact that the four Scandinavian countries have been consistently ranked among the most competitive in the world in the rankings developed by the World Economic Forum. Obviously, European economies and the European project are facing serious difficulties, but Phelps’s dismissal of them all as corporatist disasters is tendentious and unpersuasive.
To end the book, Phelps conjures two outrageous and unwarranted conclusions. He claims that that U.S. innovation and economic performance has deteriorated since 1970 because of creeping corporatism—too much government. He then argues that, since he has effectively shown that European-style corporatism cannot work, it follows that people who complain about the injustice of great extremes of income and wealth inequality in the U.S. must understand that those are the price we pay for prosperity. He is so tangled in the contradictions of his own argument that it doesn’t occur to him that income and wealth inequality were actually significantly lower in the pre-1970 period when the U.S. was supposedly a more dynamic economy than it is now. Phelps’ book is not a serious effort to analyse innovation; it is rather a restatement of prejudices that are all too common among economists.
About the author
Fred Block’s recent research focuses on the activities of the U.S. government in support of the commercialization of new technologies. He has produced a series of papers and an edited book on this research ‘State of Innovation: The U.S. Government’s Role in Technology Development’, edited with Matthew R. Keller (2011, Paradigm Publishers).
His two most recent publications are ‘Explaining the Transformation in the U.S. Innovation System: The Impact of a Small Government Program’ (with Matthew R. Keller, 2012, Socio-Economic Review) and ‘Varieties of What? Should We Still be Using the Concept of Capitalism’ (2012, Political Power and Social Theory).