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Why We Need To Invest In An Innovation Economy

2021 October 24
by Greg Satell

The Cold War was fundamentally different from any conflict in history. It was, to be sure, less over land, blood and treasure than it was about ideas. Communist countries believed that their ideology would prevail. They were wrong. The Berlin Wall fell and capitalism, it seemed, was triumphant.

Today, however, capitalism is in real trouble. Besides the threat of a rising China, the system seems to be crumbling from within. Income inequality in developed countries is at 50-year highs. In the US, the bastion of capitalism, markets have weakened by almost every imaginable metric. This wasn’t what we imagined winning would look like.

Yet we can’t blame capitalism. The truth is that its earliest thinkers warned about the potential for excesses that lead to market failure. The fact is that we did this to ourselves. We believed that we could blindly leave our fates to market and technological forces. We were wrong. Prosperity doesn’t happen by itself. We need to invest in an innovation economy.

Capitalism’s (Seemingly) Fatal Contradiction

Anyone who’s taken an “Economics 101” course knows about Adam Smith and his invisible hand. Essentially, the forces of self-interest, by their very nature, work to identify the optimal price that attracts just enough supply of a particular good or service to satisfy demand. This magical equilibrium point creates prosperity through an optimal use of resources.

However, some argued that the story wasn’t necessarily a happy one. After all, equilibrium implies a lack of economic profit and certainly businesses would want to do better than that. They would seek to gain a competitive advantage and, in doing so, create surplus value, which would then be appropriated to accumulate power to rig the system further in their favor.

Indeed, Adam Smith himself was aware of this danger. “People of the same trade seldom meet together, even for merriment and diversion, but the conversation ends in a conspiracy against the public, or in some contrivance to raise prices,” he wrote. In fact, the preservation of free markets was a major concern that ran throughout his work.

Yet as the economist Joseph Schumpeter pointed out, with innovation the contradiction dissipates. As long as we have creative destruction, market equilibriums are constantly shifting and don’t require capitalists to employ extractive, anti-competitive practices in order to earn excellent profits.

Two Paths To Profit

Anyone who manages a business must pursue at least one of two paths to profit. The first is to innovate. By identifying and solving problems in a competitive marketplace, firms can find new ways to create, deliver and capture value. Everybody wins.

Google’s search engine improved our lives in countless ways. Amazon and Walmart have dramatically improved distribution of goods throughout the economy, making it possible for us to pay less and get more. Pfizer and Moderna invested in an unproven technology that uses mRNA to deliver life-saving molecules and saved us from a deadly pandemic.

Still, the truth is that the business reality is not, “innovate or die,” but rather “innovate or find ways to reduce competition.” There are some positive ways to tilt the playing field, such as building a strong brand or specializing in some niche market. However, other strategies are not so innocent. They seek to profit by imposing costs on the rest of us

The first, called rent seeking, involves businesses increasing profits through getting litigation passed in their favor, as when car dealerships in New Jersey sued against Tesla’s direct sales model. The second, regulatory capture, seeks to co-opt agencies that are supposed to govern industry, resulting in favorable implementation and enforcement of the legal code.

Why “Pro-Business” Often Means Anti-Market

Corporations lobby federal, state and local governments to advance their interests and there’s nothing wrong with that. Elected officials should be responsive to their constituents’ concerns. That is, after all, how democracy is supposed to work. However, very often business interests try to maintain that they are arguing for the public good rather than their own.

Consider the issue of a minimum wage. Businesses argue that government regulation of wages is an imposition on the free market and that, given the magical forces of the invisible hand, letting the market set the price for wages would produce optimal outcomes. Artificially increasing wages, on the other hand, would unduly raise prices on the public and reduce profits needed to invest in competitiveness.

This line of argument is nothing new, of course. In fact, Adam Smith addressed it in The Wealth of Nations nearly 250 years ago:


Our merchants and master-manufacturers complain much of the bad effects of high wages in raising the price, and thereby lessening the sale of their goods both at home and abroad. They say nothing concerning the bad effects of high profits. They are silent with regard to the pernicious effects of their own gains. They complain only of those of other people.


At the same time corporations have themselves been undermining the free market for wages through the abuse of non-compete agreements. Incredibly, 38% of American workers have signed some form of non-compete agreement. Of course, most of these are illegal and wouldn’t hold up in court, but serve to intimidate employees, especially low-wage workers.

That’s just for starters. Everywhere you look, free markets are under attack. Occupational licensing, often the result of lobbying by trade associations, has increased fivefold since the 1950s. Antitrust regulation has become virtually nonexistent, while competition has been reduced in the vast majority of American industries.

Perhaps not surprisingly, while all this lobbying has been going on, recent decades have seen business investment and innovation decline, and productivity growth falter while new business formation has fallen by 50%. Corporate profits, on the other hand, are at record highs.

Getting Back On Track

At the end of World War II, America made important investments to create the world’s greatest innovation economy. The GI Bill made what is perhaps the biggest investment ever in human capital, sending millions to college and creating a new middle class. Investments in institutions such as the National Science Foundation (NSF) and the National Institutes of Health (NIH) would create scientific capital that would fuel US industry.

Unfortunately, we abandoned that very successful playbook. Over the past 20 years, college tuition in the US has roughly doubled in the last 20 years. Perhaps not surprisingly, we’ve fallen to fifth among OECD countries for post-secondary education. The ones who do graduate are often forced into essentially decades of indentured servitude in the form of student loans.

At the same time, government investment in research as a percentage of GDP has been declining for decades, limiting our ability to produce the kinds of breakthrough discoveries that lead to exciting new industries. What passes for innovation these days displaces workers, but does not lead to significant productivity gains. Legislation designed to rectify the situation and increase our competitiveness stalled in the Senate.

So after 250 years, capitalism remains pretty much as Adam Smith first conceived, powerful yet fragile, always at risk of being undermined and corrupted by the same basic animal spirits that it depends on to set prices efficiently. He never wrote, nor is there any indication he ever intended, that markets should be left to their own devices. In fact, he and others warned us that markets need to be actively promoted and protected.

We are free to choose. We need to choose more wisely.

– Greg


Image: Unsplash

2 Responses leave one →
  1. October 25, 2021

    Amen Greg, your many points here are spot on. For everyone’s sake including the entrenched giants innovation is the only answer. Change will come regardless of whether we wish it or not, it is the one constant but we can have some impact on whether change is constructive or destructive and who it impacts. When we ignore this, when we do not foster new ideas and approaches we simply turn up the pressure and it comes nonetheless.
    All the best

  2. October 25, 2021

    Absolutely true! Thanks Robert!

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