The State’s Role in Investment and Innovation

by Benjamin Studebaker

It is often said that the state spends money inefficiently–or at least, less efficiently than the private sector spends it. The old Hamiltonian argument, in favour of the state as an investor, an engine of growth, technological development, and innovation, often falls on deaf ears as the opposition points to Solyndra, the “crony capitalism” of investment centred states like France or Japan, and so on down the line. Today, I would like to challenge this dismissal for being much too flippant and much too anti-historical.

The argument against the state as an investor usually points to several things, all of which are true:

  1. The state’s investments do not make as much money as private sector investment generally does.
  2. The state does not invest in what the market wants, but tries to fund products and technologies that people presently are not interested in.
  3. The state has a tendency to support unprofitable enterprises due to personal relationships between the bureaucracies (crony capitalism).

The third argument has some merit and I will address it momentarily, but first I would like to say something about the first two arguments.

These arguments are not relevant because they fail to acknowledge fundamental differences between the state and private enterprise. How is the state different?

The state has an exponentially more vast sum of money (along with exponentially more vast access to cheap credit), and so can sustain large short to medium term losses easily. This enables the state to make long-term investments in the economy divorced from what is profitable right now. The state does not have to care about whether the businesses it is investing in will be profitable soon. The state can wait decades for an industry to develop via its assistance. Even if the state eats tremendous losses, even if the state never directly profits from the enterprise it is investing in (let’s say it subsidises it rather than directly owns it), if an industry eventually develops in connection with the state’s policies, the state will eventually recoup all of its losses via increased revenues.

This is the equivalent to an investment firm being able to invest billions in a given sector, lose all of that money, surrender its right to directly receive a profit from that industry, and not only not go broke from doing so, but eventually end up recouping its losses and profiting from the exercise. No private investment firm on earth can do that. No investor can profit from an enterprise that is owned by someone else. No investor can throw the kind of money the state can throw at an industry and wait half a century to get it back. No investor can slowly claw back its investment through taxes on that industry and all industries connected with that industry over long stretches of time.

For instance, the state can invest in fuel efficient vehicles even if no one wants to buy them or is going to want to buy them for fifty years anywhere in the world. If, as a result of the state’s investment–even though the companies in which it’s investing remain private and none of their profits go directly to the state–an industry springs up that makes fuel efficient cars and that is world-leading, even if it is decades down the line, the state stands to come off scot-free. The state’s huge pile of money and credit mean that even if a slew of the state’s investments fail, the state can continue to try over and over again until it manages to achieve some kind of technological breakthrough that allows it to recoup all its losses through the resultant growth and revenues.

So the US government lost $385 million on Solyndra. So what? That’s not even 1/10th of 1% of the federal budget. The US government could subsidise a hundred Solyndras every year, and even if every last one of them failed miserably, it would make no significant difference to the state’s budget. And all it would take to make all of that worthwhile? One success. One enterprise that made the US the global solar panel powerhouse. If the US were to dominate that global industry, the sheer GDP growth in the long run would be gigantic, and the revenues thereby generated easily compensating the state for its efforts. Most importantly, the innovations would help real citizens. When the state invests money, it invests money in enterprises that will, if successful, make life better for people. When the private sector invests money, it invests in whatever people will buy tomorrow. It doesn’t care if it’s good for them, or in the social interest, or any of those ethical normative principles.

Imagine if we’d had this anti-government attitude when the question of whether or not to invest in New York City by building the Erie Canal came up. Or whether to boost economic growth in the west by building the transcontinental rail road (funded by government bonds), or the question of whether or not the state should invest in the atomic energy that gave us nuclear power and brought about peace through deterrence. Think of the lost opportunities, and how much further behind we would be, if the question of whether or not to build the canal in Panama had been left up to the investors of the day, or the establishment of the airlines had been merely a private affair. Think of all the technologies produced by the funding of NASA, or the Department of Defence (which, most famously, funded the internet). The government dreams bigger, thinks bigger, than the private sector.

So to summarise what we have here:

The state is:

  • Long-term
  • Public good based

The private sector is:

  • Short-term
  • Profit based

The only argument one could make against my response to the first and second points is to say that what is profitable is what is good, but given the tendency for people to make outrageous purchases of things they don’t need or things that are detrimental to wider society, it would seem to me that the fundamental premise is self-evidently fallacious. The argument that would run along with that one, that we cannot know what the public good is and thus should refrain from acting based upon it, is itself a metaphysical claim about the good and falls under the umbrella of “bad sceptical and/or libertarian arguments that tend toward nihilism and/or anarchism, respectively”.

Now all that said, that third point, about crony capitalism, presents a challenge. When the state throws good money after bad because the individual state employees’ jobs do not depend on the success of their investments, it allows personal relationships to dilute the rational long-term virtues of state investment. I would propose two solutions to states dealing with that problem:

  1. Selection of projects for investment based on independent criteria devised beforehand.
  2. Accountability for individuals making state investment decisions.

Crony capitalism is only possible because the selection process for state investment projects is subjective and not formalised. Criteria might include projections the enterprise in question must meet to be worthy of continued subsidy, for example. At the same time, the individuals making the decisions lack incentive to avoid bad investments, which could be gained if it were possible to fire them, on the one hand, or to pay them some kind of commission based upon their results on the other. In both cases however, the policies must be muted–if the state becomes afraid to invest in risky projects like Solyndra, it becomes less likely that the state will manage to stumble upon the next great technology or industry that can serve as an engine of economic growth going forward.