You can see this pattern again and again, from the railroad to electrification and onto the world of the automobile and highways, and then the computing-internet revolution, and again and again you can see this kind of unplanned collaboration between governments driven by some kind of mission, some kind of politically legitimate mission–national development and then national security–and on the other hand financial speculators will always be looking for some opportunity for super profit, for investing in assets whose prices could rise independently of any concern with current routine, boring, cash-flow and profit.
So this interplay, this is what I call the three-player model, this interplay between the mission-driven state, the financial capitalism–financial bubbles in the market–and the market economy transformed by that mobilization of resources at far larger scales and far deeper deployment than you’d expect to see in an economy operating according to the rules of mainstream economics where investments are based on a nice calculations of cost-benefit analysis, where everything happens incrementally, and you don’t have these transformational surges that leave behind a lot of waste, a lot of wreckage, but also step-function increases in production possibilities and consumption possibilities of the economy….
At the frontier, advanced progress is made by trial-and-error and error and error and error. Efficiency in the allocation of resources means doing this calculus of net-present value, expected future cash flows, cost versus benefits. But, at the frontier, you can’t define the benefits. You don’t know what the consequences of an NSF grant to a couple of graduate students at Stanford named Larry Page and Sergey Brin is going to produce, as that is going to become the page-track algorithm that is the basis of Google.
So you need sources of funding that are not concerned with immediately visible economic value and can tolerate waste and loss. That’s where, as I say, the mission-driven state, as it was coming out of World War II and into the Cold War, mobilizing upstream resources, creating the research university, funneling resources into upstream R&D, from computer science to the science of semi-conductors, and then becoming the early customer for things that are much too unreliable, much too expensive, to be commercially relevant.
Then once it takes hold, once the transfer comes to the private sector, then there’s promise, there’s a possibility of a new economy, that motivates investors to behave like extreme speculators, escaping from the narrow bounds of efficiency. That’s where I say, at the frontier of technological innovation, efficiency is the enemy of innovation.
That was Bill Janeway on the Hidden Forces podcast.
What I quoted was his story on the supply-side of the innovation cycle. But he finds that there is trouble on the demand side as well, which is where I started to get lost.
Here is Janeway again:
What Keynes suggested was that the investment function in the private sector was so fragile, was subject to so much uncertainty about what the returns out there were going to be that would motivate me, as a businessman, to invest today, that–and he actually put it this way in the General Theory–that it may prove necessary “to more or less socialize the investment function.” That’s exactly what we did.
He talks about how the Government has risen from 7% to 35% of GDP between 1929 and 2007, and that a bigger share of public spending we have now “offsets the contraction in the private sector” resulting from business cycles. How does this square with his earlier comments?
Warning! I have not read Janeway’s book. But I’ll try to interpret his story.
What I think Janeway was saying is that Government needs to invest more on the front end of R&D, which will mature technology until it can be speculated upon by financial markets. Then, inevitably, financial speculators will be either wrong or over-exuberant, leading to bubbles and crashes. While this is a necessary step for scaling technologies into the consumer world, it can also lead to misallocation, recession, and job-loss. So the Government must also be there on the back-end, through entitlement spending and the like, to mitigate the downside of the crashes it precipitated so that we avoid Great Depression scenarios.
Here’s a clue:
… you’ve got a Government, not just in the United States, that has proved incapable of buffering its constituents from the digital revolution that it was responsible for launching. No wonder we have anger, rage, outrage, etc. There are a lot of other aspects to this, but this is the essential story that I think is really important to address.
The three-player model has a nice flow. Government provides patient capital for R&D. Financial speculators decide who gets to scale in a competitive process that creates both volatility and transition. And consumers hold speculators into account by their market choices. Completing the flow is tax dollars to Government, with balancing feedback loops from Government to stabilize financial and consumer markets.
That’s a nice model, and Janeway relates it to the complexity of arising from the interactions in the three-body problem in physics. That provides a nice analogy.
I definitely agree with his idea that cost-benefit analysis and “efficiency” considerations are the enemy of innovation. I agree that waste is a pre-requisite in many cases to step-function increases in economic progress.
It is interesting that he views finance and markets as a key aspect to growing technologies out of Government sponsored experiments, because certainly we in the DOD have a big problem transitioning technology across the “valley of death.” This seems to avoid bureaucrats picking winners and losers, or planning economic production.
But I’m not sure Janeway is giving real consideration into how Government manages itself. Government investment uses cost-benefit analysis because it doesn’t have a market test. To be accountable, the Government needs extensive justification and documentation for any decision, and that always includes some quantitative analysis. Evaluation invites all manner of bureaucrats to weigh in on what projects, and whose friends, get funded. In either case, efficiency considerations will be foremost in Government because documentation to that effect removes charges of waste or abuse.
As you grow and formalize the process, you can’t expect the Government to fund people who have non-consensual ideas, which are the ideas most likely to offer these “super profits.” That would mean someone has taxpayer money and can allocate it freely with little articulated justification. No way that flies long without a major culture change, at least in the DOD. I suppose this is why Janeway needs the introduction of financial markets, because they make bets based on unarticulated, sometimes non-rational, expectations. This exposes us to “positive black swans.”
It is true that the Government is mission-driven. But at the front-end of R&D, you can’t say what technologies will aggregate into your specified requirements. Nor can you say that seemingly unrelated technologies will not solve your requirements in a new, unspecified, way. Technologies may even solve requirements you didn’t know you had.
Nevertheless, bureaucrats will have to make speculative R&D choices, which means the introducing peculiar cultural biases that cannot be easily changed in a Government hierarchy. Janeway seems to think that the Government is mission-driven, but is willing to take far-sighted bets with highly uncertain returns. I’m not so sure that is a stable state as more money and oversight enters the system.
Which brings us to another issue. Even if bureaucrats spend R&D funds wisely, who will scale the technologies to solve Government missions? How will financial speculators provide competitive benefits when the demand for important sectors — healthcare, infrastructure, education, and defense — is managed by the Government itself. Who is scaling technologies for these growing Government controlled sectors? As the cost disease problem gets worse, the three player model closes in on itself because consumers are making fewer choices of significance.
It’s like how many specifications of the three-body problem of gravity actually end up. Resonances between orbit frequencies increase until one of the three bodies reaches a bifurcation point and is ejected from the system. What remains is a stable two-body system, where no change occurs.
I posted recently about how aerospace firms in the early days understood that technical prestige was an end in itself, regardless of cost-benefit analysis. Firms today are investing in long-term projects and intangible assets that would otherwise seem like investment in public goods. They are discovering how to monetize it. Private patronage and prizes have also been a big driver of innovation historically. So I’m not so sure that the Government is the only source of patient capital and social support, but still, I agree that it should be a major source of innovative stimulus.
Overall, the podcast conversation made me want to read Janeway’s book, Doing Capitalism in the Innovation Economy. He has a lot of experience in finance and venture capital, so I’m sure there is a big piece of the picture I am missing from that podcast conversation, and because of that, I hope I did not misrepresent his view too badly.
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