How involved should the state be in funding innovation? And how much payback should it get when state-funded ideas become commercial successes? A new book explores these issues. By Lisa Bushrod.
The question of state funding of innovation is a controversial one, with many arguing that it is best left to the private sector. The Entrepreneurial State: Debunking Public vs Private Sector Myths, by Mariana Mazzucato, seeks to argue otherwise. It lays out the case that the state can drive innovation, despite the current narrative that clamours for paring back the state’s influence, highlights its failures and ignores its successes.
The book began life as a report commissioned by centre-left think tank Demos in 2011 and has since been significantly expanded. “I wanted to convince the UK government to change strategy,” explains Mazzucato. “To not cut state programmes in the name of making the economy ‘more competitive’ and more ‘entrepreneurial’, but to reimagine what the state can and must do to ensure sustainable post-crisis recovery.”
Mazzucato points to a recent success story of state-backed involvement. “When the UK government wanted to create a website, it looked to outsource it to Serco,” she explains. “This is because the mentality in government has become, ‘We are stupid, we don’t know how to make websites’.” But Serco did not end up doing the work. “Key people in the BBC’s iPlayer team stepped in and created the www.gov.uk site at a fraction of what Serco was charging,” she says.
In the book, Mazzucato says: “...by dismissing the ability of the public sector to be an innovative force from within... this has created a self-fulfilling prophecy, where the smartest young graduates think that it will be more exciting and fun to work at Goldman Sachs or Google... The only way to rebalance this problem is to upgrade, not downgrade, the status of government – and the words and the images used to describe it.” The iPlayer team, she believes, has done just that.
“Today, there is a negative perception of what the state can do and what it should be allowed to do,” adds Mazzucato. “We need to change the narrative; have a mission and the confidence to do really different things. This means pushing the frontiers of markets, not just tweaking within existing ones.”
Financing medicines is one area that Mazzucato cites. This, she argues, is only one part of the solution to health-related issues; it should be supplemented by government-funded research on lifestyle changes. The supply of capital for such initiatives would come from a rethinking of the way that the benefits that arise from these improvements are later apportioned. “We need to look at sharing both risks and rewards,” she explains. “So that there is money coming back to the same public funding agencies that make the investments.”
Indeed, the mechanism for state rewards is one that Mazzucato believes should mean that, “‘winning’ state investments should be able to cash in so as to cover losses when they arise...”. She is concerned by how little reward the state receives, with big pharma companies being a case in point.
“How can we finance the welfare state if we get the details wrong?” asks Mazzucato. “At the moment, the state pays for the research and then pays for drugs [that stem from that research]. In the US, the Bayh-Dole Act allows for publicly funded research to cap the price at which drugs [stemming from state-funded research] are sold. Yet this is never enforced. The US Department of Defense has the right to have, at a pre-negotiated price, products for which it has underwritten the development, and this right has been exercised in the past. I don’t see why healthcare could not work that way. And this is especially relevant today with the increasing number of cases where big pharma charges exorbitant prices for drugs – most of which were already paid for by the taxpayer.”
Just how to socialise rewards, as well as the risks of state investment, remains a matter for debate. Mazzucato says: “What is the best mechanism for the state to make sure that the taxpayer receives a return on its publicly funded investments? The Israeli state retains royalties, for example, and in Finland the state retains equity. As we no longer have the tax system we used to (NASA was founded in a year when the top marginal rate was 93%), such direct mechanisms are increasingly important.”
When it comes to the state capturing rewards, British Business Bank’s Ken Cooper says: “It is very tempting for the state to take some kind of stake in the technology but there is a distinction between getting something back to reinvest and trying to make basic research commercial.
“You need to look at the failure rate of these projects and the need to leave value in the company for the next round of investors. To do that you would probably be looking at quite a small [equity] share, and then, unless it was some kind of golden share, you would face dilution issues over time. There will come a point where it isn’t cost-effective.”
While acknowledging that ensuring state rewards is complex, Cooper is clear about the impact of UK state funding on British Business Bank’s portfolio. “About a year ago we looked at our investments in early-stage venture capital funds and we found that something like 20% of the underlying portfolio investments had received a grant of some kind from Innovate UK,” he says. “If we widen that to include companies using the output of university research programmes, the percentage would increase.”
He cautions that there could be an unintended consequence of ensuring state rewards. “The state would need to realise returns in a way that does not stifle further innovation. The research output of universities is very high. But if university research were treated like a VC fund, it would be ruthless in its cuts. That would be a failing because we would lose the blue-sky research and potential products that did not have an immediately apparent commercial value.”
Singling out companies such as Apple (as Mazzucato’s book does) can also be problematic, adds Cooper. “It’s very easy to look back from a successful product and ask ‘What if?’, but it’s a numbers game and a lot of the research goes nowhere,” he says. “Apple’s success has a lot to do with good design and marketing, not just having access to the technology.”
The importance of innovation, however, and maintaining its momentum, appears universally accepted even if the mechanisms for supporting it are the subject of disagreement. “It is key that the private equity industry engages in the innovation debate, and it does – particularly at the venture end,” says Cooper. “I find myself focusing on how to promote innovation without crowding out private sector activity, and recognising that the state is generally better at supporting the overall funding environment than it is at picking winning companies.”