Government Intervention and Support for the Economy

The Postwar Innovation-Industrial Ecosystem

The Great Depression followed by the World War II mobilization had been particularly stressful and unsettling economic times. This extended period did show, however, that important productivity and employment objectives could be achieved when government, business, and labor worked together.^{Footnote 29} However, the nature and scope of business changed during this period. Self-employment and small businesses were much more common before World War II than they were by the 1970s (see Table 1). In 1948, 12.05 percent of the population was self-employed in nonagricultural industries.^{Footnote 30} By 1960, this had dropped to 10.45 percent, and by 1970 it was down to 6.94 percent.^{Footnote 31}

Table 1. Percentage of Self-Employed Workforce

Source: Bureau of Labor Statistics.

For individuals, working for a company (as opposed to being self-employed) removes many of the risks associated with employment. Large American corporations were generally very prosperous in the 1950s, largely due to the almost monopolistic position that they held both domestically and internationally and the large investments and expenditures that were being made by the federal government to fight the Cold War. Military needs dominated the research agenda and provided a secure source of revenues for defense contractors.

The innovation system had been transformed as well. The system of the 1950s was far more complex, diverse, and extensive than it had been in the 1920s.^{Footnote 32} In the 1920s and early 1930s, the research community was relatively small. Companies supported their own research. Research universities relied on private philanthropic foundations for funding.^{Footnote 33} However, the Great Depression put tremendous stresses on research funding. During this period, there was significant debate about what role the federal government could and should play in supporting research. Kurt Compton, the president of the Massachusetts of Technology (MIT), proposed that the federal government should increase its funding to research universities. Compton argued that new technologies developed in universities could help to reduce unemployment and increase business productivity.^{Footnote 34} Though no conclusions were reached during the Depression, World War II provided the justification for significant research expenditures and showed the potential benefits of such investments.^{Footnote 35}

By the end of the war, political leaders reached a general consensus that scientific research could provide an important foundation for innovation and economic growth.^{Footnote 36} The report by Vannevar Bush to President Truman in 1945 laid out a plan for funding scientific research in universities and supporting innovation. Massive increases in federal expenditures on R&D occurred for practical rather than ideological reasons. The military needs of the Cold War made spending on research and innovation a top priority. Much of this funding went to companies, as well as academic institutions.^{Footnote 37} This allowed firms and universities to substantially expand their research capabilities and facilities, with assurances of continued funding.

In the 1930s, the federal government had already recognized its responsibility in providing some social welfare programs and financial regulations. In the 1940s, this commitment extended to providing employment and economic growth. Continued economic growth and employment became the key components of the federal government’s economic policy.^{Footnote 38} The federal government took responsibility for ensuring economic prosperity and health, financial stability, and funding innovation. By necessity, the government also took much greater responsibility for mitigating any risks associated with the economy, employment, and production for both businesses and individuals.

The Influx of Knowledge Workers

Innovation depends on more than merely financial resources. There must be a capacity to effectively use these resources and an environment in which new knowledge can be created and problems identified and addressed. One of the most important, and often overlooked, components of the innovation system was the influx of human capital into American universities and national laboratories between 1930 and 1950. These individuals immigrated to the United States typically because they were either fleeing the threat of persecution posed by Nazi Germany or because they were specifically recruited after the war for their scientific skills and knowledge. Refugee scientists and engineers provided new knowledge, theories, and methods to the U.S. innovation ecosystem. And they did this without either the cost or time required to generate this capacity domestically.

Almost immediately after Adolf Hitler came to power in January 1933 in Germany, efforts began to rescue German academics at risk.^{Footnote 39} By 1935, approximately 1,600 scholars, or 32 percent of the academic community, had been dismissed for political or racial reasons. By 1938, approximately 39 percent of the academics in Germany and Austria had lost their positions.^{Footnote 40} Between January 1933 and December 1941, more than 7,500 German and Austrian refugee scholars came to America, in addition to another 1,500 artists, journalists, or other intellectuals.^{Footnote 41}

With the defeat of Germany in 1945 and the start of the Cold War with the Soviet Union, hundreds of scientists, including many accused of participating in Nazi war crimes, were brought to the United States under a secret intelligence program named “Operation Paperclip.” The purpose of this program was to acquire German scientific skills and knowledge in order to both improve the U.S. military innovation system and to prevent the Soviets from getting them.^{Footnote 42} Operation Paperclip brought another 2,000 scientific and research specialists, as well as their families, to the United States. Many of these individuals went to work in national laboratories and scientific agencies (such as NASA), while others worked for universities, private companies, defense contractors, or intelligence agencies.^{Footnote 43}

The influx of so many scholars and intellectuals into the American innovation system had a profound effect. Many of the advances in fields such as energy, aerospace, physics, mathematics, and electronics would not have been possible without the expertise and understanding provided by German scholars.^{Footnote 44} In addition, the benefits were received without the necessity of investing in their education and training, or in waiting for students to mature as scholars. Essentially, when the United States decided to invest heavily in the country’s R&D, the human resources were there to utilize these resources. If these immigrants had not come to the United States, these resources may not have been used as effectively or yielded the innovations that they did. Arguably, American scholars and companies would have eventually developed the human capital internally, but this would have delayed progress while waiting for programs and students to develop to meet the needs.

At the same time, the federal government made substantial investments in research and production facilities. For example, during World War II, private industry provided only 11 percent of the capital for new airplane facilities. Thus, at the end of the war, the government owned the vast majority of aircraft production. The aviation industry relied on the government divesting itself of the $4.6 billion worth of facilities and equipment as surplus war property at significantly discounted prices and military contracts for postwar profitability.^{Footnote 45}

Private Finance and Risk Management

Although the federal government’s new position as a major funder of research, development, and innovation, along with the influx of human resources from Europe, was essential to the U.S. innovation system, this system was (and is) absolutely dependent on the private sector. Private-sector investments and financial intermediation are crucial components of the innovation system. Between the 1930s and the 1950s, the changes in the private-sector funding of the innovation system were every bit as profound as the changes in public-sector funding.

During the 1930s and 1940s, many companies and banks became very conservative with respect to risks they were willing to take. Between 1935 and 1961, fewer than 2,100 new commercial banks opened, resulting in fewer banks than had existed before the depression.^{Footnote 46} New corporate stock offerings were relatively rare during this period, with most stock issuances coming from existing companies.^{Footnote 47} Private-sector investments in innovations came largely from internal funds (i.e., from revenues) and were generally concentrated in large corporations that could afford the risks and uncertainties of return associated with longer-term investments.

Although new products and technologies were developed, investors in postwar America were generally cautious about new businesses competing with existing corporations and were reluctant to invest.^{Footnote 48} The economic prosperity of the 1950s was generally limited to large existing corporations.^{Footnote 49} This was due to investors being unwilling to finance new companies and new technologies and to company practices that promoted economies of scale and the suppression of competition. Corporate monopolies and dominant market players were commonplace.

Risk and uncertainty were generally dealt with by avoiding them. American business had grown successful and large during World War II and the immediate postwar period. There was a widespread feeling that skillful American management had led to the successes—ignoring the contingent circumstance of the war that had severely degraded the productive capacity of most of the other leading industrial nations around the world. Business schools and writers touted the critical rise of professional managers.^{Footnote 50} Previously, managers had come from the rank-and-file and were promoted internally into management. Starting in the 1950s, managers were hired externally. Typically these new managers were college-educated and trained in business, rather than production or engineering.^{Footnote 51} Thus, there was little familiarity with production methods or employment norms. Instead, there was a focus on economies of scale, consolidation in business, and managerial control.^{Footnote 52} However, the financial success of businesses masked an underlying problem with quality and production.

In the 1950s, American companies were unconcerned about competition or quality. Product demand and production shortages meant that companies could sell everything they produced without worrying about innovation or quality. Instead, professional managers focused on what they understood: meeting schedules and maximizing profits. Managers received financial reports, but generally not on their operations, customers, or quality measures.^{Footnote 53} Companies were encouraged by consultants such as the Boston Consulting Group (BCG) to maximize their profits by focusing on getting all that they could out of successful production facilities and getting rid of less profitable ones (rather than investing in improving them).^{Footnote 54} This focus on financial results came at the expense of the declining competitive position of American industry as companies shifted their focus from production to financial success.^{Footnote 55} It also came at the expense of neglecting product and process improvements (i.e., innovations) in many large, successful industries.

The steel industry is a good example of a successful postwar industry that chose to focus on economies of scale, rather than technological innovation. According to historian Paul Koistinen, the steel industry focused on expansion of their operations using existing (nineteenth century) technologies rather than updating their operations. The managers believed that it was more cost-effective to use existing (and proven) technologies rather than taking on the risks of new innovations and technologies. Steel manufacturers neglected investments in production facilities and quality improvements in favor of maximizing profits and dividends in order to keep stock prices high.^{Footnote 56} Unfortunately, by the time it was clear that this strategy was not sustainable, international competition from more advanced production facilities put considerable pressure on American steel companies, which then sought financial incentives and trade protection from the federal government in order to preserve their dominant positions in the domestic marketplace.

From 1952 to 1973, a revolution occurred in both the understanding of risk and ideological attitudes toward risk.^{Footnote 57} In 1952, a graduate student of Operations Research at the University of Chicago, Harry Markowitz, applied the principles of statistics and mathematics to the question of portfolio management. Markowitz demonstrated mathematically that diversification allows investment portfolios to be optimized by reducing risk. He also explicitly connected rates of return with the risks that portfolios carried. His work revolutionized the way that business leaders viewed risk and investments.^{Footnote 58} Corporations, traders, and businesses began to alter their practices.

The 1960s brought two more important advances in the understanding of risk management and finance. In 1964, Bill Sharpe published a paper in the Journal of Finance, titled “Capital Asset Prices: A Theory of Market Equilibrium Under Conditions of Risk.” The paper describes the Capital Asset Prices Model, or CAPM, which can be used to predict the returns on stocks.^{Footnote 59} Sharpe separated risk into systematic and unsystematic. Systematic risk was the risk that an investor undertook by being in the market. Unsystematic risk was that of an individual stock. Thus, while unsystematic risk could be diversified away, systemic risk could not.^{Footnote 60} In 1965, Eugene Fama proposed the Efficient Market Hypothesis, in which he argued that markets were efficient at processing information, and therefore the market price of a stock was always correctly priced. Thus, it was virtually impossible to get returns higher than the market average (i.e., to beat the market).^{Footnote 61} This work laid the intellectual and mathematical foundations for managing financial risks.

During the 1950s and 1960s, there was a shift from risk avoidance to risk management.^{Footnote 62} Investors, managers, and bank officers who had come of age during the depression were replaced with those not as vividly aware of the crisis and associated risks.^{Footnote 63} At the same time, new understandings about risk, economics, and finance emerged. Risk diversification, CAPM, and the Efficient Hypothesis model were coupled with the rise of mathematical economics and econometric models.

The postwar agreements on finance and business began to break down in the 1970s, as did financial and economic stability. Volatility increased substantially. In 1971, President Richard Nixon took the United States off the gold standard.^{Footnote 69} In 1973, the economic shocks caused by the Oil Crisis disrupted the energy stability that had existed during the postwar period. Federal government expenditures driven by both the Vietnam War and the Great Society programs resulted in rapid inflation. The development of computer technologies and the microprocessor allowed for new processing applications and technologies.^{Footnote 64}

There was an ideological shift away from believing that government was needed to provide economic prosperity and stability to believing that free markets and private business could provide them.^{Footnote 65} However, this did not change the practicalities of the need for stability and investments in innovation. Thus, whenever the economy has stumbled or businesses have struggled, they have almost always turned to policymakers with an expectation that government will promote and support job growth through investments in private business, especially major corporate players.

Starting in the 1970s and accelerating in the 1980s, the changing regulatory environment, growing international competition, new ideologies and technologies, and increased economic volatility spurred financial innovation.^{Footnote 66} This innovation was aimed at shifting risks, which had the effect of allowing companies, particularly financial companies, to get as much short-term profit as possible.

Businesses became increasingly focused on short-term financial returns and less willing to undertake longer-term investments. They came to concentrate more and more on shareholder value and the need to demonstrate short-term financial prosperity and growth.^{Footnote 67} This process of shifting to being more concerned about financial than capital wealth development is called “financialization” and it has two primary causes. First, the rise of large institutional investors, including pension funds, mutual funds, and university endowments, meant that institutional investors began to have a much larger influence on any individual company. Small investors were, and are, much less likely to select and hold individual company stocks for the longer term. Companies were under increasing pressure to satisfy the expectations for returns of large institutional investors that were not loyal to a particular company and have the ability to significantly impact share prices by their buying and selling decisions, instead of responding to the concerns for longer-term health and profitability of the firm. Rather than using their investments to influence operating decisions, institutional investors focused on share prices and financial returns. In other words, institutional investors signaled that they were unwilling to take on the long-term financial risks of investing in a company’s development and innovations. On the contrary, institutional investors will support the company only so long as short-term financial expectations are sufficiently high. That is, the expected financial rewards must be sufficiently high to entice the capital investment.

The second cause of financialization was the rise of the theory of Maximizing Shareholder Value (MSV), which took root in the 1980s with the goal of aligning corporate executive compensation and shareholder interests leading to the coupling of executive compensation with stock prices. MSV established an incentive for managers to focus on increasing stock prices in the short term in order to increase their compensation, even if this had long-term adverse effects.^{Footnote 68} This incentive was further reinforced by the dramatic increase in the inclusion of stock options as a component of executive compensation during the 1990s, when stock options went from 27 percent of total compensation for CEOs in 1992 to 51 percent in 2000.^{Footnote 69}

These two changes spurred businesses to focus on shareholder value and stock prices. This necessarily resulted in investing less in long-term invention, scientific discovery, and innovation. Traditional business strategy concentrated on innovative products and product markets.^{Footnote 70} However, business strategy was now shaped less by product markets and more by capital markets and the need for financial returns and economic growth.

Businesses are most commonly interested in the latter components of the innovation process, particularly on the deployment of technology, since this is the period in which returns can be realized on previous investments. Businesses have been reducing their support and involvement in more basic research in recent decades, and have focused on activities that utilize externally produced scientific discoveries and technologies.^{Footnote 71} Policymakers, university administrators, and the public now expect tangible returns to society from public investments in research. Scientific discovery and innovation have become increasingly privatized, with policymakers, university administrators, and business leaders trying to capitalize on potentially profitable inventions. The Bayh-Dole Act of 1980, by Birch Bayh (D-Ind.) and Robert Dole (R-Kans.) gave universities in the United States the right to claim and protect their ownership of any intellectual property funded by the federal government, rather than allowing this knowledge to automatically go into the public domain. Thus, there has been increasing interaction between industry and academia to create, transfer, and utilize knowledge and inventions that may have some commercial value.

The development of information and computer technologies made financial mobility and innovation much more possible. Financial capital used to be governed by personalized relationships between commercial bankers and companies.^{Footnote 72} This is no longer the case. The globalization of finance and financial markets has shifted financial relationships from relationship based to transaction based.^{Footnote 73} These innovations have allowed financial institutions to off-load risks from their own balance sheets to capital markets. Providers of financial capital are not necessarily investing for the long term anymore, but are looking for short-term (3–5 years), high-yield returns.^{Footnote 74} These components of the new financial paradigm destabilize the economic system and can lead to greater financial crises.^{Footnote 75}

One of the great challenges of this shift toward emphasis on financial wealth is that there has been a decoupling of finance and production.^{Footnote 76} Investments in innovation are necessarily investments in production capacity and knowledge. Thus, production is tied to innovation in a way that financial resources are not. While financial resources are essential to innovation, they are able to move more freely toward or away from different innovations. This means that innovators need to demonstrate potential benefits to financial investors quickly or else financiers choose more lucrative investments elsewhere.

These financial innovations and technologies altered how firms understood and dealt with risk and uncertainty. Companies and financial institutions began to lobby for fewer restrictions and regulations in the 1970s. They also relied heavily on the mathematical models and economic theories that their risk-management programs were built on. The New Deal programs and policies were based on government taking on the risks that might threaten economic stability and prosperity. Business began to push back, confident that they could now manage the risks and reap the full rewards. Ironically (or perhaps correspondingly) with the rise of tools and technologies to manage risk, the financial markets and economy became more volatile and risky.^{Footnote 77} Financial institutions and companies demanded greater, and more immediate, returns on their investments.

Budget deficits have been a long-standing political problem in the United States. The push for smaller government was primarily a reaction to the massive expansion of government size and responsibilities from the 1930s through the 1960s. Governments have come under increasing pressure to justify expenditures and balance their budgets.

Public budgeting is the process of allocating scarce public resources among alternative activities and programs.^{Footnote 78} Numerous budgetary reforms have attempted to evaluate the effectiveness of resource allocations through the public budgeting process.^{Footnote 79} Though no performance-evaluation system has proven wholly effective and satisfactory, there continues to be increasing pressure on public administrators and policymakers to justify public investments. For example, the National Science Foundation (NSF) funds the Science of Science Policy (SciSIP) Program, which was designed to improve the allocation and effectiveness of investments in research and development in science and technology. With funding restrictions, there also necessarily comes selective funding that targets government priorities. The National Nanotechnology Initiative, National Institute for Aging (NIA), the National Institutes of Health (NIH), and NASA are all examples of targeted funding.

Scientific research at universities is primarily funded by the federal government. Federal expenditures funded 52.8 percent of all R&D expenditures at academic institutions. An additional 25.8 percent of R&D expenditures came from the academic institutions themselves, while state and local governments funded 5.7 percent. Private corporations funded the remaining 6.1 percent.^{Footnote 80}

The need to justify these public investments and increasing revenue pressures has pushed policymakers and university administrators to look for greater immediate tangible benefits of R&D expenditures and shorter pathways through the innovation process. In recent years, academic institutions have embraced greater participation in the commercialization of technologies.^{Footnote 81} Universities experienced greater incentives to push technology transfer and innovation after passage of the 1980 Bayh-Dole Act.^{Footnote 82} At the same time, state funding for higher education began to decline and universities began to look for ways to offset revenue losses.^{Footnote 83} Universities now invest in the development of intellectual property and fund start-up ventures.^{Footnote 84} Universities are not simply engaged in basic research; they are more actively leveraging and exploiting their intellectual property.

Private Financing of Innovation

The uncertainties and risks for the innovator are high. Thus, development and commercialization of a new innovation is rare and the potential rewards must be high in order to entice investors to risk their capital.^{Footnote 85} Debt financing for innovation is difficult, both because debt must be repaid regardless of the success of the investment and because banks are typically hesitant to make higher-risk loans.^{Footnote 86} In the United States, investing in innovation by the private sector has generally been self-funded or financed through equity investments.

Investments in emerging technologies were relatively static during the decades just after World War II, with the bulk of the investments being made by the federal government, or to a lesser extent by large firms. Approximately 75 percent of all research and development done by defense contractors in the 1950s was paid for by the Department of Defence.^{Footnote 87} Many of these firms had monopoly positions, as well as large contracts with the military, which ensured their ability to extract rents from any investments in their innovations. With the development of the electronics industry and information and communication technologies (ICT), investors became more interested in the potential returns to these investments.^{Footnote 88} However, these new technologies had a ready customer in the United States military. Investors were willing to speculate that the demand for these technologies by the federal government would increase, particularly after the Soviet Union launched Sputnik in 1957—creating the perception that the Soviets held an edge in technology.^{Footnote 89}

Investments in research and technology are generally assessed on the risk-reward terms proposed by Markowitz. More often than not, these are evaluated once the technology exists, rather than in the early stages of research and knowledge creation. Since proposed ventures need funding, often a lack of private capital becomes the main obstacle to development and commercialization.^{Footnote 90} Therefore, business scholarship on innovation and entrepreneurship typically focuses on private finance and frequently neglects the role of the public sector.

Undergirding the innovation ecosystem is the implicit assumption that the public sector will bear the risk of the discovery process and typically share the cost of commercialization. The government becomes the mitigator of systemic risks through policies designed to ensure financial and employment stability, as well through its role as the lender of last resort. Limited-liability statutes, bankruptcy laws, unemployment insurance, social security, workers’ compensation, and other regulatory constraints are all designed to limit risk-taking by private-sector companies and ensure that individuals have some protections against economic volatility.^{Footnote 91}

Private finance is inherently conservative. It will not participate in the markets or fund risky ventures without assurances that the potential reward makes it worthwhile. The Great Depression and World War II created an environment in which much of the risk shifted to government, and more recently back to individual workers. Since businesses and financial institutions do not bear the full cost of the risks—that is, because they bear only the individual and not the systemic risk—these firms have been willing to take greater risks, even while telling themselves that they were managing the risks through risk-management programs and mathematical models.

Extracting high financial rewards has been necessary for two reasons. First, private finance has required assurance of these rewards before it is willing to invest and act. While it may seem counterintuitive that companies are actually willing to take on less risk, given that the public sector is underwriting so much of the insurance against the risk, the reluctance of businesses and private finance to make longer-term investments reveals that the economic incentives have to be substantial in today’s innovation system. The second reason is that the role of government as the risk bearer has become enshrined in our society, even while our economic ideology claims it is unnecessary. Financial institutions were convinced that they had solved the problems of risk and uncertainty. It could be insured and parsed away, passed on to individuals who were willing to bear them. It was almost an article of faith that the systemic risk had been eliminated. However, the Great Recession of 2008–9 and the subsequent bailouts of the financial system have demonstrated that the government continues to be the guarantor of the system.