Government Investments Choke Technological Innovation & Operational Efficiency

In 1898, Samuel Langley received $70,000 from the War Department to develop a piloted airplane. This government investment was a reaction to rising global tensions as militaries sought to develop heavier than air aircraft that could provide a military edge in what many generals believed, was a global war that seemed inevitable. Such national belligerence only accelerated governments’ sponsorships in aeronautical innovation, as the promise of new ways to bomb, spy and transport was all too attractive to generals actively looking to race towards warfare.

Langley was a highly distinguished astronomer before venturing into aviation, a field that seemed to be on the cusp of finally being understood. Langley’s focus on heavier than air aircraft was to be the next evolution in a field that had captured humanity’s imagination for centuries.

While the Ancient Greek tale of Icarus’ fall was a forewarning to some of the dangers in man-made flight, it did little to restrain engineers during the 1800s when major chemical and mechanical discoveries brought man to the sky in airships. Combining the benefits of hydrogen gas’ light density and the work an internal combustion engine could provide, it was only a matter of time before pioneers like Alberto Santos-Dumont brought airships into the skies of Paris.

Alberto Santos-Dumont’s airship led him to take to the skies as much as possible, often “parking” on rooftops across Paris as he headed to a local cafe for lunch.

By the turn of the century, engineers had begun to consider the feasibility of heavier than air aircraft. Prior to this, there had been substantial development on the physics of flight mainly by Sir George Cayley who would be later credited with designing the world’s first heavier than air aircraft. Hence, with Cayley’s groundwork laid, engineers began to confront the skies themselves with two British designers, William Henson and John Stringfellow filing for a patent of a heavier than air aircraft powered by a steam engine in 1842.

As it is with any type of innovation, a process of trial and error across generations ensued, with the proceeding generation exploiting the failures of the past for what was ultimately to be for their commercial gain.

While scientific achievement was by no doubt a significant driver amongst all the engineers that sought to develop the aviation industry, it was an industry heavily-framed with financial incentives to further accelerate progress. Satos-Dumont’s flight in Paris brought him 250,000 francs, Henson and Stringfellow received £100 for their steam engine which had the best power-to-weight ratio.

While Henson’s and Stringfellow’s aerial steam engine, “Ariel” was unable to fly, it encouraged the industry to transition from gliders to power flight aircraft.

What this saw was a merger of interest between entrepreneurs looking to build their wealth, and governments wanting to solidify their militaries as nations increasingly came closer to open conflict.

Langley’s sponsorship from the government was therefore arisen from a militaristic agenda, with minimal personal reward.

As this article will explain, it therefore came as no surprise that Langley’s government financing was constrained his ability to innovate in an efficient manner. Despite his credentials and experience in aeronautical and astronomical fields, government financing had little to do with real progress.

What I’ll be exploring is how government investment fails to incentivise lean, efficient and ultimately sustainable companies that can provide long-term aid to populations.

And so to start things off, let’s conclude Langley’s tale. Which led to two failed attempts in the early 1900s prompting the New York Times to declare,

“…it might be assumed that the flying machine which will really fly might be evolved by the combined and continuous efforts of mathematicians and mechanicians in from one million to ten million years”.

9 days later, two bicycle mechanics with only 2 years of aeronautical experience launched the Wright Flyer, flying 120 feet for 12 seconds in North Carolina on 17th December 1903. Not only did Langley’s sponsorship bring no technological advancement to the field of aeronautics, it was a prime example of how a government had decelerated and distracted the industry from real progress.

The beginning.

This is…

Why Government Investment is Poison to Innovation.

Sustainable business is crucial for any corporation seeking a profit. It’s simple mathematics; the less you have to give away the more you can keep. However, when a company is provided with a large surplus of cash without stakeholders having actionable penalties for failure, the gravitas for being a sustainable business becomes tarnished.

In recent decades, this has been painfully explicit in the aerospace industry. Again, it was a nation’s militaristic agenda that provided the platform for rapid advancement in an industry that was the next logical frontier after securing the skies — space.

“Gravity” by Alfonso Cuarón.

John F. Kennedy’s proclamation to land a man on the moon before the closing of the 1960s was for him, not a scientific benchmark. It was a matter of national security in a time when Cold War tensions led to the Cuban Missile Crisis and the construction of the Berlin Wall that in effect consolidated Moscow’s growing presence in Eastern Europe.

Once again, aeronautical and aerospace engineers were treated to large financial incentives to develop rocket and missile technologies. While NASA employees sought to enhance human knowledge, White House officials pushed for securing the atmospheres above Earth against Soviet nuclear threats.

While NASA’s budget would be at most just over 4% of the U.S.’s budget, this saw NASA receive billions in taxpayer money with a sum total of $283 from 1960 to 1970. Yes this period is littered with technological and scientific achievement, culminating in Neil Armstrong’s walk on the Moon during 21st July 1969, but it is interesting to consider whether this could’ve been brought about faster had private companies led the space race.

Considering NASA’s strategy during this period was to simply contract-out components of their designs to companies across the world and subsequently organise assembly in the U.S., it comes as no surprise that this lack of vertical integration saw operational costs rapidly escalate as the complexity of designs increased to meet the ever growing requirements to ultimately land man on the Moon.

With an unexpected link to history, my father was responsible for building small metal tubes for the Saturn V when he was welder in Ireland.

Over the past decade, SpaceX has been primarily financed by Elon Musk whom not only has a 54% equity stake and hence a personal incentive to see a return, but more importantly, has mostly failed in capturing substantial government financing.

From an initial investment of $100 million in 2001, SpaceX has been the pioneer in modern aerospace engineering due to its sensible business growth. With humble beginnings at the turn of the millennium and a small workforce of less than a dozen employees, SpaceX initially focused on building the smallest useful orbital rockets, the Falcon 1.

Rocket scientists. Always different.

The Falcon 1 was designed by SpaceX from the ground-up not out of spite of NASA or government support, but because there was none. Musk’s attempts at re-starting public interest in colonizing Mars had began as a series of failed pitches but these were minimal setbacks in the context of what Musk saw as the largest failure — an absence of appropriate technology to carry out such a mission.

As a response to this void and as a consequent of minimal financial infrastructure to rely on, Musk began exploring alternatives to develop such technology. This initially led to a series of trips to Russia to purchase Dnepr rockets, refurbished ICBMs that were used to launch satellites into low-Earth orbit at altitudes between Earth’s surface and 2,000 kilometres. For reference, with the exception of the 24 astronauts involved in the Apollo program, all other manned spaceflights including those onboard the International Space Station (altitude of 340km), have taken place in low-Earth orbit.

While this rudimentary request was shunned, it spurred Musk to look elsewhere which brought him to a simple idea — construct the rockets at SpaceX. On his last flight from Russia after being told $8 million was the starting price for a Dnepr rocket (which Musk believed was too high), Musk calculated that the raw materials needed to build a rocket were only 3% of the sales price at the time. Furthering such cost-benefits, was the fact that by applying vertical integration, 85% of the Falcon 1 could be built in-house, cutting launch prices by a factor of 10 and still bringing 70% gross margins.

For context, the only other orbital launch vehicles to be privately funded were the Conestoga and Pegasus which both used a large aircraft as its first stage. What Musk was attempting was simply groundbreaking and it doesn’t come as a surprise that even today, he’s a figure often victim to disproportionate cynicism from both competitors and non-competitors.

Development of Falcon 1 was $90 million with launch prices spanning from $5.9 million ($7.4 million adjusted for inflation) to $7 million ($8.8 million). Comparatively, the Falcon 1 provided 454 kN of thrust while Dnepr gave 4,520 kN and could carry 4,500 kgs to low-Earth orbit against SpaceX’s 180 kgs. What’s interesting to note is that while the Falcon 1 was clearly less powerful it essentially served the same purpose as the Dnepr rocket which was constructed by ISC Kosmotras, a joint project between Russia, Ukraine and Kazakhstan state-sponsored space agencies.

The first Falcon 1 launch exploded at T+33 seconds. The second experienced premature engine shutdown at T+7 minutes 30 seconds and the third, the second last launch Musk was able to finance before shutting down the company also experienced “rapid unscheduled disassembly”. The fourth launch was a success and in turn allowed Musk to secure a series of commercial and government contracts that provided the cashflow necessary to continue operations.

Despite an initial string of failed launches, SpaceX’s eventual success with the Falcon 1 was able to prompt companies to reconsider why they were paying so much for what is comparatively so little?

Fast-forwarding to SpaceX today and the company’s determination for technological innovation has led to the Falcon 9 being used for the first landing of a first stage capable rocket . This not only showcased the ability of SpaceX engineers but also brought a serious reduction in manufacturing costs.

To put these savings into context, the U.S. Air Force’s 2018 budget estimates that launch prices of satellites is $422 million based on pre-existing contracts with Boeing and Lockheed Martin. These companies have been NASA’s and the Air Force’s go-to contractors, having been responsible for major components in NASA space programs including the Space Shuttle along with providing entire aircrafts to the Air Force.

Despite this historic rapport, it’s become increasingly difficult for NASA and the Air Force to remain with these companies when SpaceX can launch satellites for $65 million on their Falcon 9. Consequently, with a cost difference of $300 million and the average cost of a satellite less than $300 million, it quickly becomes apparent that constructing and launching satellites these days is comparatively “free” with SpaceX.

On a slight tangent — this is business.

Recently SpaceX won two Air-Force contracts to launch GPS-satellites for $83 million and $96.5 million. The technical and financial wizardry of SpaceX is clear, as is governments’ penchant for agreeing to inflated budgets for what have been unnecessarily large and avoidably expensive executions.

Government investment is not exclusive to large-scale scientific projects; its influence has seeped into banking with its foulness crystalised in the $700 billion bailout during the Global Financial Crisis in 2008.

Known as the Emergency Economic Stabilization Act, Bloomberg analysts have found that by March 2009, the Federal Reserve had provided $7.7 trillion to rescue financial systems. Dependence on government investment was key in resolving the banking implosion that was caused from their de-regulation and banks’ monetization of sub-prime mortgages which were marketed as little to no-risk investments.

“Do you smell that? What’s that?”… “Cologne?”…. “Opportunity?”…. “No, money”.

With credit markets on the verge of collapsing, the U.S. government was forced to consider a position that most bankers expected to eventuate into a bailout. Such predictability was almost a form of Pavlovian Conditioning, with the term “too big to fail” coined by U.S. Congressman, Stewart McKinney in a 1984 Congressional Hearing following the government’s $4.5 billion injection into Continental Illinois.

While Continental Illinois’ bailout introduced the capability of a federal government to intervene in the private sector, many Americans were unaware that five years prior the government had in fact provided the Lockheed Corporation a federal loan of $250 million.

This history meant that asthe full-force of the Global Financial Crisis began to form in early 2008, the New-York based investment bank, Bear Stearns was confident during its deep-talks with the Federal Reserve Bank of New York to receive a $25 billion loan to provide liquidity for 28-days. While the Reserve Bank of New York unexpectedly reversed their offer, Bear Stearns was able to sell the company in a stock swap with JP Morgan for a brutal $10/share. A year before, Bear Stearns was operating at $133.20 and as of February 2008, was at $93.00.

The reverse of zero-hundred but still real quick.

The new company following the merger was funded by loans of $29 billion from the Federal Reserve Bank of New York and $1 billion from JP Morgan. Evidently, this was another chapter of government investment having created a toxic expectation of security that enabled banks to operate recklessly without any sense of true policing that brought legitimate consequences.

Such a mentality explains that when Lehman Brothers, the fourth-largest investment bank in the United States, faced its own existential crisis during the Global Financial Crisis, it presumed the government would be there to help.

Despite posting a profit of $489 million and having its 55th consecutive profitable quarter in September 2007, there were sinister warnings across the market that Lehman Brothers were headed for trouble well before any inescapable collapse had amounted.

By holding large positions in subprime and other highly volatile tranches, the subprime mortgage crisis that developed from 2007 and into 2008 gently bit into Lehman’s operations with the bank lacking any clear recourse towards recovery. With a history of high-risk plays spearheaded by its CEO, Dick “the Gorilla” Fuld, Lehman had been operating for years in tactics that not only accumulated their risk, but also dug their dependence on government investment further.

The Gorilla with some fans.

Lehman’s tactics brought unparalleled revenue growth, with the company expanding by 130% between 2000 and 2006. Equity markets looked favourably to Fuld’s tenure that from 1994 to 2006 had seen Lehman grow by 600%. What happened next was high bidding on Lehman stock, seeing its market capitalization scale by 340%.

However, Lehman would close BNC Mortgage and its Korean mortgage business in wake of growing financial difficulty during 2006. Despite this setting, Lehman’s business strategy continued to support aggressive purchases of real-estate-related-assets. With $111 billion in commercial or residential real estate at the closing of 2007, Lehman had more than doubled their portfolio since 2006.

Despite Lehman’s large portfolio in property investments, its market value was anything but profitable.

This position led Lehman to comfortably gear-up, a process of borrowing money to invest in assets that are rising in value. In theory, leveraging enables banks to magnify their returns yet Lehman’s dependence on their $111 billion portfolio of only increasing in value during a time when analysts were claiming the real-estate industry had past its peak, makes such an investment at best, high risk.

Despite its uneven foundations, in 2004 Lehman was leveraging at 20:1, meaning for every $1 they had, the bank would lend $20. Reasonable banking tactics would advise leveraging at 12:1, which puts Lehman’s peak leverage at 44:1 in 2007 even more insane.

The five-year boom in domestic and commercial property prices had ceased by 2006 and in 2007 Lehman’s investments had left the company unbelievably exposed.

Collateralized Debt Obligation (CDO) was a prime villain during the GFC. Essentially a financial product with that was a mix of other loans to create an entirely new type of product and hence a new credit rating even if it was built with mostly weak loans.

Following Bear Stearns acquisition by JP Morgan, Lehman was quickly tipped to fall next, with losses continuing to rise, totalling $2.8 billion in the second-quarter. Shares continued to fall, with news of a possible acquisition by Korea Development Bank only bringing initial gains as subsequent reports of regulatory difficulties saw Lehman stock plunge by 49%.

By 13th September 2008, it had become apparent to the president of the Federal Reserve Bank of New York that Lehman’s future was bleak. Lehman’s prospects at this time were reliant on an acquisition by either Barclays or Bank of America, both which ultimately failed to come to fruition. With no acquisition possible, Lehman had expected the government to bail them out as they had done before to finance JP Morgan’s purchase of Bear Stearns.

It would not come. It seemed the government would no longer provide financing to protect banks. Banks were left to fend for themselves.

On 15th September 2008, Lehman filed for Chapter 11 Bankruptcy, with bank debt of $613 billion, $155 billion in bond debt, and assets worth $639 billion.

Following Lehman’s collapse, over $1.6 billion in legal fees have been racked up.

It therefore came as a surprise that the day after, the government provided $85 billion for American International Group.

You can then imagine the banks’ surprise when the Emergency Economic Stabilization Act of 2008 was passed in the Senate, granting government the legislation it needed to provide $700 billion to bailout the surviving banks.

The benefit and dangers of the government’s bailout do not need to be discussed here, but what does is the precedent this provides to banks.

It was seen that with Lehman’s collapse they had crossed a line the government had drawn. The bailout dismissed such ideas — showcasing that this line was only temporal and in most respects, arbitrary.

It demonstrates the key problem with government investment — negligible responsibility from both government official and the recipients. Incredibly large financial cushions are the dream to those that have nothing at their disposal but to those operating billion dollar operations, often in the tens and hundreds each day, it provides only comfort in grabbing ‘everything’.

Comfort is not a necessity.

The Wright Brothers built the Wright Flyer for $2000. Elon Musk sold Falcon 1s for no more than $7 million.

Governments tried to build planes for $70,000 and failed. Governments allowed rockets to be built for $300 million when they could be purchased for only $65 million. Governments gave $700 billion to banks that had a penchant for high-risk strategies.

Government investment in the long-term is fatal to innovation and efficient operations.

History proves you do not need silk-cushions to sit at the table of success.

As SpaceX looks to accelerate mankind’s colonisation of Mars, it’s looking to do so in the cheapest way possible by building reusable rockets. Falcon 9 flight 20 on 22nd December 2015, marked the first time an orbital rocket made a successful return and vertical landing. It had taken the company only 4978 days and $1.945 billion in revenue. NASA with it’s 21,537 days and $598.4 billion in government investment has yet to reach this achievement.