Role of State in Funding Radical Innovations — Part 2

I know many people will be shaking their heads in disapproval when I say that the State should play a more active role in the venture capital process. It must take those kind of risks that the private sector is not willing to take. Instead of just acting as a passive risk absorber of the private sector portfolio (through subsidies and tax credits), the State must be involved in managing an active portfolio of radical innovation with convex payoffs.

Here are my reasons why the State should proactively participate on managing venture investments:

1. State’s capacity to tolerate and promote economic waste: Economics is mostly about efficiency, and then you have mythological beliefs such as efficient markets, general equilibrium, etc. which create the notion that the markets will run optimally if we just leave them alone. The fact is that the market is subordinate to the State and will always be subjected to its changes. It may sound counter-intuitive, but some form of supply-side economic waste, especially to fund radical innovation, is beneficial and has essentially been a primary driver of growth in the last 100 years.

As there are substantial amount of uncertainties associated with radical innovations, private investment vehicles are unwilling to risk economic waste associated with such investments, so they focus on low-hanging technologies that can be commercialized in 3–5 years. On the other hand, the State has a strong national social network of resources, knowledge, and wealth which it can leverage to effectively transform those investments into new drivers of economic growth.

2. State can do a better job at managing intertemporal long-term portfolios: Radical innovations are all about overcoming hurdles. It starts with the invention, building prototype at lab scale, manufacturing (setting up processes, improving economics) and finally creating a new market or replacing an existing one. For technology adoption to happen, unit cost must match, or at least be comparable to, the incumbent technologies currently in use. The whole process from ideation to fruition could take 15–25 years. This requires patience and long-term portfolio management skills, which the State can provide in a much more effective manner than any private investment vehicle can.

3. Plugging the current funding gap: Commercializing radical innovations may cost hundreds of millions, which is way higher than what most venture capital will ever commit. Indeed, before the rise of shareholder value in the mid ’80s, most radical innovations were underwritten by big companies such as IBM, AT&T, Xerox, Siemens, and the like. In addition, considerable amount of State-sponsored defense budget went into financing innovations with wider societal benefits (e.g. internet, navigation systems, etc.) but now we live in an era where the State is shrinking — reduction of State budgets, austerity programs, cutting down defense programs, which directly or indirectly affects many R&D programs. So does this creates an opportunity for the State to step in and actively fund radical innovations on a broad scale.

4. To remain competitive and relevant: The whole concept of a Nation State is on the decline, thanks to the increasing free movement of capital and people around the world. In addition, the exponential growth in digitalization of businesses & internet in the last decade is directly challenging large-scale industrial systems with centralized command and control. These changes to some extent are currently manifested in uncertain economic environment, surging popularity of far-right and left political parties, and a scramble for resources by the Nation States.

In order to remain competitive and meaningful in the long run, the State needs to have a mechanism in place to be able to monetize from its investments in general-purpose technologies with capabilities to unleash economic growth and promote human capital formation. A very good example that comes to mind is Israel, where the State itself has become an incubator of new and transitional technologies and has been successfully able to commercialize a lot of cutting-edge R&D while considerably increasing its human capital formation over the last two decades.

A while back, Peter Thiel, the venture capitalist who co-founded PayPal said, “We wanted flying cars, instead we got 140 characters” — and probably there is some truth to it. If we want to see the next generation of power distribution systems or high speed transportation then the State needs to start thinking how it can participate more actively in funding radical innovation and not limit itself to just correcting market failures and de-risking the private sector investment.