The Innovation Illusion and how to avoid it

Imagine it’s 2030. We’ve failed to achieve the SDGs. We haven’t even got close. Instead, we’ve gone backwards on several of them. We’ve returned to nineteenth-century levels of inequality, causing widespread social breakdown. Never mind limiting global warming to 2 degrees, we’re on course for at least 4 degrees by the end of the century. Catastrophic weather events have become the norm.

Back in the halcyon days of 2016, we were so optimistic that capitalism’s creative juices could be harnessed to help us solve climate change, hunger, poverty and the rest. What went wrong?

Hard as it may be for some to believe right now, my answer isn’t Trump — nor the global resurgence of illiberal, nativist demagoguery, of which he is the latest manifestation.

The more fundamental reason we may find ourselves in the bleak version of the future I just described is because the financial and investment industry — as currently configured — is not up to the task of funding the breakthrough innovation we need. As things stand, financial capitalism is strangling — not supporting — big innovation.

This is the central argument of Fredrik Erixon and Björn Weigel’s brilliantly provocative new book, The Innovation Illusion. Erixon and Weigel challenge the “conventional wisdom” that says we are on the brink of a dizzying new age of innovation. Instead, they argue, ‘we should fear an innovation famine rather than an innovation feast.’

The authors acknowledge the importance of technological breakthroughs. But their argument is about how innovation translates from the lab to the marketplace. ‘The concept of innovation is useless,’ they argue, ‘unless new technologies, combinations of products and technologies, production processes, or business models force markets to adjust through diffusion, adaptation, and imitation.’

The ‘four horsemen’ of capitalist decline

They argue that this isn’t happening for four reasons — the ‘four horsemen’ of capitalist decline.

The first they label ‘gray capital’. Financialisation, the diffusion and intermediation of ownership, the rise of asset managers and the need of an ageing population to save ever larger sums for retirement — all these trends have led to a situation where stock markets have changed ‘from being a source of funding for corporations to a cash cow for savers and money managers.’

The result, argue Erixon and Weigel, is a kind of ‘capitalism without capitalists.’ A capitalist, in their definition, is an owner who exercises ‘responsibility, entrepreneurship and control.’ Asset managers and pension funds — the institutions that dominate modern stock markets — are congenitally unable to practice such ownership.

The second horseman — in many ways a product of the first — is corporate managerialism. Investors want predictability and certainty, ergo companies promote bureaucratic managers rather than entrepreneurial risk-takers. ‘Today,’ say the authors, ‘the appetite for creative destruction, the zeitgeist of capitalism, is all too often displaced by a custodian culture that is defensive about the future and protective of its privileges.’

The third horseman is globalisation. While much of the current criticism of globalisation focuses on the new competition it has brought, wiping out jobs in the developed world, Erixon and Weigel argue that its more significant — and problematic — consequence has been complexity and consolidation. On balance, forty years of horizontal expansion into new markets and integration of global supply chains has been one massive distraction, crowding out true innovation and raising barriers to entry for disruptive insurgents.

And finally, regulation. Regulators, too, succumbed to the managerialist ethic — fighting complexity with complexity and crushing capitalism’s risk-taking spirit in the process. What’s more, regulation has skewed innovation towards the trivial. A common critique of the current wave of technological innovation is that it is, in Paul Krugman’s words, “more fun than fundamental”. Mobile gaming, Erixon and Weigel point out, has grown much faster than industrial robotics. One reason for this discrepancy is different regulatory approaches. As Peter Thiel has put it, in the “world of bits”, a light touch approach prevails, whereas in the “world of atoms” regulators are much more heavy-handed. At one level, this may seem like common sense — the more trivial the innovation, the more trivial the risks associated with it — but, at a societal level, it is fuelling a spectacular misallocation of resources.

The Innovation Illusion is positioned as a ‘contrarian’ take on the state of the global economy. But Erixon and Weigel are not lone prophets in the wilderness. In fact, their account chimes with the arguments put forward in a recent collection of essays by leading economists, Rethinking Capitalism: Economics and Policy for Sustainable and Inclusive Growth, compiled by Michael Jacobs and Mariana Mazzucato.

Rethinking Capitalism diagnoses a similar set of ailments — financialisation, rent-seeking, short-termism, under-investment, secular stagnation — and argues they pose a profound challenge to the discipline of economics itself. The old paradigm of ‘market failure’ is no longer a helpful framework for thinking about contemporary capitalism’s structural flaws.

In the aftermath of the 2008 crash, economists have, perhaps, fixated on the wrong problem: they’ve been trying to make financial capitalism less risky, but the bigger problem is the way it has squashed out risk-taking in the real economy. As Carlota Perez puts it, innovation has stalled ‘in spite of the existence of plenty of technological possibilities.’ Why? ‘It results from the decoupling of the financial sector from the production economy during the boom and its reluctance to take risks investing in the real economy after the experience of the crash.’

Three statistics highlight the nub of the problem and how it’s playing out in the UK (similar statistics can be found for other developed economies):

  1. The financial economy has decoupled from the real economy to a dangerous extent. Just 3 percent of lending from UK banks goes to firms that produce goods and services.
  2. Public markets — where ‘gray capital’ rules the roost — are causing listed firms to under-invest in innovation and long-term value. According to the Bank of England’s Andrew Haldane, ‘UK private firms tend to plough back between four and eight times more of their profits into their business over time than publicly held firms.’ This observation leads to a startling conclusion: he estimates that ‘the elimination of short-termism would result in a level of output around 20 per cent higher than would otherwise be the case.’ Even if that’s a high estimate, as Haldane acknowledges it might be, it suggests that markets are stifling innovation and long-term value creation in a big way.
  3. There has been a secular — ie. cross-cyclical — decline in investment. Stephany Griffith-Jones and Giovanni Cozzi estimate that an investment ratio of 19–21% of GDP is healthy for a mature country with some industrial strength. In 2007, the ratio in Britain was already well below this: 15.9%. It fell to a mere 11% in 2012, since when it has begun, slowly, to bounce back, but is still a way off the already meagre pre-crisis level.

We need to talk about the long term

So, to quote Lenin, what is to be done? How can we change the system to ensure that breakthrough innovation doesn’t turn out to be a mirage?

Well, for a start, the relationship between investors and corporate managers is overdue a reboot. As a November 2015 Harvard Business Review article co-authored by The Generation Foundation and KKS Advisors pointed out, ‘the movement towards sustainable capitalism demands enhanced reciprocity between business leaders and the investment community… CEOs can’t expect to attract long-term capital if they never talk about the long-term.’

Accounting has a critical role to play in helping shift the conversation between CEOs and investors onto better ground. What gets measured gets done, as they say. The adoption of integrated reporting and triple bottom line accounting practices has been an important step forward, but nowhere near sufficient in the face of the challenges we now face.

In arguing for these practices, the sustainability industry has tended to accept the basic premise that financial profits are an accurate proxy for value created: you just need to find a way to price in social and environmental externalities. But, increasingly, it seems that financial profits aren’t an accurate proxy for value created.

There is a burgeoning literature highlighting the problem of ‘rent-seeking’ in modern Western economies — Rana Foroohar’s recent book, Makers and Takers, is one example. What Foroohar and others convincingly argue is that many companies — especially in the financial industry — have become more adept at value extraction than value creation.

So a more fundamental rethink of accounting is needed. The challenge now is not simply to integrate financial and non-financial value — important as that is — but, within the former, to differentiate between short-term profits and long-term value.

Straws in the wind

The growth of impact investing in recent years is another cause for celebration. But the bigger challenge now is to shift the mainstream investment community towards creating the right incentives for breakthrough innovation and long-term value creation. There are already encouraging signs of movement. Let me spotlight three, in particular:

  1. BlackRock CEO Larry Fink sent a public letter to S&P bosses last year calling on them, in effect, to stop returning so much capital to investors and start investing in their company’s long-term value. Larry didn’t write his letter because he’s recently developed a bleeding heart: he wrote it because he too is worried that tomorrow’s innovation and growth may prove to be illusory unless we implement some pretty radical changes today.
  2. Generation Investment Management, founded in 2004 by Al Gore and David Blood, is another pioneer of what a future-fit approach to investment might look like. Importantly, Generation has blurred the line between the world of “ethical” or “impact” investing and mainstream financial institutions. They incorporate analysis of investees’ sustainability into their investment decisions — not simply because they want to invest ethically, but because they see sustainability as a useful proxy for long-term value.
  3. The recent announcement that Bill Gates, Jeff Bezos and a number of other wealthy investors are set to launch a $1 billion fund — Breakthrough Energy Ventures — to invest in clean energy innovation is another straw in the wind. What matters now is that others — including investment industry incumbents with vastly more capital to invest — follow suit. In the context of the $90 trillion of public and private finance that a recent UNEP report says we need to mobilise over the next 15 years in order to achieve the SDGs, even the combined wealth of Bill Gates and his friends is but a drop in the ocean.

Individual pioneers like these are needed, but systemic challenges require a systemic response. Avoiding the grim future Erixon and Weigel argue we’re currently headed towards will require an unprecedented level of cross-industry collaboration.

One encouraging (UK-based) initiative in this respect is the BankingFutures project, convened by Meteos and Leaders’ Quest. The project working group — which includes a broad set of industry leaders — published an initial report in February 2016, which identified three top priorities to work on. The top two are especially pertinent to the challenge I’ve outlined in this blog:

  1. Forging strong links between the financial system and the real economy.
  2. Reintroducing a long-term culture into investing (in recognition that the current model has been at the expense of customers and society).

BankingFutures is a commendable attempt to break the deadlock around some of these issues, but we need much, much more of this kind of thing.

What about the state?

The public sector, too, has an important role to play in supporting and incentivising breakthrough innovation — and not just by de-regulating, which is Erixon and Weigel’s main policy prescription. Mariana Mazzucato, who studies the economics of innovation, argues that ‘the entrepreneurial state’ plays a much more active role in the innovation process than is generally acknowledged.

‘From the internet to nanotechnology,’ she writes, ‘most of the fundamental technological advances of the past half century — in both basic research and downstream commercialisation — were funded by government agencies, with private businesses moving into the game only once the returns were in clear sight.’ Public investment, according to Mazzucato, does not crowd out private investment. In fact, quite the opposite: it actually ‘crowds in’ private funding.

Take the iPhone for example. Every single one of the technologies that make the iPhone a smart phone — the internet, GPS, touch-screen display, voice-activated personal assistant — came out of R&D that relied heavily on state investment. Apple itself, the iconic poster child of Silicon Valley’s libertarian garage start-up culture, received funding in its early years from the Small Business Investment Corporation, a financing arm of the US government.

More recently, Elon Musk’s Tesla has also been the recipient of government largesse. It received a $465 million taxpayer-guaranteed loan to develop the Tesla S. The point here isn’t to undermine the importance of entrepreneurs like Musk and Steve Jobs, but rather to highlight the mutual dependence between them and the state. The US government could never have built products like the iPhone or the Tesla S, but nor could Apple or Tesla if it weren’t for the US government.

Mazzucato (and others) argue that governments have a role to play, not just in increasing the overall quantity of funding for innovation, but also in steering its direction. Carlota Perez argues that governments should not simply seek to level the playing field; they should actively tilt it in the direction of ‘green growth.’ This is, in essence, what Germany has done, using KfW, one of the largest state investment banks in the world, to help channel funding towards green innovation.

‘Time to panic’

None of the barriers to breakthrough innovation is insurmountable. As Erixon and Weigel conclude, ‘no economy is ever predestined for perdition. Now, however, is the time to panic.’

The good news is that there are pioneers out there — from BankingFutures and Generation Investment Management to Breakthrough Energy Ventures and KfW — who are already lighting the way. But we need their approach to go mainstream — and fast — if we’re to avoid the dystopian future I painted at the start of this blog.


At Volans, we’re committed to exploring these issues further and finding ways to enable system-level responses in 2017. If you’d like to share ideas or comments, please get in touch at r.roberts@volans.com.