Great Leap Forward

Mission-Oriented Finance for Innovation, London 22-24 July

Our conference begins today in London and runs for three days. This is a spin-off of an INET project that Mariana Mazzucato and I are heading, which explores an integration of Keynes, Schumpeter, and Minsky on financing the capital development of the economy. I’ll report more on our research later–the project comes to an end this fall.

The FT-Alphaville blog is running a series of guest posts on the conference. Mariana did the first one, and mine went up yesterday. My blog is here: The conference website is here:

Some of the events will be broadcast over the internet.

Here’s a quick summary of the paper Mariana and I prepared for the conference:


Our project concerns the role that finance plays in promoting the capital development of the economy. We have found it useful to synthesis the main contributions of three of the 20th century’s greatest thinkers: J.M. Keynes, Josef Schumpeter, and Hyman P. Minsky.

We will define both “finance” and “capital development” very broadly. We begin with the observation that the financial system evolved over the post-war period from one in which closely regulated and chartered commercial banks were dominant, to one in which financial markets dominated the system. Over this period, the financial system grew relatively to the nonfinancial sector, rising from about 10% of value added and a 10% share of corporate profits to 20% of value added and 40% of corporate profits. Further, as has been noted by many commentators, the nonfinancial sector became highly financialized by many measures, including debt ratios as well as proportion of income generated by financial activities (even at industrial powerhouses like GM and GE created financial arms, although most large firms began to treat cash balances as a financial asset to generate revenue).

At the same time, the capital development of the economy suffered perceptibly. If we apply a broad definition, to include technological advance, rising labor productivity, public and private infrastructure, innovations, and advance of human knowledge the rate of growth has slowed. Admittedly, this is a difficult claim to demonstrate. In some areas, advances have come at lightening, almost revolutionary, speed.  However, in many basic areas the US and UK are falling behind: universal education, health improvements, public and private infrastructure, and poverty alleviation. The American Society of Civil Engineer’s infrastructure report card awarded an overall D+ in 2013, estimating that $3.6 Trillion of infrastructure investments are needed by 2020. Almost none of the infrastructure needed to keep America competitive in the global economy received a grade above a D.

Further, even as the financial sector experienced serial booms (and busts), the infrastructure situation actually has worsened since 1998 across most of these categories, as the estimate of the spending required rose from $1.3 Trillion. Although the “grades” have risen slightly in recent years, this is mostly due to private investment in infrastructure. As the 2013 report notes, “We know that investing in infrastructure is essential to support healthy, vibrant communities. Infrastructure is also critical for long-term economic growth, increasing GDP, employment, household income, and exports. The reverse is also true – without prioritizing our nation’s infrastructure needs, deteriorating conditions can become a drag on the economy.”

The capital development of the economy advances in two ways—and we are failing in both ways across most categories. First we can improve the quantity and quality of investments that promote the capital development using state-of-the-art knowledge, techniques and processes. Since new investment in physical capital as well as in human development will generally utilize the newest knowledge, techniques and processes, new and replacement investment will usually promote the capital development of the economy. This is essentially what the ASCE grade report is highlighting, although it focuses on the needed public and private infrastructure investments to improve quantity and quality.

Second, quality can be improved through Schumpeterian innovation and “creative destruction”: new technologies come along that “destroy” the productivity of old technologies (not always in a physical sense, but in a profits sense). Schumpeter did not just mean physical investments in plant and equipment, but also new ways of doing things. For Schumpeter, economic development is the result of innovation, characterized as the carrying out of new combinations of materials and forces or productive means. It includes introduction of a new type or quality of commodity, introduction of a new method of production, opening of a new market, conquest of a new source of supply of raw materials or intermediate goods, or carrying out of a new organization of industry (eg: creation or destruction of monopoly power). This innovation is the product of the entrepreneur, who swims against the stream, putting inventions into practice.

Schumpeter emphasized that innovation must be distinguished from invention; in many cases, the entrepreneur merely borrows inventions that have not been applied precisely because they represent a break with routine. The innovation is to break habits, to break down resistance of groups threatened by use of the invention, and to get the necessary cooperation of capitalists, managers, workers and consumers. This is the role of the entrepreneur, a role that cannot be a profession, nor can there be a class of entrepreneurs.

To be clear, even Schumpeter argued that most economic development does not require innovation. However, in the increasingly globalized economy, innovation is critical to retaining and expending market share. In the 1950s, a large and relatively closed economy could rely on investment that improved the quantity and quality of the nation’s means of production—the first path to improving capital development discussed above. However, with relatively open economies today, innovation has become critical for retaining market share. Growth without innovation is becoming unsustainable.

Innovation is a key to long run growth. Innovation must be financed, so finance is central to the innovation process. Indeed, this is why Schumpeter called the banker the ‘ephor’ of the exchange economy. Yet in recent decades finance has retreated from serving the real economy: the financial sector serves itself, and companies in the real economy have become ‘financialised’.

Furthermore, for growth to be not only ‘smart’ (innovation led) but also ‘inclusive’, it must be growth that produces full employment, and less inequality. Thinking about finance in this way, i.e. restructuring it to serve the ‘real’ economy, rather than itself, and to produce both innovation led growth and full employment, is the key goal of this paper. This requires bringing together the thinking of John Maynard Keynes, Hyman Minsky, and Joseph Schumpeter, as well as understanding the role of the public sector as doing much more than fixing static market failures.

From Keynes we borrow the central insight of the theory of effective demand: firms hire the resources they think they will need to produce what they think they can sell. What this means is that employment is not determined in labor markets—but rather by the level of sales expected. Indeed, the concept of ‘animal spirits’ in Keynes is not only useful for behavioral finance, but also for Schumpeterian economists that have focused on entry and investment behavior as being driven by the ‘perception’ of where the future technological and market opportunities are.

Keynes also argued that saving is not the source of finance as he rejected the loanable funds theory that a flexible interest rate allocates a scarce supply of saving to investment. Keynes reversed the causation: spending creates income and it is the spending on investment that creates the income that is saved. This means that we must look elsewhere to find the source of finance for investment.

From Schumpeter we borrow two insights: it is critical to understand the innovation process in order to begin to analyze the dynamics of the capitalist economy, and innovation needs finance. In Schumpeter’s view this is because innovation must be financed before it can generate revenues. While in his early work he focused on the need for finance to allow new entry (into the circular flow through start-ups), in his later work he focused on the importance of internal finance for financing large R&D laboratories of established corporations. Either way, the point of finance is that it is tightly related to the ability to allow new things to happen.

From Minsky we borrow the recognition that the dynamics of the capitalist system are not necessarily stabilizing, and that when finance is brought into the analysis, the dynamics become much worse. Minsky broadened Schumpeter’s view—it is not just innovation that has to be financed, as a portion of investment is typically externally financed. [1]  He also extended Keynes’s “investment theory of the cycle” to include a “financial theory of investment.” In other words, he provided the alternative to the loanable funds theory that Keynes had rejected.

We can go further and argue that actually all production must be financed (the process “begins with money to end up with more money”—as both Marx and Keynes said). In addition, Minsky argued that finance, itself, is subject to innovation. Finally, he warned that “stability is destabilizing”, and that mainly has to do with the innovations in finance that are encouraged by the appearance of stability.

The past quarter century saw what was the greatest explosion of financial innovation the world had ever seen. Financial fragility grew until the economy collapsed into the Global Financial Crisis. At the same time, we saw that much (or even most) of the financial innovation was directed outside the sphere of production—to complex financial instruments related to securitized mortgages, to commodities futures, and to a range of other financial derivatives. Unlike Schumpeter, Minsky did not see the banker merely as the ephor of capitalism, but as its key source of instability. This comes from his understanding of finance as having a dynamic of its own (M-C-M’)—beyond a medium of exchange, an insight which of course Marx had as well.  Furthermore, due to ‘financialisation of the real economy’, the picture is not simply one of runaway finance and an investment starved real economy, but one where the real economy itself has retreated from funding investment opportunities: rather, either hoarding cash or using corporate profits for speculative investments such as share buybacks (Lazonick, 2013) . As we will argue, financialization is rooted in predation; Matt Taibbi has famously argued that Wall Street behaves like a giant blood-sucking vampire squid.

According to a recent financial newsletter, the S&P 500 companies (excluding banks and other financial institutions) were sitting on $1.3 trillion as of the 3rd quarter of 2013, up by 13.5% from the previous year. Financial investments – as opposed to productive investments (e.g. in R&D) – became key sources of profit for a great proportion of American corporations (Krippner, 2005). In some industries like pharmaceuticals and oil & gas, firms invest more on share buybacks and paying dividends than on R&D and innovation (Lazonick and Tulum, 2011; Lazonick and Mazzucato, 2013).

We position our project around five central issues:

a. The distinction between quality vs. quantity of finance.

b. The mismatch between demand and supply of finance.

c. The issue of public vs. private finance.

d. The question: where does finance come from?

e. How to promote finance for innovation and employment.

In this paper we begin to address these issues, focusing on promoting the capital development of the economy. We first provide a detailed discussion of the Keynes-Schumpeter-Minsky framework used for the analysis. We then turn to the connection between finance and innovation, arguing that the current system is failing us. We close with suggestions for reform.

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