During last Tuesday’s debate between Mitt Romney and Barak Obama, both candidates touched on the topic of government investment in businesses. The principal issue at hand was whether the government can (or should) create jobs. However, although jobs are a very valuable aspect of investment or spending, the question of whether or not the government should invest in businesses is a much larger issue.
First, to be clear, the US federal government has long standing programs for subsidizing businesses. These programs, ranging from farm aid to insurance for nuclear power plants, are designed to support industries that the federal government has decided are of national strategic importance.
Second, the US federal government rarely invests in business in the traditional sense of taking an ownership stake. The government in America has moved steadily away from ownership of any business, preferring, instead, to guarantee loans (eg: Small Business Administration (SBA) loans) or to make grants for research and development projects (eg: Small Business Innovation Research (SBIR) grants), especially for small and mid-sized businesses.
Third, because the government is not investing for direct and immediate financial gain, which is the objective of most private or corporate investors, the American government measures success in other ways than capital gain, cash flow, or IRR. The federal government invests to improve military and food security, to keep America competitive in emerging and dynamic technologies such as renewable energy and aerospace, or to create high-wage, high value-add jobs.
The US government is not, therefore, in the business of “picking winners” among businesses. It deliberately spreads its resources widely in a range of industries and individual companies with the objective of having, in the long run, a net positive impact on American competitiveness, prosperity, and security.
We can assume, therefore, that a major component of “success” requires innovation and that innovation is both an objective and a by-product of the subsidies.
SBIR grants directly encourage commercial innovation by seeding small businesses experimenting with new technologies or techniques, resulting in an average of 7 patent filings per day. In addition, insurance for nuclear power plants encourages innovation in the nuclear power industry by ensuring the survival of the industry, because private insurers are unwilling to cover all of the risks of nuclear plants and without insurance utilities would not build them.
Investing for Near and Long Term Returns
DARPA (Defense Advanced Research Projects Agency) is a government program that funds research with particular objectives and has produced, for example, the internet. One model DARPA has used successfully is to lay out a project or a problem and offer a cash subsidy for research in that area, with various companies or research centers submitting competitive proposals for the subsidies. In 2011, DARPA’s subsidies to small business research totaled just over $74M. To qualify, those businesses must have fewer than 500 employees and be independently owned and operated.
In addition to looking for near term solutions and breakthroughs, the government also provides long term stimulus to innovation. The government makes grants to academic institutions and public research institutes like the National Institutes of Health (NIH) that conduct basic research, including research in healthcare, the natural sciences, and the social sciences. The vast majority of this research has no immediate market value, so traditional market forces fail to provide incentives for businesses to invest in them.
The NIH received $30B in funding in 2011, resources that could never be matched by the private sector.
However, the results of the research paid for by the government often make their way into industry in unexpected ways. Laser cutting tools, gene therapy, and non-stick surfaces on fry pans are commercial applications based on research originally funded by the government.
Contemporary cancer treatment is directly derived from research done at NIH 20-30 years ago, so the companies that make the instrumentation and chemical/biological products used in those treatments are direct financial beneficiaries of that research.
Some projects are simply too big for private enterprise. When President Kennedy set the objective of going to the moon by the end of the 1960s, the government created a whole new agency, NASA, to take up the challenge. From the outset, the implications for national defense as well private industry were understood as significant. While no business was large enough to invest the billions of dollars it took to eventually reach the moon and we all paid for those visits through our taxes, private business spinoffs that use technologies developed for NASA now produce consumer and commercial products, including specialty materials and computing systems, that have generated billions of dollars in revenue over the last four decades.
Today, since the basic technologies for space launches are widely understood and can be produced economically and used (relatively) safely, private enterprise is taking over the industry, launching rockets with commercial, government, academic, and even private citizen payloads into orbit. Earlier this month, SpaceX became the first commercial rocket launch company to resupply the International Space Station.
Rules and Regulations
Getting back to the debate. Governor Romney has consistently argued that regulation gets in the way of private enterprise, and with it innovation. And he makes a good point. Evidence of this can be seen outside the US in countries where regulation of business is more pronounced. In France and India, for example, laying off employees requires considerable red tape and cash layouts, a well intentioned set of rules that protects existing jobs and the individuals who lose them, but also compels companies to add new employees slowly and carefully, resulting not only in prolonged periods of high unemployment but also a reluctance to try new businesses because the financial obligations that come with failure are high.
Without a doubt, therefore, government has to consider unintended consequences of its regulations, and citizens have to evaluate the tradeoff between the intended benefits of regulation and the impact they have on business. For example, when the EPA imposes rules on how toxic substances are handled, the rules may be well intended efforts to protect homeowners, schools, workers, or natural resources such as lakes and streams, but the regulations may also impact the ability of the businesses using those substances to profitably conduct research or manufacture products.
There are, however, regulations that impose costs that businesses are willing to bear because business benefits from those regulations. For example, intellectual property (IP) protection is a form of regulation that prevents one business from using the protected innovations of other businesses without permission. Through laws that protect IP, the government ensures that innovative businesses can reap the benefits of their investments in research and development. The cost of filing and defending patents is not trivial, but the financial consequences of not doing so make the costs worthwhile. The government’s role in managing patents and providing a mechanism for businesses to defend those patents is indispensable, and companies and entrepreneurs will not set up businesses in countries in which the government does not offer adequate IP protection.
Similarly, an often underrated role of government in innovation lies in providing a predictable environment for the conduct of business. Rule of law, public safety, and a stable political and economic structure are essential for businesses and entrepreneurs to take the risks that go along with innovation. When social, political, and economic environments are unpredictable, businesses and individuals focus on survival rather than positive innovation because they do not know whether unanticipated, changing circumstances will allow them to make a return on the investments they make on improvements.
Government, therefore, plays a valuable role, directly and indirectly, in the innovation we see around us. At the most fundamental level, government supports innovation by providing the social, political, and economic stability necessary for businesses to invest in new ideas. In addition, government contributes to long term innovation by paying for basic research in healthcare, physical sciences, and social sciences and by taking on large projects that are beyond the scope of private industry. Finally, the government primes the pumps of near term innovations by making grants to innovators in areas that are of national strategic interest and offering incentives in the form of prizes to student, academic, and business teams that compete to find solutions to problems that benefit the government and society as a whole.