Edmund Phelps: Free innovators from the state’s deadening hand

Henry Ford’s low-cost car and Steve Jobs’ iPhone have enriched millions of lives in ways that no one envisioned. Yet neither sprung from groundbreaking scientific advances. Their genius was to use old technology in creative ways. Societies will be richly rewarded if they can find a way to quicken the pace of innovation. Yet misconceptions of the way forward are putting this goal farther out of reach.

A century ago, historians and economists linked innovation to the discoveries of scientists and navigators. As long as scientists were outside the economy – locked in ivory towers or embarking on distant expeditions – productivity gains were seen as beyond the influence of economic policy. The economist and political scientist, Joseph Schumpeter, supposed so for decades.


In Schumpeter’s time, however, scientists were coming inside the economy to engage in projects and innovate at companies from Bayer to DuPont. Economic theorists increasingly thought of the nation’s innovation as governed by a simple mechanism. How much research is conducted, and at what price, is determined by consumers’ demand for innovations and the supply of researchers to make them. If society cuts taxes on profit or boosts the supply of researchers, faster innovation is supposed to follow.

But this mechanist theory has done badly at explaining actual events. America’s slow technical progress since 1970 can now be understood as an effect of slowing innovation. In the mechanist view, this must mean one of two things. Either the profitability of innovations must have fallen, deflating demand; or the availability of researchers has fallen, choking supply. Neither explanation withstands scrutiny. Gross business profit relative to business output is near all-time highs; research spending relative to business output is not so low as to suggest a dearth of researchers. The theory also flunked the great test of history. The birth in about 1815, in Britain and America, of the first modern economies – economies rife with innovation – was not augured by any surge of scientists or of profits as a share of output.

The mechanical view of innovation means new practice, not invention or discovery. Most of it derives from having original ideas about what would be useful or enjoyable – thus using existing technology in new ways. Such leaps of imagination are more likely to come from business people of a practical bent than cloistered scientists.

A true innovation is rarely the result of noticing an opportunity. It depends on a vision of a new product or method, and an insight into how the economy will react to it. These often come from an idiosyncratic blend of experience and knowledge that is hard to convey to a chief executive or a government official.

Trying to innovate is not like planting cotton. It is a leap into the void, with unforeseeable costs and an unknown market reception. Success requires an entrepreneur with the right stuff – and a canny financier to spot him or her.

Most importantly, a high volume of homegrown innovation requires widespread dynamism, across the economy and down to the grassroots – so new ideas can come from anyone and anywhere.

Finally, innovation within a company requires employees, managers and owners who are in it not only for the small chance of a large material reward but also for the non-material rewards of mental stimulation, exploration and personal growth that innovative work usually presents – even if the project fails.

Yet we now see trained economists turning to the mechanist manual for switches to throw to regain lost dynamism. Proposed cuts in profit tax would not obviously coax innovative talent from established companies to start-ups, from which no profit flow is expected soon. It is cuts in capital gains taxes – paid as soon as a founder sells shares – that might give start-ups new blood.

Proponents of expanding government institutes for the advancement of science seem unaware that the explosion of productivity from 1820 to 1940 was driven by grassroots innovation, not big science; forgetful that true discoveries, like innovations, are a shot in the dark; and innocent of the institutional politicking that determines which ideas get funding.

Some mechanists say that if the financial sector will not lend to innovators, let the state supply more finance. Such suggestions are unhistorical: the colossal projects that have won state support have rarely matched the innovation brought by grassroots dynamism. They are also unworldly. Officials lack the insight and experience to know what partners to take on.

The state is no better suited to take a big role in technical innovation than in artistic creation. Nations with once-dynamic economies will be helpless to recover their prosperity as long as they misunderstand what causes economic progress.


Edmund Phelps


FT