Fill out the brief form below for access to the free report.

The Capitalism America Needs

Article by Eric Schmitterer August 14, 2012 //   9 minute read

The United States is currently facing an economic situation in which traditional tools, such as fiscal and monetary policy, are not providing sufficient economic stimulus. To achieve strong and sustained growth, economic policy needs more fundamental reform. To find these necessary reforms, we can look to “Good Capitalism, Bad Capitalism, and the Economics of Growth and Prosperity” (Yale University Press, 2006), a book by William J. Baumol, Robert E. Litan, and Carl J. Schramm that provides a blueprint showing how innovation and entrepreneurship induce growth and create prosperous economies. Baumol, Litan, and Schramm explain that there are a number of different types of capitalism, including state-guided capitalism, oligarchic capitalism, big-firm capitalism, and entrepreneurial capitalism. In state-guided capitalism the government, rather than the private sector, decides which industries and firms have the most promise and therefore devotes vast resources to ensure their success. Oligarchic capitalism is similar to state-guided capitalism but differs because a very small group of people holds the vast majority of power and wealth, and government policies are designed to keep the ruling autocrats in power. Big-firm capitalism is dominated by large established enterprises. Entrepreneurial capitalism, on the other hand, consists of an economy made up of many small innovative companies. The authors write persuasively that a blend of “big-firm” and “entrepreneurial” capitalism is the key to a growing economy. Innovative entrepreneurs are defined in the book as those who produce “a new product or service or that develop and use new methods to produce or deliver existing goods and services at lower cost.” These entrepreneurs create innovations, but big firms are crucial as well to commercialize those innovations on a mass scale and bring products to market. For countries that already have high living standards, Baumol, Litan, and Schramm assert that there are four conditions that are necessary to allow innovative entrepreneurs to thrive. First, it must be easy and inexpensive to start a business. For example, there should be few licensing requirements, it should be easy to fill out the necessary applications, and the time to get approval should be short. In addition, bankruptcy protection and easy access to finances are important in order to promote entrepreneurship by rewarding, rather than penalizing, those who take risks. Second, productive entrepreneurial activity must be rewarded. Property and contract rights are important in order to assure entrepreneurs that their hard work will be secure. Patents are also important to stimulate innovation by rewarding new ideas. However, it is important to realize that patents can also discourage entrepreneurship by preventing others with novel ideas from entering the marketplace. Baumol, Litan, and Schramm argue that the United States patent system has become too protective, and that patents, as of 2005, are being awarded for inventions that are “obvious” rather than “novel.” In order to correct the system, they suggest that the U.S. more closely emulate the Japanese patent system, which defines patents very narrowly, increasing competition and thus encouraging Japanese firms to enter into cross-licensing arrangements with rivals. Baumol, Litan, and Schramm explain that large enterprises often do little radical R&D in-house but rather purchase many technological innovations from third parties. Therefore, one important way to increase the flow of technological innovations to large firms is to ensure that university-based research is brought to the marketplace. Despite the apparent success of the Bayh-Dole Act — which allows universities and their faculty to profit from the commercialization of their federally funded research — Baumol, Litan, and Schramm argue that the time it takes to disseminate university research is too slow and could be greatly decreased. (After their book was published, more recent research by Irene Abrams, Grace Leung, and Ashley J. Stevens, from 2009, suggests that transfer offices can actually be bottlenecks to commercialization.) Baumol, Litan, and Schramm conclude that technology transfer offices are too small to realize economies of scale and have difficulty competing with the private sector over expert personnel. The authors contend that universities could improve their own transfer offices by allowing their faculty members to choose between them and outside intellectual property agents, spurring competition and forcing the universities’ offices to improve. The authors believe geographically clustered universities should create a single technology transfer office focused on maximizing the number of “deals” they arrange rather than trying to maximize profits, which can waste time involved in negotiating. Third, unproductive activities should be discouraged. For example, it is important to reduce unlawful activities, such as theft and bribery, which redistribute wealth rather than create it. Similarly, it is important to reduce lawful activities that likewise merely transfer wealth. One example of such “rent seeking” is “sham litigation”— lawsuits that bear no merit but are filed by less successful firms to attack competitors that have price advantages. Measures to combat these lawsuits could include requiring the loser of a lawsuit to pay the legal costs of both parties, or removing the treble-damages provision from U.S. antitrust law — a statute that allows the court to triple the amount of the compensatory damages to be awarded to the plaintiff. Fourth, entrepreneurs should be encouraged to continue innovating once successful, rather than becoming stagnant or turning to “rent seeking.” Antitrust laws are one obvious method to encourage competition and therefore innovation, but there are also many other ways to motivate large successful U.S. firms to continue to innovate. For example, Baumol, Litan, and Schramm stress that trade and international competition are particularly important. The government should help facilitate, through the creation of a government office, the use of foreign technology by U.S.-based firms, which U.S. firms can adapt to domestic needs or adopt for their own ventures. The authors also argue there are benefits to allowing U.S. producers to “off-shore” their production to countries that pay lower wages: Companies “are exploiting their comparative advantage in bringing innovations to market more rapidly and cost-effectively.” Furthermore, by innovating more rapidly, the U.S. will stand to increase its trade, and thereby create jobs and economic growth. As foreign countries, such as China and India, become wealthier, they provide bigger markets for U.S. imports. For example, despite U.S. imports rising to 17% in 2004 from 11% in 1995, over the same period, median family income increased by 8%, GDP rose by more than 30%, and total employment increased by 12%. This suggests that freer trade, off-shoring, and direct foreign investment in the U.S. create economic growth as well as provide customers with a wider range of goods and services at lower prices. Baumol, Litan, and Schramm argue that the U.S. needs a well-trained workforce in order to remain competitive in the innovation arms race. They believe the U.S. government needs to continue subsidizing education for engineers and scientists as well as providing research funds through universities. But better monitoring of how education money is spent is more important, they argue. More research needs to be done on what educational practices best improve the performance of underprivileged students. The authors believe charter schools can improve performance by increasing competition. In addition, to better attract and retain talent from abroad, the authors feel that U.S. immigration policy should encourage foreign students, for example by granting immediate citizenship to foreign students who earn degrees in math and science-related fields. The U.S. economy has undergone a tremendous shock since “Good Capitalism, Bad Capitalism” was published in 2006. However, the advice contained in the book remains very relevant today. Policy makers looking for a new approach to achieving long-term economic growth would benefit highly from this important contribution by three of America’s foremost experts on innovation, entrepreneurship, and economic prosperity.