Fill out the brief form below for access to the free report.
Innovation and the Next Big Thing
Matthew Rooney and Cullum Clark recently conducted an email exchange about how American can unleash a new wave of innovation. Rooney, director of the George W. Bush Institute’s Economic Growth program, and Clark, an economist at Southern Methodist University and director of a new SMU economics research center, explore how U.S. fiscal, monetary, and other policies can help ensure that the U.S. remains in the lead of the global economy.
Over time, America’s economy has been powered by innovations in such fields as technology, energy, and manufacturing. Those breakthroughs didn’t just happen, of course. They required creative thinkers, a receptive market, and a smart set of policies.
Given that our private sector remains innovative and our market receptive, the question is, how can America unleash a new wave of innovation? Matthew Rooney and Cullum Clark recently conducted an email exchange about this challenge. Rooney, director of the George W. Bush Institute’s Economic Growth program, and Clark, an economist at Southern Methodist University and director of a new SMU economics research center, explore how U.S. fiscal, monetary, and other policies can help ensure that the U.S. remains in the lead of the global economy.
Rooney: It feels to me like the American innovation machine has stopped, or at least slowed significantly. Of course, technology continues to evolve and find its way into more and more corners of the manufacturing process – but, having invented the internet 20 years ago, there is no sign of The Next Big Thing emerging from the United States.
Even the innovations we have seen in energy generation and storage have been marginal in the sense that each new generation has emerged organically from the last – and the U.S. has arguably not been the leader of the pack in this area.
It feels to me like the American innovation machine has stopped, or at least slowed significantly. Of course, technology continues to evolve and find its way into more and more corners of the manufacturing process – but, having invented the internet 20 years ago, there is no sign of The Next Big Thing emerging from the United States.
Clark: I agree we should be quite concerned about the health of America's innovation engine. One disturbing trend is the very significant decline in startup activity. Another is our obvious inability at present to produce anywhere close to enough workplace-ready graduates with strong backgrounds in science, technology, engineering, math, and design.
At the macro level, we've now experienced more than a decade of productivity growth well below the average level we had come to expect over the previous century. Robert Gordon's seminal book, The Rise and Fall of American Growth, speaks to this slowdown in concrete, historical terms and should be required reading for policy-makers across a range of areas.
Whether the U.S. remains the leader of the pack in key emerging technologies is a complex question. On the one hand, virtually all of the major companies currently leading the innovation race in large sectors of the economy -- Apple, Google, Amazon, and Facebook in the digital consumer sector; Celgene, Biogen, Illumina, and Thermo Fisher in biopharma and life sciences; Pioneer, EOG, Schlumberger, and Halliburton in oil and gas -- are based in this country.
On the other hand, there are a number of potential technologies of the future in which other countries might be leading the way. China seems to be taking the lead in solar and wind technology, thanks to massive state support, as well as in facial recognition technology. Startups in Europe and Asia are in a strong position in blockchain and other areas of financial technology. It's too early to say how these innovation races will play out, I think.
But I agree with you, and with Bob Gordon, that a number of the most hyped innovations rolling out in the last few years can be characterized as "marginal," relative to the most important technological improvements of the past 150 years. The stock market is perhaps saying the same thing, in the lackluster reception it's given to some companies that have recently gone public.
I agree we should be quite concerned about the health of America's innovation engine. One disturbing trend is the very significant decline in startup activity. Another is our obvious inability at present to produce anywhere close to enough workplace-ready graduates with strong backgrounds in science, technology, engineering, math, and design.
Rooney: It seems to me that the zero- to negative-interest rate environment of the past decade has played a role in stifling investment in innovation by removing the measuring stick by which markets gauge risk and return. At the same time, the federal government remains a major net borrower. Are we looking at a sort of double “crowding-out” effect?
Clark: Our current policy regime of sustained ultra-low interest rates has contributed to this slowdown in innovative activity. My own research points to several mechanisms through which such counterproductive effects might operate.
First, persistently low interest rates have promoted very high valuation levels for stocks and other financial assets, and arguably contributed to boom-bust tendencies in the market. There is considerable evidence that this side effect has made it more attractive for financial institutions, including not only banks but also hedge funds, private equity firms, and others, to engage in speculative trading and financial engineering activities at the expense of channeling resources to the innovative sector.
Second, high asset valuation levels associated with the policy regime have helped to create a super-sized financial sector, which literally competes with innovative sectors for scarce resources like human talent and capital, siphoning away many of the best minds, among other resources.
Third, ultra-low interest rates choke off the incentives for banks to lend, as they become indifferent between lending and holding cash, or reserves at the Fed -- which are the same thing.
And fourth, a super-sized financial sector is arguably able to exert greater market power than it otherwise would. There is substantial evidence that the modern finance sector uses this power to push non-financial companies towards greater shorter-termism, for instance emphasizing stock buybacks and financial engineering over R&D and capital investment.
I agree that we are currently seeing crowding-out effects in the economy, but we have to be clear about what the data are telling us. It would be hard to argue that government borrowing is crowding out borrowing by the private sector as a whole, since private sector debt levels are extremely elevated as a percentage of GDP, and growing fast.
Rather, the asset classes that are growing in today's ultra-low rate setting include U.S. Treasury debt but also other categories that can easily be packaged, levered up, and securitized for yield-hungry investors. I'm thinking primarily of investment-grade and high-yield corporate debt, commercial real estate debt, and residential mortgage debt, which is booming again. It also includes debt that will likely never be repaid, like a great deal of today's student lending.
What's being crowded out? Private-sector research and development and non-real estate corporate capital investment -- especially at small- to mid-sized firms -- come to mind. One could argue that firms are also systematically under-investing in the "human capital" of their employees, potentially contributing to the anemic productivity growth of recent years.
Meanwhile, large publicly-traded firms have seen record profit margins over the last five years or so, and are buying back stock at an unprecedented rate, in response to the insistent demands of institutional investors. Also, while investment by venture capital firms is booming, it's going disproportionately to later-stage investments in a handful of popular sectors --- for instance, to "unicorn" companies in social media, ride-sharing, and a few other hot areas. Earlier-stage innovative companies are among the categories that are being crowded out, I suggest.
Persistently low interest rates have promoted very high valuation levels for stocks and other financial assets, and arguably contributed to boom-bust tendencies in the market.
Rooney: The disincentive to invest in R&D created by ultra-low interest rates strikes me as interesting and even counter-intuitive. Shouldn’t low rates drive a search for higher returns, which would normally lead to a higher risk tolerance and greater investment in innovation?
Clark: What counts for a firm in deciding its investment program is not the Federal Reserve's policy interest rate but the firm's own cost of capital, that is, the rate of return required by its debt and equity capital providers. Simple textbook models assume that the Fed's policy rate and required returns in the private sector are tightly correlated, so that an ultra-low Fed funds rate leads to a similarly low cost of capital, and therefore to greater investment in innovation.
But substantial evidence argues that this relationship has broken down in the world of zero and negative interest rates. In particular, the cost of capital for smaller firms does not seem to have reached sufficiently low levels to induce a more robust degree of investment in innovative activities. So the transmission mechanism isn't working as textbook theories predict.
Why is this? We badly need more empirical research into what happens when interest rates reach zero or even below. In my work, I argue that the financial sector is always choosing how to allocate its capital and other resources, and that ultra-low rates and high asset valuation levels increase the attractiveness of deploying capital to speculative asset market activities -- for instance proprietary trading or mergers and acquisitions -- relative to financing capital investment and innovation.
Another possibility is that firms and investors in the real world require some minimum absolute expected return to incur the unavoidable risks associated with innovation, for institutional or behavioral reasons. It may be, then, that below some threshold level, still-lower interest rates make no difference to required rates of return.
Rooney: So, how does this end? Is there a benign scenario out there where higher rates boost innovation, productivity, investment and growth, supporting a return to a more normal monetary environment?
Clark: Yes, I can't help but be a long-term optimist on the American economy. It's straightforward to sketch out what a relatively benign scenario would look like.
First, the Fed would institute a true regime change in monetary policy -- not just two or three more increases in the Fed funds rate in the short term, but a credible commitment to move towards meaningfully positive interest rates adjusted for inflation, keep rates above the inflation rate in all but the most recessionary environments, and acknowledge that the great experiment with "quantitative easing" and severely negative real interest rates has not worked out as intended.
Second, federal and state governments would shift towards a lighter regulatory touch across a range of domains -- financial sector regulation, occupational licensing, health insurance rules, and regulation of the Internet and telecommunications, to start with.
Third, Congress would significantly simplify and streamline the corporate and personal income tax systems, with an eye towards the countless anti-growth, anti-innovation measures that have accumulated over the past 30 years.
Fourth, the federal government would at least sustain current levels of spending on basic research at the NIH, the NSF, DARPA, and other funding agencies.
And fifth, the federal government would resist the temptation towards tighter trade and immigration rules, and would indeed accept more of the world's most highly skilled knowledge workers than it has done under our dysfunctional H-1B visa system.
Yes, I can't help but be a long-term optimist on the American economy. It's straightforward to sketch out what a relatively benign scenario would look like.
Smarter education policies, like greater openness to innovative models within districts and to the expansion of successful charter school organizations, would be a game-changing policy shift, but of course would take longer than these other measures to play out in influencing the pace of innovation.
How likely is it we'll see the "benign scenario"? I agree with the recent outburst by JP Morgan CEO Jamie Dimon about how frustrated he is with the extreme dysfunction in economic policy-making in Washington.
The good news, in my view, is that we don't need to reach a "nirvana" or "A-plus" policy mix to restore the economy to more historically normal levels of innovative activity. Being an optimist, I'm convinced that if we can just raise our grade for long-term economic policy-making up to, say, a C-plus or B-minus, we will see a measurable improvement before long. I think it's more likely than not that it will happen.