Americans, Swedes, and the Alchemy of Innovation

Stockholm Photograph by Davide Monteleone/Contrasto/Redux

From the steam engine to the Internet, innovation has been the driver of rising living standards in capitalist countries. Economist Joseph Schumpeter wonderfully captured the role of innovation in a capitalist economy: “The fundamental impulse that sets and keeps the capitalist engine in motion comes from the new consumers’ goods, the new methods of production or transportation, the new markets, the new forms of industrial organization that capitalist enterprise creates.”

Nowhere is the association between innovation and entrepreneurship as deeply ingrained in popular culture as in the U.S. Starting with the textile mill owners of 19th century Lowell, Mass., and continuing right up to the men and women who built Silicon Valley, Americans have believed that innovation and risk-taking are two sides of the same coin. This common cultural touchstone helps explain why U.S. businesses have so much leeway to succeed and fail. Taking a long-term perspective on American history, it’s hardly surprising that a major public policy passion has been how best to encourage more entrepreneurship. This policy concern is certainly animating the battle for the White House between Mitt Romney and Barack Obama.

Perhaps the current charged political climate helps explain why a 47-page, highly abstract scholarly paper (PDF) with plenty of equations and multiple references to world equilibrium model, risk aversion, time-varying rewards structures, and so on has ignited a flurry of interest in the blogosphere. Its title is provocative, too: Why Can’t We All Be More Like Scandinavians: Asymmetric Growth and Institutions in an Interdependent World. MIT economist Daron Acemoglu, Paris School of Economics professor Thierry Verdier, and Harvard professor of government James A. Robinson model a relationship between two forms of capitalism, “cutthroat” and “cuddly.” The U.S. is an exemplar of cutthroat capitalism, offering risk-takers the prospect of big money, a weak safety net, and wide inequality. The paragons of cuddly capitalism are the Scandinavian nations, with a generous cushion against risk, a smaller payoff to entrepreneurs, and less inequality.

To recap the paper, the scholars argue the cutthroat U.S. economy expanded rapidly, thanks to incentives rewarding innovation. However, living standards among the cuddly Nordic nations eventually catch up as they adopt the innovations generated by U.S. entrepreneurs. Cuddly capitalism and cutthroat capitalism rely on one another in an interconnected world economy. The scholars conclude: “[W]e cannot all be like the Scandinavians, because Scandinavian capitalism depends in part on the knowledge spillovers created by the more cutthroat American capitalism.”

The paper raises many intriguing questions. The most important for people who aren’t academic economists is whether it’s true a stronger social safety net discourages entrepreneurship. My suspicion is that the exact opposite is the case. Modern finance theory—hardly a bastion of socialist support—suggests that strong safety nets which minimize the downside of bets gone bad encourage greater risk-taking. Without a backstop they can rely on, “people are afraid to venture out into the rapids where real achievement is possible,” writes Yale University economist Robert Shiller in The New Financial Order: Risk in the 21st Century. “Brilliant careers go untried because of the fear of economic setback.”

The story told by worldwide innovation indexes is very different than what the authors suggest, says Lane Kenworthy, sociologist at the University of Arizona. The Global Innovation Index for 2012, compiled by INSEAD and the World Intellectual Property Organization (the latter a specialized agency of the United Nations), ranks Switzerland first, followed by Sweden, Singapore, and Finland. The U.S. is 10th. The top four innovation countries offer their citizens universal health and retirement benefits. The World Economic Forum’s Global Competitiveness Index, 2012-2013 rates Sweden the world’s most innovative nation, followed by Finland. The U.S. is sixth on the list. Closer to home, the 2012 State Entrepreneurship Index compiled by the University of Nebraska-Lincoln put Massachusetts, which has universal health care, on top. Louisiana is at the bottom.

A similar insight comes from an examination of whether there is “entrepreneurial lock” with America’s employer-based health-care system. A 2011 Kauffman-RAND Institute for Entrepreneurship Public Policy study looked into whether people with employer-based insurance were more likely to become self-employed if they could get their health insurance through a spouse. For the entire U.S. population, the annual base rate of business creation is 3 percent. Among men, the study found that entrepreneurial lock reduced business creation by a percentage point. The same pattern held for women. Eligibility for universal coverage under Medicare also affected entrepreneurship rates. For men just under age 65, the business ownership rate is 24.6 percent, a figure that jumps to 28 percent for men just over 65. “The availability of affordable health insurance for the self-employed has an important impact on whether individuals are likely to become entrepreneurs,” concludes Robert Fairlee, a RAND economist.

More important, it’s a mistake to frame the public policy issue of fostering innovation and entrepreneurship as a choice between security and risk-taking. Finance theory offers a richer perspective. Finance is all about the management of risks—hedging away risks you don’t want, minimizing the impact of inherent risks, and embracing the bets you desire to make. In the stock market, diversification, asset allocation, and investing globally allow for smarter portfolios and more reasonable gambles. Investment analysts Scott L. Lummer and Mark W. Rieppe nicely captured the critical role of risk management in a 1994 paper. Mark Twain in Pudd’nhead Wilson wrote, “the wise man saith ‘Put all your eggs in the one basket and—WATCH that basket.’” But Miguel de Cervantes in Don Quixote de La Mancha believed, “’Tis the part of a wise man to keep himself today for tomorrow, and not venture all his eggs in one basket.” The finance authors noted that Cervantes and Twain were great writers, but Cervantes would have made for a better investor.

The reason America doesn’t have more entrepreneurs than it does largely reflects a frayed safety net, a rise in income volatility, and too much risk concentrated in the household. Fledgling entrepreneurs without family wealth to tap would have every incentive to try their hand at starting their own business if they were confident the risk of entering old age without retirement savings is hedged and knew that their children would have decent health insurance. Who knows how many Horatio Algers are stuck in a cubicle, developing their business plan in their garage office at night yet unable to pull the trigger, worried about retirement savings and medical bills? “Finance helps us realize our dreams by enabling creators and innovators to pursue their ideas without bearing all the risks themselves and encourages them to take great risks for good purposes,” writes Robert Shiller. “We need to democratize finance and bring the advantages enjoyed by the client of Wall Street to the customers of Wal-Mart.”

Shiller’s fertile economic imagination has developed a number of broad-based risk management tools, including income-linked loans and livelihood insurance. He’s on the right course. In the meantime, let’s move the public policy conversation away from talk of a tragic, yet inevitable trade-off between security and innovation. Instead, focus on constructing a larger safety net that encourages entrepreneurs. For many people these days, a pledge from Washington that universal health care is here to stay may be enough to break the dam of entrepreneurial lock. The debate could then concentrate on the design of universal coverage, not the promise. The same framing should go with reforms to the retirement savings system. The payoff: Greater economic security and greater economic growth will reinforce one another.

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