The state doesn't need the private sector to be entrepreneurial

It is widely accepted that business is more dynamic -- but in fact, the state is crucial to innovati

The government's economic strategy isn't working. The post-crisis hangover remains, with growth subdued and recovery elusive and there's little on the horizon to stimulate the optimism and confidence needed to kick start the vibrant economy needed to secure sustainable growth and future prosperity. As Keynes claimed, investment is not driven by simple tax cuts but by the much less predictable "animal spirits" of investors, and such spirits are not currently running high.

Why? Current economic policy is based on the false premise that innovation-led growth will only happen if we pull back the role of the state and unleash the power of entrepreneurship in the private sector. This feeds a perceived contrast that is repeatedly drawn by the media, business and libertarian politicians of a dynamic, innovative, competitive private sector versus a sluggish, bureaucratic, inertial, "meddling" public sector. So much so that it is virtually accepted by the public as a "common sense" truth. In the March 2011 Cardiff Spring Forum, the Prime Minister, David Cameron, brought this view to an extreme when he called "bureaucrats in government departments" the "enemies of enterprise".

It is not a view that is unique to the UK government. The Economist, which often refers to the government as a Hobbesian Leviathan, recently argued that government should take the back seat and focus on creating freer markets and the right conditions for new ideas to prosper, rather than taking a more activist approach. In painting this contrast, it is assumed that the private sector is inherently more innovative, able to think "out of the box" and lead a country towards long-run, innovation-led growth.

However, countless examples in the history of innovation reveal a different picture: one of a risk-taking innovative state -- especially in the most uncertain phases of technological development and/or in the most risky sectors -- versus a more inertial private sector which only enters and invests once the state has absorbed most of the uncertainty, before walking off with all the gains. In pharmaceuticals it is the state, through the NIH in the USA or the MRC in the UK, that has funded most of the priority rated new molecular entities (innovative drugs) with private pharma concentrating on slight variations of existing ones ("me too" drugs). From the development of aviation, nuclear energy, computers, the internet, the biotechnology revolution, nanotechnology and green technology today, it has been the state, not the private sector, that has often engaged with the most high-risk entrepreneurial activities, kick-starting and developing the engine of growth.

It has not done so not just by funding basic research, or "fixing" market failures. It has created new markets; formulating a vision of a new area, investing in the earliest-stage research and development, identifying new pathways to market and adjusting rules to promote them, creating networks that bring together business, academia and finance, and being constantly ahead of the game in areas that will drive the next decades of growth. Ironically, although the US economy is often discussed as a market-based system compared to Europe, in fact, the US federal government has been one of the most active agents in creating new sectors and related technologies: it was civil sector workers in the US Department of Defence that dared to think up the internet. The same is true of nanotechnology, where publicly funded scientists convinced both Congress and the business community that nanotechnology was a key sector. The National Nanotechnology Initiative invented the very idea of nanotechnology.

Of course there are plenty of examples of private sector entrepreneurial activity, from the role of new, young companies in providing the dynamism behind new sectors to the important source of funding from private sources like venture capital. But, generally, it is only this story which is told. Silicon Valley or the biotech revolution are usually attributed to the geniuses behind small, high tech firms like Facebook or the plethora of small biotech companies in Boston or Cambridge. How many people know that the algorithm that led to Google's success was funded by a public sector National Science Foundation grant? Or that many of the most innovative, young companies in the US were funded not by private venture capital but by public venture capital (Small Business Innovation Research, SBIR)?

The most successful economy in Europe, Germany, understands the need for an entrepreneurial state. While fiscal expenditure, like elsewhere, has been cut (from €319.5bn last year to €307.4bn this year), the Ministry of Education and Research's budget is rising by 7.2 per cent; which includes €327m for university research excellence alone. Support for research and development at the Federal Economics Ministry is also increasing. The German government is one of the lead spenders on green technology, stimulating business to do the same. Thus, while Angela Merkel wants Greece to reduce state expenditure, in her own country she claims " the prosperity of a country, such as Germany, with its scarce mineral resources, must be sought through investment in research, education and science, and this to a disproportionate degree." China is following in Germany's footsteps, with the Chinese National Sciences Foundation (equivalent to the UK research councils), increasing its budget this year by 17 per cent, which will mean its budget will have doubled from 2009 to 2011. It is this long run growth strategy that should be feared, rather than the usual talk of the flood of low cost Chinese goods.

This is not the time for our public sector to step back. Now, more than ever, we need an assertive, entrepreneurial state, identifying areas for new growth and investing strategically in early stage innovation. Major growth opportunities are there. Green technology is poised to be the next great technological revolution, and being first will really matter, as the global race for pole position is well underway. This is within our grasp, but only if the government makes it a priority and provides that daring, forgiving investment. The Green Investment Bank is a start but it is not enough. Despite the Prime Minister's pledge to lead the UK's "greenest government ever", there is currently no break from the long trend of below-average business R&D in this sector. Under 1 per cent of UK Gross Domestic Product is being invested in green technologies; half of what South Korea currently invests and less than what the UK spends annually on furniture.

Making the right investments means a new philosophy about what the state's role is in the economy. It is not about just creating the right conditions for innovation, but also having the courage to make direct investments that are subject to high failure rates, which the private sector notoriously shies away from. It is the risk associated with new innovations which challenge the status quo that the UK should specialise in, not just risk-management in the financial sector: risk-taking for creative destruction, not for destructive destruction.

Mariana Mazzucato is Professor in the Economics of Innovation at The Open University. Her book, The Entrepreneurial State, is published today.

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We're racing towards another private debt crisis - so why did no one see it coming?

The Office for Budget Responsibility failed to foresee the rise in household debt. 

This is a call for a public inquiry on the current situation regarding private debt.

For almost a decade now, since 2007, we have been living a lie. And that lie is preparing to wreak havoc on our economy. If we do not create some kind of impartial forum to discuss what is actually happening, the results might well prove disastrous. 

The lie I am referring to is the idea that the financial crisis of 2008, and subsequent “Great Recession,” were caused by profligate government spending and subsequent public debt. The exact opposite is in fact the case. The crash happened because of dangerously high levels of private debt (a mortgage crisis specifically). And - this is the part we are not supposed to talk about—there is an inverse relation between public and private debt levels.

If the public sector reduces its debt, overall private sector debt goes up. That's what happened in the years leading up to 2008. Now austerity is making it happening again. And if we don't do something about it, the results will, inevitably, be another catastrophe.

The winners and losers of debt

These graphs show the relationship between public and private debt. They are both forecasts from the Office for Budget Responsibility, produced in 2015 and 2017. 

This is what the OBR was projecting what would happen around now back in 2015:

This year the OBR completely changed its forecast. This is how it now projects things are likely to turn out:

First, notice how both diagrams are symmetrical. What happens on top (that part of the economy that is in surplus) precisely mirrors what happens in the bottom (that part of the economy that is in deficit). This is called an “accounting identity.”

As in any ledger sheet, credits and debits have to match. The easiest way to understand this is to imagine there are just two actors, government, and the private sector. If the government borrows £100, and spends it, then the government has a debt of £100. But by spending, it has injected £100 more pounds into the private economy. In other words, -£100 for the government, +£100 for everyone else in the diagram. 

Similarly, if the government taxes someone for £100 , then the government is £100 richer but there’s £100 subtracted from the private economy (+£100 for government, -£100 for everybody else on the diagram).

So what implications does this kind of bookkeeping have for the overall economy? It means that if the government goes into surplus, then everyone else has to go into debt.

We tend to think of money as if it is a bunch of poker chips already lying around, but that’s not how it really works. Money has to be created. And money is created when banks make loans. Either the government borrows money and injects it into the economy, or private citizens borrow money from banks. Those banks don’t take the money from people’s savings or anywhere else, they just make it up. Anyone can write an IOU. But only banks are allowed to issue IOUs that the government will accept in payment for taxes. (In other words, there actually is a magic money tree. But only banks are allowed to use it.)

There are other factors. The UK has a huge trade deficit (blue), and that means the government (yellow) also has to run a deficit (print money, or more accurately, get banks to do it) to inject into the economy to pay for all those Chinese trainers, American iPads, and German cars. The total amount of money can also fluctuate. But the real point here is, the less the government is in debt, the more everyone else must be. Austerity measures will necessarily lead to rising levels of private debt. And this is exactly what has happened.

Now, if this seems to have very little to do with the way politicians talk about such matters, there's a simple reason: most politicians don’t actually know any of this. A recent survey showed 90 per cent of MPs don't even understand where money comes from (they think it's issued by the Royal Mint). In reality, debt is money. If no one owed anyone anything at all there would be no money and the economy would grind to a halt.

But of course debt has to be owed to someone. These charts show who owes what to whom.

The crisis in private debt

Bearing all this in mind, let's look at those diagrams again - keeping our eye particularly on the dark blue that represents household debt. In the first, 2015 version, the OBR duly noted that there was a substantial build-up of household debt in the years leading up to the crash of 2008. This is significant because it was the first time in British history that total household debts were higher than total household savings, and therefore the household sector itself was in deficit territory. (Corporations, at the same time, were raking in enormous profits.) But it also predicted this wouldn't happen again.

True, the OBR observed, austerity and the reduction of government deficits meant private debt levels would have to go up. However, the OBR economists insisted this wouldn't be a problem because the burden would fall not on households but on corporations. Business-friendly Tory policies would, they insisted, inspire a boom in corporate expansion, which would mean frenzied corporate borrowing (that huge red bulge below the line in the first diagram, which was supposed to eventually replace government deficits entirely). Ordinary households would have little or nothing to worry about.

This was total fantasy. No such frenzied boom took place.

In the second diagram, two years later, the OBR is forced to acknowledge this. Corporations are just raking in the profits and sitting on them. The household sector, on the other hand, is a rolling catastrophe. Austerity has meant falling wages, less government spending on social services (or anything else), and higher de facto taxes. This puts the squeeze on household budgets and people are forced to borrow. As a result, not only are households in overall deficit for the second time in British history, the situation is actually worse than it was in the years leading up to 2008.

And remember: it was a mortgage crisis that set off the 2008 crash, which almost destroyed the world economy and plunged millions into penury. Not a crisis in public debt. A crisis in private debt.

An inquiry

In 2015, around the time the original OBR predictions came out, I wrote an essay in the Guardian predicting that austerity and budget-balancing would create a disastrous crisis in private debt. Now it's so clearly, unmistakably, happening that even the OBR cannot deny it.

I believe the time has come for there be a public investigation - a formal public inquiry, in fact - into how this could be allowed to happen. After the 2008 crash, at least the economists in Treasury and the Bank of England could plausibly claim they hadn't completely understood the relation between private debt and financial instability. Now they simply have no excuse.

What on earth is an institution called the “Office for Budget Responsibility” credulously imagining corporate borrowing binges in order to suggest the government will balance the budget to no ill effects? How responsible is that? Even the second chart is extremely odd. Up to 2017, the top and bottom of the diagram are exact mirrors of one another, as they ought to be. However, in the projected future after 2017, the section below the line is much smaller than the section above, apparently seriously understating the amount both of future government, and future private, debt. In other words, the numbers don't add up.

The OBR told the New Statesman ​that it was not aware of any errors in its 2015 forecast for corporate sector net lending, and that the forecast was based on the available data. It said the forecast for business investment has been revised down because of the uncertainty created by Brexit. 

Still, if the “Office of Budget Responsibility” was true to its name, it should be sounding off the alarm bells right about now. So far all we've got is one mention of private debt and a mild warning about the rise of personal debt from the Bank of England, which did not however connect the problem to austerity, and one fairly strong statement from a maverick columnist in the Daily Mail. Otherwise, silence. 

The only plausible explanation is that institutions like the Treasury, OBR, and to a degree as well the Bank of England can't, by definition, warn against the dangers of austerity, however alarming the situation, because they have been set up the way they have in order to justify austerity. It's important to emphasise that most professional economists have never supported Conservative policies in this regard. The policy was adopted because it was convenient to politicians; institutions were set up in order to support it; economists were hired in order to come up with arguments for austerity, rather than to judge whether it would be a good idea. At present, this situation has led us to the brink of disaster.

The last time there was a financial crash, the Queen famously asked: why was no one able to foresee this? We now have the tools. Perhaps the most important task for a public inquiry will be to finally ask: what is the real purpose of the institutions that are supposed to foresee such matters, to what degree have they been politicised, and what would it take to turn them back into institutions that can at least inform us if we're staring into the lights of an oncoming train?