Financing Innovation: an Application of a Keynes-Schumpeter-Minsky Synthesis
This project integrates two research paradigms. The first is the Keynes-Minsky vision that puts effective demand front and center of economic analysis, and the second is the Schumpeter-Minsky vision that focuses on innovation and competition. We will bring the two visions together to provide rigorous and critical analysis of competition in the financial sphere and how it interacts with competition in the industrial sphere. This will enable us to make policy recommendations to reform finance to promote the capital development of the economy. Finance which helps to create value rather than just extract it: finance for creative destruction, not destructive creation.
We will use this synthesis to understand the current state of the global financial system and to assess its weaknesses. While in a very important sense, the economy has become “financialized”, we find that in many important areas projects cannot get financed. This is particularly true in the more innovative sectors of our economy. As a consequence we have poverty (underfunding) in the midst of plenty (tens of trillions of dollars of wealth in search of high returns). The policy problem, then, is to explore alternative ways to redirect existing finance, and to create new funding methods, to finance the innovation that we will need for the 21st century.
The first tradition is concerned with finding the point of effective demand in conditions of uncertainty. Expectations and what Keynes called monetary production in early drafts of the General Theory are the critical determinants. Disappointment is possible, which can change expectations and result in a different equilibrium. Macroeconomic identities and particular causal implications allow us to avoid fallacies of composition as the identities serve as a check on what is possible for individual behavior. Kalecki augmented Keynes’s framework by distinguishing the capital- and consumer-goods sectors, and showing how investment generates profits at the macro-economic level, competitive firms’ pricing (and profit) can be a function of their internally-financed investment target, and innovation can determine the growth rate of capital through its impact on profits. Minsky followed Kalecki but formulated his financial theory of investment to introduce financial decisions and conditions into determination of the point of effective demand. All of this can be put in the context of growth, although the efforts to date are not satisfactory. At best, the Keynes-Minsky vision provides reason to believe that growth will not be steady and that it will normally be demand-constrained.
The second is concerned with evolution of the structure of the economy over time—those factors that disturb equilibrium, and can spur growth. Schumpeter introduced innovation into the analysis of competition, allowing the feedback between innovation and industry structure to cause the linear structure-conduct-performance (SCP) approach of industrial organization to fall apart. The Schumpeterian approach to competition is thus centered on understanding the co-evolution of those mechanisms that create differences between firms and the mechanisms of competitive selection that winnow in on the differences allowing only some firms to survive and grow. Innovation, births and deaths of firms are engines of growth and structural change. While some innovations allow incumbents to maintain their lead, radical innovations tend to destroy it. This is the essence of Schumpeter’s famous term creative destruction.
The banker, Schumpeter’s “ephor of capitalism”, plays an important role in helping to get innovations financed, and Minsky extended Schumpeter’s innovation to the financial sector itself. Like any other firm, a bank continually seeks to reduce costs and increase revenues, with innovations helping to do both while also changing the structure of the financial system and hence the structure of the nonfinancial system whose behavior is heavily influenced by the structure of finance. As is well-known, he developed the “investment theory of the cycle and the financial theory of investment” to put the Keynesian model in the context of the business cycle. The first part of this is Keynesian, the second brings in Schumpeter’s ephor. Over the cycle, the structure of the economy and most importantly the structure of its finance changes in a manner that makes it fragile.
There are structures that are conducive to what Minsky called the “capital development” of the economy—which is broadly defined to go beyond privately owned capital equipment to include technology, labor productivity, and public infrastructure. Minsky believed that a high wage, high employment, “big government” economy would be more stable and would tend to channel finance in the direction of capital development. Further, finance needs constraints because of the inevitable thrust to innovation; that, in turn, is a problem because the “market” forces that direct finance toward capital development of the economy are not always operative, so the innovations in finance can actually hinder capital development. This appeared especially true in the Anglo-Saxon economies from the mid-1990s, when low capital costs linked to falling equity risk premiums led to a ‘search for yield’ in financial rather than real-sector innovation, so that strong corporate profitability did not translate into strong investment outside the financial sector, whose GDP share and indebtedness consequently grew.
What is relatively lacking in the Schumpeter-Minsky approach is the innovation and dynamism in the nonfinancial sector. However, there is an emerging literature that does build on Schumpeter’s work to examine innovation and structural transformation of the “real” sector: the new Evolutionary economics. The work of Richard Nelson and Sydney Winter (among others) is increasingly recognized as providing the possibility of a new theory of the firm, as well as a more dynamic treatment of market structure. While Schumpeterian-evolutionary analysis provides insights on the dynamics of structural/technological change in the real economy, Minsky’s insights can provide a theory of money and financial fragility, which is virtually lacking in Schumpeterian models. Indeed many of these do not include money and finance at all. Our synthesis seeks to fill this lacuna: we will link the real with the monetary as well as provide a theory of competition in both the financial and non-financial sectors.
The empirical side of the project will focus on specific sectors, mainly biotechnology and the emerging green technology sector, as well as related macro aggregates. Core questions will centre around:
The goal of this project is to identify the micro-level obstacles to channeling of investment into new growth-promoting technologies and the macro-level effects of disruptive innovation, by applying Minsky’s insights on financial innovation and the Evolutionary-Schumpeterian insights on “real sector” innovations. Given institutional barriers worsened by the financial crisis, the role of the government must increase. However, exactly how the government can play that role, and how it can encourage private finance, is an open question to be addressed by this study. Finally, the role of government at the macro level for the generation of adequate demand and aggregate profits will be discussed. For example, in spite of subsidies provided to green tech we are currently witnessing failures due to the macroeconomic environment in which firms operate. This macroeconomic environment can, in turn, be destabilized by micro-level financial innovation around new technologies – as it was, for example, when finance mobilized behind ‘new economy’ enterprise which became the Dot-Com bubble of 2000-01, and when private equity groups evolved into highly leveraged shadow banks before the larger crash of 2008. The Keynes/Minsky approach (with input from Godley’s sectoral balance approach) will be used to assess the important role played at the macro level by government.
Background work by Mazzucato and Wray
FINNOV, a 3 year EC funded project directed by Prof. Mazzucato, has produced 3 Policy Briefs relevant to the INET project:
Mazzucato, M. (2011) “The Entrepreneurial State”, Demos, ISBN 978-1-906693-73-2. http://www.demos.co.uk/files/Entrepreneurial_State_-_web.pdf
Mazzucato, M. and Tancioni M. (2012), “Innovation and Stock Prices,” Journal of Evolutionary Economics, Vol. 22 (4):811-832
Mazzucato, M (2012a), ‘Rebalancing What?’ Policy Network Discussion Paper, June 24, 2012. http://www.policy-network.net/publications/4201/Rebalancing-What-
Mazzucato, M. (2002), “The PC Industry: New Economy or Early Life-Cycle,” Review of Economic Dynamics, Vol. 5 (2), pp.318-345.
Mazzucato, M. (2003), “Risk, Variety and Volatility: Innovation, Growth and Stock Prices in Old and New Industries,” Journal of Evolutionary Economics, Vol. 13 (5), pp.491-512.
Wray, R. (2011), Working Paper No. 653 | Financial Keynesianism and Market Instability http://www.levyinstitute.org/pubs/wp_653.pdf.
Wray, R. (2011), Working Paper No. 661 | Minsky’s Money Manager Capitalism and the Global Financial Crisis http://www.levyinstitute.org/pubs/wp_661.pdf.
Wray, R. (2011), Working Paper No. 717 | Introduction to an Alternative History of Money http://www.levyinstitute.org/pubs/wp_717.pdf.
Wray, L.R. (1993) “Government Deficits, Liquidity Preference, and Schumpeterian Innovation”, Levy Working Paper No. 99, October. http://www.levyinstitute.org/publications/?docid=367
Wray, L.R. (2010) “What do banks do? A Minskian Analysis”, Levy Institute Public Policy Brief No. 115, September.
Background work by Keynes, Minsky and Schumpeter
*Note: Minsky’s full publications are available from the Levy Institute archive: http://digitalcommons.bard.edu/hm_archive/ and also http://www.levyinstitute.org/publications/?auth=193
Keynes, J. M (1936 ) “The General Theory of Employment, Interest and Money”. Macmillan .
Keynes, J. M (1979) “The Collected Writings of John Maynard Keynes”, Volume XXIX, (ed) Donald Moggridge, MacMillan, London.
Minsky, H. (1975/2008) [1st. Pub. 1975] “John Maynard Keynes”. McGraw-Hill Professional.
Minsky, H. (1978) “The Financial Instability Hypothesis: An Interpretation of Keynes and an Alternative to Standard Theory”, in Minsky, H. (1982).
Minsky, H. (1980) “Finance and Profits: The Changing Nature of American Business Cycles”, in Minsky, H. (1982), pp. 14-58.
Minsky, H.(1990) “Schumpeter: Finance and Evolution”, Evolving Technology and Market Structure: Studies in Schumpeterian Economics, (ed) Arnold Heertje and Mark Perlman, Ann Arbor: The University of Michigan Press, pp. 51-74.
Minsky, H. (1992) “Commentary”, in Entrepreneurship, Technological Innovation, and Economic Growth: Studies in the Schumpeterian Tradition, (ed) Frederic M. Schererand Marc Perlman, The University of Michigan Press, Ann Arbor, p. 363.
Minsky, H.(1993) “Schumpeter and Finance”; in Markets and Institutions in Economic Development: Essays in Honour of Paolo Sylos Labini, (ed) Salvatore Biasco, Alessandro Roncaglia, and Michele Salvati, St. Martin’s Press, NY, pp. 103-115.
Schumpeter, J. (1951) “The Instability of Capitalism” in Clemence, R (ed.)
Schumpeter, J. (1997 ) “The Theory of Economic Development”, Transaction Publishers.
Schumpeter, J. (1939) “Business Cycles” (2 vol), McGraw Hill.
Schumpeter, J. ([1942/1992]) “Capitalism, Socialism and Democracy”, Routledge.
Schumpeter, J: (1944) “The Analysis of Economic Change”, in Readings in Business Cycle Theory, The AEA, The Blakiston Co., Philadelphia p. 1-19. Reprinted from The Review of Economic Statistics, vol 27(4), May 1935, pp. 2-10.
Schumpeter, J. (1949) “The Theory of Economic Development: An Inquiry into Profits, Capital, Credit, Interest, and the Business Cycle”, Harvard University Press, Cambridge Mass.
*Also useful and referred in the text above: Godley, Wynne. (1996) “Money, finance, and national income determination”, Levy Working Paper 167.
Mazzucato ‘in the news’ talking finance and innovation
Mazzucato, M., “Without banking reform, investing in innovation is too great a risk” – The Guardian, 11 September 2012
Mazzucato, M. “Public money spent on 'digging ditches' won't stimulate the economy” – The Guardian, 2 September 2012
Mazzucato, M. “Banks must learn to reward the good risks” The Guardian, 24 June 2012
Mazzucato, M on Bloomberg news (September 21, 2012) discussing how austerity is failing Europe: http://www.bloomberg.com/video/austerity-seen-failing-in-southern-europe-pmXCMCjdTmymdgmcBfTikw.html
Mazzucato, M on Bloomberg news (June 19, 2012) on why Italy will be the next country to ask for a bailout: http://www.bloomberg.com/video/94931795-mazzucato-italy-will-be-next-to-ask-for-bailout.html
More Mazzucato in the news: http://www.marianamazzucato.com/media/
Wray’s popular Minsky blogs
Three part series of blogs on Minsky, responding to blogs by Professor Paul Krugman that appeared to be dismissive of Minsky’s importance—these generated lots of comments on the blogsphere:
These are two blogs on the financial system, innovations, and reform:
This blog begins with a methodological argument against “value-free” economics, and then turns to the “free market” view that even moderate government intervention is potentially devastating for the smooth functioning of the “invisible hand”. Instead, the position is advanced that capitalism is remarkably robust and indeed is made stronger when government plays a guiding role.
This blog addresses the issues of productivity, efficiency and Schumpeterian creative destruction:
University of Sussex
Professor of Economics
University of Missouri-Kansas City