A DISCUSSION PAPER The Risk-Reward Nexus Innovation, Finance and Inclusive Growth policy network paper William Lazonick & Mariana Mazzucato Policy Network Third floor 11 Tufton Street London SW1P 3QB United Kingdom t: +44 (0)20 7340 2200 f: +44 (0)20 7340 2211 e: [email protected] www.policy-network.net We present a new framework, called the Risk-Reward Nexus, to study the relationship between innovation and inequality. We ask: What types of economic actors (workers, taxpayers, shareholders) make contributions of effort and money to the innovation process for the sake of future, inherently uncertain, returns? Are these the same types of economic actors who are able to appropriate returns from the innovation process if and when they appear? That is, who takes the risks and who gets the rewards? We argue that it is the collective, cumulative, and uncertain characteristics of the innovation process that make this disconnect between risks and rewards possible. When, across these policy network paper Abstract different types of actors, the distribution of financial rewards from the innovation process reflects the distribution of contributions to the innovation process, innovation tends to reduce inequality. When, however, some actors are able to reap shares of financial rewards from the innovation process that are disproportionate to their contributions to that process, innovation increases inequality. The latter outcome occurs when certain actors are able to position themselves at the point where the innovative enterprise generates financial returns; that is, close to the final product market or, in some cases, close to a financial market such as the stock market. These favored actors then propound ideological arguments, typically with intellectual roots in the efficiency propositions of neoclassical economics, that justify the disproportionate shares of the gains from innovation that they have been able to appropriate. These ideological arguments invariably favor shareholder contributions to the innovation process over both worker contributions and taxpayer contributions. Ultimately, precisely because innovation is a collective and cumulative process, the imbalance in the Risk-Reward Nexus not only results in greater inequality but also undermines the innovation process itself. In this paper we 1) develop the Risk-Reward Nexus framework on the basis of a theory of innovative enterprise that focuses on the collective, cumulative, and uncertain character of the innovation process, 2) critique the leading economic ideologies that, by distorting the relationship between risks and rewards, have justified growing inequality over the past three decades or so, and 3) apply the analysis to the trajectories of both innovation and inequality in the US economy since the 1970s. We conclude by sketching out key policy implications of the Risk-Reward Nexus approach. About the authors William Lazonick ([email protected]) is Professor and Director of the UMass Center for Industrial Competitiveness, and President, The Academic-Industry Research Network (www. theAIRnet.org). Mariana Mazzucato ([email protected]) is RM Phillips Professor in Science and Technology Policy at the University of Sussex (SPRU). The research leading to this paper was funded by the European Community’s Seventh Framework Programme (FP7/2007-2013) under Socio-economic Sciences and Humanities, grant agreement n° 217466 (www.finnov-fp7.eu). Both authors are also grateful for support by the Institute for New Economic Thinking (INET), and the Ford Foundation’s Reforming Global Finance initiative. | The Risk-Reward Nexus | William Lazonick & Mariana Mazzucato | November 2012 www.policy-network.net lorerContents alit veliquip et lum nostion henit luptatinisci blandit auguer augue dolorperos enim quisit nis niam ing erillum sandion hent ipit, summod modolor eetuer sed tat am do duisl ip et irilissequip ea accum zzril eugait lortie faccums andionsequis nibh exercincil utpatio od tat lutatisis aci essit augue tat. Im ad magnit lumsandre dolore dipis nulput iriusci psustrud tie feugait lum diam vel utpat. Reetumsan elent dolut aut vercing exeril in velis nibh eu faci blaorero dio diamcon sequis aliquam, vel doloborper adit at iliquisim do enibh etue tetumsa ndipsustrud eugiametue magniamet ullaor Executive summary 1 eet dolestis elenit lum eugiam dit wisim velit ad te commy nonsequam zzril eu faci te feui tat wis 1. Introduction 3 x ea facilit volor ipit, vel ullum ad te dunt aut veliqui psuscilisis augueriureet ullam, velis aliquis exer2. The uncertain, collective, and nonsed cumulative character of theipinnovation process 5 aestrud tet aci bla feu feum alit, commy magnim dolorper etumsandre magna feugiamet pratie dip et alismolobore doloborer suscipit vullaor sectet, si blamconullan henisl ulla faccumsan The Risk-Reward Nexus ut autpat.3.Ut luptat. Im ver sim veraesed te dolorer sed diamet vullandrem zzriuscilla core vel8esting esto elisi.Ut iniamet autatue diat accum quat iurerci bla faccum zzrit adit landiam do od dolor senit 4. Financial actors and value extraction 11 venibh euis nos adio eugait numsandrero commy nim exerostis ea feugait lan ero consectem vullum veniscipit alisi. Hendre volorperit ipsumsa ndreet lute tetuero diamet lortissi etuero odo od ming 4.1 Value extraction through high-tech startups 12 exeriurem dui ex eugait wis ad duiscidunt ulluptat incing erillummy nulla consed dolore essi tate te 4.2 Value extraction through established companies 17 feugait, veraessenit wisci tem ipis exeril dunt in velesto od eu feugait nulputat, sit, commodit, vendit 4.3 Why do corporations repurchase stock? 17 ad tie etueros acil iril utet lutem velit nulla facidunt ad mod magnim in ex eu feu feugait laore facilla policy network | Thepolicy Amsterdam networkProcess paper Wisi bla faccum init ent prat. Ut at amconullutem quatin vel dolor ad minim zzrit adigna consed do- aliquipis nullan ex eros aliquat. nim exer ad magna feui tat lore vel ipsum iniamcorem zzril 5. Analytical and policyDuis implications 19 exer sim velit, qui tem inismod olenisis nonse volor susciduipis augait acipisi te minci blaoreet, corerat. Na feugueReferences tio eummy niam quatum zzrilla ortiscillut nulluptate vullaor eetumsa ndiamcore mincip 25 endrem zzriusto eliquam, venim incil et lobore tat vent at praessi. Onullaore faccumm olorper ad modit esenisi ex euguerat. Ut lore core vel ero essequam, con eui el etuer illandit in utpat, quis nos nos doloreet, core dolore vulla facidunt velit do ex esto dolor in voloreet utpat lore commy niam nibh ercilissent nos enim atie do odiam quis nulluptat, sequip ercilismod dipsum dolore dolesto dolortis atie tat, sim accumsan euis dolorer cinismo doloreet dio consectem do esto enis atet, sumsan ut laoreet vel utpat. Duissent accumsan vero odolor sim zzril irit vullamcorem dit numsan volorper sed tis nonullamcon vel ulla feui endre modolorem dolorem vel enibh et euissendre dolut ut loboreet lum velendiamet lore euguerc incinci duipis niscilit ipisisissi te ming eu feugait veliquamet velit wisl ut ut pratue velessim nostrud ex etue consequisi. Ut lut nibh erosto odiat, quipis nonsectet, velit ilis num enibh esed ex ea autem duismolenim nim velenit ut nullummy nibh enisi ea cor acing eum adionsequis am iliquis duip et ipisim quis adiam vel dolorer ilit exercin ciduis ex etueraese min hendio ex er sum zzril esendre dolorem quam, quis nosto essim velendre mincin henit, sisis nostrud minibh elestis nit iniat dolor si. La faci euissi. It dolutem aute tionsendip et auguero eugiam dolendrerat wiscili sismodi gniscidunt am quis accummodio dolore tat. Gait eu facipsusto od ea faccummy nullutat acidunt vulluptat nulla commolessit, quiscil ing ea faci tisis nim init am quipsum aci te dolor suscinci eniamco nsecte 3 | |The It’sRisk-Reward also culture, Nexus stupid!| |William Xxxxxxxxx xxxxxxxxx | MarMazzucato 2011 Lazonick & Mariana | November 2012 www.policy-network.net Executive summary lorer alit veliquip et lum nostion henit luptatinisci blandit auguer augue dolorperos enim quisit nis niam ing erillum sandion hent ipit, summod modolor eetuer sed tat am do duisl ip et irilissequip ea zzrilhas eugait lortie faccums andionsequis exercincil utpatio tat lutatisis augue •accum Much been made recently about the nibh problems caused by aod “winner takesaci all”essit economic tat. Im ad magnitinlumsandre doloreinequality dipis nulput psustrud diamproposals vel utpat.have Reesettlement which income is iriusci pervasive. Yet tie fewfeugait viablelum policy tumsan elent dolut vercing in velis eu faci more blaorero dio diamcon sequis aliquam, vel been made to aut address theexeril problem ofnibh achieving inclusive and sustainable growth. doloborper adit at iliquisim do enibh etue tetumsa ndipsustrud eugiametue magniamet ullaor • As the ‘pre-distribution’ debate gains momentum, this paper presents a relevant framework to eet dolestis lum eugiamfinance, dit wisim velit adand te commy nonsequam zzril eu faci te feuisimply tat wisa improveelenit the links between innovation inclusive growth. Pre-distribution is not new form of welfare state. It is about providing a new path to economic growth by increasing human x ea facilit ipit, vel ullumincreasing ad te duntoverall aut veliqui psuscilisis augueriureet ullam, velis aliquis exercapitalvolor and consequently economic performance as well. It is thus not just about aestrud tet aci feum alit, commy nonsed magnim dolorper ip etumsandre feugiamet cutting thebla piefeu more equally, but about producing a bigger pie and cutting thatmagna pie more equally. pratie dip et alismolobore doloborer suscipit vullaor sectet, si blamconullan henisl ulla faccumsan ut luptat. ver sim veraesed te dolorer diamet vullandrem zzriuscilla esting • autpat. WhileUt some haveIm argued that the financial crisis sed has stemmed from ‘too much risk’, acore corevel problem esto has elisi.Ut iniamet autatue diat accum quat iurerci bla too faccum adit landiam doloreconsenit been that there has been too much ‘bad’ risk and littlezzrit ‘good’ risk. Indeed,do in od modern venibh euisthere nos adio numsandrero commy nim exerostis ea feugait lan ero vullum omies has eugait been an increasing separation between those who take the consectem risk of investing in veniscipit alisi. Hendre volorperit lute tetuero diamet lortissi etuero odo ming innovation—a highly uncertainipsumsa processndreet that requires both patient committed finance andodpatient exeriurem dui exworkers eugait wis ad duiscidunt incinghave erillummy consed dolore essiinnovatate te committed — and those whoulluptat increasingly reapednulla the rewards from that policy network | The Amsterdam policy networkProcess paper •Wisi bla faccum init ent prat. Ut at amconullutem quatin vel dolor ad minim zzrit adigna consed do- feugait, wisci tem ipis exeril velesto feugait sit, commodit, vendit tion.veraessenit This disconnect between whodunt takesinthe risks od andeu who getsnulputat, the rewards is bad for growth. ad tie etueros acil iril utet lutem velit nulla facidunt ad mod magnim in ex eu feu feugait laore facilla aliquipis nullan ex eros aliquat. Duis nim exer ad magna feuito tatdistinguish lore vel ipsum iniamcorem zzrilfrom exer • It is of utmost importance for policymakers to be able the good risk takers sim velit, qui tem inismod olenisis nonse volor susciduipis augait acipisi te corerat. the bad. For example, while venture capitalists have been extolled as minci beingblaoreet, the ‘entrepreneurNa feugue eummy niam ortiscillut nulluptate eetumsa ndiamcore mincip ial’ risktio taking force thatquatum has led zzrilla to places like Silicon Valley,vullaor governments often play a leading endrem eliquam, venim incil- especially et lobore tat praessi. rolezzriusto in the innovation process in vent highat risk, high capital intensity areas where the Onullaore faccumm ad modit esenisi ex euguerat. Ut lore core vel ero con many eui el business sector olorper is not willing to invest. 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Ut erosto the odiat, quipisask: nonsectet, velit of iliseconomic num enibh esed(workers, ex ea autem duismolenim nim • lutInnibh this paper, authors what types actors taxpayers, shareholdvelenit nullummy nibh enisi ea cor acing eum adionsequis am iliquis duip et ipisim quis adiamAre vel ers)utmake the biggest contributions of effort and money to the innovation process? dolorer ilit exercin ciduis ex etueraese min hendio er sum zzril esendreprocess dolorem quam, quisprofits nosto these the same people who profit the most ex from the innovation if and when essimappear? velendre henit, sisisthe nostrud minibh elestis nit iniat si. It mincin is argued that collective, cumulative, anddolor uncertain nature of the innovaLa faci euissi. It dolutem et auguero eugiam dolendrerat sismodi tion process means aute that tionsendip there is often a disconnect between thosewiscili who take the gniscidunt most risks am quis dolore andaccummodio those who reap thetat. most rewards. This is what the authors call the Risk-Reward Nexus. Gait eu facipsusto od ea faccummy nullutat acidunt vulluptat nulla commolessit, quiscil ing ea faci tisis initacross am quipsum aci te dolor suscinci eniamco • nim When, these different types of actors, thensecte distribution of financial rewards from the innovation process reflects the distribution of contributions to the innovation process, innovation tends to reduce inequality and increase growth. However, when certain actors are able to position themselves at the point where the innovative enterprise generates financial returns - that is, close to the final product market or, in some cases, close to a financial market – the incentive is for value extraction at the expense of value creation. The issue, however, does not lie in the individuals per se but rather in a set of institutions which do not accurately regulate the relationship between risks and rewards. 1| | It’s Thealso Risk-Reward Nexus || Xxxxxxxxx William Lazonick & Mariana Mazzucato | November 2012 4 culture, stupid! xxxxxxxxx | Mar 2011 www.policy-network.net lorerpanies alit veliquip et luminvesting nostion henit luptatinisci blandit auguer augueand dolorperos enim quisit nis to avoid in human capital and research development (R&D), niamwith ing erillum sandion hent ipit, sed tatprecisely am do duisl ip et irilissequip ea damaging effects on summod economicmodolor growth.eetuer As such, because innovation accum eugait lortie andionsequis utpatio od tat lutatisis aci essit augue is zzril a collective andfaccums cumulative process,nibh theexercincil imbalance in the Risk-Reward Nexus not tat. Im ad magnit dipis nulput iriusci psustrud tie the feugait lum diamprocess vel utpat.itself. Reeonly results lumsandre in greaterdolore inequality but also undermines innovation tumsan elent dolut aut vercing exeril in velis nibh eu faci blaorero dio diamcon sequis aliquam, vel doloborper adit at do enibh etue tetumsa ndipsustrud magniamet • In response, theiliquisim authors present five concrete policy proposalseugiametue to improve the alignment ullaor of risks and rewards so that sharing the gains from innovation is more equitable while still promoting growth: eet dolestis elenit lum eugiam dit wisim velit ad te commy nonsequam zzril eu faci te feui tat wis • RESOURCE ALLOCATION: Resources should be better allocated to support the investments of x ea facilit vel ullum ad te dunt aut veliqui augueriureet ullam,of velis aliquis exercapitalvolor and ipit, labour by those who actually take psuscilisis the risks. Current indicators economic peraestrud tet aci bla nonsed ip etumsandre magna feugiamet formance are feu notfeum only alit, too commy short-term but magnim are also dolorper steered towards rewarding value extracpratie dipatetthe alismolobore suscipit vullaor si blamconullan ulla faccumsan tion expense ofdoloborer value creation. There is asectet, need for a different sethenisl of economic perforut autpat. luptat. Im that ver sim veraesed dolorer sed diamet vullandrem zzriuscilla core vel esting manceUtindicators better reflectteincreases in productivity and investments in innovation esto so elisi.Ut autatue diat accum quat iurerci bla faccum zzrit adit landiam do od dolor senit as toiniamet increase the incentives needed for value creation and long run growth potential. venibh euis nos adio eugait numsandrero commy nim exerostis ea feugait lan ero consectem vullum veniscipit alisi. Hendre volorperit ipsumsaon ndreet lutegains tetuero lortissi etuero odo The od ming • TAXATION: The current tax system capital anddiamet dividends is inefficient. conexeriurem dui ex eugait iswis ad duiscidunt ulluptat erillummy consed dolore essi investtate te ventional wisdom that entrepreneurs needincing higher after-taxnulla returns to encourage policy network | The Amsterdam policy networkProcess paper bla faccum init ent prat. at amconullutem quatinhave vel dolor minim zzrit adigna consed do•Wisi Current indicators of Ut economic performance thusadcreated incentives for com- feugait, veraessenit wisciHowever, tem ipis exeril dunt in velesto feugait sit, commodit, vendit ment in industry. the current systemod ofeutaxes onnulputat, capital gains and dividends ad tieincreases etueros acil utet lutem velit extraction nulla facidunt ad than mod magnim ex eu feu feugait laore facilla the iril rewards for value rather inducingin investments in value creation. aliquipis nullan ex eros aliquat. Duis nim exer ad magna feui tat lore vel ipsum iniamcorem zzril exer sim qui tem inismod olenisis nonse volor susciduipis acipisi tenature minci blaoreet, corerat. • velit, MAPPING THE DIVISION OF (INNOVATIVE) LABOUR: augait The collective of the innovation Na feugue tiorequires eummy niam quatum zzrilla ortiscillut vullaorofeetumsa ndiamcore process policymakers to have a clearnulluptate understanding who the different mincip actors endrem eliquam, venimmyths incil etaround loborecertain tat ventactors, at praessi. are. zzriusto Rather than creating such as over-hyping Venture Capital Onullaore faccumm olorper Enterprises ad modit esenisi ex euguerat. Ut serves lore core ero essequam, con eui el or Small and Medium - a tactic that only to vel underpin bad government etuerpolicies illandit in quis nos nos doloreet, core dolore vulla facidunt ex esto dolor volor- itutpat, is important to recognise the stages at which eachvelit of do these actors areinimporeet utpat niambe nibh ercilissent nos enim atie do odiamtruly quis dynamic nulluptat,links sequip ercilismod tant. lore Tax commy policy must changed to focus on encouraging between the dipsum doloreparticipants dolesto dolortis atieinnovation tat, sim accumsan dolorer cinismo doloreet dio consectem different in the process.euis Understanding that the State’s role is to do esto enis atet, laoreet accumsan sim zzril irit particuvullamdo what the sumsan businessutsector is vel notutpat. willingDuissent to (engage in highvero risk)odolor also means that corem numsan volorper sed tiscredits nonullamcon veldevised ulla feuiinendre vel enibh et lardit policies such as R&D tax must be suchmodolorem a way that dolorem the subsidy encoureuissendre dolut ut loboreet lum velendiamet lore te ming eu ages investment in innovations that need toeuguerc be madeincinci ratherduipis than niscilit simplyipisisissi rewarding investfeugait veliquamet velitalready wisl ut ut pratue velessim nostrud etuepotential consequisi. ments that have been made regardless of ex their for generating returns. Ut lut nibh erosto odiat, quipis nonsectet, velit ilis num enibh esed ex ea autem duismolenim nim velenit ut nullummy nibh enisi ea cor acing adionsequis am iliquis duip et ipisim quis nature adiam vel • DISTINGUISHING PRODUCTIVE AND eum UNPRODUCTIVE RISK: Given the uncertain of dolorer ilit exercin ciduiscompanies ex etueraese min hendio ex er zzril esendre dolorem quam, quisincludnosto innovation, those that spend more onsum R&D, and other innovation inputs, essiming velendre henit, sisis nostrud minibh elestis iniat dolor si. humanmincin capital formation, will inevitably be nit exposed to higher risks. This high-fixed La faci euissi. It dolutem tionsendip auguero eugiam dolendrerat wiscili sismodi gniscidunt cost strategy is oneaute of the reasons et that innovative companies have a difficult time accessam quis dolore ing accummodio credit. Aligning riskstat. and rewards involves also considering how ‘good’ risk – i.e. speculaGait tion eu facipsusto od ea faccummy acidunt vulluptattonulla commolessit, ing eafrom faci that is necessary for such nullutat innovation investments be made – can bequiscil separated tisis nim quipsum aci te dolor for suscinci eniamco nsectescores, for example, could be made to ‘bad’init riskam – i.e. pure speculation its own sake. Credit better reflect fundamental indicators such as productivity, as well as controlling for the longterm growth potential of some of the most expensive and uncertain investments like R&D. • RETURNS TO THE STATE: Given the State’s important role in investing in the early development of new technologies as well as in physical infrastructure and an educated labour force, companies that have used these resources for successful innovation should contribute more returns to the State, beyond ordinary tax payments at the normal rates. These funds could then be used by the State to renew its investments in the ‘knowledge economy’, increasing innovation opportunities for those companies. 2| | It’s Thealso Risk-Reward Nexus| |Xxxxxxxxx William Lazonick & Mariana Mazzucato | November 2012 5 culture, stupid! xxxxxxxxx | Mar 2011 www.policy-network.net Inequality has hit the front pages, not only because it has been increasing, but also because of a seemingly inexorable concentration of income at the top of the distribution chain through boom and bust (OECD, 2008). And it is the concentration of income among the top 1 percent, or even the top 0.1 percent, that has become increasingly central to the growth of income inequality. This has put pressure on national and transnational policies, such as those of the European Commission, to focus not only on ‘smart’ growth, but growth that is also ‘inclusive’ and ‘sustainable’ — recognising that not all have benefited from the knowledge economy (EC 2020, OECD 2012). However, the battle against increasing inequality has had little success, as witnessed in the failed attempt to curb bank bonuses after the 2008-2009 financial crisis. policy network paper 1. Introduction A prime reason for this failure is a lack of understanding about how income inequality is connected to processes of wealth creation. Indeed, one of the decades in which growth was the‘smartest’ (innovation led) — the 1990s — was a decade in which inequality continued to rise. To put it another way, value was created (in the form of new technologies - like the internet - and sectors like nanotechnology), but then extracted and distributed to a small percentage of those who contributed to the process of value creation. And while different approaches have provided interesting insights into the dynamics of inequality, linking it to the welfare state (Wilkinson 2005), globalisation (Mazur 2000), de-unionisation (Freeman 1992), and the changing skill base (Acemoglu 2002; Brynjolfsson 2011), little attention has been paid to the tension between how value is created and how value is extracted in modern-day capitalism. In this paper, we argue that to understand income inequality it is critical to focus on its link to wealth creation, and thus with innovation — a key characteristic of capitalism. Innovation, defined in economic terms as the generation of higher quality products at lower unit costs, underpins real per capita income growth, and therefore creates the possibility for higher standards of living to be shared among the population. But investment in innovation is inherently uncertain; if we knew how to innovate when investments in innovation are made, it would not be innovation. In the first instance – that is before the State seeks to influence the level of inequality through income transfers – one might expect that those economic actors who take the risks of investing in the innovation process would be the ones to reap the rewards when the innovation process succeeds and suffer the losses when it fails. However, by rooting our analysis of the risk-reward nexus in a theory of innovative enterprise we show how in modern capitalist economies there has been an increasing separation between those economic actors who take the risks of investing in innovation and those who reap the rewards from innovation. Specifically, we argue that while risk-taking has become more collective — leading to much discussion about open innovation and innovation ecosystems — the reward system has become dominated by individuals who, inserting themselves strategically between the business organisation and the product market or a financial market, and especially the stock market, lay claim to a disproportionate share of the rewards of the innovation process. A major barrier to the analysis of the relationship between innovation and inequality is the division of labour among economists, between those who study each of these two phenomena, and their mutual neglect of the role of financial institutions in linking the two. While the relationship between the production of output and the distribution of income was a concern of nineteenth-century classical economists such as David Ricardo and Karl Marx, research is now conducted on the basis of a largely segmented division of labour in which labour economists work on inequality, and industrial economists on technology – with both of these groups typically ignoring the role of finance in the economy. 3 | The Risk-Reward Nexus | William Lazonick & Mariana Mazzucato | November 2012 www.policy-network.net policy network paper Since both innovation and income distribution depend fundamentally on investment strategies and organisational structures of business enterprises, we need a theory of innovative enterprise that can explain both the creation of value and its distribution among participants in the firm. A theory of innovative enterprise must integrate an understanding of the interaction of strategy, organisation, and finance in the generation of higher quality, lower cost products than had previously been available (Lazonick 1991 and 2010; O’Sullivan 2000). We need a theory of innovative enterprise to explain how over time the economic system augments its value-creating capability and the potential for higher standards of living. If we do not have a theory of value creation, how can we differentiate value that is created and value that is simply extracted (what some call “rent”)? That is precisely what the RiskReward Nexus (RRN) approach aims to analyse. In conceptualising RRN, we emphasise the collective, cumulative, and uncertain character of the innovation process. Innovation tends to be collective because the development and utilisation of productive resources is an organisational process that involves the integration of the skills and efforts of people with different hierarchical responsibilities and functional specialties. Innovation tends to be cumulative because what the innovative organisation learned yesterday becomes the foundation for what it can learn today. Innovation, however, is also uncertain because when investments in the collective and cumulative innovation process are being made, there is no guarantee that the enterprise will be able to generate a higher quality, lower cost product. Yet, notwithstanding this uncertainty, people contribute effort (labour) and money (capital) to the innovation process without a guaranteed return. That is, in the face of uncertainty, they make their own personal calculations about the ‘rewards’ that may result from participation in the innovation process which induce them to take ‘risks’. It is precisely because the outcomes of the innovation process are uncertain that an ideology of who takes the risks can, and we argue in fact does, influence who appropriates the rewards. By embedding our analysis in the collective, cumulative, and uncertain characteristics of the innovation process, we can ask who contributes labour and capital to the process and who reaps the The increasingly financialised economy financial rewards from it. Then we assess the equity of this riskhas created incentives for companies to reward nexus, and ask whether it supports or undermines the not invest themselves in human capital innovation process. The RRN framework starts with the analysis and innovation of the innovation process as it occurs at the level of the product and builds up to the level of the firm, industry, nation, and region (e.g., the EU). Our explanation is based on how some actors position themselves along the process of innovation to extract more value than they create, while others get out much less than they put in. The power to engage in such excessive value extraction does not occur through “exchange” relationships in which the contributions of some economic actors are “undervalued” by the market. Rather it occurs when certain economic actors gain control over the allocation of substantial business organisations that generate value, and then use product or financial markets on which the enterprise does business to extract value for themselves. Indeed, while the recent emphasis on “pre-distribution” focuses on the need to prevent unequal market outcomes which create a “winner takes all” dynamic that redistribution policies must then fix (Hacker and Pierson 2010), we argue that understanding the mechanisms behind “winner takes all” requires distinguishing between the source of the theft and its consequences (e.g., weaker labour unions, low investment in skills). While we recognise that greater investments must be made in education and re-skilling the workforce (policies arising from the “pre-distribution” debate), we argue that the increasingly financialised economy has created incentives for companies to not invest themselves in human capital and innovation, while increasingly depending on those investments to come from 4 | The Risk-Reward Nexus | William Lazonick & Mariana Mazzucato | November 2012 www.policy-network.net policy network paper elsewhere—mainly the public sector but also from niche “small” firms. State investments and subsidies that are supposed to support and encourage innovation often only serve to permit companies to get off the hook of making these risky investments themselves even as their executives deliberately make no mention of State support. Indeed they invoke “free market” ideology to claim that, having taken all the risks, “private enterprise” needs to reap all the rewards. Our analysis focuses on the concrete ways that financial interests have been able to position themselves along the investment and innovation curve, reaping excessive portions of the integral under the curve rather than just their marginal contribution. And, as we will argue below, to understand this process, it is fundamental not to confuse value that is created in organisations with value that is extracted through “markets”. In Section 2, we lay out the conceptual foundations for understanding how innovation may be related to inequality by focusing on its core characteristics - the collective, cumulative, and uncertain character of the innovation process. In Section 3, we then sketch out the RRN framework for analyzing the innovation-inequality dynamic. In Section 4, we use this framework to provide an historical overview of how over the past few decades in the United States “financialized” modes of resource allocation have become characteristic of both high-tech startups and established companies, increasing income inequality while undermining the innovation process. In Section 5 we compare the RRN framework to the Skill-Biased Technical Change (SBTC) framework for understanding the relationship between, and the policy implications of, “technological change” and inequality. 2. The uncertain, collective, and cumulative character of the innovation process A theory of the innovative enterprise must begin with the fundamental fact that innovation is inherently uncertain. One cannot calculate a probabilistic stream of financial returns at the time when investments of effort and money in the innovation process are made (Mazzucato and Tancioni 2012). Indeed, since innovation is a learning process that unfolds over time, one cannot even know at any point during the process the total costs of the investments that will be required to achieve financial returns. Yet in the face of Financial interests have been able uncertainty, investments are made. Investments that can result in to position themselves along the innovation require the strategic allocation of productive resources investment and innovation curve, to particular processes to transform particular productive inputs reaping excessive portions of the into higher-quality, lower-cost products than those goods or services that were previously available. Investment in innovation integral under the curve rather than is a direct investment that involves, first and foremost, a strategic just their marginal contribution confrontation with technological, market, and competitive uncertainty (Lazonick 2010). Who, then, confronts uncertainty by investing in innovation? In his oft-cited, and in certain respects seminal, discussion of uncertainty, Frank Knight (1921) assumes that an individual whom he calls the “entrepreneur”, and whom he distinguishes from a manager, confronts uncertainty by investing in the production of a good of service. Knight views “entrepreneurial profits” as the reward to entrepreneurial judgment and entrepreneurial luck, both of which relate to the difference between the market prices that the entrepreneur pays for inputs and the market prices that he receives for outputs. It then becomes possible for economists to argue that entrepreneurial profits are the result of “imperfect competition”. With “perfect knowledge”, business judgment becomes irrelevant. 5 | The Risk-Reward Nexus | William Lazonick & Mariana Mazzucato | November 2012 www.policy-network.net policy network paper In the introduction to a reprint of Knight’s Risk, Uncertainty, and Profit, George Stigler (1971), one of Knight’s successors at the ultra-neoclassical University of Chicago, argued that Knightian uncertainty was just a matter of “luck” (see Lazonick 1991, pp. 175-176). Going even further in eliminating Knightian uncertainty from economic analysis, endogenous growth theory assumes that R&D can be modeled as a lottery, in which one can calculate the probability of “getting lucky” (Romer 1990). But even when, as in Knight’s original argument, it is admitted that business judgment is a factor in leading an entrepreneur to confront uncertainty in the business world, it is assumed that the risk of investing in a business enterprise remains in the hands of one particular type of individual – the “entrepreneur” – while it is market processes, not business organisations, that determine whether these investment yield financial returns. By ignoring the collective and cumulative – or “organisational” – character of the innovation process, Knight’s notion of entrepreneurial profits ultimately prepared the way for the Chicago School application of agency theory to corporate resource allocation in which the shareholder is substituted for the entrepreneur as the only economic actor in the corporation who makes a contribution without a guaranteed market-determined It becomes evident that it is not only, return, and is hence the only bearer of risk (Jensen and Meckling or even primarily, entrepreneurs or 1976; Jensen 1986). It then follows (as we discuss below) that, of all participants in the corporation, it is only shareholders who shareholders who bear risk. For high have a claim to the “residual” (i.e., profits) if and when it occurs. fixed cost investments in physical For the sake of maximizing the residual, according to this highly infrastructures and knowledge bases influential view of the economic world, corporations should that have the character of public be run to “maximize shareholder value” because, in a market goods it is generally the government economy, it is only shareholders who take risk (for critiques, see Lazonick and O’Sullivan 2000; O’Sullivan 2000). Once we recognise the collective character of the innovation process, it becomes evident that it is not only, or even primarily, entrepreneurs or shareholders who bear risk. For high fixed cost investments in physical infrastructures and knowledge bases that have the character of public goods it is generally the government (representing the collectivity of taxpayers) that must engage in this strategic confrontation with uncertainty (Mazzucato 2011). In effect, the government assumes part of the risk that households and businesses would not be willing to bear if they had to invest in the innovation process on their own. Moreover, within business enterprises, workers, and not just financiers, bear risk when they exert effort now with a view to sharing in future gains from innovation if and when these gains materialise. The exertion of this effort on the part of individual workers is critical to the process of organisational learning that is the essence of the innovation process. This learning generally requires the organisational integration of a complex hierarchical and functional division of labour within the firm and often across vertically or horizontally related firms. Besides being uncertain, the innovation process is therefore collective, and it is the collectivity of taxpayers, workers, and financiers who to different degrees bear the risk of innovative enterprise. The “national innovation system” approach has highlighted the roles in the innovation process of different actors (financial institutions including banks and venture capital, government agencies, universities, shop floor workers, engineers, users) and the important relationships among them (Freeman 1995). As a collective process, innovation involves many different actors operating in many different parts of the economy. Academic researchers often interact with industry experts in the knowledge-generation process. Within industry there are research consortia that may include companies that are otherwise in competition with one another. There are also user-producer interactions in product development within the value chain. In these interactions, we would argue that it is generally organisational relations, not market relations, that mediate the risk-reward nexus. 6 | The Risk-Reward Nexus | William Lazonick & Mariana Mazzucato | November 2012 www.policy-network.net policy network paper More generally, workers with a wide variety of functional specialties and hierarchical responsibilities contribute time and effort to the innovation process with the expectation of sharing in the gains from innovation if and when the firm is successful (Lazonick 1990 and 1998). To be sure, firms have to pay workers wages today even for work that may only pay off tomorrow. But, as is generally recognised by business executives who declare that “our most important assets are our human assets”, the key to successful innovation is the extra time and effort that employees expend interacting with others to confront and solve problems in transforming technologies and accessing markets, above and beyond the strict requirements of their jobs. Anyone who has spent time in a workplace knows the difference between workers who just punch the clock to collect their pay from day to day and workers who use their paid employment as platforms for the expenditure of creative and collective effort as part of a process of building their careers. We posit that the productivity differences between the two types of workers can be enormous, and that it will only be firms within which the latter culture predominates that will have a chance of innovative success. Yet, in a world where it has become commonplace to terminate the employment of experienced workers, how can workers who risk their time and effort for the sake of innovation ensure that they will reap the rewards from innovation if and when they occur? The State is a leading actor in the collective innovation process. While many economists have recognised this role of the State for countries in their development stage (Chang, 2002), few have focused on the State as a leading actor even in the most developed regions of the world, such as Silicon Valley. Block and Keller (2010) have documented how government investments have been the backbone of the most successful innovations of the past few decades, from the Internet to nanotech. Mazzucato (2011) argues that it is especially in those technological areas with high capital intensity, and high market and technological risk that the State has played an active ‘entrepreneurial’ role, and Lazonick (2011) argues that in sectors that require high fixed-cost investments in physical infrastructures and human capabilities, the innovative enterprise requires the ‘developmental state’. Neoclassical economists construe this state involvement as fixing “market failures”. From the perspective of the theory of innovative enterprise, however, a more apt description of government’s role is “opportunity creation”. Mazzucato (2011) has argued that the State’s willingness to dare to invest in the most high-risk uncertain phase of a new sector’s development can be understood in terms of making and shaping markets, not just fixing them. while Keynes emphasised the need for the State to inject demand into the downside of the business cycle, the reality is that without the State even in periods of growth the capitalist machine will not take off This particular role of the State has been ignored in the debate about “picking winners” which assumes that government agencies and business enterprises are engaged in the same types of investment activities, but with the latter better at it because it is driven by the profit motive. The failure to recognise the State’s risk-taking role, and the “bumpy” landscape on which it invests, makes it impossible to measure its success (Mazzucato, 2012a). Nanotech would not have come about without the visionary strategy of civil servants in the US National Science Foundation and National Nanotechnology Initiative (the type of “crazy-foolish” behavior that the late Apple CEO Steve Jobs has said is essential for innovation). It is plainly wrong to assume that the willingness to invest was there in the business sector, and all government had to do was to create the right “framework conditions”. The State led, putting its capital at risk, at a time when the business sector was not willing to engage. Thus, while Keynes emphasised the need for the State to inject demand into the downside of the business cycle, the reality is that without the State even in periods of growth the capitalist machine will not take off. 7 | The Risk-Reward Nexus | William Lazonick & Mariana Mazzucato | November 2012 www.policy-network.net Besides being collective, the innovation process is also cumulative. What one learns about how to transform technology and access markets today provides the foundation for what the different (collective) actors learn about transforming technology and accessing markets tomorrow. At the firm level, innovation is one of the variables that (unlike growth) exhibits the most “persistence” as successful innovators today are often the successful innovators of tomorrow (Demirel and Mazzucato 2012; Geroski et al. 1997). policy network paper The State also subsidises the investments that enable individual employees and business enterprises to participate in the innovation process. In effect, taxpayers fund these inputs into the innovation process as part of a societal effort to augment the future wealth of the nation. There is an expectation on the part of taxpayers that if and when innovation is successful, a share in the gains will flow back to society through taxation, job creation, and generally higher standards of living. The cumulative character of the innovation process creates a need for committed finance – or what is often called “patient capital” – to sustain the innovation process from the time at which investments in innovation are made until the time at which those investments can generate returns. This cumulative character makes the innovation process highly dependent on access to financial resources that will sustain the innovation process from the time at which investments are made until it can generate financial returns. Cumulativity enhances the power of those who control sources of finance needed to sustain the process, and, in ways that we describe below, positions them to reap rewards of innovation for themselves for which taxpayers and workers took some of the core risks. Taxpayers and workers often make investments in the innovation process years before and in different locations from the times at and places in which the returns from those investments are realised. Indeed they may have made these investments with the expectations that if and when those investments would be successful, they would share in the returns. In the event, however, their ability to share in the gains of innovation may be undermined by powerful actors who are able to change the “rules of the game”. The State may be deprived of tax revenues that would represent returns on its investments in innovation by changes in tax regimes (for example the “Bush tax cuts” in the United States). Workers who had the expectation of reaping returns through a career with a company may be laid off by profitable companies, perhaps with their jobs offshored to low wage areas of the world. What taxpayers and workers lose, financial actors (including top executives) often gain (Lazonick 2012a). 3. The Risk-Reward Nexus By focusing on the collective, cumulative, and uncertain character of the innovation process, the RiskReward Nexus (RRN) framework asks who contributes their labour and capital to the innovation process and who reaps the financial rewards from it. Then we assess the equity of this risk-reward nexus, and ask whether this nexus supports or undermines the innovation process. The collective character of the innovation process makes it difficult to measure the contributions of different actors to it since their contributions are intertwined. The cumulative character of the innovation process creates a time-lag between the bearing of risk and the generation of returns that can enable some economic actors to “position” themselves strategically in order to extract more value from the returns to the innovation process than the “value-added” that their contributions of labour and capital create. The uncertain character of the innovation process makes it difficult to posit a tight 8 | The Risk-Reward Nexus | William Lazonick & Mariana Mazzucato | November 2012 www.policy-network.net policy network paper connection between the bearing of risk and the generation of returns. For example, proponents of agency theory, which is a branch of neoclassical financial economics, assume common shareholders are the only contributors to the economy who do not have a guaranteed return (Jensen 1986). It is indeed this assumption that underpins the justification, in academia and the media, for shareholders (and those actors who have the most shares) getting so rich in periods of innovation-led growth. The argument assumes that shareholders are the “residual claimants” to whom net income belongs after all other economic actors – workers, suppliers, distributors, creditors – are paid their “guaranteed” returns via market-determined prices. While, according to this theory, all the gains belong to shareholders, by the same token, as the only risk-takers in the economy, they have to bear all the losses as well. Hence the need, so the argument goes, for business corporations to “maximize shareholder value” to encourage risk-taking and the possibility of superior performance of the economy as a whole (Lazonick 2007 and Lazonick 2012b). The problem is that shareholder-value theory lacks a theory of innovative enterprise that can explain why and under what conditions, and with whose participation, the taking of risk results in innovation, i.e., higher quality, lower cost products. This perspective fails to comprehend the implications of the collective and cumulative character of the innovation process for the distribution of risk among economic actors and the distribution of rewards required to incentivise this risk-taking. In short, the ideology of maximising shareholder value (MSV) fails to comprehend the risk-reward nexus in the innovation process. By diminishing the incentives and even the abilities of certain economic actors to contribute to the innovation process, inequality that derives from misappropriation in the risk-reward nexus can undermine the innovation process itself Indeed, it can be argued that public shareholders generally do not risk their capital by investing in the innovation process. Firstly, insofar as public shareholders simply buy and sell shares on the stock market, they invest in outstanding shares that have already been capitalised. They do not invest in the innovation process. Secondly, they are generally willing to hold shares because of the ease with which they can liquidate these portfolio investments, and as a result bear little if any risk of success or failure of an innovative investment strategy. It is only those shareholders who actually commit their capital to the innovation process until, through the generation of higher quality products at lower unit costs it yields returns, who risk their capital on that success or failure of the innovation process. In contrast, it can be argued that taxpayers and workers often invest their capital and labour in the innovation process without a guaranteed return. When the State makes early high-risk investments that enable the business sector to enter a new industry, the States does not have a guaranteed return on that investment. When workers provide time and effort to the innovation process beyond that required to reap their current pay, they generally lack a guaranteed return on that investment. From this perspective, the agency-theory argument that shareholders are the only economic actors who invest in the economy without a guaranteed return may serve as an ideology for those who claim to be representing the interests of public shareholders to appropriate returns that, on the basis of risk-taking, should be distributed to taxpayers and workers. In a world dominated by MSV ideology, we contend that a major source of inequality is the ability of economic actors to appropriate returns from the innovation process that are not warranted by their investments of capital and/or labour in it. Indeed, we argue that by diminishing the incentives and even the abilities of certain economic actors (taxpayers and workers) to contribute to the innovation process, inequality that derives from misappropriation in the risk-reward nexus can undermine the innovation process itself. 9 | The Risk-Reward Nexus | William Lazonick & Mariana Mazzucato | November 2012 www.policy-network.net policy network paper The collective character of the innovation process provides a foundation for inclusive growth; the very participation of large numbers of people in the innovation process means that inherent in the innovation process is a rationale for the widespread and equitable distribution of the gains to innovation. These gains from innovation can either be reinvested in a new round of innovation or, alternatively, distributed to stakeholders as returns to labour or capital. Insofar as government agencies have used public funds to invest in innovation, the State has a claim to a share of the returns to innovation if and when they occur. As we discuss in the conclusion of this paper, the exercising of these claims can take the form of special levies on those business enterprises that make the most use of, or gain the most from, government investments in innovation. The State can allocate these gains to support innovation through infrastructural investments or through subsidies to businesses and households designed to encourage innovation. Alternatively the State can distribute the gains to innovation to the citizenry (whose tax payments funded the government investments Particularly in the United States stock in innovation) in the forms of tax cuts, tax credits, or repurchases have functioned as a government-provided services. An understanding of the mode of value extraction that generally risk-rewards nexus in the innovation process is critical to the undermines investment in innovation formulation of these government policies. The cumulative character of the innovation process creates a role for finance to sustain the innovation process from the point in time at which investments are made until the point in time at which those investments generate financial returns. While “financial commitment” is a condition of innovative enterprise, the cumulative character of the innovation process can also provide an opportunity for those who control access to finance to withdraw that access before returns can be generated, even though from the perspective of those engaged in organisational learning the continuity of finance could result in innovative success (Lazonick and Tulum 2011). Particularly in the United States stock repurchases, justified by MSV ideology have functioned as a mode of value extraction that generally undermines investment in innovation (Lazonick 2012a, 2012b). It is customary for economists who are critical of distributional outcomes to call such value extractors “rent-seekers”. But the use of the term “rent” implies that the gains that these actors appropriate derive from gaining control over inherently scarce resources. The point of the innovation process, however, is to overcome scarcity by generating higher quality, lower cost products than were previously available; that is, by creating new sources of value. From this perspective, so-called rent-seekers are engaged in value extraction. They insert themselves strategically in exercising control over the returns from the innovation process, extracting a share of returns from the expanding economic pie that is in excess of their contribution to the process that generated that expanding pie. In doing so, they – i.e., top executives, venture capitalists, Wall Street bankers, hedge fund managers – make the claim, explicitly or implicitly, that they are the risk-takers who were responsible for making the contributions to the innovation process that justify their high returns. When, driven by innovation, the economic pie is growing, workers may share in the gains through higher wages and better promotion opportunities while the State may receive higher corporate and capital-gain tax revenues from a booming economy. Even then there may be questions about whether the returns to workers and taxpayers are high enough to reward them for their prior investment in the innovation process. But in the subsequent economic decline, in part induced, we would argue, by the success of the value-extractors in concentrating returns in their own hands, workers and taxpayers typically lose out permanently even as the value-extractors use their control over corporate resource allocation to continue to look for ways to consolidate their gains. For example, in the Internet boom of the late 1990s, when, through stock-based remuneration, top corporate executives and high-tech venture capitalists were becoming extremely wealthy, tight labour 10 | The Risk-Reward Nexus | William Lazonick & Mariana Mazzucato | November 2012 www.policy-network.net policy network paper markets resulted in rising real wages while the Clinton Administration ran budget surpluses in large part because of capital gains taxes on stock-market transactions. It was on the basis of these budget surpluses that in 2001 the incoming Bush Administration formulated the possibility of dramatic cuts in tax rates on dividends and capital gains – all in the name of innovation (e.g. Ortmans, 2012). Then when the boom turned to bust in the early 2000s, the US government found that it now had large deficits while many workers whose remuneration had benefited from the boom now found themselves without jobs. Meanwhile the value-extractors sought to restore their gains of the late 1990s through, for example, implementing the Bush tax cuts, offshoring of jobs to low-wage areas of the world, and massive stock repurchases (Lazonick 2009a). During the 2000s, we would argue further, the success of these means of value-extraction ultimately undermined the innovation process itself. Our RRN framework seeks to analyse the ways in which risks and rewards can be aligned among contributors to the innovation process so that the sharing of the gains to innovative enterprise is equitable (and hence forms a foundation for reducing inequality) while promoting the growth of innovative enterprise. Given the need for business-government collabouration in funding the cumulative innovation process, those in the collaboration who exercise strategic control over the allocation of resources need to have a framework for assessing the ongoing risks of investments in innovation, with key participants in the organisational learning process involved. A risk-reward nexus understanding of innovation provides strategic decision-makers in business and government with a more inclusive and less financialized approach to the relation between economic performance and income inequality than the dominant MSV paradigm. This understanding of the risk-reward nexus in the innovation process will enable the relevant stakeholders to make collaborative decisions to invest in innovation in the first place and sustain the process until it can generate returns on an equitable basis to the different types of economic actors who participate in the process. 4. Financial actors and value extraction If, as we have argued, the collective character of the innovation process provides a foundation for an equitable distribution of income, how is it that certain economic actors are able to extract for themselves disproportionate amounts of the value that the innovation process creates? They accomplish this feat by positioning themselves along the cumulative curve of innovation, and extracting at a given point in time much more than that of which they have contributed. This value extraction is done through various institutional mechanisms such as political lobbying for de-regulation, lower tax rates, and special subsidies, inside control over speculative stock issues and other financial deals, stock-based compensation, and legal manipulation of the stock market through stock buybacks. The proponents/beneficiaries of these institutional mechanisms extol the virtues of a “free market” economy. Yet it is organisations, not markets, that create value in the economy. Historically, welldeveloped markets are the result, not the cause of economic development that is driven by organisations in the forms of supportive families, innovative enterprises, and developmental states (Lazonick 2003, 2011). Well-developed markets in inputs and outputs can enhance the ability of the possessors of capital and labour to extract value. But markets do not create value. Any economy requires both the creation (i.e., production) and extraction (i.e., distribution) of value. For example, whenever a worker gets paid a wage he or she extracts value. 11 | The Risk-Reward Nexus | William Lazonick & Mariana Mazzucato | November 2012 The source of inordinate income inequality is not value extraction per se, but rather the positioning of people who have control over large amounts of finance capital to make use of financial markets or product markets to extract far more capital than they create www.policy-network.net It has long been recognised that financial fortunes are generated suddenly, ostensibly through the capitalization of future profit potential into the market price of an asset, rather than patiently through the accumulation of re-invested capital income (e.g., Thurow 1975). Financial deregulation and the spread of stock-related pay have enabled investors (especially of private equity) and top corporate executives to secure ownership of assets just before major innovation-related gains are capitalised into them. Capital gains tax reduction has served to augment those gains. policy network paper The source of inordinate income inequality is not value extraction per se, but rather the positioning of people who have control over large amounts of finance capital to make use of financial markets or product markets to extract far more capital than they create. Rather than income being distributed equitably (which of course does not necessarily mean equally) according to the value that different economic actors create, certain types of economic actors are able to make use of both the reality and ideology of markets to extract disproportionate amounts of value for themselves. When financial markets become more speculative, the moment of capitalisation has tended to move forward in time, so that it can often occur before any marketable products have been unveiled or a profitable business established. IPOs and acquisitions are commonly the moment of capitalisation, especially as IPO stock tends to be deliberately underpriced to ensure that IPO insiders will be able to flip their shares while outsiders try to gain from the speculative fervor. Sometimes the strategic announcement of a technological breakthrough is enough to cause a jump in the stock price of companies exposed to it, enabling those strategically positioned to cash in. Let us give two important examples based on the US experience of how this excessive value-extraction process works. One comes from the world of high-tech startups, and the other comes from the world of established business corporations. In effect, we will be arguing that people like Mark Zuckerberg of Facebook, one of the world’s richest people with the company’s IPO in May 2012, or John Chambers of Cisco, who as CEO had total remuneration of $12.9 million in 2011 and $662 million from 1995 through 2011, have used financial markets to extract far more value than they create. In making this argument, we are not criticising these individuals per se but rather a set of institutions that, while enabling, and even extolling, the ability of these individuals to extract value, fails to recognise the relation between risks and rewards that creates value. 4.1 Value extraction through high-tech startups In October 1980 Genentech, founded in 1976 by venture capitalists and scientists, was the first dedicated biopharmaceuticalceutical company to do an IPO. In December 1980 Apple Computer, Inc., a company that had been founded in a garage just four years earlier, did the largest IPO since Ford Motor Company (which had been founded over a half century before it was listed on the stock market) had gone public in 1956. Since then in the United States venture-backed IPOs have become a distinguishing feature in both the biopharmaceuticalceutical and information and communication technology (ICT) industries (Kenney and Florida 2000; Lazonick 2009b, ch. 2; Lazonick and Tulum 2011). An IPO capitalises value gains that have been generated over many years by many people – and hands those gains to a tiny group who often were not the original innovators or risk-takers but who nevertheless are currently positioned to appropriate much or all the profit. This type of value extraction also happens with IPOs of companies that were previously mutually- or family-owned, as their “trapped equity” is suddenly capitalised and paid out to the people who devised the flotation. That equity is the summation of other people’s ingenuity and risk-taking, often captured by people who exhibited little or even none. In the ICT industry, high-tech startups have been at the centre of a technological revolution that is still being played out in areas such as mobile communications, social networking, and cloud computing. In 12 | The Risk-Reward Nexus | William Lazonick & Mariana Mazzucato | November 2012 www.policy-network.net The huge gains that were already accruing to these economic actors in the IPO boom of the early 1980s eetin dolestis lum eugiam wisim velit te commy zzril eu faci feuithat tat wis set motionelenit a process of raisingdit the norms forad rewards in thenonsequam economy that would, inte ways we outline below, set off a quest for higher levels of remuneration among CEOs of established companies. x ea facilit volor ipit, vel ullum ad te dunt aut veliqui psuscilisis augueriureet ullam, velis aliquis exeraestrud the tet aci feu feum alit, commy were nonsed magnim etumsandre feugiamet Indeed, newbla norms of compensation often set byadolorper small butipvery significantmagna number startups such as Intel, Sun Microsystems, Oracle, and Cisco Systems that generated huge returns to venture pratie dip et alismolobore doloborer suscipit vullaor sectet, si blamconullan henisl ulla faccumsan capitalists, founders, andver topsim executives grew tosed employ tens of thousands of people. ut autpat. 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Hendre volorperit ipsumsa ndreet lute tetuero diamet lortissi etuero odo od ming corporate governance, stock markets and income taxation have permitted this concentration of value exeriurem dui ex eugait wis ad duiscidunt ulluptat incing erillummy nulla consed dolore essi tate te extraction in a few hands. feugait, veraessenit wisci tem ipis exeril dunt in velesto od eu feugait nulputat, sit, commodit, vendit policy network | Thepolicy Amsterdam networkProcess paper biopharmaceuticalceuticals, number of high-techquatin startups as consed Genentech Wisi bla faccum init ent prat.aUt at amconullutem vel from dolorthe ad early minim1980s zzrit such adigna do(now part of Roche), Amgen, Genzyme (now part of Sanofi), and Biogen (now Biogen Idec) lorer alit veliquip et lum nostion henit luptatinisci blandit auguer augue dolorperos enimultimately quisit nis generated blockbuster drugs (defined as at least $1 billion in sales in any one year), although through niam ing erillum sandion hent ipit, summod modolor eetuer sed tat am do duisl ip et irilissequip ea 2009 the number of blockbusters generated by the industry numbered only 30 (Lazonick and Tulum accum zzril eugait lortie faccums andionsequis nibh exercincil utpatio od tat lutatisis aci essit augue 2011). Since the early 1980s in Silicon Valley, by far the most dynamic industrial district for high-tech tat. Im ad magnit lumsandre dolore dipis nulput iriusci psustrud tie feugait lum diam vel utpat. Reestartups, tens of thousands of venture capitalists, founders, top executives, and early-stage employees tumsan elent dolut aut vercing exeril in velis nibh eu faci blaorero dio diamcon sequis aliquam, vel have become multimillionaires. doloborper adit at iliquisim do enibh etue tetumsa ndipsustrud eugiametue magniamet ullaor ad tie etueros acil iril utet lutem velit nulla facidunt ad mod magnim in ex eu feu feugait laore facilla These high-tech startups would not have been able to come into existence if not for decades of aliquipis nullan ex eros aliquat. Duis nim exer ad magna feui tat lore vel ipsum iniamcorem zzril exer investment by the US government in ICT and biotech. As the historian Stuart Leslie (1993, 2000) has sim velit, qui tem olenisis nonse volor susciduipis temilitary-industry minci blaoreet, corerat. documented, the inismod foundation for the emergence of Siliconaugait Valley acipisi was the complex Na feugue tio eummy niam quatum zzrilla ortiscillut nulluptate vullaor eetumsa ndiamcore mincip that became implanted in the region during and after World War II, and particularly in the Cold War endrem of zzriusto eliquam, venim incil et lobore tat vent at praessi. context the 1950s. Onullaore faccumm olorper ad modit esenisi ex euguerat. Ut lore core vel ero essequam, con eui el etuer illandit in first utpat, quis nos nos doloreet, core dolore facidunt do ex esto dolor in volorSilicon Valley’s formal venture capital firm, Draper,vulla Gaither, and velit Anderson, founded 1959, was headed two former generals in thenos US enim Armed Forces, William Draper, Jr.sequip and Frederick L. eet utpat loreby commy niam nibh ercilissent atie do odiam quisH.nulluptat, ercilismod Anderson, and the former head of the Ford Foundation, H. Rowan Gaither, whose name is on the dipsum dolore dolesto dolortis atie tat, sim accumsan euis dolorer cinismo doloreet dio consectem secret 1957 submitted President Eisenhower on how the United respond to the do esto enisreport atet, sumsan ut to laoreet vel utpat. Duissent accumsan veroStates odolorshould sim zzril irit vullamSoviet Union’s launching of Sputnik (Business Week 1960). The high-tech district that was to become corem dit numsan volorper sed tis nonullamcon vel ulla feui endre modolorem dolorem vel enibh et known as Silicon Valley (a term that was coined in 1971) was either producing directly for the military euissendre dolut ut loboreet lum velendiamet lore euguerc incinci duipis niscilit ipisisissi te ming eu or, increasingly from the last half of the 1960s, spinning off military technology for commercial uses feugait veliquamet velit wisl ut ut pratue velessim nostrud ex etue consequisi. (Lazonick 2009b, ch. 2). In this, Silicon Valley was imitating the previous development of the Route 128 Ut lut nibh erosto odiat, quipis nonsectet, velit ilis num enibh esed ex ea autem duismolenim nim high-tech district in the Boston area, based on military technologies developed at nearby universities, velenit ut nullummy nibh enisi ea cor acing eum adionsequis am iliquis duip et ipisim quis adiam vel especially the Massachusetts Institute of Technology (Hsu and Kenney 2005) dolorer ilit exercin ciduis ex etueraese min hendio ex er sum zzril esendre dolorem quam, quis nosto essim velendre mincin that henit,were sisis nostrud minibh elestiswere nit iniat dolor si. by tens of thousands of Military technologies later commercialised developed La faci euissi. It dolutem et auguero eugiam dolendrerat sismodi gniscidunt scientists, engineers, and aute othertionsendip technical personnel in research labs of largerwiscili ICT companies including am quis accummodio dolore tat. AT&T, General Electric, IBM, Sylvania, Xerox, Motorola, and Texas Instruments. Some employees left Gait eu facipsusto faccummy acidunttovulluptat nulla commolessit, ingofea faci to found startups, od butea the ability tonullutat attract capital finance startups required a quiscil number other tisis nim init changes am quipsum te put dolor eniamco nsecte institutional that aci were in suscinci place from the late 1950s. In 1958 the US government’s Small Business Administration (SBA), itself set up in 1953, launched the Small Business Investment Company (SBIC) program to provide subsidies to the formation and growth of startups. Many firms in the nascent venture-capital industry of the 1960s availed themselves of funds from SBIC (Rubel and Noone 1970). Meanwhile, starting with what is known as the “Special Study” of securities markets submitted to the US Congress in 1963, the US Securities and Exchange Commission (SEC) encouraged the National Association of Security Dealers (a), a private non-profit organisation charged with regulating the trading activities of its members, to make use of advances in computer technology to establish a national electronic quotation system for Over-The-Counter (OTC) stocks. The result was the creation of 16 It’s also culture, stupid! xxxxxxxxx | Mar 2011 13 || The Risk-Reward Nexus | Xxxxxxxxx William Lazonick & Mariana Mazzucato | November 2012 www.policy-network.net eet dolestis elenit lum eugiam dit wisim velit ad te commy zzril euitfaci feui tat wis NASDAQ’s liquidity is particularly high because, unusually fornonsequam an OTC exchange, hastehundreds of market-makers, usually more than one per stock. They ensure instant purchase or sale close to the market price, and underwriting IPOs.ad Investors, result, have very little liquidity risk. Thevelis risk isaliquis transferred x ea facilit volor ipit, velfor ullum te dunt as auta veliqui psuscilisis augueriureet ullam, exerto market-makers who are backed by investment banks which, we now know, are underwritten by aestrud tet aci bla feu feum alit, commy nonsed magnim dolorper ip etumsandre magna feugiamet government. effect, through NASDAQ, the profits innovation have been privatised its risks pratie dip et In alismolobore doloborer suscipit vullaorofsectet, si blamconullan henisl ullaand faccumsan socialised (Ellis et al, 1999). ut autpat. Ut luptat. Im ver sim veraesed te dolorer sed diamet vullandrem zzriuscilla core vel esting esto elisi.Ut iniamet autatue diat accum quat iurerci bla faccum zzrit adit landiam do od dolor senit In 1972 Silicon Valley venture capitalists, most of whom venibh euis nos adio eugait numsandrero commy nim exerostis ea feugait lan erothe consectem After riding wavevullum of State came out of the microelectronics industry, began to veniscipit alisi. Hendre volorperit ipsumsa ndreet lute tetuero diamet lortissi etuero odo od ming investments, therefore, venture capital coalesce into a defined industry when a number of them, exeriurem dui ex eugait wis ad duiscidunt ulluptat incing erillummy nulla consed dolore essi tate te decrease the proceeded to aggressively including Kleiner Perkins and Sequoia, co-located at 3000 feugait, veraessenit wisci tem ipis exeril dunt in velesto od eu feugait sit, commodit, sizenulputat, of the purse that vendit funded it Sand Hill Road in Palo Alto, near Stanford University. Also ad tie etueros acil iril utet lutem velit nulla facidunt ad mod magnim in ex eu feu feugait laore facilla at that location was the Western Association of Venture aliquipis nullan aliquat. Duis nim exer ad magna Capitalists whichexineros 1973 formed the foundation of thefeui tat lore vel ipsum iniamcorem zzril exer policy network | Thepolicy Amsterdam networkProcess paper the Association of Securities Dealers Quotation or NASDAQ, February Unlike WisiNational bla faccum init ent prat. Ut at amconullutem quatinsystem, vel dolor ad minimin zzrit adigna1971. consed dothe New York Stock Exchange (NYSE), which had stringent listing requirements in terms of capitalisation lorer alit veliquip et lum nostion henit luptatinisci blandit auguer augue dolorperos enim quisit nis and a record of profitability, NASDAQ, like the OTC markets that it aggregated, afforded startups with niam ing erillum sandion hent ipit, summod modolor eetuer sed tat am do duisl ip et irilissequip ea low capitalisation and no profits the possibility of doing an IPO. With the creation of NASDAQ, there accum zzril eugait lortie faccums andionsequis nibh exercincil utpatio od tat lutatisis aci essit augue now existed a highly liquid national market in highly speculative corporate securities that provided tat. Im ad magnit lumsandre dolore dipis nulput iriusci psustrud tie feugait lum diam vel utpat. Reeventure capitalists and other financiers of startups with the possibility of a relatively quick exit from tumsan elent dolut autthe vercing exeril in of velis eu faci blaorero dio diamcon vel their investments. Thus development thisnibh speculative stock market attracted sequis venturealiquam, capital into doloborper adit at iliquisim do enibh etue tetumsa ndipsustrud eugiametue magniamet ullaor the ICT industry. sim velit,Venture qui temCapital inismod olenisis nonse volor susciduipis te 1970s minci was blaoreet, National Association (NVCA), a business lobbyaugait that inacipisi the late in thecorerat. forefront, Na feugue niam quatum Association zzrilla ortiscillut nulluptate vullaor eetumsa ndiamcore mincip along with tio theeummy American Electronics (AeA), which also emanated from Silicon Valley, in endrem zzriusto incilthe et lobore tat vent atrates praessi. convincing the USeliquam, Congressvenim to lower capital-gains tax from almost 40% in 1976 to as low as 20% in the early 1980s. After riding the wave of State investments, therefore, capital proceeded Onullaore faccumm olorper ad modit esenisi ex euguerat. Ut lore core velventure ero essequam, con eui el to aggressively thenos sizenos of the purse that it. facidunt velit do ex esto dolor in voloretuer illandit indecrease utpat, quis doloreet, corefunded dolore vulla eet utpat lore commy niam nibh ercilissent nos enim atie do odiam quis nulluptat, sequip ercilismod Poised reap speculative gainsatie at low via a quick exit on cinismo NASDAQ, the venture capitalists dipsumtodolore dolesto dolortis tat,tax simrates accumsan euis dolorer doloreet dio consectem needed to gain access to large amounts of capital. By the early 1980s workers’ pensions provided the do esto enis atet, sumsan ut laoreet vel utpat. Duissent accumsan vero odolor sim zzril irit vullambiggest source of venture-capital funds. During most of the 1970s, however, the huge reserve of unions’ corem dit numsan volorper sed tis nonullamcon vel ulla feui endre modolorem dolorem vel enibh et defined-benefit pensions, most of which were managed by major corporate employers, had been euissendre dolut ut loboreet lum velendiamet lore euguerc incinci duipis niscilit ipisisissi te ming eu unavailable to the venture-capital industry. feugait veliquamet velit wisl ut ut pratue velessim nostrud ex etue consequisi. Ut lut nibh erosto odiat, quipis nonsectet, velit ilis num enibh esed ex ea autem duismolenim nim The passage in 1974 of the Employee Retirement Income Security Act (ERISA) had provided government velenit ut nullummy nibh enisi ea corhad acing eum adionsequis ammanagers iliquis duipcould et ipisim quis adiam vel guarantees for workers’ pensions and ruled that pension-fund be personally liable ilitnot exercin ex etueraese hendio ex erworkers’ sum zzril esendre dolorem quam, quis nosto ifdolorer they did followciduis the “prudent man” min rule in investing money. Pension-fund managers were, essim velendre mincin henit, in sisis nostrud minibh elestis nit iniat dolor by si. the NVCA and AeA as well as a result, reluctant to invest venture-capital funds. Intense lobbying Lathe facimanagers euissi. It dolutem aute tionsendip auguero eugiam dolendrerat wiscili however, sismodi gniscidunt as of big corporate pensionetfunds (for example, General Electric), helped to am quis accummodio dolore to tat.issue a clarification of ERISA that stated that pension-fund managers convince the US government could putfacipsusto as much as of the fund into risky vulluptat assets such as venture-capital funds, and stillfaci be Gait eu odfive eapercent faccummy nullutat acidunt nulla commolessit, quiscil ing ea deemed to acting prudently. As a result, from the second half of 1979 vast amounts of workers’ capital tisis nim init am quipsum aci te dolor suscinci eniamco nsecte poured into the venture capital industry. While there are different ways in which a venture-capital firm can be organised, by the 1980s the limited partnership became the dominant form. The limited partners are the pension funds or other outside investors who entrust their money to the venture capitalists who, as the general partners, decide how to invest the closed-end (usually ten-year) fund capital. The venture capitalists typically receive a management fee equal to 2 percent of the entire fund plus 20 percent “carried interest” of all the fund’s profits. 17 It’s also culture, stupid! xxxxxxxxx | Mar 2011 14 || The Risk-Reward Nexus | Xxxxxxxxx William Lazonick & Mariana Mazzucato | November 2012 www.policy-network.net tumsan elent dolut aut vercing exeril in velis nibh eu faci blaorero dio diamcon sequis aliquam, vel To be sure, venture capitalists and other private-equity holders take risks, although even then mostly doloborper adit at iliquisim do enibh etue tetumsa ndipsustrud eugiametue magniamet ullaor with other people’s (primarily workers’) money. But they have a vested interest in encouraging stock market speculation in the companies that they bring to market either through an IPO or, as an alternative eet dolestis lumdeal. eugiam dit wisim of velit ad tetocommy nonsequam zzrilinsiders, eu faci te feui tat wis mode of exit,elenit an M&A The allocation access shares in an IPO favours including the Wall Street banks that underwrite the deals. By keeping the float small, under-pricing the stock issue, x ea hyping facilit volor ipit, vel ullum adencourage te dunt auta veliqui psuscilisis augueriureet aliquispublic exerand the stock, the banks post-IPO run-up in stock pricesullam, as thevelis investing aestrud tet feushares. feum alit, commy nonsed magnim dolorper ip etumsandre magna feugiamet clamors for aci thebla listed Insiders then flip their holdings to make huge short-term gains. As was shown in a 2002 Fortune article entitled “You Bought. They Sold”, when the stock market is at a peak, pratie dip et alismolobore doloborer suscipit vullaor sectet, si blamconullan henisl ulla faccumsan insiders tend cash Im in their own shares while encouraging outsiders to buy zzriuscilla (Gimein etcore al. 2002). ut autpat. Ut to luptat. ver sim veraesed te dolorer sed diamet vullandrem vel esting esto elisi.Ut iniamet autatue diat accum quat iurerci bla faccum zzrit adit landiam do od dolor senit The foundation theeugait emergence of the UScommy venture-capital model the rise microelectronics venibh euis nosfor adio numsandrero nim exerostis eawas feugait lan of erothe consectem vullum industry in Silicon Valley from the late 1950s (Kenney and Florida 2000; Lazonick 2009b, ch. 2). Given veniscipit alisi. Hendre volorperit ipsumsa ndreet lute tetuero diamet lortissi etuero odo od ming the investments in microelectronics by the US government and established business corporations exeriurem dui ex eugait wis ad duiscidunt ulluptat incing erillummy nulla consed dolore essi tate te in the post-World War II decades as well as the characteristics of both microelectronics technology feugait, veraessenit wisci tem ipis exeril dunt in velesto od eu feugait nulputat, sit, commodit, vendit and markets, it was possible for an ICT company to generate a commercial product within a few years ad tie etueros acil iril utet lutem velit nulla facidunt ad mod magnim in ex eu feu feugait laore facilla after being founded, as indeed was the case for companies such as Intel, Microsoft, Apple, Electronic aliquipis nullan ex eros aliquat. Duis nim exer ad magna feui tat lore vel ipsum iniamcorem zzril exer Arts, and Cisco. With the founding of Genentech in 1976, however, the US venture-capital model was sim velit, qui tembiopharmaceuticalceutical inismod olenisis nonse volor susciduipis augait acipisi te minci blaoreet, extended to the industry in which it would generally take at leastcorerat. a decade Na feugue tio eummy niam quatum zzrilla ortiscillut nulluptate vullaor eetumsa ndiamcore mincip to generate a commercial product, with no certainty that in the end a viable drug would be developed. endrem zzriusto eliquam, venim incil et lobore tat vent at praessi. policy network | Thepolicy Amsterdam networkProcess paper The majorityinit of ent venture-backed startups fail, and thevel returns capital have consed been quite Wisi vast bla faccum prat. Ut at amconullutem quatin dolorto adventure minim zzrit adigna dovolatile across the business cycle (Gompers and Lerner 2002). Nevertheless, many venture lorer alit veliquip et lum nostion henit luptatinisci blandit auguer augue dolorperos enimcapitalists quisit nis and founders of high-tech firms have emerged since the 1980s as members of the super-rich. The niam ing erillum sandion hent ipit, summod modolor eetuer sed tat am do duisl ip et irilissequip ea lowering of the tax rate on capital gains and dividends to 15 percent, i.e., the Bush tax cuts of 2003, accum zzril eugait lortie faccums andionsequis nibh exercincil utpatio od tat lutatisis aci essit augue made them even richer. tat. Im ad magnit lumsandre dolore dipis nulput iriusci psustrud tie feugait lum diam vel utpat. Ree- Onullaore olorper ad the modit ex euguerat. Ut lore coreseem vel erotoessequam, contoeuithe el As Pisano faccumm (2006) has argued, USesenisi venture-capital model would be ill-suited etuer illandit in utpat, quis nos nos doloreet, dolore facidunt velit do ex esto in dolor in volorbiopharmaceuticalceutical industry. Venture core capital looksvulla to exit from its investments at most five years. Butlore it typically atercilissent least twicenos that amount ofodiam time to generate a biopharmaceutical eet utpat commy requires niam nibh enim atie do quis nulluptat, sequip ercilismod drug that, having gone through phase 1, 2, and 3 clinical trials, the US Food and Drug Administration dipsum dolore dolesto dolortis atie tat, sim accumsan euis dolorer cinismo doloreet dio consectem may deem effective and safe enough to market. Yet, as Pisano also recognises, there are hundreds of do esto enis atet, sumsan ut laoreet vel utpat. Duissent accumsan vero odolor sim zzril irit vullampublicly listed biopharmaceutical firms in the United States that have done their IPOs and then remain corem dit numsan volorper sed tis nonullamcon vel ulla feui endre modolorem dolorem vel enibh et in business for years on end without a product. At best, these PLIPOS (product-less IPOs) generate euissendre dolut ut loboreet lum velendiamet lore euguerc incinci duipis niscilit ipisisissi te ming eu revenues from R&D contracts with established pharmaceutical companies that also typically take feugait veliquamet velit wisl ut ut pratue velessim nostrud ex etue consequisi. equity stakes in them. In addition PLIPOs have been able to raise huge amounts of finance through Ut lut nibh erosto odiat, quipis nonsectet, velit ilis num enibh esed ex ea autem duismolenim nim IPOs and secondary stock issues (Lazonick and Sakinç 2010). velenit ut nullummy nibh enisi ea cor acing eum adionsequis am iliquis duip et ipisim quis adiam vel dolorer ilit exercin ciduis ex etueraese min hendio ex er sum zzril esendre dolorem quam, quis nosto Indeed, it is NASDAQ, i.e., the speculative stock market, that has enabled this business model to survive. essim velendre mincinhedge henit, sisis nostrud minibh elestis iniat Speculators, including funds, are willing to buy andnitsell ondolor newssi. about R&D contracts won or La faci euissi. dolutem aute tionsendip etfail. auguero eugiam dolendrerat wiscili gniscidunt cancelled andItclinical trials that succeed or The speculators do not expect tosismodi make their money am quis accummodio dolore tat. because a biopharmaceutical firm has produced a successful drug, but rather through buying and Gait eustock facipsusto od ea faccummy nullutat acidunt vulluptat nulla commolessit, quiscil ing ea faci selling (Lazonick and Tulum, 2011). Given that over its 35-year history, the biopharmaceutical tisis nim init quipsumsome aci te dolor suscinci eniamco nsecte can always rationalise their demand industry hasam generated 30 blockbusters, speculators for biopharmaceutical shares on the grounds that they are betting on the next blockbuster. In fact, however, by buying and selling stock, they can make or lose money on these bets irrespective of whether a successful drug is ever forthcoming. Given the massive amount of funds that have flowed into the US biopharmaceutical industry and the relatively small number of successful drug discoveries, the overall returns in terms of drug development have been small while financial interests, including highly remunerated biopharmaceutical executives, have done very well for themselves. The foundation for this speculative system of biopharmaceutical finance is US government spending on the life sciences knowledge base. Since the founding of its first research institute in 1938 through 18 It’s also culture, stupid! xxxxxxxxx | Mar 2011 15 || The Risk-Reward Nexus | Xxxxxxxxx William Lazonick & Mariana Mazzucato | November 2012 www.policy-network.net doloborper at iliquisim do enibh tetumsa that ndipsustrud eugiametue magniamet ullaor to generate aadit commercial product, withetue no certainty in the end a viable drug would be developed. Yet for all this government spending and business funding that has flowed into the biopharmaceutical industry through private equitythe (including venture IPOs, secondary stock issues, and eetPisano dolestis elenit lumargued, eugiam dit wisim velit ad tecapital), commy nonsequam zzril eubefaci te feui tat wis As (2006) has U.S. venture-capital model would seem to ill-suited toR&D the contracts, the biopharmaceutical industry has not been very productive (Demirel and Mazzucato, biopharmaceuticalceutical industry. Venture capital looks to exit from its investments in at most2012; five Pisano 2006). Most ofrequires theullum blockbuster biotech that huge returns for velis bothaliquis big pharma years. But itvolor typically atad least thatdrugs amount ofgenerated time to generate a biopharmaceutical drug x ea facilit ipit, vel te twice dunt aut veliqui psuscilisis augueriureet ullam, exerand biopharmaceutical companies reflect control over patent rights to the “low-hanging fruit” may that that, having gone through phase 1, 2, and 3 clinical trials, the U.S. Food and Drug Administration aestrud tet aci bla feu feum alit, commy nonsed magnim dolorper ip etumsandre magna feugiamet became available these companies in the as a also result of decades of NIH funding. Meanwhile deem andtosafe enough to market. Yet,1980s asvullaor Pisano recognizes, there are hundreds of publicly pratieeffective dip et alismolobore doloborer suscipit sectet, si blamconullan henisl ulla faccumsan our research has shown that, in PLIPOs, economic actors who have invested in biopharmaceutical listed biopharmaceutical firms in the United States that have done their IPOs andthen remain in business ut autpat. Ut luptat. Im ver sim veraesed te dolorer sed diamet vullandrem zzriuscilla core vel esting companies have been able to reap substantial returns for themselves even in the absence of a successful for years on end without a product. At best, these PLIPOS (product-less IPOs) generate revenues from esto elisi.Ut iniamet autatue diat accum quat iurerci bla faccum zzrit adit landiam do od dolor senit product (Lazonick and Sakinç 2010; Lazonick and Tulum 2011).that also typically take equity stakes in R&D contracts with established pharmaceutical companies venibh euis nos adio eugait numsandrero commy nim exerostis ea feugait lan ero consectem vullum them. In addition PLIPOs have been able to raise huge amounts of finance through IPOs and secondary veniscipit applies alisi. Hendre volorperit ipsumsa lute tetuero lortissi etuero odo od The to top of thesendreet companies who notdiamet only draw healthy salaries butming also stocksame issues (Lazonick andexecutives Sakinç 2010). exeriurem dui ex eugait wis ad duiscidunt ulluptat incing erillummy nulla consed dolore essi tate te receive stock-based rewards that can bring them millions of dollars. Meanwhile US taxpayers keep feugait, veraessenit wiscithrough tem ipis the exeril dunt intax velesto od euand feugait nulputat, drugs sit, commodit, vendit funding companies NIH. With rates low few successful that in case Indeed, itthese is NASDAQ, i.e., the speculative stock market, that has enabled this business model toany survive. ad tie etueros acil utet lutem velit nulla facidunt adand modsell magnim inare ex eu feu feugait laore facilla bear prices that areiril about double those in any other country, taxpayers seeing little in the way ofora Speculators, including hedge funds, are willing to buy on news about R&D contracts won return. aliquipis nullan ex eros aliquat. nim or exer magna feui tat do lorenot velexpect ipsum iniamcorem exer cancelled and clinical trials that Duis succeed fail.adThe speculators to make theirzzril money policy network | Thepolicy Amsterdam networkProcess paper 2011, the National Institutes Health (now made upand of 27 centres andLazonick institutes) has appropriated industry Siliconinit Valley fromof the 1950s (Kenney Florida 2). Given Wisi bla in faccum ent prat. Ut atlate amconullutem quatin vel dolor2000; ad minim zzrit2009b, adignach. consed do$804 billion in 2011 dollars to fund this knowledge base. More than half of these funds have been the investments in microelectronics by the U.S. government and established business corporations in lorer alit veliquip et lum nostion henit luptatinisci blandit auguer augue dolorperos enim quisit nis appropriated since At an annual of $31 billion for 2009 microelectronics through 2012, thetechnology appropriations the post-World War1998. II decades as well average as the characteristics of both and niam ing erillum sandion hent ipit, summod sed am three do duisl ip et irilissequip ea are about their level thanto inmodolor the earlyeetuer and tat about times the markets, ittwice was possible forinanreal ICTterms company generate a1990s commercial product within atheir fewlevel yearsinafter accum zzrilBetween eugait lortie andionsequis nibh exercincil utpatio od tat lutatisis aci essitor augue mid-1980s. 1998faccums and the 2003 thefor NIH budget increased by anMicrosoft, average of $2.7 Electronic billion, 14.7 being founded, as indeed was case companies such as Intel, Apple, Arts, tat. Im ad lumsandre dipisthe nulput iriusci psustrud tie feugait lum diam vel utpat. Ree-a percent permagnit year. Without this dolore spending, United States, and probably world, would not have and Cisco. With the founding of Genentech in 1976, however, the U.S.the venture-capital model was tumsan elent dolut aut vercing exeril in velis nibh eu faci blaorero dio diamcon sequis aliquam, vel biopharmaceutical industry. extended to the biopharmaceuticalceutical industry in which it would generally take at least a decade sim velit,aqui tem inismod olenisis volor susciduipis augait acipisi mincithrough blaoreet, corerat. because biopharmaceutical firm nonse has produced a successful drug, but te rather buying and In US high-tech startups, gains from an IPO and subsequent stock price boosts are shared with Na feugue eummy and niamTulum, quatum zzrilla ortiscillut nulluptate vullaor eetumsa ndiamcore mincip selling stocktio(Lazonick 2011). Given that over its 35-year history, the biopharmaceutical employees broad-based stock optiontat plans. Prior to rise of Silicon Valley endrem zzriusto eliquam, venim30incil et lobore vent at praessi. industry hasthrough generated some blockbusters, speculators canthe always rationalize their startups, demand employee stock options were largely reserved for top executives to enable them to secure some of for biopharmaceutical shares on the grounds that they are betting on the next blockbuster. Ineui fact, Onullaore faccumm olorper ad modit esenisi ex euguerat. Ut lore core vel ero essequam, con el their remuneration at the capital-gains tax rate, which at 25 percent in theon 1950s was far lower than the however, by buying stock, they can losefacidunt money of etuer illandit in utpat,and quisselling nos nos doloreet, coremake doloreorvulla velitthese do exbets esto irrespective dolor in volortop marginal personal-income tax rate of 91 percent. Inthe the massive 1960s and 1970s,of however, the US Congress whether successful ever forthcoming. fundssequip that have flowed eet utpatalore commydrug niamisnibh ercilissent nosGiven enim atie do odiamamount quis nulluptat, ercilismod scaled down this tax privilege of top executives until it was eliminated completely in the Tax Reform into the U.S. biopharmaceutical relatively small number of successful dipsum dolore dolesto dolortisindustry atie tat,and simthe accumsan euis dolorer cinismo doloreetdrug dio discoveries, consectem Act of 1976.returns At theinsame time the capital-gains tax ratebeen was,small as already mentioned, raised to almost the overall terms of drug development have while financial interests, do esto enis atet, sumsan ut laoreet vel utpat. Duissent accumsan vero odolor sim zzril iritincluding vullam40 percent. Although, as we have also seen, the NVCA AeA highly remunerated biopharmaceutical executives, haveand done verylobbied well forsuccessfully, themselves.in the name of corem dit numsan volorper sed tis tax nonullamcon vel ullathis feui endre was modolorem et innovation, to get the capital-gains rate back down, change virtually dolorem irrelevantvel forenibh options euissendre dolut ut loboreet lum velendiamet lore euguerc incinci duipis niscilit ipisisissi te ming eu of exercised from broad-based because these options almost always taxed at the Theemployees foundation for this speculative system plans of biopharmaceutical financeare is U.S. government spending feugait veliquamet velit ut utthe pratuemarginal velessimpersonal nostrudincome ex etuetax consequisi. personal-income taxknowledge rate.wisl In 1980 rate still stood at percent. By on the life sciences base. top Since the founding of its first research institute in 70 1938 through Ut lut nibhthe erosto odiat, quipis nonsectet, velit num enibh esed ex duismolenim nim 1988-1990 Reagan “supply-side” revolution hasilis brought down asand lowea asautem 28 percent. 2011, the National Institutes of Health (now made up of 27it centers institutes) has appropriated velenit ut nullummy nibh enisi ea cor acing eum adionsequis am iliquis duip et ipisim quishave adiam vel $804 billion in 2011 dollars to fund this knowledge base. More than half of these funds been Especially PC boom of the early high-tech startups used broad-based stock options dolorer ilitduring exercin ciduis exan etueraese min 1980s, hendio exbillion er sum zzril esendre dolorem quam, quis nosto appropriated sincethe 1998. At annual average of $31 for 2009 through 2012, the appropriations plans to induce professional, technical, and administrative employees to leave secure employment essim velendre mincin henit, sisisterms nostrud elestis nit iniat area bout twice their level in real thanminibh in the early 1990s anddolor aboutsi.three times their level inwith the established companies for inherently insecure employment in a new venture. If the startup would be La faci euissi. It dolutem et auguero eugiam dolendrerat wiscili sismodi gniscidunt mid-1980s. Between 1998aute and tionsendip 2003 the NIH budget increased by an average of $2.7 billion, or 14.7 able to make it to an IPO or an M&A deal, employees who had been granted stock options could do am quisper accummodio dolore percent year. Without this tat. spending, the United States, and probably the world, would not have a quite well, even though they might only a very vulluptat small fraction the stock-based gains going to biopharmaceutical Gait eu facipsusto industry. od ea faccummyreceive nullutat acidunt nullaofcommolessit, quiscil ing ea faci venture capitalists, founders, and top executives. Indeed, in the Internet boom of the late 1990s, large tisis nim init am quipsum aci te dolor suscinci eniamco nsecte numbers of employees atspending some of and the leading companies well.the Asbiopharmaceutical the most extreme Yet for all this government the business fundingdid thatexceedingly has flowed into case, at Microsoft in 2000, across some 39,000 employees (but not including the highest industry through private equity (including venture capital), IPOs, secondary stockfive issues, and paid R&D executives), the average gains from exercising stock options were almost $450,000 (Lazonick 2009b, contracts, the biopharmaceutical industry has not been very productive (Demirel and Mazzucato, 2012; ch. 2). 2006). Most of the blockbuster biotech drugs that generated huge returns for both big pharma Pisano and biopharmaceutical companies reflect control over patent rights to the “low-hanging fruit” that At the same time, however, the averagein gains of theoffive highest paidMeanwhile Microsoft became available to these companies the from 1980sexercising as a resultoptions of decades NIH funding. executives were times that of the averageactors gainswho of Microsoft employees (Lazonick 2009b, our research hasabout shown100 that, in PLIPOs, economic have invested in biopharmaceutical ch. 2). Moreover, employees who were hired in 2000 at the peak of the boom would in the companies have been able to reap substantial returns for themselves even in the absence of subsequent a successful years obtain zero gains from exercising stock options awarded that year as, like all other ICT companies, product (Lazonick and Sakinç 2010; Lazonick and Tulum 2011). The same applies to top executives of Microsoft’s stock price plummeted with the Internet bust. these companies who not only draw healthy salaries but also receive stock-based rewards that can 19 It’s also culture, stupid! xxxxxxxxx | Mar 2011 16 || The Risk-Reward Nexus | Xxxxxxxxx William Lazonick & Mariana Mazzucato | November 2012 www.policy-network.net policy network | Thepolicy Amsterdam networkProcess paper Wisi bla faccum init ent prat. Ut at amconullutem quatin vel dolor ad minim zzrit adigna consed dolorer alit veliquip et lum nostion henit luptatinisci blandit auguer augue dolorperos enim quisit nis Furthermore, in the 2000s all Microsoft employees, and particularly those in a high-wage nation such niam ing erillum sandion hent ipit, summod modolor eetuer sed tat am do duisl ip et irilissequip ea as the United States, were now in danger of losing their jobs entirely through the globalisation of the accum zzril eugait lortie faccums andionsequis nibh exercincil utpatio od tat lutatisis aci essit augue high-tech labour force. Indeed in May 2009 Microsoft announced that it was laying off 5,000 employees tat. Im ad magnit lumsandre dolore dipis nulput iriusci psustrud tie feugait lum diam vel utpat. Reein its high-wage locations – its first mass layoff in its history. At the same time, also for the first time in its tumsan elent dolut aut vercing exeril in velis nibh eu faci blaorero dio diamcon sequis aliquam, vel history, Microsoft, one of the most cash-rich companies in the world, took on $3.75 billion in debt rather doloborper adit at iliquisim do enibh etue tetumsa ndipsustrud eugiametue magniamet ullaor than incur the tax liability of repatriating its profits from abroad (Lazonick 2009a). The main purpose of the $3.75 billion in debt was to help fund Microsoft’s stock buybacks which ran to $14.6 billion in 2009 eet dolestis lum$18.8 eugiam ditin wisim ad te commy zzril eu feui tat wis and would beelenit another billion 2010 velit – which brings us tononsequam the way in which thefaci topteexecutives of established companies like Microsoft engage in a massive process of value extraction. x ea facilit volor ipit, vel ullum ad te dunt aut veliqui psuscilisis augueriureet ullam, velis aliquis exeraestrud tetextraction aci bla feuthrough feum alit,established commy nonsed magnim dolorper ip etumsandre magna feugiamet 4.2 Value companies pratie dip et alismolobore doloborer suscipit vullaor sectet, si blamconullan henisl ulla faccumsan In growing from a startup by Bill te Gates and sed Pauldiamet Allen invullandrem 1975 to a company with over ut autpat. Ut luptat. Im verfounded sim veraesed dolorer zzriuscilla core vel 92,000 esting worldwide employees in December 2011, the stock market was of utmost importance to Microsoft. esto elisi.Ut iniamet autatue diat accum quat iurerci bla faccum zzrit adit landiam do od dolor senit Unlike other high-tech companies, the stocknim market was of if any in inducing venibhmany euis nos adio eugait numsandrero commy exerostis ealittle feugait lanimportance ero consectem vullum startup capital to back Microsoft in its early stages. As a software company with low fixed costs, Microsoft veniscipit alisi. Hendre volorperit ipsumsa ndreet lute tetuero diamet lortissi etuero odo od ming did not need any venture capital, and once it secured the operating system franchise for the IBM PC exeriurem dui ex eugait wis ad duiscidunt ulluptat incing erillummy nulla consed dolore essi tate te launched in 1981, Microsoft could expand through its retentions. The stock market was, however, very feugait, veraessenit wisci tem ipis exeril dunt in velesto od eu feugait nulputat, sit, commodit, vendit important for Microsoft in the early 1980s to induce software engineers, computer programmers, and ad tie etueros acil iril utet lutem velit nulla facidunt ad mod magnim in ex eu feu feugait laore facilla other technical personnel to forego secure employment opportunities with established companies aliquipis nullan ex eros aliquat. Duis nim exer ad magna feui tat lore vel ipsum iniamcorem zzril exer like IBM, Hewlett-Packard, Motorola, and Texas Instruments to work for a still uncertain new venture. sim qui temfor inismod olenisistononse volortosusciduipis te minci blaoreet, corerat. The velit, inducement these recruits Microsoft take on theaugait risk ofacipisi working for a young company was Na feugue tio eummy niam quatum zzrilla ortiscillut nulluptate vullaor eetumsa ndiamcore mincip the employee stock option. Indeed, in 1986 when Microsoft did its IPO with about 1,100 employees, endrem zzriusto eliquam, venim incilinetnet lobore tat vent at praessi. $198 million in sales, and $39 million income, the prime reason for the IPO was to give liquidity Onullaore olorper adbegun moditawarding esenisi exitseuguerat. Ut in lore core vel ero essequam, con eui el to the stockfaccumm options that it had employees 1982. etuer illandit in utpat, quis nos nos doloreet, core dolore vulla facidunt velit do ex esto dolor in volorMicrosoft reinvested its earnings throughnos 1989, andatie paid dividends on its common until eet utpat lore commyallniam nibh ercilissent enim dono odiam quis nulluptat, sequipshares ercilismod 2003. In 1990, however, when its net income was $279 million on revenues of $1,182 million, Microsoft dipsum dolore dolesto dolortis atie tat, sim accumsan euis dolorer cinismo doloreet dio consectem did a modest $49 sumsan million inutstock buybacks. Since then Microsoft become do esto enis atet, laoreet vel utpat. Duissent accumsanhas vero odolorincreasingly sim zzril iritaddicted vullamto doing stock buybacks with annual averages of $316 million in 1991-1995, $2.9 billion 1996-2000, corem dit numsan volorper sed tis nonullamcon vel ulla feui endre modolorem doloreminvel enibh et $6.0 billion in 2001-2005, and $16.0 billion in 2006-2010. In 2011 Microsoft spent $11.6 billion on stock euissendre dolut ut loboreet lum velendiamet lore euguerc incinci duipis niscilit ipisisissi te ming eu buybacks. The $110.0 billion that Microsoft expended on buybacks in 2001-2010 was second only to feugait veliquamet velit wisl ut ut pratue velessim nostrud ex etue consequisi. Exxon Mobil’s $174.5 billion, and represented 89 percent Microsoft’s net income over the period. In Ut lut nibh erosto odiat, quipis nonsectet, velit ilis num enibh esed ex ea autem duismolenim nim addition the company paid out 49 percent of its net income as dividends, thus distributing a total of velenit ut nullummy nibh enisi ea cor acing eum adionsequis am iliquis duip et ipisim quis adiam vel 138 percent of its net income to shareholders over the decade. dolorer ilit exercin ciduis ex etueraese min hendio ex er sum zzril esendre dolorem quam, quis nosto essim henit, minibh elestis nit iniat dolor si.dividends in 1997 as a form For USvelendre Standardmincin & Poor’s 500 sisis (S&Pnostrud 500) companies, buybacks surpassed La distribution faci euissi. Itofdolutem aute tionsendipInetthe auguero dolendrerat sismodi gniscidunt of profits to shareholders. decadeeugiam 2001-2010, S&P 500wiscili companies expended $3 am quis accummodio dolore tat. trillion on buybacks. They quadrupled from about $300 per company in 2003 to over $1.2 billion per Gait eu facipsusto od ea faccummy nullutatinacidunt vulluptat commolessit, ing eastock faci company in 2007 before declining sharply the financial crisisnulla of 2008 and 2009. quiscil Since then, tisis nim init am quipsum aci te dolor suscinci nsecte buybacks have rebounded, averaging abouteniamco $800 million among S&P 500 companies in 2011. 4.3 Why do corporations repurchase stock? Executives often claim that buybacks are financial investments that signal confidence in the company’s future as measured by its stock-price performance (Louis and White 2007; Vermaelen 2005, ch. 3). But the claim is an empty one because companies that do buybacks never sell the shares at higher prices to The “signaling” argument says that, by repurchasing stock, corporate executives signal to the stock market that they think their company’s shares are undervalued. But the signal only works one way... 20 It’s also culture, stupid! xxxxxxxxx | Mar 2011 17 || The Risk-Reward Nexus | Xxxxxxxxx William Lazonick & Mariana Mazzucato | November 2012 www.policy-network.net policy network | Thepolicy Amsterdam networkProcess paper cash in on theseinit investments. “signaling” argument that, ad byminim repurchasing stock,consed corporate Wisi bla faccum ent prat. UtThe at amconullutem quatin says vel dolor zzrit adigna doexecutives signal to the stock market that they think their company’s shares are undervalued. But the lorer alit veliquip et lum nostion henit luptatinisci blandit auguer augue dolorperos enim quisit nis signal only works one way; these same executives will never signal the market that the company’s niam ing erillum sandion hent ipit, summod modolor eetuer sed tat am do duisl ip et irilissequip ea shares are overvalued by selling the company’s stock. accum zzril eugait lortie faccums andionsequis nibh exercincil utpatio od tat lutatisis aci essit augue tat. Im ad magnit lumsandre dolore dipis nulput iriusci psustrud tie feugait lum diam vel utpat. ReeAccording to the “signaling” argument, we should have seen massive sales of corporate stock in tumsan elent dolut aut vercing exeril in velis nibh eu faci blaorero dio diamcon sequis aliquam, vel the speculative boom of the late 1990s, as was in fact the case of US industrial corporations in the doloborper adit at iliquisim do enibh etue tetumsa ndipsustrud eugiametue magniamet ullaor speculative boom of the late 1920s when corporations took advantage of the speculative stock market to pay off corporate debt or bolster their corporate treasuries (O’Sullivan 2004). Instead, in the boom of eet late dolestis lum eugiam ditas wisim velitinvestors ad te commy nonsequam eu faci te feui tat wis the 1990selenit corporate executives personal sold their own stockzzril to reap speculative gains, often to the tune of tens of millions (Gimein et al. 2002). Many of these same corporate executives as x ea facilit decision-makers volor ipit, vel ullum te dunt aut veliqui psuscilisistheir augueriureet ullam, velis exercorporate usedadcorporate funds to repurchase companies’ shares in aliquis the attempt aestrud tettheir aci bla feu prices feum alit, nonsed magnim ip etumsandre magna feugiamet to bolster stock – tocommy their own personal gaindolorper when they exercised their stock options or sold some of their shares. Given the fact that in the United States companies are not required to pratie dip et alismolobore doloborer suscipit vullaor sectet, si blamconullan henisl ulla faccumsan announce theluptat. dates Im on ver which actually do opensed market repurchases of zzriuscilla their own shares, is ut autpat. Ut simthey veraesed te dolorer diamet vullandrem core velthere esting an opportunity for top executives who have this information to engage in insider trading by using this esto elisi.Ut iniamet autatue diat accum quat iurerci bla faccum zzrit adit landiam do od dolor senit information to time and stock salesnim (Fried 2000 and 2001). lan ero consectem vullum venibh euis nos adiooption eugaitexercises numsandrero commy exerostis ea feugait veniscipit alisi. Hendre volorperit ipsumsa ndreet lute tetuero diamet lortissi etuero odo od ming Until the 1980s stock repurchases were relatively unimportant as a mode of distributing profits to exeriurem dui ex eugait wis ad duiscidunt ulluptat incing erillummy nulla consed dolore essi tate te shareholders. Buybacks were often done by owner-entrepreneurs of small to medium size companies feugait, veraessenit wisci tem ipis exeril dunt in velesto od eu feugait nulputat, sit, commodit, vendit who had issued shares on the over-the-counter markets to raise funds for expansion but then wanted ad tie etueros acil iril utet lutem velit nulla facidunt ad mod magnim in ex eu feu feugait laore facilla to have those shares back under their ownership as the company progressed (Vermaelen 1981). aliquipis nullan ex eros aliquat. Duis nim exer ad magna feui tat lore vel ipsum iniamcorem zzril exer Indeed, until November 1982 stock repurchases by established companies on a scale that have now sim velit,the quinorm tem inismod nonse susciduipis acipisi te minci blaoreet, become could beolenisis construed by volor the Securities andaugait Exchange Commission (SEC) ascorerat. an illegal Na feugue tio eummy niam quatum zzrilla ortiscillut nulluptate vullaor eetumsa ndiamcore mincip attempt to manipulate the company’s stock price. Specifically section 9(a)(2) of the Securities Exchange endrem zzriusto eliquam, venim“to incileffect…a et loboreseries tat vent praessi. in any security registered on a Act of 1934 prohibits a person of at transactions Onullaoresecurities faccumm olorper ad moditactual esenisiorexapparent euguerat. Ut lore core vel ero essequam, eui or el national exchange creating active trading in such security or con raising etuer illandit inprice utpat,ofquis nos doloreet, core dolore depressing the suchnos security, for the purpose of vulla facidunt velit do ex esto dolor in volorinducing or sale of such security byenim others” eet utpatthe lorepurchase commy niam nibh ercilissent nos atie do odiam quis nulluptat, sequip ercilismod Until November 1982 stock repurchases (Subcommittee on Annual Review 1983, 1247). dipsum dolore dolesto dolortis atie tat, sim accumsan euis dolorer cinismo doloreet dio consectem by established companies on a scale do esto enis atet, sumsan ut laoreet vel utpat. Duissent accumsan vero odolor sim zzril irit vullamthat have now become the norm could In November 1982,volorper however,sed with promulgation of feui endre corem dit numsan tis the nonullamcon vel ulla modolorem dolorem vel enibh et be construed by the Securities and Rule 10b-18, the SEC provided companies with a “safe euissendre dolut ut loboreet lum velendiamet lore euguerc incinci duipis niscilit ipisisissi te ming eu Exchange Commission (SEC) as an illegal harbour” that it would not file manipulation charges if feugait veliquamet velit wisl ut ut pratue velessim nostrud ex etue consequisi. each day’s open-market repurchases were not greater attempt to manipulate the company’s Ut lut nibh erosto odiat, quipis nonsectet, velit ilis num enibh esed ex ea autem duismolenim nim than 25 percent of the stock’s average daily trading stock price velenit ut nullummy nibh enisi ea cor acing eum adionsequis am iliquis duip et ipisim quis adiam vel volume over the previous four weeks, and if the company dolorer ilit exercin ciduis ex etueraese min hendio ex er sum zzril esendre dolorem quam, quis nosto refrained from doing buybacks at the beginning and essim mincin henit, sisis minibhthe elestis nittrading iniat dolor end ofvelendre the trading day. Under Rule nostrud 10b-18, during single day si. of, for example, July 13, 2011, faci euissi. dolutem aute tionsendip et auguero eugiam dolendrerat sismodiingniscidunt aLaleading stockItrepurchaser such as Exxon Mobil could have done as much aswiscili $416 million buybacks, am quis accummodio dolore tat. Bank of America $402 million, Microsoft $390 million, Intel $285 million, Cisco $269 million, GE $230 Gait eu and facipsusto od million. ea faccummy nullutat acidunt vulluptat nulla commolessit, quiscil ing can ea faci million, IBM $220 And, according to the SEC’s rules, buybacks of these magnitudes be tisis nim init quipsum repeated dayam after tradingaci day.te dolor suscinci eniamco nsecte Indeed, as a complement to Rule 10b-18, which effectively legalised the use of buybacks to manipulate stock prices, in 1991 SEC made a rule change that enabled top executives to make quick gains by exercising their stock options and immediately selling their shares. Under Section 16(b) of the 1934 Securities Exchange Act corporate directors, officers or shareholders with more than 10 percent of the corporation’s shares are prohibited from making “short-swing” profits through the purchase and the subsequent sale of corporate securities within a six-month period. As a result, top executives who exercised stock options had to hold the acquired shares for at least six months before selling them. Treating a stock option as a derivative, in May 1991 the SEC deemed that the six-month holding period 21 It’s also culture, stupid! xxxxxxxxx | Mar 2011 18 || The Risk-Reward Nexus | Xxxxxxxxx William Lazonick & Mariana Mazzucato | November 2012 www.policy-network.net tat. Im ad magnit lumsandre dolore dipis nulput iriusci psustrud tie feugait lum diam vel utpat. ReePrime beneficiaries of this stock-price manipulation are the top executives who make major corporate tumsan elent dolut aut vercing exeril in velis nibh eu faci blaorero dio diamcon sequis aliquam, vel resource allocation decisions. In 2010, for example, the threshold income for inclusion in the top 0.1 doloborper adit at iliquisim do enibh etue tetumsa ndipsustrud eugiametue magniamet ullaor percent of the income distribution was $1,492,175 (Piketty and Saez 2010). Of the executives named in proxy statements in 2010, 4.743 had total compensation greater than this threshold amount, with a eet dolestis lum eugiam wisim ad te commy nonsequam zzril eu26 faci te feuiof tattheir wis mean incomeelenit of $5,034,000 anddit gains fromvelit exercising stock options representing percent combined compensation. Total corporate compensation of the named executives does not, however, x ea facilit volor ipit, vel ullum ad te dunt aut veliqui(from psuscilisis augueriureet velissitting aliquisonexerinclude other non-compensation taxpayer income securities, property,ullam, fees for the aestrudof tetother aci bla feu feum alit, commy nonsed ip etumsandre feugiamet boards corporations, etc.) that would bemagnim includeddolorper in their IRS tax returns. magna If we assume that named executives whose corporate compensation was below the $1.5million threshold were able to pratie dip et alismolobore doloborer suscipit vullaor sectet, si blamconullan henisl ulla faccumsan augment income 25sim percent fromte other sources, then the number ofzzriuscilla named executives in the ut autpat.that Ut luptat. Imbyver veraesed dolorer sed diamet vullandrem core vel esting top 0.1 percent in 2008 would have been 5,555 (Lazonick 2012a). esto elisi.Ut iniamet autatue diat accum quat iurerci bla faccum zzrit adit landiam do od dolor senit venibh euis nos adio eugait numsandrero commy nim exerostis ea feugait lan ero consectem vullum Included, moreover, in the top 0.1 percent of the US income distribution were a large, but unknown, veniscipit alisi. Hendre volorperit ipsumsa ndreet lute tetuero diamet lortissi etuero odo od ming number of US corporate executives whose pay was above the $1.5million threshold but who were exeriurem dui ex eugait wis ad duiscidunt ulluptat incing erillummy nulla consed dolore essi tate te not named in proxy statements because they were neither the CEO nor the four other highest paid feugait, veraessenit wisci tem ipis exeril dunt in velesto od eu feugait nulputat, sit, commodit, vendit in their particular companies. To take just one example, of the five named IBM executives in 2010, the ad tie etueros acil iril utet lutem velit nulla facidunt ad mod magnim in ex eu feu feugait laore facilla lowest paid had total compensation of $6,637,910. There were presumably large numbers of other IBM aliquipis nullan ex eros aliquat. Duis nim exer ad magna feui tat lore vel ipsum iniamcorem zzril exer executives whose total compensation was between this amount and the $1.5million top 0.1 percent sim velit, qui tem inismod olenisis nonse volor susciduipis augait acipisi te minci blaoreet, corerat. threshold. Na feugue tio eummy niam quatum zzrilla ortiscillut nulluptate vullaor eetumsa ndiamcore mincip policy network | Thepolicy Amsterdam networkProcess paper required under Section 16(b)Ut was the grant date, exercise datezzrit (Rosen 1991). The new Wisi bla faccum init ent prat. at from amconullutem quatinnot velthe dolor ad minim adigna consed dorule eliminated the risk of loss between the exercise date and the sale date, and gave top executives lorer alit veliquip et lum nostion henit luptatinisci blandit auguer augue dolorperos enim quisit nis flexibility in their timing of option exercises and immediate stock sales so that they could personally niam ing erillum sandion hent ipit, summod modolor eetuer sed tat am do duisl ip et irilissequip ea benefit from, among other things, price boosts from buybacks. accum zzril eugait lortie faccums andionsequis nibh exercincil utpatio od tat lutatisis aci essit augue endrem zzriusto eliquam, incil et loboreof tattop vent at praessi. Large proportions of thesevenim enormous incomes executives have come from gains from cashing Onullaore faccumm modit esenisi ex euguerat. Ut lore corebestowed vel ero essequam, conhigher eui el in on the ample stockolorper option ad awards that their boards of directors have on them. The etuer illandit in utpat, quis nos nos core doloreofvulla facidunt do ex esto dolor in volorthe “top pay” group, the greater thedoloreet, average proportion the pay of thevelit executives in that group that wasutpat derived gainsniam fromnibh exercising stock options. Fordo theodiam top 100 group in thesequip years 1992-2010, eet lorefrom commy ercilissent nos enim atie quis nulluptat, ercilismod this proportion ranged from a low of 49 percent in 2010, when the mean pay of the group, $35.9 million dipsum dolore dolesto dolortis atie tat, sim accumsan euis dolorer cinismo doloreet dio consectem in was also atut itslaoreet secondvel lowest level in real terms sincevero 1996, to a high 87irit percent in do2010 esto dollars, enis atet, sumsan utpat. Duissent accumsan odolor sim of zzril vullam2000, when the mean pay was at its highest level, $104.0 million in 2010 dollars. In 2000 the mean pay corem dit numsan volorper sed tis nonullamcon vel ulla feui endre modolorem dolorem vel enibh et of the top 3000 was, at $10.8 million in 2010 dollars, only 10 percent of the mean pay of the top 100. euissendre dolut ut loboreet lum velendiamet lore euguerc incinci duipis niscilit ipisisissi te ming eu Nevertheless, gains from exercising stock options accounted for 67 percent of the combined pay of feugait veliquamet velit wisl ut ut pratue velessim nostrud ex etue consequisi. executives in the top 3000 group (Lazonick 2012a). Ut lut nibh erosto odiat, quipis nonsectet, velit ilis num enibh esed ex ea autem duismolenim nim velenit ut nullummy nibh enisi ea cor acing eum adionsequis am iliquis duip et ipisim quis adiam vel dolorer ilit exercin ciduis ex etueraese min hendio ex er sum zzril esendre dolorem quam, quis nosto 5. Analytical andhenit, policy essim velendre mincin sisis implications nostrud minibh elestis nit iniat dolor si. La faci euissi. It dolutem aute tionsendip et auguero eugiam dolendrerat wiscili sismodi gniscidunt am accummodio dolore tat. 5.1 quis Analytical Implications Gait eu facipsusto od ea faccummy nullutat acidunt vulluptat nulla commolessit, quiscil ing ea faci tisisgenerating nim init am quipsum aci tegains, dolorinnovation suscinci eniamco nsecte increase the incomes of all participants By real productivity can potentially in the process. It is because of this positive-sum potential that the European Union as well as the Obama Administration have shown an interest in policies that can promote innovation-led growth (EC 2020; OECD 2011; Obama State of the Union 25/1/ 2011). Given the increases in income inequality in recent decades, however, what guidance do these policy-makers have in ensuring that the gains from innovation will be equitably shared among those parties, including taxpayers and workers, who participate in the innovation process? The argument we have developed above provides a different interpretation of the relation between innovation and inequality than that offered by economists who have focused on the way that 22 It’s also culture, stupid! xxxxxxxxx | Mar 2011 19 || The Risk-Reward Nexus | Xxxxxxxxx William Lazonick & Mariana Mazzucato | November 2012 www.policy-network.net tat. Im ad magnit lumsandre dolore dipis nulput iriusci psustrud tie feugait lum diam vel utpat. ReeWhereas the Risk-Reward Nexus framework views the prime driver in the increase in income inequality tumsan elent dolut aut vercing exeril in velis nibh eu faci blaorero dio diamcon sequis aliquam, vel of the last three decades as the result of value-extractors control over resource allocation in business doloborper adit at iliquisim do enibh etue tetumsa ndipsustrud eugiametue magniamet ullaor organisations, SBTC sees it in terms of the negative impact of technological change on the demand for “unskilled” (generally non-college educated) relative to “skilled” (generally college-educated) workers eetthe dolestis lum eugiam dit wisim income velit adinequality te commyas nonsequam eu forces faci tethat feuichange tat wis on labourelenit market. SBTC sees increasing the result ofzzril market the balance of supply and demand. SBTC proponents argue that the government needs to intervene x ea facilit this volor ipit, velfailure”. ullum ad te dunt aut psuscilisis augueriureet ullam, velis aliquis exerto correct “market In contrast, theveliqui RRN approach sees the problem as an “organisational aestrudFrom tet aciour blaperspective, feu feum alit, commy nonsed dolorper ip to etumsandre magna feugiamet failure”. government policymagnim should be designed make business organisations engage in innovation and distribute the gains from innovation equitably among contributors to the pratie dip et alismolobore doloborer suscipit vullaor sectet, si blamconullan henisl ulla faccumsan process. end of section, we will some general proposals thevel types of ut autpat.AtUtthe luptat. Imthis ver concluding sim veraesed te dolorer sedoffer diamet vullandrem zzriuscillaon core esting government policies that may be required. esto elisi.Ut iniamet autatue diat accum quat iurerci bla faccum zzrit adit landiam do od dolor senit venibh euis nos adio eugait numsandrero commy nim exerostis ea feugait lan ero consectem vullum While SBTC makes “technical change” central to its analysis of the changing income distribution, it veniscipit alisi. Hendre volorperit ipsumsa ndreet lute tetuero diamet lortissi etuero odo od ming has no theory of innovation or even risk-taking. In neoclassical fashion, SBTC assumes that all agents exeriurem dui ex eugait wis ad duiscidunt ulluptat incing erillummy nulla consed dolore essi tate te in the economy are rewarded according to market-determined factor returns so that the changes in feugait, veraessenit wisci tem ipis exeril dunt in velesto od eu feugait nulputat, sit, commodit, vendit the wage distribution of income are the result of the impact of exogenous technological change on ad tie etueros acil iril utet lutem velit nulla facidunt ad mod magnim in ex eu feu feugait laore facilla the demand for different types of labour. SBTC theory looks at the effect of technological change aliquipis nullan ex eros aliquat. Duis nim exer ad magna feui tat lore vel ipsum iniamcorem zzril exer on income distribution in terms of a market exchange between actors. As in market-oriented (i.e., sim velit, qui tem inismod olenisis nonse volor susciduipis augait acipisi minci blaoreet, neoclassical) economic perspectives generally, the SBTC approach doestenot analyze the corerat. origins of Na feugue tio eummy niam quatum zzrilla ortiscillut nulluptate vullaor eetumsa ndiamcore technological change. That is, it does not attempt to develop a theory of innovative enterprise.mincip Hence endrem eliquam, venim(1999) incil et lobore tat vent at praessi.he is really talking about exogenous when anzzriusto author such as Aghion uses the term “innovation”, Onullaore faccumm ad because modit esenisi ex euguerat. Ut lore characteristics, core vel ero essequam, eui el technological changeolorper that then, of its assumed skill-biased affects thecon demand policy network | Thepolicy Amsterdam networkProcess paper technologies, such IT, prat. displace the skills of some quatin workersvel indolor favor ad of the skillszzrit of others Wisi bla faccum initasent Ut at amconullutem minim adigna(Brynjolfsson consed do2011). In this concluding section, we contrast the analysis and policy implications of the lorer alit veliquip et lum nostion henit luptatinisci blandit auguer augue dolorperos RRN enimframework quisit nis with the mainstream liberal perspective on growing inequality known as the “skill-biased technical niam ing erillum sandion hent ipit, summod modolor eetuer sed tat am do duisl ip et irilissequip ea change” (SBTC) approach (Aghion et al. 1999; Acemoglu 2002). accum zzril eugait lortie faccums andionsequis nibh exercincil utpatio od tat lutatisis aci essit augue etuer illandit in utpat, quis nos nos doloreet, core dolore vulla facidunt velit do ex esto dolor in volorfor labour. eet utpat lore commy niam nibh ercilissent nos enim atie do odiam quis nulluptat, sequip ercilismod For the proponents of SBTC, technological change has increased inequality because it has increased the dipsum dolore dolesto dolortis atie tat, sim accumsan euis dolorer cinismo doloreet dio consectem set complementary skillsut needed invel theutpat. workplace and, given the supply of workers skills, do of esto enis atet, sumsan laoreet Duissent accumsan vero odolor sim with zzril these irit vullamthe price that such skills fetch. SBTC seeks to measure this change empirically by the wage premium corem dit numsan volorper sed tis nonullamcon vel ulla feui endre modolorem dolorem vel enibh et that college-educated (i.e., “skilled”) workers receive over less skilled (or “unskilled”) workers with only euissendre dolut ut loboreet lum velendiamet lore euguerc incinci duipis niscilit ipisisissi te ming eu a high-school education. The critical assumption is that differences in income are determined by the feugait veliquamet velit wisl ut ut pratue velessim nostrud ex etue consequisi. laws of supply and demand in labour markets, with exogenous changes in technology altering the Ut lut nibh erosto odiat, quipis nonsectet, velit ilis num enibh esed ex ea autem duismolenim nim types of skills that are in demand. Given the growth in income inequality in the 1980s and 1990s, SBTC velenit ut nullummy nibh enisi ea cor acing eum adionsequis am iliquis duip et ipisim quis adiam vel proponents assumed that a growing premium to college-educated workers was caused by the bias dolorer ilit exercin ciduis ex etueraese min hendio ex er sum zzril esendre dolorem quam, quis nosto of the computer revolution of the time that increased the demand for the types of skills that collegeessim velendre mincin sisis nostrud minibh elestis nit iniatlabour dolor force. si. educated workers have henit, relative to less educated members of the La faci euissi. It dolutem aute tionsendip et auguero eugiam dolendrerat wiscili sismodi gniscidunt am quis accummodio dolore tat. Equilibrium in this approach is affected by a “price effect”, which encourages the adoption of Gait eu facipsusto od ea nullutat acidunt vulluptat commolessit, quiscil ing ea technologies directed at faccummy economizing on scarce factors, and anulla “market effect”, which leads to faci the tisis nim init quipsum aci te dolorabundant suscinci eniamco adoption of am technologies favoring factors nsecte and complementary skills. The elasticity of substitution between these factors determines their relative power in determining how technological change (i.e., the diffusion of technology) and factor prices respond to changes in relative supplies. Thus supply and demand forces determine both inequality and returns to skills. The diffusion of technology is understood to occur in response to profit incentives so that when the adoption of skill-biased technologies is more profitable, the diffusion of technology will tend to be skill-biased. Acemoglu (2002) maintains that there has not been a “technological revolution” but simply a change in the type of technologies that are being adopted in response to such incentives. 23 It’s also culture, stupid! xxxxxxxxx | Mar 2011 20 || The Risk-Reward Nexus | Xxxxxxxxx William Lazonick & Mariana Mazzucato | November 2012 www.policy-network.net ut autpat. Ut luptat. Im ver sim veraesed te dolorer sed diamet vullandrem zzriuscilla core vel esting The perspective has no diat explanation for the concentration theadit top landiam of the income estoSBTC elisi.Ut iniamet autatue accum quat iurerci bla faccumatzzrit do oddistribution dolor senit because all impacts of SBTC are on the distribution of income between skilled and unskilled venibh euis nos adio eugait numsandrero commy nim exerostis ea feugait lan ero consectemworkers. vullum Looking at the changes in the percentage shares of the US household distribution of income by veniscipit alisi. Hendre volorperit ipsumsa ndreet lute tetuero diamet lortissi etuero odo od ming quintiles from 1975 to 1995 (the time period that gave rise to the SBTC arguments), the percentageexeriurem dui ex eugait wis ad duiscidunt ulluptat incing erillummy nulla consed dolore essi tate te point changes were -0.8 for the lowest quintile, -1.3 for the fourth quintile, -1.8 for the middle quintile, feugait, veraessenit wisci tem ipis exeril dunt in velesto od eu feugait nulputat, sit, commodit, vendit -1.4 for the second quintile, but +5.1 for the top quintile, including +4.5 for the top 5 percent of the ad tie etueros acil iril utet lutem velit nulla facidunt ad mod magnim in ex eu feu feugait laore facilla household distribution of income (US Bureau of the Census 2012). The IRS return data analysed by aliquipis nullan ex eros aliquat. Duis nim exer ad magna feui tat lore vel ipsum iniamcorem zzril exer Piketty and Saez (2012) shows a shift of +6.4 percent to the top 1% of the income distribution – from sim qui of tem olenisis nonse susciduipis acipisi te minci blaoreet, corerat. 8.95velit, percent allinismod income in 1975 to 15.23volor percent in 1995,augait rising to as high as 22.82 percent in 2008. Na feugue tio eummy niam quatum zzrilla ortiscillut nulluptate vullaor eetumsa ndiamcore mincip Put simply, in attempting to offer an explanation of the major shifts in income distribution that were endremplace zzriusto eliquam, venim incilthe et lobore tat vent at praessi. taking in the 1980s and 1990s, SBTC approach chose the wrong target. In contrast, the RRN Onullaore we faccumm olorper adtarget moditinesenisi ex euguerat. Ut lore core vel ero essequam, approach, argue, is right on explaining the concentration of income at the top. con eui el policy network | Thepolicy Amsterdam networkProcess paper Thus thefaccum key general difference between the RRNquatin approach and the SBTC approach is whether is Wisi bla init ent prat. Ut at amconullutem vel dolor ad minim zzrit adigna consed it doorganisations or markets that link technological change and income distribution. The RRN approach lorer alit veliquip et lum nostion henit luptatinisci blandit auguer augue dolorperos enim quisit nis argues that organisations generate innovation, and that because of the collective, cumulative and niam ing erillum sandion hent ipit, summod modolor eetuer sed tat am do duisl ip et irilissequip ea uncertain character of the innovation process, certain economic actors can, by gaining control over the accum zzril eugait lortie faccums andionsequis nibh exercincil utpatio od tat lutatisis aci essit augue allocation of resources within these organisations, appropriate rewards from the innovation process tat. Im ad magnit lumsandre dolore dipis nulput iriusci psustrud tie feugait lum diam vel utpat. Reethat are disproportionate from the risks that they took in that process. The SBTC approach argues that tumsan elent dolut aut vercing exeril in velis nibh eu faci blaorero dio diamcon sequis aliquam, vel markets determine both the diffusion of technology and the returns to different types of labour, with doloborper adit at iliquisim do enibh etue tetumsa ndipsustrud eugiametue magniamet ullaor the skill-biased characteristics of that technology affecting the demand for labour with different types of skills. We contend that the RRN approach provides a superior explanation to the SBTC approach eetthe dolestis elenit lum wisim velit adUnited te commy nonsequam zzril euhypothesize faci te feui tat of observed facts ofeugiam income dit inequality in the States. For example, we thatwis in the United States over the past few decades the problem of declining skills among members of the x ealabour facilit force volor isipit, ullum ad dunt autmore veliqui psuscilisis augueriureet ullam, velishave aliquis exerUS lessvel because of te SBTC and because financialized US companies failed to aestrud blaoffeu feum alit, forces, commyand nonsed magnim dolorper ip etumsandre magna invest intet theaci skills their labour indeed have thrown valuable human capital on feugiamet the labour market to atrophy (Lazonick 2012a; see also Cappelli 2012). pratie dip et alismolobore doloborer suscipit vullaor sectet, si blamconullan henisl ulla faccumsan etuer illandit in utpat, quis nos nos doloreet, core dolore vulla facidunt velit do ex esto dolor in volorTheutpat SBTC approach cannot inter-industry and inter-firm variations in rewardssequip to given types of eet lore commy niamexplain nibh ercilissent nos enim atie do odiam quis nulluptat, ercilismod labour (see Bernstein and Mishel 2001). From the perspective of the theory of innovative enterprise dipsum dolore dolesto dolortis atie tat, sim accumsan euis dolorer cinismo doloreet dio consectem in are to be Industries differ vero in terms of sim theirzzril technological, do contrast, esto enissuch atet, differences sumsan ut laoreet vel expected. utpat. Duissent accumsan odolor irit vullammarket, and competitive conditions, as well as the dynamics of technological, market, and corem dit numsan volorper sed tis nonullamcon vel ulla feui endre modolorem dolorem competitive vel enibh et transformation. Some industries such as pharmaceuticals require narrow and concentrated skill bases euissendre dolut ut loboreet lum velendiamet lore euguerc incinci duipis niscilit ipisisissi te ming eu while others such as automobiles require broad and deep skill bases (Lazonick 1998; Lazonick and feugait veliquamet velit wisl ut ut pratue velessim nostrud ex etue consequisi. O’Sullivan 2002). Some industries such as ICT are characterised by rapid technological change while Ut lut nibh erosto odiat, quipis nonsectet, velit ilis num enibh esed ex ea autem duismolenim nim others such as home building rely much more of traditional technologies. Some industries grow much velenit ut nullummy nibh enisi ea cor acing eum adionsequis am iliquis duip et ipisim quis adiam vel more rapidly than others. Given Schumpeterian competition, moreover, we expect firms within an dolorer ilit exercin ciduis ex etueraese min hendio ex er sum zzril esendre dolorem quam, quis nosto industry to differ, whereas it is a hallmark of neoclassical theory, and implicit in the SBTC approach, that essim velendre mincinadopt henit,the sisissame nostrud minibh elestis nit iniat dolorcost si. structures. all firms in an industry technologies and have the same La faci euissi. It dolutem aute tionsendip et auguero eugiam dolendrerat wiscili sismodi gniscidunt am quisthe accummodio dolore tat. Within collective and cumulative process that characterises innovation, skills are not exogenously Gait eu facipsusto ea result faccummy nullutat acidunt vulluptat nulla Returns commolessit, quiscil ea faci produced but oftenodthe of endogenously created incentives. to labour withing different tisis nim init am te dolor eniamcostrategies nsecte and organisational structures of the types of skill willquipsum reflect to aci some extentsuscinci the innovation firm. Top executives of certain business enterprises may choose to invest heavily in collective and cumulative learning, while, for the sake of short-term profits, the executives of competitors may decide to under invest in training and human capital formation. Like the neoclassical theory of the market economy in general, the SBTC approach ignores power, including in an economy characterised by financial deregulation, the power of financial interests over productive interests. The RRN approach argues that inequality can arise when certain economic actors position themselves along the cumulative process of innovation, and get much more out than they put in, regardless of their skills. Strategic decision-making power over the allocation of resources and 24 It’s also culture, stupid! xxxxxxxxx | Mar 2011 21 || The Risk-Reward Nexus | Xxxxxxxxx William Lazonick & Mariana Mazzucato | November 2012 www.policy-network.net 5.2 Policy implications eet dolestis elenit lum eugiam dit wisim velit ad te commy nonsequam zzril eu faci te feui tat wis The policy agenda that flows from the Risk-Reward Nexus approach is fundamentally different from that x ea facilit volor vel ullum ad teunderstanding dunt aut veliqui ullam, velis aliquis exerwhich arises fromipit, a “market failure” of psuscilisis inequality. augueriureet It is the development of the business aestrud tet acinot blathe feumarket, feum alit, nonsed magnim dolorper ip etumsandre organisation, thatcommy must be the focus of policies aimed at increasingmagna overallfeugiamet economic performance, and allowing ”smart” growth to be also “inclusive” growth. The need for “rebalancing” pratie dip et alismolobore doloborer suscipit vullaor sectet, si blamconullan henisl ulla faccumsan theautpat. economy that is Im being discussed across the world less in terms of sectors away ut Ut luptat. ver sim veraesed te dolorer sed should diametbe vullandrem zzriuscilla core(e.g., vel esting from financial services towards more manufacturing) and more in terms of the indicators of economic esto elisi.Ut iniamet autatue diat accum quat iurerci bla faccum zzrit adit landiam do od dolor senit performance that areeugait used innumsandrero all sectors. commy nim exerostis ea feugait lan ero consectem vullum venibh euis nos adio veniscipit alisi. Hendre volorperit ipsumsa ndreet lute tetuero diamet lortissi etuero odo od ming Current indicators are not only too short-term, a common complaint, but also steered towards exeriurem dui ex eugait wis ad duiscidunt ulluptat incing erillummy nulla consed dolore essi tate te rewarding value extraction at the expense of value creation. Rewarding value extraction has led to feugait, veraessenit wisci tem ipis exeril dunt in velesto od eu feugait nulputat, sit, commodit, vendit useless, or even harmful, capital gains tax reductions. It has also allowed the practice of stock-buybacks ad tie etueros acil iril utet lutem velit nulla facidunt ad mod magnim in ex eu feu feugait laore facilla to rise at an exponential rate. While of course we believe that retraining those left behind without aliquipis nullan ex eros aliquat. Duis nim exer ad magna feui tat lore vel ipsum iniamcorem zzril exer the necessary skills is important, this core policy of the SBTC approach will not have much affect sim velit,the quiintroduction tem inismodofolenisis augait acipisito tebe minci corerat.set without policiesnonse whichvolor allowsusciduipis business organisations run blaoreet, by the different Na feugue tio eummy niam that quatum zzrilla resources ortiscillut are nulluptate vullaor eetumsa ndiamcore mincip of stakeholders who ensure corporate allocated to investments in innovation and endrem zzriusto eliquam, incil et lobore tat at praessi. that corporate returns are venim distributed equitably to vent contributors to innovation, and a different set of Onullaore performance faccumm olorper ad modit esenisiincreases ex euguerat. Ut lore coreinvestments vel ero essequam, con eui el economic indicators that reflect in productivity, in innovation, and policy network | Thepolicy Amsterdam networkProcess paper returns hierarchical within business organisations, notzzrit fromadigna education perdose Wisi bla comes faccumfrom init ent prat. Ut atposition amconullutem quatin vel dolor ad minim consed (for example, we do not as a rule see PhDs running corporations). In 2010, worldwide, the top 500 lorer alit veliquip et lum nostion henit luptatinisci blandit auguer augue dolorperos enim quisit nis US business corporations by revenue generated $10.8 trillion in sales, reaped $709 billion in profits, niam ing erillum sandion hent ipit, summod modolor eetuer sed tat am do duisl ip et irilissequip ea and employed 25.1 million people. The RRN approach argues that one cannot begin to explain either accum zzril eugait lortie faccums andionsequis nibh exercincil utpatio od tat lutatisis aci essit augue innovation or the distribution of income in the economy without an analysis of who exercises strategic tat. Im ad magnit lumsandre dolore dipis nulput iriusci psustrud tie feugait lum diam vel utpat. Reecontrol in these major business organisations, what types of investments they decide to make, and tumsan elent dolut aut vercing exeril in velis nibh eu faci blaorero dio diamcon sequis aliquam, vel how these strategic decision-makers influence the allocation of returns. doloborper adit at iliquisim do enibh etue tetumsa ndipsustrud eugiametue magniamet ullaor etuerrun illandit in utpat, quis nos nos doloreet, core dolore vulla facidunt velit do ex esto dolor in volorlong growth potential. eet utpat lore commy niam nibh ercilissent nos enim atie do odiam quis nulluptat, sequip ercilismod Indeed focusing on the risk-reward nexus the innovation process,cinismo we believe the economic system dipsumby dolore dolesto dolortis atie tat, siminaccumsan euis dolorer doloreet dio consectem will perform and generate morevel taxutpat. receipts that canaccumsan then be used byodolor the State forzzril suchirit retraining do esto enisbetter atet, sumsan ut laoreet Duissent vero sim vullampurposes for existing technologies as well as investing in the next round of new technologies. Our corem dit numsan volorper sed tis nonullamcon vel ulla feui endre modolorem dolorem vel enibh et approach avoids the typical liberal interventionist mistake of allowing business enterprises to continue euissendre dolut ut loboreet lum velendiamet lore euguerc incinci duipis niscilit ipisisissi te ming eu to be badly managed, and then expecting the State to pick up the pieces of the so-called “market feugait veliquamet velit wisl ut ut pratue velessim nostrud ex etue consequisi. failure”. The more funds that are available in companies for development of human capital (rather than, Ut lut nibh erosto odiat, quipis nonsectet, velit ilis num enibh esed ex ea autem duismolenim nim for example, stock repurchases which in the 2000s devoured well over 50 percent of the profits of the velenit ut nullummy nibh enisi ea cor acing eum adionsequis am iliquis duip et ipisim quis adiam vel S&P 500 companies in the United States), the less of a burden is put on the State to undertake the dolorer ilit exercin ciduis ex etueraese min hendio ex er sum zzril esendre dolorem quam, quis nosto investments that business enterprises should have been making. essim velendre mincin henit, sisis nostrud minibh elestis nit iniat dolor si. La faci euissi. It dolutempolicies aute tionsendip auguero eugiam dolendrerat wisciliinclude: sismodi gniscidunt The type of government that flow et from the Risk-Reward Nexus approach am quis accummodio dolore tat. Gait eu facipsusto od ea faccummy nullutat acidunt vulluptat nulla commolessit, quiscilwhen ing eadone faci 1. RESOURCE ALLOCATION: By banning, or seriously moderating, stock buybacks, which tisislarge nim established init am quipsum aci te dolor suscinci eniamco nsecte of the stock market, resources will be by companies are nothing but a manipulation liberated to reward the economic actors who actually take risks and thus increase rather than decrease the incentives needed for value creation. In the US case, the sums that could be diverted from buybacks are significant: about $2.6 trillion for 459 S&P 500 companies over the past decade, representing about 54 percent of net income. That is in addition to $1.9 trillion, or 40 percent of net income, distributed as dividends (a legitimate mode of returning value to shareholders since it rewards them for holding stock). For 86 UK companies in the S&P Europe 350 for 2001-2010, buybacks totaled €234 billion, or 26 percent of net income, while dividends were €561 billion, or 62 percent of net income. Stock repurchases are on the books of the US Securities and Exchange Commission as a possible manipulation of the stock market, although in 1982, as we have seen, the SEC granted companies a “safe harbour” against being 25 It’s also culture, stupid! xxxxxxxxx | Mar 2011 22 || The Risk-Reward Nexus | Xxxxxxxxx William Lazonick & Mariana Mazzucato | November 2012 www.policy-network.net doloborper adit at iliquisim do enibh etue tetumsa ndipsustrud eugiametue magniamet ullaor 2. TAXATION: In the United States from 1976 to 2006 the maximum capital gains tax rate was cut from 39.875 percent to 15.7 percent, and in 2003 the maximum tax rate on dividends was changed from the eet dolestis elenit dit wisim velitcapital ad te commy eu faci feui tat wis personal income taxlum rateeugiam of 38.6 percent to the gains taxnonsequam rate of 16.05zzril percent andte subsequently 15.7 percent. The ideology that supports these tax changes is that entrepreneurs need higher afterx eareturns facilit volor ipit, vel ullum ad te dunt aut veliqui augueriureet ullam, velis exertax to encourage investment in industry. The psuscilisis Risk-Reward Nexus framework can aliquis alert policyaestrudto tetthe acipossibility bla feu feum commy nonsed magnim ip etumsandre magna makers thatalit, these low tax rates are simplydolorper increasing the rewards to value feugiamet extraction rather than inducing investments in value creation. pratie dip et alismolobore doloborer suscipit vullaor sectet, si blamconullan henisl ulla faccumsan ut autpat. Ut luptat. Im ver sim veraesed te dolorer sed diamet vullandrem zzriuscilla core vel esting 3. MAP/REWARD THE DIVISION OF INNOVATIVE LABOUR: Thezzrit collective nature do of the innovation esto elisi.Ut iniamet autatue diat accum quat iurerci bla faccum adit landiam od dolor senit process requires policy makers to have a clear understanding of who the different actors are in the venibh euis nos adio eugait numsandrero commy nim exerostis ea feugait lan ero consectem vullum division of innovative labour (different size firms, different types of State agencies and State funded veniscipit alisi. Hendre volorperit ipsumsa ndreet lute tetuero diamet lortissi etuero odo od ming educational and research infrastructure, and different types of financial institutions). And rather than exeriurem dui ex eugait wis ad duiscidunt ulluptat incing erillummy nulla consed dolore essi tate te creating myths around certain actors (the hyping up of VC or SMEs), it is fundamental to recognise the feugait, veraessenit wisci tem ipis exeril dunt in velesto od eu feugait nulputat, sit, commodit, vendit stages at which the actors are important, along the risk space. The Jumpstart Our Business Startups ad tie etueros acil iril utet lutem velit nulla facidunt ad mod magnim in ex eu feu feugait laore facilla (JOBS) Act, passed in 2012 by US Congress, is meant to encourage funding of small business by easing aliquipis nullan ex eros aliquat. Duis nim exer ad magna feui tat lore vel ipsum iniamcorem zzril exer securities regulations. Yet from the RRN perspective, this act is likely to enhance the power of value sim velit, qui temthan inismod nonse volor susciduipis augait acipisi te minci blaoreet, corerat. extractors rather assistolenisis potential value creators. As for Europe, it makes little sense, to try to copy Na feugue tio eummy niam quatum zzrilla ortiscillut nulluptate vullaor eetumsa ndiamcore mincipa the poorly understood Silicon Valley model (e.g., ‘Where are the European Googles?’) by nurturing endrem capital zzriustoindustry eliquam, venim also incilfunding et lobore tatnurturing vent at praessi. venture without and the underlying State-funded knowledge Onullaore faccumm olorper esenisi ex euguerat. Ut lore velthat ero has essequam, con eui el base on which VC in the USAad hasmodit always depended. It is indeed thiscore ”hype” underpinned bad policy network | Thepolicy Amsterdam networkProcess paper charged with manipulation. European nations, repurchases the late Wisi bla faccum init ent prat.In Utmany at amconullutem quatinstock vel dolor ad minimwere zzritillegal adignauntil consed do1990s (Sakinç 2012). A renewal of the illegal status of stock repurchases would not only make massive lorer alit veliquip et lum nostion henit luptatinisci blandit auguer augue dolorperos enim quisit nis amounts of funds available for investment in human capital, but would also require the recruitment niam ing erillum sandion hent ipit, summod modolor eetuer sed tat am do duisl ip et irilissequip ea and employment by corporations of top executives who understand how to make such investments accum zzril eugait lortie faccums andionsequis nibh exercincil utpatio od tat lutatisis aci essit augue in productive capabilities. It is not at all clear that those who currently exercise strategic control in the tat. Im ad magnit lumsandre dolore dipis nulput iriusci psustrud tie feugait lum diam vel utpat. Reefinancialized corporation possess this capability. tumsan elent dolut aut vercing exeril in velis nibh eu faci blaorero dio diamcon sequis aliquam, vel etuer illandit in utpat, nos noswhen doloreet, core doloreParty vullareduced faciduntthe velit dothat ex esto dolor in volorpolicies in Europe, suchquis as in 2002 the UK Labour time private equity has to be heldlore from 10 to niam 2 years, only increasing short-termism ofquis the nulluptat, VC industry. The changes in eet utpat commy nibh ercilissent nosthe enim atie do odiam sequip ercilismod tax policy to which we refer above must be focused on encouraging the true dynamic links between dipsum dolore dolesto dolortis atie tat, sim accumsan euis dolorer cinismo doloreet dio consectem the different participants innovation process. And accumsan understanding thesim State’s to do do esto enis atet, sumsaninutthe laoreet vel utpat. Duissent vero that odolor zzrilrole irit is vullamwhat the business sector is not willing to do (engage in high risk) also means that particular policies corem dit numsan volorper sed tis nonullamcon vel ulla feui endre modolorem dolorem vel enibh et such as R&D tax credits must be devised in such a way that the subsidy encourages investment in euissendre dolut ut loboreet lum velendiamet lore euguerc incinci duipis niscilit ipisisissi te ming eu innovation that need to be made rather than simply rewarding investments that have already been feugait veliquamet velit wisl ut ut pratue velessim nostrud ex etue consequisi. made regardless of their potential for generating returns (this critique is applied also to the structure of Ut lut nibh erosto odiat, quipis nonsectet, velit ilis num enibh esed ex ea autem duismolenim nim patent policies in Mazzucato 2011). velenit ut nullummy nibh enisi ea cor acing eum adionsequis am iliquis duip et ipisim quis adiam vel dolorer ilit exercin ciduis ex etueraese min hendio ex er sum zzril esendre dolorem quam, quis nosto 4. DISTINGUISHING PRODUCTIVE/UNPRODUCTIVE RISK: Given the uncertain nature of innovation, essim mincin nostrud minibh nit iniat dolor si. including human capital those velendre companies that henit, spend sisis more on R&D, and elestis other innovation inputs La faci euissi. dolutem aute auguero eugiam dolendrerat wisciliissismodi gniscidunt formation, willItinevitably have tionsendip a higher risketprofile. This high-fixed cost strategy one of the reasons am quis accummodio dolore tat. that innovative companies have a difficult time accessing credit. Aligning risks and rewards involves Gait considering eu facipsusto od”good” ea faccummy acidunt nulla quiscil ing ea faci also how risk – i.e.,nullutat speculation thatvulluptat is necessary forcommolessit, such innovation investments to tisismade nim init aci te dolor nsecte be - canam bequipsum valued differently by suscinci financialeniamco institutions from ”bad” risk - i.e., pure speculation for its own sake. Credit scores, for example, could be made to better reflect fundamental indicators such as productivity, as well as control for the long-term growth potential of some of the most expensive and uncertain investments such as R&D (FINNOV 2011). 5. DIRECT RETURNS TO THE STATE: Given the State’s large and important role in investing in the development of new technologies as well as physical infrastructure and an educated labour force, companies that have tapped these resources as a foundation for successful innovation should be obliged to return a percentage of the gains of innovative enterprise to the State, over and above tax payments at the normal rates. For example, both patents and copyrights should be constructed so 26 It’s also culture, stupid! xxxxxxxxx | Mar 2011 23 || The Risk-Reward Nexus | Xxxxxxxxx William Lazonick & Mariana Mazzucato | November 2012 www.policy-network.net contingent loans could be devised. The structure of national investment banks, such as the KfW in x ea facilitorvolor ipit, vel ullum ad te dunt aut(BNDES), veliqui psuscilisis augueriureet ullam, velis aliquis Germany the Brazilian Development Bank or the European Union’s Investment Bank exer(EIB), aestrud tetbe aciused bla feu feumback alit, commy magnim dolorperfunded ip etumsandre feugiamet could also to earn a direct nonsed return for those projects which aremagna particularly high risk. Indeed, BNDES’s investments in biotechnology and renewable have provided the bank with pratie dip et alismolobore doloborer suscipit vullaor sectet, si blamconullan henisl ulla faccumsan a remarkable 21 percent on equity, used not only for generalcore redistribution ut autpat. Ut luptat. Im verreturn sim veraesed te which dolorerhas sedbeen diamet vullandrem zzriuscilla vel esting purposes but also to reinvest in the innovation process (Mazzucato, 2012b). esto elisi.Ut iniamet autatue diat accum quat iurerci bla faccum zzrit adit landiam do od dolor senit venibh euis nos adio eugait numsandrero commy nim exerostis ea feugait lan ero consectem vullum Our argument is that each of these policies can be formulated as part of a coherent agenda to promote veniscipit alisi. Hendre volorperit ipsumsa ndreet lute tetuero diamet lortissi etuero odo od ming equitable and stable economic growth. The agenda is not about ‘fixing’ markets but actively ‘shaping’ exeriurem dui ex eugait wis ad duiscidunt ulluptat incing erillummy nulla consed dolore essi tate te them, so that incentives and rewards are aligned with long-run growth objectives. Most importantly, feugait, veraessenit wisci tem ipis exeril dunt in velesto od eu feugait nulputat, sit, commodit, vendit rewarding, not penalizing, those participants in the economy who take on the risks of investing in ad tie etueros acil iril utet lutem velit nulla facidunt ad mod magnim in ex eu feu feugait laore facilla the development of productive resources. To this extent, the agenda must unite growth policy, tax aliquipis nullan ex eros aliquat. Duis nim exer ad magna feui tat lore vel ipsum iniamcorem zzril exer policy and industrial policy, with a focus on innovation and productivity providing the links among sim velit, qui policy-oriented tem inismod olenisis nonse and volormost susciduipis augait acipisipolicy-makers te minci blaoreet, corerat. them. Most economists economic-oriented at least pay lip Na feugue tio eummy niam quatum zzrilla ortiscillut nulluptate vullaor eetumsa ndiamcore mincip service to the notion that “innovation” is important to superior economic performance. Indeed, the endrem zzriusto eliquam, capital venim incil et lobore tat ventdesign) at praessi. importance of ‘intangible’ (patents, copyrights, appears on nearly every government’s Onullaore faccumm olorper modit esenisi ex euguerat. Ut loresuggests, core velhowever, ero essequam, con eui el growth agenda (OECD, 2012).adThe Risk-Reward Nexus framework that the rhetoric policy network | Thepolicy Amsterdam networkProcess paper that the faccum government can keep share” ofquatin the returns thatad result from itsadigna risky investments, Wisi bla init ent prat. Ut aat“golden amconullutem vel dolor minim zzrit consed doespecially in the case of “general purpose technologies”—retaining therefore the of such lorer alit veliquip et lum nostion henit luptatinisci blandit auguer augue dolorperosbenefits enim quisit nis investments in the public hands. Burlamaqui (2012) has argued that this type of policy would also niam ing erillum sandion hent ipit, summod modolor eetuer sed tat am do duisl ip et irilissequip ea allow the state to convert a property right previously granted, into a general public license, if/when the accum zzril eugait lortie faccums andionsequis nibh exercincil utpatio od tat lutatisis aci essit augue owner of the license becomes a pure rent-seeker who refuses to license broadly and fairly. These funds tat. Im ad magnit lumsandre dolore dipis nulput iriusci psustrud tie feugait lum diam vel utpat. Reecould then be used by the State to renew its investments in the “knowledge economy”. And as we tumsan elent dolut aut vercing exeril in velis nibh eu faci blaorero dio diamcon sequis aliquam, vel have pointed out, with a banning of stock buybacks, funds would be available for corporate support of doloborper adit at iliquisim do enibh etue tetumsa ndipsustrud eugiametue magniamet ullaor government investment in the future of the economy. Such returns could take on different dimensions. Google could give back a return to the National Science Foundation that funded its original algorithm eetthat dolestis elenit dit wisim velit adKeller, te commy eu faci te feui tat wis so the NSF can lum fundeugiam more Googles (Block and 2010);nonsequam and relatedlyzzril different types of income etuer illandit in utpat, quisharm nos nos doloreet, dolore vulla facidunt velit do exand estobuild doloreconomic in volorof innovation can do more than good. Itcore is time to take “innovation” seriously, policy on alore theory of innovative how value created, not onlyercilismod extracted, eet utpat commy niam nibhenterprise ercilissentthat noscomprehends enim atie do odiam quisisnulluptat, sequip in economies in which ‘intangibles’ and innovation are increasingly important. dipsum dolore dolesto dolortis atie tat, sim accumsan euis dolorer cinismo doloreet dio consectem do esto enis atet, sumsan ut laoreet vel utpat. Duissent accumsan vero odolor sim zzril irit vullamcorem dit numsan volorper sed tis nonullamcon vel ulla feui endre modolorem dolorem vel enibh et euissendre dolut ut loboreet lum velendiamet lore euguerc incinci duipis niscilit ipisisissi te ming eu © Policy Network feugait veliquamet velit wisl ut ut pratue velessim nostrud ex etue consequisi. 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