Special Report:
Introduction:
The Next Frontier

The future of America’s economy is riding on its entrepreneurs. The future of its entrepreneurs is riding on government.

By Paul Kedrosky

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Special Report ContentsThis spring, during the battle over the stimulus package, I stumbled upon a television news program where analysts were debating whether government or entrepreneurs would get us out of the economic crisis. As someone who both invests in and studies the history of business start-ups, I was glad to see the subject of entrepreneurship being discussed. But the way the question was posed was hopelessly wrong: the notion that our economic salvation lies in either government or entrepreneurs is a classic false choice. And yet it corresponds to certain battle lines that many have drawn over economic policy.

On one side is the belief that government stimulus spending will be the primary force in our eventual recovery. This view holds that the key to exiting economic downturns is countercyclical public spending to keep the U.S. economy closer to its optimal level of activity. You should deficit-spend when the economy is operating at less than its full capacity; you should shrink spending and manage debts when the economy is back to normal. It is, in short, the Keynesian view, named for economist John Maynard Keynes and widely held by congressional Democrats. And there’s some truth to it. Massive government spending can cushion the blow when an economy shrinks as severely and as quickly as this one has. But imagining that a fiscal stimulus, however outsized, can compensate for indebted consumers hell-bent on saving their way back to (relative) solvency is high-definition dreaming.

The other policy perspective is that greater government spending only leads to higher tax rates, hence to declining incentives for investors to take risks. Better, in this view, to allow the economic crisis run its course, permit large firms to collapse, and let entrepreneurs pick up the pieces and create new companies, jobs, and wealth. This is the "Hayekian" view (à la Austrian economist Friedrich von Hayek), widely held by congressional Republicans, and there’s some truth in it, too. Higher tax rates will, at some point, undermine investment incentives (though the evidence suggests that we’re not very close to that point yet). Downturns—especially severe ones—do disrupt markets and provide opportunities for innovators. Microsoft, Allstate, Morgan Stanley, and many other companies rose from the wreckage of economic downturns. Small companies have been the primary source of job creation in the United States over the last few decades. Unless you expect that trend to change, start-ups and small companies must, by definition, play a major role in any meaningful recovery.

But the purist Hayekian view is as misguided as the purist Keynesian one. For one thing, downturns are just as hard on entrepreneurs as they are on the rest of us. There is less investment capital available for start-ups, prospective customers are less willing to spend money, and fewer people and companies want to take chances buying from "risky" start-ups and small companies. All of these issues cannot be simply brushed aside with a wave of a laissez-faire wand. More broadly, the followers of Hayek tend to ignore the vital role government has played in opening up new entrepreneurial opportunities, from Thomas Jefferson’s Louisiana Purchase, which made land available to generations of frontiersmen, to the Defense Department’s creation of the Internet. Indeed, it’s often at times of major economic distress that government has the most political latitude to make such bold moves. So while it’s true that our best hope for future growth is riding on America’s entrepreneurs, the best hope for our entrepreneurs may be riding on government.


This isn’t the first time an economic crisis has provided the potential for gutsy public policies that benefit entrepreneurs. The Panic of 1857 was sparked by a U.S. banking crisis that in turn caused a sharp recession. (Sound familiar?) While the banking crisis itself passed relatively speedily, new fears about the banking system and the economy had political consequences that helped to bring to power the newly formed Republican Party. Comprised in large part of entrepreneurs and Northern industrialists, they had a more Hamiltonian view of the role of government and its capacity to spur economic development; the Democrats were still dominated by Jacksonian agrarians—suspicious, to a fault, of government power.

Momentum grew among Republicans to aid commerce and settlement by building a transcontinental railroad, but that would be costly. A westward-bound U.S. railroad line would require, as economist Joseph A. Schumpeter has said, "building ahead of demand in the boldest acceptance of the phrase," something that only government could help do. In 1862 President Lincoln signed into law the Pacific Railway Act—which gave land grants to railroads and helped finance line construction with thirty-year Treasury bonds—and by decade’s end the first rail line reached San Francisco. This extraordinary feat made possible the rise of whole new industries, such as the retail catalog business (think Sears, Roebuck and Co.), and would account for half of the increase in urbanization in the Midwest, according to a paper by Jeremy Atack of Vanderbilt University.

Lincoln’s Republicans used their power to make other audacious moves to further economic growth, including passage of the National Banking Act, which established a national currency and national bank charters, and the Morrill Act of 1862, which created the land grant college system. The latter spread knowledge of the applied sciences, especially in agriculture and mechanics, throughout the country, which economist Robert Gordon argues contributed directly to the rapid pace of productivity improvement seen in the U.S. through the Second Industrial Revolution and into the 1920s. This deepening of human capital through education leading to entrepreneurship is now central to most modern theories of economic growth.

No economic crisis gave Washington more political leverage than did the Great Depression. While FDR and his New Dealers were not specifically focused on reviving entrepreneurship, as opposed to just getting the economy off its knees, some of their signature policy efforts had precisely that long-term effect. For example, new banking regulations—like the Glass-Steagall act, which established the Federal Deposit Insurance Corporation—combined with massive numbers of Depression-era bank failures to transform the banking landscape. The U.S. was almost certainly overbanked in the pre-Depression period: in 1920, more than 29,000 banks competed for a population of 106 million. Banking laws had created an absurdly fragile system, with banks too limited in their geographic scope and (with rare money center exceptions) too small to lend at the scale increasingly required by entrepreneurs who were creating new manufacturers and farms. The combination of bank failures and deposit insurance stabilized the system, eliminating bank runs and increasing bank balance sheets—average assets per bank doubled by 1942—thus making it possible for banks to finance the capital-intensive manufacturing entrepreneurs of the era.

Another opportunity came in the Depression-era electric grid. In the 1920s, electrification outside of cities was largely nonexistent, and those rural customers paid twice as much per month as did urban customers. In the absence of electricity productivity, economic growth stagnated outside of cities, especially on farms. As a result, in 1935 President Roosevelt created the Rural Electrification Administration, which provided federal loans to local governments, farmer cooperatives, and the like to extend electrical service outside cities. It succeeded. In a little less than two years the REA helped bring electricity to more than a million farms in forty-five states while the cost of a mile of rural electrical line had fallen by more than two-thirds, to less than $800. Newly grid-connected rural and suburban families purchased appliances in droves, thus creating a new cadre of entrepreneurs in the electrical and plumbing trades. Agricultural productivity soared on the back of rural electrification (and mechanization), making it possible for U.S. farmers to serve a fast-growing nation’s needs. The REA helped create a new national electrical grid, a forerunner to the Internet and the Interstate highway system; this is now widely thought to have been among the most successful examples of crisis economic policymaking.


What do all of these initiatives have in common? They took advantage of the economic crisis to rise above it and create—on purpose or through happy accidents—new platforms on top of which entrepreneurs could generate economic growth. Can we do the same thing now? Yes, and more, because we have a much better understanding than we did half a century ago of how government policy affects entrepreneurship, human capital, and economic growth, and a better sense of what government should and shouldn’t try to do.

One example where policy could help with entrepreneur-friendly change is energy. America’s electrical grid has changed surprisingly little since its
Depression-era build-out. Consequently, it’s an industrial anachronism, a
failure-prone, dumb, and output-only power network that should be more like the Internet: two-way, resilient, and with more of the intelligence at the edges. A smarter grid would make possible vast improvements in energy efficiency while providing a platform for a whole new wave of entrepreneurial innovation—for instance, the creation of electrical appliances that can sense when to increase or dial back their energy usage based on second-by-second changes in electricity-price signals from utilities. The Obama administration has included $4.5 billion in the stimulus package to encourage the creation of a smart grid. But to truly transform the grid will take major—and controversial—changes in regulations that Washington has only begun to think about. (See Mariah Blake, "Grid Unlocked.")

The Depression transformed the U.S. banking system. Something similar can happen now. A postcrisis banking system should be flatter and more distributed, and contain fewer banks that are too big to fail. Some entrepreneur-driven changes in that direction have been under way in recent years, but they were thrown into disarray late in the Bush administration. Fast-growing so-called micro-lending sites like Prosper were allowing people to bypass the banking system and make loans mediated through Web sites, sort of like an eBay of loans. Despite that being valuable and important, especially in the credit crisis, the micro-lending industry was severely hobbled by the Securities and Exchange Commission. In a little-noticed November 2008 decision, the SEC ruled that these loans were actually securities, and therefore required registration on a loan-by-loan basis, whether the amount was $100 or $25,000. This heavy-handed and expensive approach has forced micro-lenders to go dark and enter a time-consuming registration process, just when they are most needed in the economy. While there is nothing
wrong with forcing micro-lenders to be transparent and open, applying the same regulations to these next-generation services is inappropriate. All of these services were already publishing more detailed information on their loan markets than you could ever get from a "safe" regulated bank. Banking need not look the same as it did in the recent past for it to successfully finance economic growth in the economy. The Obama administration should revisit this SEC decision, perhaps developing new rules scaled for micro-lending operations.

Another way government could boost entrepreneurship is by making sure affordable health insurance is available to all Americans. (See Jonathan Gruber, "A Shot in the Arm.") While younger entrepreneurs, still in the flush of invulnerability and without families, will often start companies without worrying overly about health care, middle-aged would-be entrepreneurs do not have the same luxury. And if you think that innovative entrepreneurship is entirely the province of twentysomethings in a garage near Palo Alto, California, think again. James Clark cofounded Silicon Graphics at the age of thirty-eight and Netscape at fifty. Ray Kroc started McDonald’s at the age of fifty-two. The great P. T. Barnum only created his namesake circus at the age of sixty-one. According to a Ewing Marion Kauffman Foundation study, the U.S.-born founders of high-tech companies are twice as likely to be over the age of fifty as they are to be under the age of twenty-five. But to the extent that the level of entrepreneurship among older Americans is less than it would otherwise be because of health care worries, a strong case can be made for a simplified base level of national health care that is portable across states.

Perhaps the most straightforward action government could take to boost innovation and entrepreneurship is to reform its immigration laws. Foreign-born entrepreneurs are responsible for many of the fastest-growing companies in America, from Google on outward. Studies have shown that skilled immigrants, in particular, account for a high percentage of the founders of Silicon Valley start-ups. Of the technology companies founded in major tech hubs between 1995 and 2005, 31 percent had an immigrant as a key founder, according to research by Vivek Wadhwa. The U.S. should be doing everything it can to facilitate their arrival and permanent addition to the U.S. workforce, whether through expanded visa programs, the attachment of green cards to U.S. graduate degrees, or the outright purchase of skilled immigrant status as is the case in Canada and elsewhere. (See T. A. Frank, "Green Cards for Grads.") It is crucial in this downturn to fight back anti-immigration sentiment, as well as the predictable xenophobia.


The current economic crisis has many proximate causes: lax federal regulations, opaque debt instruments, market groupthink, and so on. But it is also the result of economic exhaustion. In a healthy economy, growth comes from companies exploiting new technologies and from innovations that solve real-world problems. But when fresh opportunities for growth begin to disappear, economic actors often turn to the performance-enhancing drug called "financial leverage" (i.e., excessive debt) to stay in the game. Such periods of boosted performance inevitably end badly. But they can also mark transitional periods from one economic state to another. The Great Depression initiated a transition from the Second Industrial Revolution to a more modern industrial capitalism. We are going through a similar change now, one that policymakers can facilitate, with financial services set to shrink in importance, while peak oil and environmental worries create new opportunities for clever entrepreneurs to build on a new and more sustainable socioeconomic platform.

We are headed to a "new normal" in U.S. economic life. While that will be painful and disruptive, it can lead to a wave of entrepreneurial capitalism, with sustainable and necessary change in how we work, travel, communicate, and power our lives. Prior crisis-driven interventions produced some of the longest periods of peacetime economic expansions in U.S. history, driving job growth, wealth creation, and productivity. The same can happen today if Washington acts wisely and intrepidly. Immense opportunities remain ahead, from energy to disease to resources to telecommunications. Yes, new economic powerhouses are emerging in Brazil, India, China, and elsewhere, but the United States has something the rest of the world doesn’t: the foremost entrepreneurial economic culture on the planet. With appropriate assistance, entrepreneurs can drive the next stage of U.S. economic growth, taking us past this current downturn. The resulting opportunities will be legion for these innovators, and therefore for all of us.


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Paul Kedrosky is a senior fellow at the Ewing Marion Kauffman Foundation and editor of
Infectious Greed, a popular finance and economics blog.
 
 
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