It is baffling to what extent the dominant faith in the market keeps us from even posing certain questions. What is it really that makes a society productive, creative, innovative, and prosperous? And what incentives and power relations lead to diminishing wealth and economic decline? What economic framework do we need for a good life, and what conditions stand in our way?
Many of us have given up reflecting on the rationality of our social institutions. According to the dominant article of faith, whatever the market generates is efficient, otherwise it would not have come into existence. Yet, as we have seen in the preceding chapters, our economic life is rarely the result of spontaneous market decisions. We feel we are ruled by anonymous markets, while failing to notice that powerful economic interests have been in charge for a long time.
Our property law, our monetary order, and our currency system are institutions that have come into being as a result of political decisions—or non-decisions. They have not always existed. Over the past few decades they have in part changed dramatically, most recently under the influence of new digital technologies. Of course we are free to design these institutions in a different way if we conclude that they don’t work in their present form and that they benefit a small minority while short-changing a large majority. Since they are man-made, we do not have to accept these institutions as they are.
Institutional change starts with the realization that institutions can be changed. Each of us now has the right to transfer with the push of a button a million euros from their bank account to Singapore or Panama, or to buy shares on Wall Street. This has not always been the case. Is this right, which most people will never exercise in the course of their lives, really so sacrosanct that we are willing to put up with the many downsides of the free flow of capital, such as large-scale tax evasion and the vulnerability of states to blackmail? Wouldn’t it be much more important to have a financial system in which every qualified entrepreneur has access to capital?
The history of humankind has always known both periods of general prosperity motivating the spirit of innovation, improving production techniques, and significantly raising the standard of living for a large number of people, as well as periods in which great civilizations broke up, newly developed technical knowledge was forgotten, and life once again became harder, more hopeless, and poorer. The best-known example for the rise and decline of great systems is the history of the Roman Empire from its beginnings several hundred years before the start of the Christian calendar to its end between the fifth and seventh centuries. Indian cultures, ancient Egypt and Greece had similar, if more short-lived, experiences. China experienced several ages of prosperity and subsequent decline.
Wars and civil wars frequently destabilized societies, thus causing economic decline. It is not difficult to see why. The more people’s lifetimes are wasted on military service, and thus for destruction rather than for production and trade, the poorer a society will be. If wars or civil wars continue for extended periods, insecurity grows and investment in larger projects will come to a halt. Dangerous transport routes impair trade or destroy it altogether. Technologies that are profitable only on large scales will no longer be produced. Since they are no longer used, they will eventually be forgotten.
After the fall of the Roman Empire, its European network of roads fell into disuse, cities declined, farmers returned to subsistence production, mansions were replaced by huts and castles. Only a tiny minority learned how to read and write. Contemporary examples of countries that had attained a respectable level of development with good health and education systems but were ruined by wars and civil wars can be found in the Middle East and North Africa. Iraq and Syria belong to this group, as does Libya. These countries have by now lost almost all their former prosperity.
However, there is also the opposite phenomenon—decline in times of peace, precisely as a result of stability. The U.S. economist Mancur Olson was the first to investigate this phenomenon, and it is at the centre of his theory of the rise and decline of nations. Olson’s point of departure is the thesis that small social groups with similar interests are better able to organize themselves than larger ones. Since the upper class of a society is a relatively small group, it is also particularly well organized and networked. This holds all the more true the more stable a system is over a long period of time.
Since people who are doing well would like to preserve this state of affairs and preserve it for their children, privileged sectors of society always have an interest in securing their position in a way that makes it as independent as possible from actual performance, and in this form pass it on to their offspring. This is why at the top continuing stability gives rise to what Olson calls an “exclusive distributional coaltion”. Social rules are made that prevent those who are not already part of the self-appointed elite from joining this exclusive group. The hereditary principle of the nobility is such a rule, as are ownership rights that restrict access to capital primarily to heirs.
Of course exclusive institutions don’t emerge only for the protection of the upper class. They also exist in other sectors. What is crucial is really only that a relatively small interest group has sufficient power in society to refuse outsiders access to the sector in which they earn their living, and if possible to provide for the privileged access of their own offspring. Exclusive institutions thus do not reward skills and performance, but descent and blood relations. Ultimately, the goal is always the elimination of potential competitors and the securing of incomes without work. Not only antiquity and the feudal age, but capitalism as well, as we have seen, were and are in many sectors based on exclusive structures. If these structures come to dominate societies, their economies become sluggish and inflexible because opportunities for creativity and talent are closed to a large part of the population.
Inclusive institutions, according to Olson, are the exact opposite. They are open to everyone as long as they have the requisite talent and knowledge. An inclusive society thus would be one in which every true talent can make it to the very top, irrespective of social class. In its pure form such a society has never existed, but the closer the ideal can be approximated, the better the society will be off because it will be able to make full use of its creative and intellectual potential.
Ancient China had one of its golden ages during the Ming Dynasty between the fourteenth and seventeenth centuries. A major characteristic of this time was the selection system for higher state offices, the Mandarins. Whereas in Europe at that time political leadership positions were simply inherited, the positions of the Mandarins were in principle open to everyone. Applying for this office required passing a complicated examination system, and whoever did best among hundreds of applicants got the job. As historian Fernand Braudel notes, as a result of this system, for the offspring of poorer classes top positions in the Chinese state bureaucracy were “in any event significantly more accessible than the large Western universities as late as the nineteenth century.”76 The result was not only social mobility but, above all, a higher quality of public administration.
The golden age of the trading city of Venice was also related to career opportunities that were unusual for the time. They were based on a specific legal form of commercial firm that opened a road to the top for enterprising young men who did not come from wealthy families and had no capital of their own. This legal form, the commenda, was a partnership set up by two merchants for the purpose of a trade mission. What was special about this arrangement was that only one of the two had to contribute capital. While the capital investor as the financier of the project stayed in Venice, the other partner accompanied the cargo and lived through the dangers and uncertainties of the long trip. If the project was a success, the travelling merchant received 25 percent of the profit. If he had contributed himself a small sum to the project up front, the profit was often equally divided between the two.
The commenda ensured that on the historical lists of the Venetian upper class from the years 960, 971, and 982, a majority were new names. On the downside, of course, families from the old elite were displaced and could not pass on their privileged position to their children. This did not sit well with those who had made it to the top. The Venetian nobility eventually decided to transform itself into a hereditary nobility open only its own descendants. The commenda was outlawed. Subsequently, the old established elites once again had exclusive control over lucrative trading routes, no longer sharing their profits with anyone. This turning point was recorded in history under the name of serrata, the “closure”.
For the community, such closures always meant losses in wealth. It is not difficult to understand that a society in which anyone can become a physicist will have better physicists than one in which only a small group will be instructed in basic mathematical and physical knowledge. In the latter case there is a much greater danger that an Einstein will not be recognized and end up as a farm labourer. And naturally a society in which in principle anyone can become an entrepreneur if they have the skills and good ideas will have the better entrepreneurs compared to a society in which such activities are open only to a few due to a lack of generally accessible start-up financing. In this respect, the capitalist system is guilty of an immense waste of creativity and talents. Without sufficient capital, even the best entrepreneurs will frequently end in failure—unless they were smart enough from the start not to try to set up an enterprise.
As we have seen, capitalism in the industrialized countries during its golden years, i. e. in the decades following World War II, created career opportunities for many, even if they never made it to the very top. The enormous dynamism of this period is closely related to the openness and permeability of social institutions. One key was the democratization of education all the way to the university level. Equally important was the existence of many well-paid positions in the public sector as well as in the private economy that could be attained even without access to capital. Only the latter continued to be largely reserved for the upper class.
This is now history. Today children from the poorer sections of society grow up without higher education, in part even without elementary skills in mathematics, reading, and writing. Many do not have a command of their own mother tongue, but possess only a minimal vocabulary with which, untroubled by the rules of grammar, they cobble together incomplete sentences. Such deficits can be easily corrected during Kindergarten and elementary school. However, it cannot be done in a chronically underfunded education system that is short on everything from the number of teachers to modern teaching technology. If this is not addressed, the job opportunities of young people who cannot even speak properly seem a foregone conclusion.
For reasons of social justice as well as for economic reasons, a modern economic order should create institutions that ensure that children’s opportunities depend as little as possible on their social environment and as much as possible on their own abilities. The primary prerequisite is an education system that makes it possible to discover such talents in the first place. Since the European Enlightenment, the meritocratic idea of performance-driven career opportunities as opposed to feudal privileges and inherited prerogatives has been a basic demand. It has not been fulfilled to this day.
One part of the answer to the question of what makes a society prosperous is this: societies will be the wealthier the better they use their creative and intellectual potential. Exclusive institutions are obstacles in this respect. Since, in the long run, any stable society has a tendency to give rise to such institutions, a conscious effort is necessary to erect barriers against attempts at closing off privileged terrain.
But this is only half the truth. Obviously, social creativity can be unleashed and directed at hideous goals. The atom bomb was invented by creative minds as well. Not all technological progress is desirable, some of it is destroying the basis of our lives. What are the technologies and innovations that really make it possible for us to have a better life? And what are the economic incentives we need in order to focus invention talents on such steps forward?
Evidently material welfare is not dependent on how much money we have in the bank but on what we can buy with our money. We can buy what our economy produces in a certain period of time, which in turn depends on the technologies being applied. In agriculture this is self-evident. As long as we tilled our fields with horse-drawn wooden ploughs, a large segment of the population had to live on and work the land, since otherwise society would have simply starved. Nowadays, based on modern technology, an individual farmer can work 100 hectares of land, guaranteeing the food supply of half a small city. Most people are therefore free to deal with other things. Without this kind of technological progress, industrialization could never have occurred.
In the industrial sector, the same process was repeated. While in the 1880s the cheapest bicycle cost an average worker in France or Germany six months’ wages—which obviously meant that he couldn’t afford it—by 1910 production costs had declined so much that one month’s wage was enough. Today an average earner works less than a week for an inexpensive bicycle. Cars too did not become a mass product until people with regular incomes could earn the amount in a manageable period of time. While in 1908 in the United States about 4,700 hours at average wages were necessary to be able to afford a standard model, the value of a mid-range car today is about 1,000 hours.
The decisive factor underlying these price drops is the application of labour-saving technology. The production of most goods today requires much less work effort than one or even two centuries ago—just as every loaf of bread we eat today contains much less labour than in previous times. Labour saving means that we can produce more or different things in the same time. This is a major reason why we live better today than our ancestors. In this sense we could say: an economy makes us wealthier if it motivates us to apply labour-saving processes, as well as to discover and supply new useful goods or services.
There has to be an appropriate environment for people to come up with innovations, new labour-saving methods or new products. And there need to be incentives for new ideas to be applied in the economy. This may sound trivial but it isn’t. Economic history is rich in inventions that arrived too early or in the wrong environment, which is why they disappeared in the archives.
The steam engine, for instance, was based on principles known since Archimedes. But why should the Greeks or Romans have built such engines if they had slaves who worked for them, pretty much for free. In 1313 the Chinese Wang Zhen described a “machine for the spinning of hemp fibre” that came pretty close to the spinning jenny and the water frame, the most important machines of the industrial revolution. He was not successful; no one built and used his machine. In England, in 1589, one William Lee constructed a knitting machine that would have made the manufacturing of textiles much more productive, i. e. less labour-intensive. He presented the machine to Elizabeth I. The queen of England was not pleased, for the reason that such mechanization would have horrendous consequences for those whose livelihood depended on the manufacturing of wool by arduous manual labour. Only with capitalism would such reservations come to be ignored.
The profit calculus is a strong incentive to apply labour-saving technology and to bring new products and services to market. Whoever produces something novel that no one else supplies will, if successful, realize large profits. The same applies to those who make products similar to those of others, but on account of a new technology do so more cheaply. The enormous advances in productivity of the past two centuries and the inexhaustible wealth of ideas in the discovery of new things are by and large based on this basic motivation. As a result, more and more work came to be done by machines and devices, while society as a whole became richer.
To be sure, this capitalist engine of innovation works only within the limitations discussed in earlier chapters. Within firms, the innovation process requires well-equipped development departments. If the firms have shareholders on their backs who would rather see the money in their bank accounts, the innovation dynamic may come to a halt for this reason alone. If, in a firm, a radically new technology is discovered that might reduce the value of the capital invested and perhaps even call into question its entire business model, the most likely response will be to keep the inventions under locks. An engineer of the Eastman Kodak Company, at the time the global leader in the production of films and cameras with the old analogue technology, is said to have invented the first digital camera as early as 1975. The firm filed the unwelcome innovation—until others started to market it.
Fundamental innovations are therefore most successful in new enterprises. However, if there is a lack or shortage of start-up capital, the dynamic will stop. Patent law is another way by which the economic application of innovations may be postponed for many years.
A serious impediment for the use of labour-saving technologies are schemes to lower the cost of labour, which can ultimately make production even cheaper than adopting a more modern technology. It was no coincidence that the German neoliberal reform package Agenda 2010 went hand in hand with a massive reduction in private sector investment. Part of the reason was that through temporary work, contracts, and other modifications the average cost of labour was cut, which significantly reduced the payoff of investments in labour-saving technology.
This applies even more forcefully on the global scale. In this context, the dynamic is self-reinforcing. Low-wage countries are generally less innovative than high-wage countries. Of course countries manufacturing for the most part non-innovative standard products are faced with much greater competition, which is also why they cannot afford to pay higher wages. In the context of high-tech products, on the other hand, talk about wage competition as a rule is a front for other considerations. Firms manufacturing things that Romania or Bangladesh can’t produce do not need to worry about the wage levels in those countries.
An innovative economy has to provide incentives for the development of new technologies and products and for their commercialization. Let’s begin by focusing on the first point. What is the best environment for ideas and inventions to emerge? Since no other economic order has generated as many innovations as capitalism, the standard theory is that inventions are made because there is an opportunity to commercialize them, which in turn promises large profits. The typical inventor would therefore be the amateur working out of his garage, who subsequently sets up an enterprise, concluding his life as a billionaire. In this context, the argument is made that patents and copyrights are of such importance because they alone secure the economic return on his ideas for the inventor.
The fallacy of this theory is that it describes the exception rather than the rule. In his excellent book Where Good Ideas Come From77, U.S. author Steven Johnson examines the conditions under which the 200 most important innovations and scientific breakthroughs of the past 600 years were made. He distinguishes four main types of inventions: innovations made by a small circle of people within a firm or by an individual inventor, he classified as “individual”. Innovations developed by a larger group with several teams and a division of tasks are referred to as “networked”. With respect to both “individual” and “networked” innovations, he distinguishes between those that were developed from the start for commercial purposes and those that were not. Innovations developed on the basis of such motives fall under the heading of “market-oriented”. In contrast, anything developed simply out of passion or enthusiasm is referred to as “not market-oriented”.
Johnson’s classification is thus composed of four categories, or in a graphic representation, four quadrants. The first category or quadrant contains “individual” and “market-oriented” innovations, i. e. everything developed by small firms and individual entrepreneurs. The second quadrant, “networked” and “market-oriented”, includes technological breakthroughs that emerged from the research sections of large enterprises or from inter-firm cooperation with commercial goals. The third quadrant is populated by “individual” and “not market-oriented” lone wolves, i. e. individual thinkers, amateur scientists, and hobbyists who are not after big money but rather recognition from others to whom they are happy to give their ideas. Finally, the fourth quadrant of “networked” and “not market-oriented” innovations encompasses everything developed in academic and open source environments, i. e. in large cooperative networks in which ideas are constantly elaborated and improved.
It is widely assumed that for the most part, innovations show up in the first quadrant, i. e. under the rubrics of “individual” and “market-oriented”. That would appear to be the typical capitalist mode of technological progress. Johnson shows, however, that reality is quite different. In the early beginnings of capitalism in the seventeenth and eighteenth centuries, most innovations were developed in a more academic environment rather than in a commercial environment. The great minds of this era—Newton, Franklin, Priestley, Hooke, Jefferson, Locke, Lavoisier, Linné—did not keep their ideas locked up for the purpose of commercial use, but they did whatever they could to spread them and make them available to others for further investigation and development.
True, even in this period there were a number of market-oriented inventions, though on the whole less by individuals than by larger groups. Frequently, the phenomenon of multiple invention has occurred: the same thing is discovered simultaneously by different people. A steam engine was constructed not only by James Watt but also by others. The reason is that such inventions rest on the accumulated knowledge of many creative minds. Then, at some point, the time has come for such a breakthrough. As Johnson concludes, “most of the key technologies that powered the Industrial Revolution were instances of what scholars call ‘collective invention’.”78
For the capitalist epoch proper, i. e. the time from the beginning of the nineteenth century to the present, Johnson’s classification is even more to the point. The first quadrant, i. e. that of individual market-oriented innovation, once again has the fewest cases. For every lone wolf who in his own lab devises a patent-protected innovation, there are a half dozen collective inventions that were developed either by the development departments of large firms and networks of firms, or even more likely in the market-removed environment of the university or other public research institutions, i. e. on intellectual commons. In the end, Johnson arrives at the unequivocal conclusion that “competition turns out to be less central to the history of good ideas than we generally think.”79
There are a number of reasons for this. To start with, great ideas mature best through exchange, openness, and communication—something that patents and copyrights tend to discourage if not rule out. Of course there are also forms of competition in the academic environment, e.g. for the number of citations as well as recognition and top positions. What does not exist are legal walls that protect ideas from further development and improvement by others. Researchers that constantly have to keep in mind legal questions will not be able to give full attention to their work. If development has to occur around the licensing rights of others, progress will be slowed down or made impossible unless it happens on the initiative of the patent owner. Since a research or development project may quickly violate the patents of others, there will also be increasing costs. This is all the more true since large enterprises are registering patents for the express purpose of creating obstacles for others.
Johnson refers to the Internet as an example. If its inventors had required licensing fees for any technology based on it, Tim Berners-Lee, programmer of HTML, would have probably never tried to create the World Wide Web. Especially since this was just a side project for which he had no funding. There are quite a few arguments in support of the view that an economy without patents would be more innovative and dynamic. The concern that without patents the motivation for the development of new technological developments would be lost is contradicted by the considerable development efforts made in many small and medium-sized enterprises that for reasons of cost never make it to patent registration. (If patent law actually is to provide exclusive temporary protection for genuinely individual ideas, it will have to be fundamentally redesigned.)
Fundamental scientific breakthroughs, as we have seen, are for the most part based on research in the public sphere rather than in the commercial world. To motivate such research does not require the prospect of future patent protection—the existence of commercial patents in fact creates problems and obstacles for such research. It is not necessary, but rather absurd, that private enterprises should be allowed to transform the results of publicly funded research into private ownership and patent rights.
This creates high costs for society as a whole. In his book The Conservative Nanny State, U.S. author Dean Baker demonstrates this with respect to the pharmaceutical industry. According to recent figures, the industry has sales of 220 billion dollars in prescription drugs alone. Since prices for patent-protected drugs are more than three times those of generics, the public could save about 140 billion dollars a year if patent protection was eliminated. According to statistics by the pharmaceutical industry, their annual expenses for research into new drugs are about 41.1 billion dollars. Through higher prices for patent-protected drugs, the public thus pays 3 dollars for every dollar spent on research.
A considerable part of the development expenses of 41 billion dollars is so-called copycat research—i. e. drugs with a similar spectrum of actions as existing ones that are developed only because the original drugs are still under patent protection. Such expenses would be eliminated if patents did not exist. According to pharmaceutical firms, about two-thirds of all newly approved drugs are in this copycat category. These drugs therefore do not cure what existing ones could not. This is a significant waste of research funds. U.S. pharmaceutical corporations thus do not actually spend 41 billion dollars but only about 17 million on genuine drug innovation. And for these 17 billion in research expenses society pays 140 billion dollars as a result of increased prices, or an 8 dollar surcharge on every real research dollar. A pretty bad deal.
In addition to commercial spending, the United States annually allocates 30 billion dollars of public money to pharmaceutical research. Dean Baker offers the following simple calculation. If government were to eliminate patent protection while at the same time doubling public research spending on new drug development, this would more than make up for the current spending of the pharmaceutical industry. There would be no more need for research into duplicates. The 30 billion dollars in additional public spending would be offset by public savings of 140 billion dollars in lower prices as a result of the elimination of patent protection, and probably better results from pharmaceutical research. Who, other than the big pharma lobbyists with their tall tales, could object to embarking on such a route?
Since we are used to equating innovation with spontaneity and state activity with bureaucratic inertia, the idea of placing important areas of economic innovation under state authority may at first glance appear strange. It is true that innovation cannot be planned. Nevertheless, innovation has surprisingly frequently been promoted under state auspices and with public funding. Joseph Schumpeter, certainly no advocate of state intervention, in principle saw two ways of advancing innovative ideas and technologies. One is the innovative and creative individual entrepreneur who is driven by a desire to put his discovery to commercial use. The other is an innovation process that is based on the institutionalized cooperation of specialists.
In the earlier section on “the visible hand of the state”, we saw that in the crucial technological breakthroughs of the past 150 years—from the railways to the Internet and nanotechnology—the state has always been involved, while the role of private enterprises was much smaller than is generally assumed. Especially fundamental innovations can be developed only in organized innovation systems that integrate basic research, applied research, and development and in which state institutions and public funding play a central role. Only the state is capable of financing research that does not have to pay off in the short term.
Society can profit from these innovation processes only if it prevents the intellectual commons from being fenced in by private interests that transform publicly funded research results into private rights for the profit-making of large corporations and their shareholders. Of course innovations have to find their way into economic practice. Innovations need enterprises that apply them and turn them into a marketable product. But with viable innovative products, any well-managed enterprise can earn money even without patent rights, especially if the question of financing for young entrepreneurs is addressed more effectively than it currently is. It is therefore most important to facilitate the market success of innovations with start-up support for new enterprises, public loan guarantees, and state venture capital funds.
It is hard to imagine that the energy problem will be solved in other ways than by state initiative, since this will be a matter not only of technology but also the provision of new infrastructure. If the German government had used the 100 billion euros spent since the start of the new millennium on targeted research instead of on a failed energy reform, there might well be better storage technology and more efficient solar cells available now. At the same time, fewer fortune hunters would have exploited the allegedly green reform program.
An innovative economy should achieve two goals. First, it should provide opportunities for creative individuals and facilitate the practical realization of their ideas if they are viable. Second, it should finance effective units for long-term research tasks and promote their commercialization through start-up support for young enterprises. “Competition as a method of discovery”, as Hayek has poignantly described it, needs a place alongside a government-organized innovation process. There are after all different kinds of innovation. Solving the energy problem or a breakthrough in cancer research are challenges of a different order than making a joint-friendly running shoe, a kiss-proof lipstick, or a highly effective anti-pimple cream for teenagers.
This is not to say that the latter are unimportant. It is not only the major breakthroughs that make our lives better and more beautiful. Some large global corporations are in part based on inventions that appear banal, but that with respect to a specific problem have made life easier or more enjoyable. The entrepreneurial key to success of the pharmacist August Oetker was the idea to manufacture baking powder of consistent quality and package the exact amount necessary for a cake using 500 grams of flour. The inventor of gummy bears, Hans Riegel, rose to wealth with this innovation. And the chocolate manufacturer Rudolf Lindt once forgot to turn off his waterwheel-powered mixer, which made for an exceptionally creamy chocolate. For baking powder, gummy bears, or creamy chocolate, there is no need for state-funded research labs. But of course life would be poorer without them.
Innovations and ideas of this sort make the market irreplaceable. This is also the reason why an economic order with more real competition would be more prosperous and innovative than capitalism. If the role of markets was limited to the signalling effect of prices for supply and demand, the market economy as a model would soon become obsolete with the Internet of things and the digitally networked creation of value. In many sectors, “business on demand” is already standard practice—production does not respond to an anonymous market but to previously established demand.
However, with the deconcentration of corporations and improved start-up and financing opportunities for young enterprises, what functioning markets could do even better than today is making use of society’s creative potential in the discovery of “minor” innovations—discovering market niches, improving existing products, refining labour-saving technologies, and experimenting with new ideas. No other mechanism provides as powerful a motivation for such achievements as free competition between many economic actors and the permanent openness of markets for new entrants. This is the field for private initiative and commercial activity.