Unleash creative destruction

Capitalism has a bad reputation nowadays. Though some tolerate it as the “least awful” of alternatives, many accuse it of having led to unacceptable inequality, disastrous climate change and fractured societies. Some believe that these consequences are enough to advocate abandoning it altogether.

It is easy to associate the failures of modern capitalism with the rise of inequality, post-financial-crisis stagnation, inadequate responses to climate change, and even COVID-19. Polarised political parties offer a choice only between different visions of a stronger state. And almost everyone seems to agree that now is a good time to beat up on the tech giants.

In The Power of Creative Destruction: Economic Upheaval and the Wealth of Nations, published earlier this year, Philippe Aghion, Céline Antonin, and Simon Bunel suggest that our thinking about this is mistaken.

They remind us of an influential neoclassical paradigm which only economists would know about. It is a mystery term labelled “total factor productivity” – a measure of how well the economy converts inputs such as capital and labour into output. The secrets of long-term growth are hidden in this unexplained “black box”. It took the book’s authors ten years of academic research to open this black box.

In the tradition of the early 20th century Austrian economist Joseph Schumpeter, they emphasise that growth comes about when entrepreneurs innovate, creating new goods and increasing productivity but in the process destroying existing jobs and firms. Throughout, the authors rely on the theoretical construct in their title: “creative destruction”, a concept first advanced by Schumpeter.

Policy-makers must switch their attention to innovation-promoting policies to compete within the world of developed economies.

Now, of course, the man in the street would not welcome creative destruction. It presages uncertainty, unemployment, loss of income, and loss of dignity. Trade unions loath it as a threat to their membership. Communities dread it as socially ruinous. Governments take umbrage when loss-making factories close down. They find it difficult to imagine something creative in all this.

The book reports a vast quantity of empirical research, most of it recent, which shows how creative destruction works in practice. It shows, for example, that new businesses create a large proportion of new jobs. Many of these businesses and jobs then disappear. But the more intense this Darwinian process, the faster the economy grows.

For Aghion and his colleagues, the “creative destruction” paradigm explains how this happens. Export markets reward the most innovative, while imports and foreign direct investment bring new ideas and the competition that spurs the best firms to keep improving. Vibrant financial markets provide the capital that successful new firms need to thrive and expand. Fighting climate change calls for a green technological revolution. Much inequality should be accepted or even celebrated as the price of incentivising innovation.

Governments which adopt the creative destruction paradigm as part of their policy-mix should protect patents and avoid excessive taxation, insure the losers from the destructive part of creative destruction, accompany flexible labour markets with “active” labour market policies to help people find new jobs, and support basic research. And they need to avoid being co-opted by yesterday’s innovators trying to entrench their position, easier in a democracy.

One of the main things that struck me in this book was the authors’ discussion of an “enigma” involving the relationship between competition and innovation. Those investing in innovation must earn rents (excess profits) as an incentive for that investment. Yet the purpose of creative destruction is to have new competitors, at some point, take those rents away.

We need to motivate new players who are not trapped by past successes. We need new industrial sectors.

“Capitalism must reward innovation, but it must be regulated to prevent innovation rents from stifling competition and thus jeopardising future innovation,” they write. Regulations are needed to keep the path open for new entrants. This is a big issue today, for example, when discussing the market dominance of Big Tech. The fear is that Big Tech uses its rents to acquire emerging new entrants before they are large enough to compete on their own.

It reminds me of the agonising debates in the Nineties about the number of taxis we should have in Malta and whether new firms should be allowed to enter the market. Any hint of competition was anathema. Taxis were few, expensive, delivered bad service, and were badly patronised. Enter creative destruction and now we have all sorts of alternatives. The result? We are spoilt for choice, enjoy cheaper fares, and have excellent service.

The political economy of innovation and creative destruction might be feared, but it delivers results. The process is defined by a “critical triad of the market, the state, and civil society”. It is most interesting to read how the authors define the role for each of these three entities saying, “the market provides incentives to innovate and constitutes the framework in which innovative firms compete. The state is there to protect property rights on innovations, to enforce contracts, and to act as an investor and insurer. Finally, civil society — the media, labour unions, non-profits — generate or call for the enforcement of constitutional provisions intended to check executive power and ensure greater efficiency, ethics, and justice in the operation of the market.”

In the early and middle stages of economic development, the focus is on implementing investment-focused policies to catch up. However, at some point, policy-makers must switch their attention to innovation-promoting policies to compete within the world of developed economies. A crisis can help with that painful transition to a more Darwinian setting. If not, the nation’s growth stalls as the well-fed incumbents guard their turf and block new competition.

Malta, in my opinion, is at that stage. Unless we embark on rapid innovation in new directions, our growth will stall. We need to motivate new players who are not trapped by past successes. We need new industrial sectors.

The chart shows how Malta is the third-strongest in a group of nine moderate innovators, but behind a group of 11 strong or leading innovators. In 2020 we achieved a level which, relative to the rest of the EU, was that achieved by the EU six years earlier. So, I would describe our performance as rather lacking.

A necessary condition for rapid innovation is a financial system able and willing to invest in new companies. The book explains how the US benefits from a skilled venture capital industry, which knows how to nurture nascent businesses, and from a large base of institutional investors, who will support these companies as they grow. We do not have that in Malta, as our retail banks are extremely conservative and institutional investors scarce. This is a role that only the Malta Development Bank can play, alongside the EU’s arms in Malta.

In 2020, thank God (and COVID?), the EU launched The Innovation Fund, one of the world’s largest funding programmes for the demonstration of innovative low-carbon technologies. It focuses on mature, highly innovative technologies and big flagship projects with European value added that can bring on significant emission reductions. Around €10bn will be made available from 2020 to 2030.

The target areas include innovative renewable energy generation, energy storage, carbon capture and utilisation, carbon capture and storage as well as low-carbon processes in energy intensive industries. This fund will be financed through the EU Emissions Trading System (EU ETS) and unspent funds from its predecessor, the NER 300 programme. The Fund issues calls directed towards large-scale projects with total capital above €7.5m, yet small-scale projects may still benefit from separate calls having simplified application and selection procedures.

In the meantime, earlier this year, The European Innovation Council (EIC) announced Angele Giuliano and André Xuereb as the National Champions for its programme in Malta. Ms Giuliano is CEO and owner of AcrossLimits, which describes itself as “a technology company with a heart”, providing project and business consultancy for local and international clients, as well as President of the Foundation for Women Entrepreneurs. Mr Xuereb has a more academic background, as Associate Professor and Head of Department of Physics at the University of Malta and as Ambassador for Digital Affairs for the Government of Malta.

At the launch, Ms Giuliano emphasised that the EIC will seek to help companies “bridge the gap of the infamous valley of death in between raising initial funding, and real scale up.” Apart from the money, the programme offers coaching, mentoring, and networking.

Going back to the book, it cogently shows that there is no trade-off between creative destruction and basic security for the population. On the contrary, people will be more willing to accept the former, if they enjoy the latter. The Danish model of “flexicurity” is, they suggest, the best approach. Denmark is the third strongest innovator in the EU and, at the same time, has one of the lowest AROPA (At Risk of Poverty and Exclusion) rates in the EU.

Crucially, the success of creative destruction depends on the existence of an effective, non-corrupt, law-governed, competition-promoting state. This is possible only in a constitutional democracy, with an active civil society, independent institutions and free media. All please note.

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