Venture capital didn’t build that

William H. Janeway

Monday, Dec. 31, 2012 | 2 a.m.

Can government play a positive role in economic development?

To understand who built what in the construction of the American economy from its pre-industrial origins, a look at one of the drivers of U.S. innovation — venture capital — is instructive.

For more than three decades, American venture capitalists have concentrated their activities and earned their returns in a very small number of industrial domains. In booms and in slumps, in bull markets and in bear markets, the information and communications technology and biomedical sectors together have consistently accounted for 80 percent of venture capital investment.

Why has it been in the world of information technology and, secondarily, biomedicine that venture capitalists have been successful? In brief: Only in these sectors did the state invest at sufficient scale in scientific research and in its translation to working technology. In over 40 years as a working venture capitalist, I learned that my colleagues and I and the entrepreneurs whom we backed were all dancing on a platform constructed by the federal government.

Let’s focus on information and communications technology. National funding of the basic research that enabled the IT revolution was overwhelmingly provided by the Defense Department. The Soviet threat, crystallized in the years after 1945 and amplified by the Korean War in 1950 and the launch of Sputnik in 1957, was the context for the U.S. military’s massive commitment to renewing its wartime role as the principal financier of technical research and the principal customer for the products that research generated.

The scale of research and development funding was substantial. For 25 years through 1978, federal sources accounted for more than 50 percent of national R&D expenditures and exceeded the R&D expenditures of the other governments in the Organization for Economic Cooperation and Development combined. From microelectronics and semiconductor devices through computer hardware and software and on to the Internet, development of all of the components of digital information and communications technology reflected state policies for R&D and procurement.

There is a larger lesson here. Over 250 years, economic growth has been driven by successive processes of trial and error and error and error: upstream exercises in research and invention, and downstream experiments in exploiting the new economic space opened by innovation. Each of these activities necessarily generates much waste along the way, such as dead-end research programs, useless inventions and failed commercial ventures. In between, the innovations that have repeatedly transformed the architecture of the market economy, from canals to the Internet, have required massive investments to construct networks whose value in use could not be imagined at the outset of deployment.

At every stage, the innovation economy depends on sources of funding decoupled from concern for economic return. As economists have long recognized, such funding will not be delivered by competitive markets. Only an active state in pursuit of politically legitimate missions — national development, national security, conquering disease — can play the required role.

Thus, from the Erie Canal to the Internet by way of the transcontinental railroads and the Interstate Highway System, the American state has played a strategic role in the deployment of the transformational technologies that have created a succession of “new economies.” In disregard of this history, forces have been at work for a generation to delegitimize the state as an economic actor — even as the next new economy can already be defined in broad strokes.

For example, a low-carbon economy can be built only on a base of substantial state support. A host of technologies — batteries and solar cells and fuel cells among them — require extended investment to improve absolute performance and the ratio of performance to cost. As in the development of the digital economy, state procurement programs open to all will prove more effective than selective state subsidies to would-be winners.

Government cannot play the role either of entrepreneur or venture capitalist in creating the low-carbon economy. But entrepreneurs and venture capitalists cannot build this new economy by themselves. The venture capital model is radically unsuited to investment in fundamental science or in technological invention in its nascent stages. For the next generation of entrepreneurs and venture capitalists to have their opportunity to dance, they need government agencies as active and creative as those that served my generation.

One final challenge confronts us. As in all the strategic economic contributions by government, a legitimizing mission is required. Responding to the existential threat of climate change presents just such a mission. So are the climate change deniers who have stalled needed state investments motivated by skepticism of the scientific consensus? Or is their asserted skepticism motivated by the knowledge that acceptance of the reality of climate change will bring the state back in as a legitimate economic actor? These are the questions we need to be asking.

William H. Janeway is a managing director and senior adviser of a leading private equity firm and a visiting lecturer at Cambridge University. He wrote this for the Los Angeles Times.