Risks of government investment in innovation

25 Jan 2012 Sandeep Mehta

We have often talked about the role of the government investment in driving innovation (and here).  We had identified the risks of government investment as corruption and inefficiency.  We had also discussed potential solutions: 1) Have a large number of industry participants competing for government investment and 2) address smaller industries such as wind power for innovation investment (as opposed to large fixed cost industries such as high speed rail).

The article How do we know that China is overinvesting? by Prof. Pettis has one additional major risk – lost economic value.  The article discusses large investment made by the Chinese government in the electric car industry:

The electric car industry was often Exhibit A in the argument that Chinese investment was in the aggregate rational and economically sensible. This industry is clearly the industry of the future, the China bulls argued, and China’s massive investment in the technology, which would allow the country to dominate one of the key sectors of the future, showed why it was mistaken to complain about capital misallocation. This kind of investment was actually very clever stuff.

Prof. Pettis points out two major concerns about the investment:

  1. Whether the total economic costs of investment are less than the total economic benefits: Innovation should create additional wealth for the country that more than offsets the government investment.
  2. Whether there is a mismatch in the timing of costs and benefits: Even if the value generated is positive in the long-term, it might be negative for short to medium term and harmful to the economy.

These are good question to ask, but probably difficult to answer effectively.  Computing economic value of an innovation investment is likely expensive.  It would be difficult to build a business case to invest in the effort to compute economic value.  However, the key problem that the article identifies is very valid:

… risky high-technology ventures are not best funded and directed by companies, industries and policymakers who are historically weak in the technology sector, especially when they have no shareholder or budget constraints and have almost unlimited access to heavily-subsidized capital. This seemed to me a recipe for wasted investment.”

After the significant thrust by the Chinese government in electric vehicles, the reality set in – there was no market for the electric vehicles.  Instead of redirecting the innovation investment, the government tried to compensate for it through regulation:

…a directive signed by four government ministries encouraging 25 pilot cities, including major markets such as Beijing and Shanghai, to “actively study” exemptions for electric cars from license plate lotteries and auctions, as well as a host of other purchase restrictions.

Hence, the industry was propped up:

The only way to make electric cars economically viable in China, in other words, is to put into place administrative measures that divert buyers, but as any economics student can tell you, these kinds of administrative measures simply shift resources from one sector of the economy to another without creating wealth. In fact because they force consumers to choose something that they otherwise wouldn’t, they actually reduce overall wealth.

One way to justify this additional regulation could be reduced emission / pollution.  But the fact that the regulation was not planned in the first place, and is being considered solely to account for lack of market demand reduces the efficacy of that justification.

So, we could add a couple more solutions to our list: 3) Target small businesses for the bulk of the innovation investment; 4) Focus on investment, not regulation to promote adoption of innovation; and 5) if regulation is necessary, plan for it upfront while deciding the investment.

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