Organizations and wealth creation

Uwe E. Reinhardt, a noted economics professor, has posted a series of essays at the Economix blog on wealth creation — the latest being Who Creates the Wealth in Society? In this essay, he expands upon the basic theme:

It is now well recognized that the wealth of modern societies is dictated not so much by the natural resources at their disposal, but by their human capital — the knowledge and skill of human beings and their ability to learn and apply new knowledge on their own.

This leads him to the important role of the family – as the original institution for fostering human capital.
I would push this a step further. It is not just human capital — “knowledge and skill of human beings and their ability to learn.” It is the organizations and the other framework conditions that allow for that human capital to be used. As I hinted at in the previous posting, too many organizations focus only on certain parts of their human capital. All parts of facets of an organization’s human capital need to be fully engaged. We used to call this the “high road” strategy of high skills and high wages.
But that is not enough, the organizational structures themselves need to promote knowledge creation, sharing and utilization. At one point, we called these high performance work organizations or learning organizations or innovative organizations.
No matter what we call them, the point is the same. The way in which human capital is organized is just as important as the human capital itself.
Reinhardt ends his essay with the following:

Governments everywhere in modern societies provide the legal and much of the physical infrastructure on which private production and commerce thrive. Imagine a world in which private contracts can be adjudicated and enforced only by private thugs rather than in the civil courts.
Just as sports contests could not be fairly conducted without a strict set of rules and referees with power, so private markets could not thrive without regulations and regulators with power. A truly laissez-faire market economy would be apt to be a mess, as what Wall Street made of its own business in recent years reminds us.
. . .
A nation’s wealth is truly a joint creation in which individuals, families, business and government all play crucial parts. Finding just that mix of efforts and regulations that will maximize society’s well-being is a tricky and never-ending quest.

But governments need to do much more than play the referee. They need to be involved in helping create the intellectual capital that makes the economy work. Part of that is active assistance in fostering the organizational capital needed for the I-Cubed Economy.
In that regard, I have been advocating for changes in public policies to foster greater utilization of intellectual capital (see our Policy Brief Intellectual Capital and Revitalizing Manufacturing). These include:

Expand the Manufacturing Extension Partnership (MEP) to Boost Intellectual Capital. The Administration’s budget appropriately calls for doubling the MEP budget, but the scope of this assistance to manufacturers needs to be expanded to include innovation, new product development, and utilization of intellectual capital. Manufacturing companies have a wealth of intellectual capital that they often do not recognize or manage well. MEP services must include intellectual resource management that covers a broad array of assets, beyond help with intellectual property. The program’s budget increase should be used to expand services and staffing in areas such as marketing, finance, and business model development, in addition to new product development and process adoption.
Help Entrepreneurs Manage Intellectual Capital. The Administration’s A Framework for Revitalizing American Manufacturing specifically cites efforts by the U.S. Small Business Administration (SBA) to provide entrepreneurship training and to foster partnerships with community colleges, universities, and others. It also mentions the U.S. Economic Development Administration (EDA) program of supporting business incubators. But most of these training programs do not explicitly recognize the importance of managing intangible assets and intellectual capital. Programs that support entrepreneurs need to incorporate these topics as part of their activities and impart these essential skills to would-be innovators.

We need to move ahead with programs like this if we are to truly restore wealth creation in this country.

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Investing in people pays off – all the way down the hierarchy

How often have we heard the cliché, “our people are our most valuable asset”? Of course, those of us who have been studying the knowledge economy have known that for a long time. But too often, we see company executives mouthing the phrase without any real understanding. For them, what they mean is “our highly paid workers, like me, are our most valuable assets.” Hence the rationale for CEO compensation scheme, bidding wars for “talent” and “key individual” insurance policies.
A new report should help break that mindset — Profit at the Bottom of the Ladder: A Summary Report on the Experiences of Companies that Improve Conditions at the Base. The report outlines a number of steps companies can take to increase profitability by investing in line workers. That includes increased attention to workers’ health, training, incentives, and engagement. As the report notes, companies need to better understand who is actually performing the work and realize that these workers are key to both the ongoing success of the company and future productivity and efficiency.
One of their conclusion is something I have been advocating for years:

As practices on Wall Street and in firms are being rethought, along with the role of the public sector in rendering the investment process more transparent, one of the areas needing a new approach is the evaluation of and reporting on long term investments in employees. (Emphasis in original).

For a summary of the research, see this recent piece in the New York Times Economix blog — Finding Profit From Investing in Workers.

Using bank loans to finance innovation

There is a new paper on the role of bank loans in innovation — Beg, Borrow, and Deal? Entrepreneurship and Financing in New Firm Innovation by Sheryl Smith of Temple University. Using data from Kauffman Firm Survey (KFS), she looks at the financing of start-up. She also reviews the theoretical literature of why entrepreneurs would choose equity or debt financing and the relationship of that decision to innovation and risk. The findings point to why fostering the opportunity for debt financing may benefit innovation:

With regard to debt financing, the evidence in this paper suggests that information asymmetry combined with technical risk influences the ability to secure bank financing. Banks, unlike providers of equity finance, do not share in a potential upside of a high growth firm. However, there is evidence that as information asymmetry is lessened over subsequent periods, banks are more likely to lend to high tech firms. As the riskiness of a high-tech firms decreases, they are increasingly likely to receive business bank loans over time, suggesting the likelihood of business bank loans targeting the firms, over time, with higher growth potential. This is consistent with the literature on bank lending to new ventures, and in particular the role of monitoring and risk reduction in bank lending to entrepreneurs.

The results of the probit [a statistical technique] estimations in this paper suggest that increasing leverage over time might provide nascent technology entrepreneurs with financial slack that may enable with innovation. This implication bears closer attention in further work. The entrepreneur launching a new technology venture faces significant resource constraints, and the attendant need to secure financing. For firms with adequate financial resources, lower leverage, i.e. debt relative to total debt plus equity, is associated with greater financial slack and enhanced innovation. In this case, lower leverage would be necessary for firms competing significantly on the basis of innovation (O’Brien, 2003). However, when financial resources are highly constrained, as in a new entrepreneurial venture, the relationship between slack and performance is nuanced (George, 2005). While traditionally the finance literature associates increasing leverage with lower innovation, it seems highly plausible that in truly nascent technology firms additional debt relaxes the major capital constraints faced by the entrepreneur.

From a public policy point of view, that conclusion begs the next question: how can we help those nascent technology firms access that debt as appropriate? We have long advocated the use of IP and other intangibles assets as collateral on loans. As noted in an earlier posting, the KFS will be asking more in-depth questions on company borrowing, including whether they are putting up their IP as collateral. That will give us some idea to the extent of the practice. More survey’s would also be useful — specifically of banks and other lenders. And we need to move forward on creating underwriting standards for intangible-backed loans. Smith’s research point the way toward understanding the positive role debt financing plays in innovation. We should build upon and expand that work.

Innovation, the history of spintronics and the linear model

I recently ran across an interesting history of nanoelectronics — aka spintronics. The article (From Lab to iPod: A Story of Discovery and Commercialization in the Post-Cold War Era) by history professor W. Patrick McCray describes how a scientific discovery of giant magnetoresistance (GMR) led to a series of technological advances in electronics. The bases for these advances was the ability to control electrons’ spin, not just charge — hence the term “spintronics.” This made possible a number of breakthroughs in memory storage (both in size and in the ability of devices to retain their information without a power source). It also spurred interest in nanotechnology in general.
What is more interesting is McCray’s conclusion:

The story of spintronics can also shed light on debates that have reemerged among scholars about some major historiographical questions. One of these concerns the validity of the linear model of research. Presented most famously by Vannevar Bush in his 1945 report, Science: The Endless Frontier, the most basic form of the model supposes a direct path from scientific discovery to application. While historians have examined, refined, and problematized it for decades, this model remains a point of contention and scholarly inquiry.85 To a first order of approximation, the case of spintronics appears to lend credence to the traditional linear model, which posits science as a prime mover for technological applications. As members of the 2007 Nobel committee saw it, an unexpected laboratory discovery inspired IBM’s industrial research and successful exploitation of the phenomenon and consequently billions of computers and iPods followed. The full story, of course, was much more complex, revealing the interplay among basic science, instrumentation, federal policy, industrial research, and commercial goals. One cannot help but conclude that the “simple” linear model, when examined closely enough, is anything but.

So even in the cases whether the linear model seems to fit, it doesn’t. The case study really points out the role of the ecosystem — with numerous elements all coming together to make the technology possible.
McCray has written a more recent essay on that topic — Re-Thinking Innovation. In that essay he notes:

For decades, the predominant model was linear. Based on Science: The Endless Frontier, Vannevar Bush’s 1945 social contract for science, the linear model posited that investments in basic science research would produce new technologies and societal benefits–meaning innovation. Rhetorically powerful as well as easy to understand and explain to policymakers, deployment of the linear model ignores the historical contingency of Bush’s report, which has, for better or worse, been the touchstone for much U.S. R&D policy.

I would highlight just one other paragraph.

Historically, artistic endeavor, broadly construed, has been a powerful driver of technological innovation. Advances in metalworking and ceramics traditionally originated in the workshops of artisans who produced objects valued more for their aesthetic quality than purely utilitarian ones. The feedback is powerful–in Renaissance Venice, improvements in glassmaking stimulated the production of more capable scientific instruments that played central roles in the Scientific Revolution.

Clearly, the process has always been a lot messier than the linear model posited.

New growth economics book

I’ve just finished reading a new book on “new growth economics” — From Poverty to Prosperity: Intangible Assets, Hidden Liabilities and The Lasting Triumph over Scarcity by Arnold King and Nick Schulz. The first 3 chapters and especially the conversation with Paul Romer make up one of the best explanations of the new economy I’ve seen.
Unfortunately the rest of the book is not as good. It pains me to say it, but the chapter on entrepreneurship descends to a level of gross oversimplification and glorification bordering on psycho-babble. That is a real missed opportunity, because it touches upon and begins to delve into a real issue in innovation: the principal-agent problem. The point is important in their discussion about innovation inside and outside of organizations. As they point out, innovators inside organizations are playing with the company’s dime. And the systems inside companies are set up to prevent rogue employees from taking overly risky bets. Thus, there are some real reasons why organizations are resistant to change — that goes beyond the standard explanation of “cultural resistance.” It would have been a major step forward if the authors had explored these issues in greater detail.
I also think that they overplay how the external entrepreneur bears the cost of failure (in contrast to the internal innovator). One of the strengths of the US entrepreneurial system is that the market in the US is relatively tolerant of failure. The key is to fail small and fail quickly. Those types of failures are accepted as part of the learning process. If we had a market system where failure was severely punished, then the innovation ecosystem would be very different.
The chapter on financial intermediation seems thrown in to dealt with a perceived need to say something about the financial meltdown.
The book also has a pretty evident ideological bias — both anti-“industrial policy” and anti-government — which is clear in the authors’ talk at Cato Institute. It would have been a far more interesting book if they had a more balanced set of interviews of people you have made important contributions — like Joseph Stiglitz and Paul Krugman among others.
As a result of their ideological bias, they completely dismiss any role of government in fostering the creation of intangible assets and promoting innovation. Instead they repeatedly assert a version of the simplistic “markets good; government bad” rhetoric. That version is based on a good concept — adaptive or dynamic efficiency (they use the terms “adaptive” and “dynamic” interchangeably). But they seem incapably of accepting that government can play a positive role in promoting adaptive efficiency. Even though one of the interview explicitly talks about the importance of anti-trust regulations, the conclusion is that regulation hurts, everywhere, all the time. Likewise they use broad strokes to deny that governments can be innovative — pulling out that hoary old chestnut of the Department of Motor Vehicles (again without an apparent understanding of how DMV’s have changed in the past decade to utilize information technology).
Again here they miss a wonderful opportunity to explore the pressures that make governments innovative and compare them to markets. In fact, the rhetoric that “of course we all know governments can innovate” is itself a major barrier to innovation. Like the little train that can’t, if you are always told you can’t innovate, you won’t. The discussion of adaptive efficiency could have been an important contribution to the innovation debate. Instead, it was used to assert that government is bad.
Too bad. If they had taken a more open minded approach, this could have been an excellent book. As it is, this is merely a book with some very good parts.

Open innovation and economic development

Here is an interesting new article published in Economic Development Quarterly (subscription required) – Catching Up: The Role of State Science and Technology Policy in Open Innovation:

This article examines the impact of the emerging model of open innovation on state public policy, particularly the practice of technology-based economic development in weak research and development (R&D) states. Open innovation describes the nascent practice of firms using knowledge created outside their boundaries and also marketing ideas they would not commercialize themselves. Firms engaging in open innovation thrive on knowledge spillovers, and weak R&D regions could benefit from this model through the creation of Marshallian externalities. It is therefore interesting to ask whether weak R&D states take advantage of this model. This case study analysis shows that states involved in the Experimental Program to Stimulate Competitive Research partially support the emerging open innovation paradigm. All states have science and technology strategies and actively support and invest in their higher education infrastructure. They show variation in their support for university-industry partnerships, entrepreneurship, capital access, commercialization, and technology transfer. None of the states, however, uses the open innovation framework explicitly.

That conclusion — the open innovation framework is not explicitly incorporated into economic development activities — should not, unfortunately, surprise anyone. Just one more example where our public policy has not caught up with the shift to the I-Cubed Economy.
(Thanks to Innovation Daily for a heads up on this article).

Design your own — the shirt on your back

One of the changes happening in manufacturing is the shift to what used to be called mass customization. Sunday’s New York Times had an article Putting Customers in Charge of Designing Shirts describing one example. In this example, however, it appears that the production is still labor intensive using low cost labor. Essentially it is the internet version of the old-time famous Hong Kong suit (for those who aren’t old enough to remember – visitors to Hong Kong would buy tailors suits at every trip because of the low costs — my versions come from Singapore). But as the story notes, there is a growing trend to “co-creation” — where customers customize (see earlier posting).
Combining co-creation technologies with advanced manufacturing capabilities will change the nature of the production of goods and services. As I’ve said before, the key phrase in manufacturing has moved beyond “just-in-time” (inventory management aimed at low cost through efficiency) to “just-for-me.”