It is through innovation (technological, institutional, organizational and cultural) that economic development– or the ‘capital development of the economy’ (in the words of Minsky) – occurs. In Schumpeter’s analysis of the capitalist economy, innovation comes about only if new purchasing power (credit) is made available to entrepreneurs willing to take the risk of innovating. Thus Schumpeter assigns a central role to bankers, whom he sees as the ‘capitalist per excellence’, because they create purchasing power by lending to risk-taking entrepreneurs. In Schumpeter, the prototypical function of the financial system (represented by ‘the banker’) is therefore to provide finance for innovative industrial activities and thus promote economic development.
Innovation, however, does not occur only in industry – it also occurs in the financial system itself. And Schumpeter’s ‘rosy’ view of finance, ignoring the ‘gambler’ speculative role –emphasized more by both Keynes and Minsky – has rendered the ‘Schumpeterian’ perspective obsolete to understand innovation in the financial sphere, which has a dynamics of its own. This is also due to the fact that credit in Schumpeter continues to be treated principally as greasing the wheels of capitalism. Indeed, a key goal of our Project is to bring together Schumpeter’s understanding of innovation, applying it to finance, but within a perspective where finance is more than just means of exchange, more than a veil blurring the real economy. It can have a dynamic of its own. And as such, it may not only promote but also hurt innovation.
In the past three decades, concomitant to the dominance of neoliberal ideology in economics and politics, important innovations changed the character of the global financial system. These financial (and institutional) innovations included the collapse of the Bretton Woods arrangements in the early 1970s and the establishment of a floating exchange rate regime, with the U.S. dollar emerging as the main reserve (fiat) currency; the growth of derivative markets and the publication and diffusion of the Black-Scholes option-pricing model (1973); the ‘Big Bang’ deregulation policies of finance (including derivative markets) of the 1980s in Europe and the U.S., which continued until the end of the 1990s; the incremental relaxation and ultimate repeal of key provisions of the Glass-Steagal Act of 1933, which had limited commercial banks’ speculative activities and separated investment from commercial banks; the replacement of merchant banking by investment banking and the refocusing of commercial banking on household lending; the move by nonfinancial corporations toward viewing cash management as a source of revenue; the rise of the shadow banking system (including hedge funds, private equity groups, venture capital and ‘business angels’); the move by nonfinancial giants like GE and GM into financial services; and the growth of securitization of debts and structured finance through innovative financial products (Asset-Backed Securities). The result was steep growth of the financial sector and a relative decline of industry, together with the financialization of industry practices targeted at short-term returns and maximization of market values. Using Keynes’ famous distinction, speculation came to dominate industry.
Paradoxically, while at the macro level there was ‘far too much’ finance supplied relative to the ‘real’ activities, at the micro level there was ‘far too little’ finance supplied to nonfinancial innovations. Thus, while many ‘industry’ (product and process) innovations also occurred in these decades, it is not clear whether the transformed financial system continued playing its crucial role of funding the capital development of the economy. On the surface, it appears instead that those financial innovations have led to simple ‘value extraction’ at the expense of ‘value creation’, with the collateral effect of income polarization. This has indeed been the view expressed by Minsky in his works post-1986. Putting Schumpeter’s theoretical analysis into perspective, Minsky argued that the financial system (and its profit-seeking innovations) contributes to the capital development of the economy only if the appropriate institutional and incentive structures are in place. In the absence of such structures, financial innovations undermine economic development, as it diverts credit from entrepreneurs and innovative activities of industry, and can ultimately lead to financial and economic crisis. The Great Financial Crisis that began in 2007 is a prime example of the destructive force of financial innovation and predatory practices of the financial services sector.
Because of the collective (i.e. the synergic combination of skills and resources), cumulative (i.e. history and experience matter) and uncertain (i.e. there is no guarantee of success) characteristics of the innovation process, the transformed financial sector was (and still is) able to extract more value than it creates in the form of economic rent. Indeed, in many of the financial arrangements, top management of financial institutions would “win” no matter what happened to the nonfinancial sector; and in some cases, money managers actually benefited from losses incurred by customers on both sides of the balance sheet. In other words, decision makers in the financial services sector have been ‘rewarded’ disproportionately to the risks they took in the innovation process, although in the process they destroyed massive amounts of the economy’s financial wealth that they had been trusted to manage When finance is geared to short-term, ‘certain’ returns, radical innovations struggle to flourish, because the time required from basic research, through invention and development to diffusion in markets is too long and uncertain. The biotech sector is a case to point, where investors are interested in easy, profitable exits for their investments in a narrow window of a few years. Another example are recent investments in renewable energy companies, such as Solyndra (solar energy), where the early exit of the ‘impatient’ venture capital backing it meant its bankruptcy. Some countries have shown that an alternative to private funding of radical innovations exist in the form of national development banks (such as BNDES in Brazil, KfW in Germany, or CDB in China), which are positioned to invest in long-term investments and able to bare the risk of failure.
The financial ‘eco-system’ needs to be rebalanced towards value-creating activities and innovations, so that it is rewarded for its right contribution to the capital development of the economy. Reforming finance is therefore crucial for the world-wide economic recovery to take off. While green technologies offer the potential to become the new growth-engine, their development and diffusion require long-term committed – or patient – capital, plus enabling policies to overcome barriers in e.g. the demand market. While the works of Schumpeter, Minsky, Keynes and others offer key insights into the changes needed to ‘heal’ the global economy, the new 21st Century context presents idiosyncrasies that may defy their theory and analysis. Standing on the shoulder of those ‘giants’, we hope that contributions to this workshop will update and combine their insights, thus helping address the pressing challenge of putting the world economy back into the path of smart, inclusive and sustainable growth.