How American Capitalism Really Works

Some Lessons for Developing Countries

William Lazonick

Defined as the act of forming a new business, entrepreneurship is viewed as a prime way in which individualism can contribute to economic development.  Recently The Economist depicted entrepreneurs as “global heroes” who can lead us out of the current economic crisis.[1] Nevertheless, the same Economist report asked: “Why have so many once-celebrated entrepreneurs turned out to be crooks?” In either case, a focus on entrepreneurship emphasizes, for better or for worse, the individualistic character of the capitalist economy.

The history of successful capitalist development shows, however, that state intervention creates the fundamental conditions under which entrepreneurial individualism can flourish.  A growing body of research has analyzed the symbiosis between the developmental state and high-tech entrepreneurship in different national contexts.  Indeed, as I argue in this article, the national economy that most exemplifies this symbiosis is the United States of America.

Policy makers in developing economies have much to learn from the development experiences of rich nations such as the United States, but those experiences must reflect economic reality, not economic ideology.  Operating on its own, entrepreneurial individualism will, at best, fail to generate economic development, or, at worst, degenerate into rent-seeking behavior.  An understanding of how American capitalism really works calls into question the free market ideology that, for the sake of economic development, only individual activity is creative while collective activity is destructive. 

The Developmental States of America

In all the advanced economies over the past century, first and foremost the United States where the ideology of ’free market’ entrepreneurialism is most virulent, successful entrepreneurship  has depended heavily upon government investment in the knowledge base, state sponsored protection of markets and intellectual property rights, as well as state subsidies to support business investment strategies.  Scholars of the developmental state have tended to see it as a Japanese, and by extension East Asian, phenomenon, while neglecting the role of the developmental state in the United States, the world’s largest and arguably the most entrepreneurial of the advanced economies. Yet, during the twentieth century, the US state has been far more developmental than the Japanese state. Scholarly works have been written on the evolution of particular US industries – for example, agriculture, airliners, aircraft engines, computers, the Internet, biotechnology – that support this proposition.  Biopharmaceuticals provide a case in point.

Government Support for Innovative Enterprise

From the late 1990s to 2007, the US biotechnology industry was booming, with venture capital investment in biopharmaceutical start-ups at extraordinarily high levels. Comparing 2000-2007 with 1992-1999, the average annual number of private equity deals increased sharply from 214 to 351, while the average annual amount of investment in 2007 almost tripled, rising from US$ 1,419 million to US$ 3,856 million.  Yet it requires about US$ 1 billion to develop a new drug over a timeframe of 10-15 years, with absolutely no guarantee of success.  The biotechnology industry is now well into its fourth decade of existence, but it remains an industry in which on the whole, it is difficult to generate a profit on the basis of drug sales.

Indeed the biotechnology industry would not even exist in the United States (or elsewhere for that matter) were it not for a long history of large scale and persistent government investment in the life sciences knowledge base. From 1938, when the first National Institute of Health was launched, until 2007, the National Institutes of Health (NIH) expended US$ 615 billion in 2007 dollars on building a knowledge base on which biopharmaceutical firms can draw to develop new drugs. In 2008 the NIH budget was US$ 29.2 billion, with an equal amount allocated for 2009. Annual expenditures in the last half of the 2000s are in real terms about twice their levels a decade earlier. 

These funds support research, training, fellowships, and R&D contracts through nearly 50,000 competitive grants to more than 325,000 researchers at over 3,000 universities, medical schools, and other research institutions, including 6,000 researchers at the 27 NIH centers in Bethesda, Maryland.  In 2008 US$ 9.8 billion, or one-third, of the NIH research funds went to biotechnology (a classification that cuts across centers). As one of the NIH’s 27 centers, for example, the National Human Genome Research Institute received over US$ 5.9 billion in 2007 dollars since its inception in 1989 through 2007, and in 2008 was allocated US$ 487 million.

From the late 1970s, government regulation encouraged entrepreneurial start-ups to make use of this knowledge base. Encouraged by intense lobbying by the National Venture Capital Association, the US Congress lowered the capital gains tax rate from a historic high of 49 percent in 1976 to a maximum of 20 percent in 1980. The Bayh-Dole Act of 1980 gave university and hospital research labs clear property rights to new knowledge that resulted from US government-funded research so that they could license the results of their research to new technology firms. The main motivation for Bayh-Dole was the growing number of biotech inventions emanating from NIH research that, it was argued, would be left unexploited but for the Act’s less restrictive conditions for the transfer of intellectual property. In 1980 as well, a Supreme Court decision that genetically engineered life forms are patentable facilitated the opportunity for the types of knowledge transfers that Bayh-Dole envisioned.

In 1983 another important inducement to biotech investment took the form of the Orphan Drug Act, which gave generous tax credits for research and experimentation as well as the possibility of seven-year market exclusivity for companies that developed drugs for ‘rare’ diseases. It was argued that without these financial incentives, many potential medicinal drugs that could be developed for relatively small markets would remain ‘orphans’: pharmaceutical or biotech companies would not have been willing the make financial commitments of the size and duration required to nurture these drugs from infancy to adulthood. From 1983 through 2008, the FDA designated 1,951 orphan drug submissions and granted market exclusivity on 327 drugs that reached approval.  Of 31 biotech drugs that through 2007 had become ‘blockbusters’ with US$ 1 billion or more in sales in at least one year, 20 originated as orphan drugs. In 2001 the European Union followed the US lead by passing its own Orphan Drug Act.

Publicly Funded Education as the Foundation of Entrepreneurial Innovation

The previous example illustrates that in the first decade of the twenty-first century the United States still possesses a formidable developmental state. In the previous decades Japan was able to grow rich without its state being as developmental as that of the United States because its firms could take advantage, through licensing and joint ventures, of knowledge created in the United States. Nevertheless, the further development and utilization of this knowledge to engage in indigenous innovation required that Japanese firms had sufficient ‘absorptive capacity’ to transform knowledge transferred from abroad into indigenous innovation. As a precondition for absorptive capacity and hence indigenous innovation, a nation has to have already made the most strategic and most expensive investment of them all: investment in a public system of primary, secondary and tertiary education. The economic institutions that support entrepreneurship and innovation in the United States and Japan may differ radically, but what these, as well as other advanced economies, have in common are long histories of massive investment in their education systems.

Such US government investment began with the Morrill Land Grant Act of 1862, out of which emerged a nationwide system of higher education oriented toward industrial development, including universities such as MIT, Cornell, Michigan, Purdue, Iowa, and the University of California, Berkeley. In the development of Silicon Valley, the key institution of higher education was Stanford University, founded in 1885 on the basis of railroad wealth (an industry that in the nineteenth century was itself heavily subsidized by government land grants). From the 1930s Stanford oriented itself to support industrial development.

The key ‘public entrepreneur’ at Stanford was Frederick Terman. With an electrical engineering doctorate from MIT, Terman was a professor of engineering at Stanford in the 1930s, spent the Second World War directing the Harvard University Radio Research Lab, returned to Stanford after the war as its dean of engineering, and became the University’s provost in the 1950s. Two of Terman’s students in the 1930s were William Hewlett and David Packard, who in 1939, on the urging of Terman, founded the eponymous firm adjacent to Stanford.  Government military contracts were critical to Hewlett-Packard’s early growth. In the 1940s and 1950s the area around Stanford became a prime location for high-tech businesses engaged in military research and manufacturing for the US government.

The founding of Hewlett-Packard reflected Terman’s vision of Stanford as a high-tech industrial district that would spawn start-ups. In the Boston area, Georges Doriot, a professor at Harvard Business School, had a similar vision. After the Second World War, Doriot and a number of academic and business leaders in the Boston area, through the pioneering venture capital firm, American Research & Development, made a conscious and successful attempt to commercialize the military technologies that had accumulated at the Massachusetts Institute of Technology, by far the most important university in the nation for military research. The result by the 1950s was the emergence of ‘Route 128’ in the Greater Boston area as the world’s leading high-tech industrial district.

In the post Second World War decades, Japan, South Korea and Taiwan transformed themselves from low-income to high-income nations by making use of well-educated populations as the foundation for industrial development. In the case of Japan, laws dating back to 1886 made primary education universally free and compulsory, and by 1909, 98 percent of all school age children went to primary school. Japan also developed a system of higher education from the late nineteenth century that sent its graduates into industry. Additionally, also from the late nineteenth century, Japanese companies engaged in the practice of sending university educated employees abroad for extended periods of time to learn about Western technology. Of utmost importance to Japan’s post Second World War development was the fact that for decades Japanese industrial enterprises had made university educated engineers integral to their managerial organizations.

The cases of South Korea and Taiwan should give pause to arguments that investments in knowledge-intensive sectors are not of much relevance to very poor nations such as those in Africa. While most African nations are certainly not well positioned to compete in high-tech industries, it must be remembered that South Korea’s GDP per capita was only 10 percent of that of the United States in 1960 and 13 per cent in 1970, while that of Taiwan was just 13 per cent in 1960 and 20 percent in 1970. In 2006, South Korea’s GDP per capita was 58 percent of that of the United States and Taiwan’s 63 percent. In the 1980s and 1990s through ‘indigenous innovation’ – improvements in technologies that are transferred from abroad – these nations, like Japan about a quarter century before, transformed themselves from poor nations into rich nations.

Now China and India, with one third of the world’s population, are also developing rapidly on the basis of indigenous innovation. India’s system of higher education has provided a foundation for the developmental of world-class capabilities in IT services.  But the fact that as late as 2000, 44 percent of Indians age 15 or older had no schooling has prevented the nation from developing such capabilities in manufacturing industries, in sharp contrast to China with its far more egalitarian educational system.

Concluding Remarks

It is a mistake, therefore, to associate growth enhancing entrepreneurship with free market individualism. There is no shortage of entrepreneurial individualism in American-style capitalism, but its transformation into higher standards of living has depended critically on investments, protections and subsidies provided by the developmental state. In addition, as is discussed fully in my WIDER discussion paper from which this article is drawn, even at the level of the business enterprise, entrepreneurial individualism is at best a transitory phenomenon as, through the collective and cumulative learning processes that are the essence of innovative enterprise, entrepreneurial start-ups are transformed into professionally managed going concerns. Far from disrupting this model of collective capitalism, the policies that are required to extricate the US economy from its current crisis would strengthen it as the developmental state commits to new investments in the knowledge base and new financial subsidies as a foundation for a renewal of vigorous entrepreneurship.  

For developing countries the lessons are clear: the attainment of higher standards of living requires state intervention that goes beyond ensuring property rights and the rule of law.  The state must be regulatory, but it also must be developmental. At the same time, the instability and inequity that accompanies economic growth under American-style capitalism should lead policymakers in developing countries to seek to identify those varieties of capitalism in the advanced nations that can serve as superior models for generating stable and equitable economic growth.

[1] “A special report on entrepreneurship: Global heroes”,Economist Intelligence Unit, March 18, 2009.

WIDER Angle newsletter, April 2009

ISSN 1238-9544