When the bubble bursts

Economist Mariana Mazzucato on the “creative destruction” initiated by technological innovation and the brazen “destructive creation” of speculative finance.

Mariana _1

Mariana wears a jumper by Joseph from Net-a-Porter.com.

In the two years since Tank first featured Mariana Mazzucato, her stock as one of the world’s foremost economic authorities has risen exponentially. When we last spoke to her, her book The Entrepreneurial State: Debunking Public vs. Private Sector Myths (Anthem, 2013) had just been published to lavish acclaim. Her passionate argument for the need to develop new frameworks to understand the role of the state in economic growth – and to enable the resulting rewards to be as “social” as the risks – saw it catapulted onto the Financial Times’ 2013 Books of the Year list. She is currently working on research projects commissioned by organisations from NASA to the Brazilian Ministry for Science and Technology, is a member of the Labour Party’s Economic Advisory Committee and the Scottish Government’s Council of Economic Advisors.

Focusing on the relationships between financial markets, innovation and economic growth – at the company, industry and national levels – Mazzucato continues to work at the cutting edge of economics. Her charismatic approach underpins a radical re-evaluation of the state’s role in funding and developing innovation, bringing it to the forefront of both policy debate and popular discussion. She has spoken emphatically in favour of “green growth” – economic development led by smart, ecologically sound policy, which can stimulate both private and public investment. She has reported on the ways in which Apple’s phenomenal financial success has depended, to a great extent, on state-sponsored R&D, and has asked where is the return for the taxpayer that might help found future investment in innovation. And she has investigated some of the most precarious and contentious economic activity of recent years, contrasting the over-investment in technology that creates fruitful technological bubbles (the economist Joseph Schumpeter’s concept of “creative destruction”) with the “destructive creation” of financial speculation. This distinction is vital in the current economic landscape. Mazzucato describes how John Maynard Keynes’ “animal spirits” are essential for driving investment in new technological capital, and are equally likely to lead to a financial crisis when confidence in future profits collapses. Even when investment bubbles burst, the technological innovations that survive can spur future growth. Yet the financial crisis of 2008 offers an example of pure speculation – destructive creation at its most brazen.

Unsurprisingly, her work has attracted a certain degree of controversy. The vigour with which she pushes back against the established blind spots of economic theory has been displayed to extraordinary effect in forums from World Economic Forum to Newsnight, and her forward-thinking, no-nonsense arguments continue to reframe both debates and policy. So when Tank considered bubbles, we naturally turned to her.

Are bubbles just madness?

Economic bubbles arise when there is over-investment in a particular area. By “over” I mean above and beyond the ability of the economy to absorb such investment in terms of productive capacity or consumer demand, whether it be in railways (more than what is needed) or in real estate (more than what consumers can actually afford). 

On the business investment side, the reason we have over-investment is due to how expectation formation works. Investment is not driven by simple things like taxes or interest rates – though they will affect it – but by the expectations of investors about future growth opportunities in an area. While taxes and interest rates may affect these expectations, they do not drive decisions on long-run investment. Such expectations can be affected by what Keynes called “animal spirits”, the gut instincts of investors. These gut instincts are affected by “herd effects” and “bandwagon effects” (both studied in behavioural finance), so that a person might invest in an area not because she really knows any of its fundamentals, like underlying earning power, productivity measures, etc., but because her colleagues and friends are investing in it, and they are doing so because they are watching others too. This is just as true for investments in technology as it is for investments in financial assets. And it is why we often get share prices of a company rising much more than its underlying earnings – there are huge expectations around particular companies, say in dot-com or biotech companies, even when they are earning nothing. 

As far as technology is concerned, we must remember that most attempts at innovation fail. Even when innovation succeeds, the ability of the economy to actually absorb all the new products or services is limited. If you look at the 19th-century railway bubble, rail was laid down, but there was only so much capacity that could be absorbed. The same is true of biotechnology or nanotechnology. With technological bubbles, when the bubble bursts, it will cause unemployment and destroy output, but at least in the end you have something useful left over: you have the internet; you have railroads; you have canals; infrastructure that will enable growth for decades. 

Researchers like Carlota Perez, a co-author of mine, have argued that in order to get technological revolutions, you actually need these cycles of expectation and over-investment. This is because no one knows beforehand what the future will bring, and the expectation formation process is both dangerous and essential, to allow the status quo – e.g., existing technologies – to be replaced by new technologies. Indeed, J.P. Morgan apparently told Ford that cars would only be “rich man’s toys” and so decided not to invest. He was too risk-averse. Luckily, Ford found financing elsewhere, including from the purchasing power of the US government during the war. So with too much rationality, there would be too little investment, and radically new technologies would never come about. My own research for The Entrepreneurial State showed how it has often been patient, long-term, committed finance from the government that has allowed some of the most disruptive technologies to emerge, from the US Department of Defence funding the internet and GPS to CERN in Europe funding HTML. The same is true for advances in aerospace and shale gas today. Private finance, even venture capital, is often too risk-averse to be willing to make long-run, high-risk bets – preferring to come in only after the taxpayer has laid the groundwork.  

And how does uncertainty fit into this?
Innovation is not only risky but truly uncertain – a distinction that both Frank Knight and John Maynard Keynes made in the 1920s. Any time you have real uncertainty, you can’t draw probability distributions around a situation, as you can for winning the lottery. That’s risk. Uncertainty is when you simply do not know. The probability that your boyfriend or girlfriend will break up with you, or Napoleon’s probability of success in a battle: no idea! Economists pretend that it’s all just about calculable risk, which means you can draw probability distributions around it. Innovation is extremely uncertain: whether an R&D experiment on a new drug is going to work, or the internet before the internet. 

This underlying uncertainty is also tied to another aspect: overconfidence. When the car was first invented in the late 1800s, there were 3,000 producers in the US alone, but a decade later only 300 of them were actually producing cars, of which only about 30 ever sold a car, and then after another few years, only three remained: GM, Ford and Chrysler! So there’s often over-entry into sectors, and we see this in sectors as different as autos, computers and biotech. If any of these new entrants actually looked at the probability of failure, they wouldn’t even enter. But everyone is overconfident about their own particular ability, which causes over-entry and eventually a bust, in the sense that most of the companies fail. Yet the word “bubble” in some ways confuses things. It is a catch-all word. What I have just described is more of a “shake-out”: an empirical regularity whereby about 75% of new entrants in all industries – whether cars or dot-com – fail. This happens for structural reasons too, such as product standardisation, which then causes price-cost ratios to fall, after which only the strongest firms, that are able to deal with lower profit margins, will survive. This happened after the Wintel model replaced the IBM platform or when the Ford Model T became a new standard. In both cases, many firms were forced out. The word “bubble” kind of conflates all that. 

What about financial bubbles?
With financial bubbles or real-estate bubbles, like the one we just lived through, what do you have at the end? Nothing! You just have a lot of dead companies. So one of the big differences is that with tech bubbles, we’re actually talking about investment in the real economy, and expectations about actual innovation, actual products, whether infrastructure or gadgets, and related services. You might have hype around them, but they are real. Whereas when you have over-investment in financial assets, including house prices, then there’s betting with speculation for speculation’s sake.

Let’s be clear. You need finance in order to get tech innovation, but that’s different from, say, financial bubbles, which are finance betting on finance, or the mortgage bubble, credit default swaps or hedge funds or derivatives. Indeed, the size of the financial sector has grown massively, precisely because finance was lending to… itself! So that was a pure financial bubble that had nothing to do with technology. There was of course financial innovation, but it was all aimed at itself (related to what Hyman Minsky called Ponzi finance), not at nurturing the capital development of the economy. So that’s a very important distinction: technological bubbles that result from over-financing in particular technologies should be distinguished from financial bubbles that are caused by speculation for speculation’s sake. I call it “creative destruction” – what Schumpeter talked about – versus “destructive creation”. 

What is the role of the state in this?
We’re living in an era in which governments fear providing too much of a direction. They pretend that the government needs only to level the playing field and the “market” will decide on what we produce – but that confuses what the market is.

The market is an outcome of the interactions between different economic actors: public actors and private actors, as well as pressure from civil society. So it’s not like you have the market here and policy “intervention” there. Policy has a role in shaping and creating markets – from the IT revolution to the emerging green revolution. In both “fixing” markets when things go wrong (we have just lived through a period in which things went massively wrong) and in creating something new and positive for the future.

There is so much misunderstanding about the financial crisis. What caused it was not public debt but private debt. In many parts of the Western world, real incomes haven’t increased since the 1980s. This means that people have had to take on debt in order to keep their living standards constant. On top of that low interest rates and government “help to buy” [homes] policies, encouraged people to take on even more debt. So there was a bubble in the housing market, the purchase of houses was beyond people’s ability to pay back those loans. When housing prices dropped, reducing personal equity, the bubble burst with massive foreclosures and so on. What should have happened from the policy perspective is that more and better paid jobs should have been created, through industrial and innovation policies, for example, and social policies should have been developed, around social housing or rental caps, so that people did not feel the pressure to buy but could rent in affordable ways, as occurs in Germany.

While it was private debt that caused the crisis and public spending that saved the day (bailing out banks, and providing stimulus to prevent the recession from becoming a full-blown depression), public debt got blamed and austerity became the name of the game. When cuts then occurred to public-sector wages, social services and public investment in general, this lowered tax receipts and increased the amount of welfare benefits being handed out, both increasing public debt. So a vicious cycle began: austerity cuts caused lower incomes which caused lower tax receipts, which caused lower demand, lower investment and so on.

Furthermore, there is a misunderstanding about the difference between deficts and debts. Many countries, such as Italy and Portugal, have very high debt-to-GDP ratios, not because deficits have been particularly high (the rate of growth of the numerator of debt/GDP), but because the denominator (GDP) has not been rising. And this has been because these countries have not had enough public investment in strategic areas like education, R&D, human capital formation. So the indiscriminate cuts to public expenditure that have been imposed on these countries, and that continue to be imposed, have only made things worse because they do not go to the root of the problem.

The scary thing is that things are not getting any better. Personal debt-to-income ratios are still very high. The student-loan bubble in the US – and now in the UK, where the Westminster government has started charging three times what it used to for a university education – is massive. Most of these loans, which in the US total more than $1 trillion, are not going to be paid back. It’s a ticking time bomb. Mark my words!

So maybe “bubble” isn’t the most helpful term?
The word “bubble”, in economics, is mainly used to denote over-investment which then bursts. But an economy crashing and a bubble bursting are not the same thing. An economy can crash due to structural reasons, and even many firms can be driven out of a market due to structural reasons like those I mentioned above.

The word “bubble” usually describes something that is very distant from an underlying truth. Financial bubbles are ones in which the “financial” measures for a firm – or for an entire national economy – are ones that have a minimal relationship with the underlying fundamentals, i.e. actual profits, earnings and levels of productivity. So things keep moving along until the real state of the economy, or of the firm in question, is discovered. And often by that time it’s too late.

What we should hope is that some lessons have been learned after this latest financial crisis, about how to steer the economy in a way that limits the damaging effect of bubbles. And while all bubbles are dangerous, we should hope for ones that are more technology-driven, allowing us to have something in the end, rather than purely financial ones that end with share prices crashing, companies going down and massive unemployment. With the government having to step in, again, to clean things up… and then getting blamed! §

The Entrepreneurial State, published by Public Affairs, is out now in the US.

Mariana _2bLeft, Mariana wears a shirt by J.Crew Mens, trousers by 3.1 Phillip Lim from Net-a-Porter.com and a silver bracelet by Tiffany & Co. Her shoes, necklace and rings are all her own. Right, Mariana wears a suit by BOSS and shoes by L.K.Bennett with a top, earrings and rings that are all her own.

Interview: Thomas Roueché / Photography: Lowe H. Seger / Styling: Nobuko Tannawa / Hair: Daniel Dyer at David Artists using Aveda / Make-up: Carol Morley using Clinique from Net-a-Porter.com / Photography assistant: Luca Nocera / Location: Spring Studios