Beware the Siren’s Call of Industrial Policy

To say we live in perplexing times is an understatement. Everything seems to be shifting beneath our feet, often with seemingly little thought. One example is the move to change how the federal government supports research.

In the waning days of World War II, President Roosevelt asked Vannevar Bush what the country should do with the impressive federal R&D system that helped win the war. For the first time, Washington had become a driver in research. Bush’s reply came in his opus: Science, the Endless Frontier. He argued that the government should assume the non-traditional role of supporting basic research as well as continuing to fund mission research to increase human knowledge while strengthening the economy.

That led to a flourishing of science but little was being translated into the economy because resulting inventions were made freely available. Basic research is where breakthrough technologies are most likely to occur but they require significant amounts of money and time from the private sector to turn them into useful products and that wasn’t being done.

The U.S. Path to Success in Science

It wasn’t until the passage of the Bayh-Dole Act in 1980, which injected the incentives of patent ownership into the system, that the situation changed. And the result was dramatic.

At the time it looked like the Japanese model of government-led industrial policy was the wave of the future, as the bureaucracy and a few chosen companies worked together to dominate key industry sectors. Many Beltway pundits urged the United States to adopt that model.

But we chose a different path. Rather than centralizing power in Washington, Bayh-Dole decentralized technology ownership and management into the hands of those conducting federally funded research. The law provided the incentives and authorities to encourage development of resulting inventions, set up a few simple rules and got the government out of the way.

Here’s how The Economist Technology Quarterly described the result:

“Possibly the most inspired piece of legislation over the past half century was the Bayh-Dole Act of 1980… More than anything, this single policy measure helped reverse America’s precipitous slide into industrial irrelevance.”

The resulting public and private sector R&D alliances vaulted the United States back into technological leadership across the board. As the game changed, Japan stumbled into the doldrums as their much-vaunted industrial policy couldn’t adapt.

A Backwards Slide

But now that we have renewed challenges from China, we appear to be questioning what made us successful. As a Wall Street Journal headline states, “Washington Rewrites the Rule of Funding Technological Innovation”:

“Away from basics?

The new strategy is part of a shift in the U.S. government’s relationship with scientific and technological innovation that is giving priority to private-sector research over basic science. For decades, the federal government supported basic scientific research, hoping for breakthroughs that would eventually reach industry and the military.

“Now, fearing competition from China and the loss of U.S. manufacturing, the new industrial policy is being embraced across Democratic and Republican administrations…

“But there is still a debate going on—about whether the government should still keep backing basic research in a big way, or devote the lion’s share of resources to helping industry.”

China sees things differently:

“Intent on ensuring that China leapfrogs the U.S. as the world’s pre-eminent power, Xi Jinping recently made the gutsy and perhaps counterintuitive decision to invest massively in an arena of American strength—basic research. While a variety of factors drove China to invest in research, the Covid pandemic was a wake-up call that accelerated these efforts. Having seen that Western researchers produced Covid vaccines with higher efficacy rates months before China, Mr. Xi directed his government to close the technological gap across the board.”

And industry is responding:

“Not long ago, China was a backwater for drug research. Its companies made pharmaceutical ingredients or lower-cost generic drugs. Its patients offered an opportunity for big drugmakers to sell medicines developed in the West.

Now it’s a major player in biotechnology. Researchers and startups in China are racing to develop hot new medicines for cancer, weight-loss and other diseases. Many are on the cutting edge of molecular biology.

“China is rallying their innovation to degrees that we haven’t seen before,” Pfizer Chief Executive Albert Bourla said.

Looking to tap in to the innovation, big drugmakers and investors are spending billions to lock up rights to promising Chinese-originated drug candidates …”

Growing Misuse of OTAs

But we’re doing more than backing away from our commitment to basic research. Agencies are now shifting from funding universities through grants, which are covered by Bayh-Dole, in favor of “other transaction agreements” (OTA’s) where the law doesn’t apply. OTAs were originally designed as a work around the onerous requirements of the Federal Acquisition Regulations to entice innovative companies into government contracts.

Now they are being misused so that agencies can require academic institutions to compromise their Bayh-Dole rights giving agencies a stake in any subsequent success and even dictating how the technology must be managed.

A weakness in the Bayh-Dole system is that it did not create any new bureaucracy nor did it cost taxpayers an additional dime. Thus, it lacks institutional cheerleaders inside the government protecting it.

However, central planning has a much more serious flaw. Innovation is highly unpredictable and spotting breakthroughs when they occur is exceedingly difficult. Stanford University was unable to find any licensees interested in the search engine which became Google, nor could the University of California- Berkeley find a licensee for a decade to what became a Nobel Prize winning cancer treatment. Cal Tech couldn’t find a licensee for the technology now embedded in every iPhone so you can take pictures. Yet each of these were turned into successful technologies because their inventors were able to either start companies themselves or continued to work on their ideas until an entrepreneurial company was interested.

Under our system, those companies are almost always small businesses that assume the considerable risk, expense and dedication needed to turn these ideas into products improving lives here and around the world. We’re the only economy where innovation is driven by small businesses.

Entrepreneurial companies depend on the government enforcing the laws fairly and predictably as they challenge dominant companies in the marketplace. But being a fair umpire is hard to do when the government not only backs favored companies but acquires their stock in return for Washington support.

Let’s Avoid the Same Mistake as Japan

When disruptive technologies threaten that investment, the government will be sorely tempted to protect the status quo. History shows that’s a serious problem, as the Japanese found out to their sorrow.

As circumstances changed, the entanglement of government and dominant companies that looked so promising in the 1970s made it impossible to respond effectively, plunging Japan into “The Lost Decades.”

Conversely, the decentralized American model launched one of the greatest renaissances of innovation in human history, leading to The Economist Technology Quarterly’s comment posted earlier.

When government industrial policy gets it wrong, the result is catastrophic. When decentralization gets it wrong, the losses are paid by entrepreneurs, not all of society. We see what works and go on.

While messy and unpredictable, the “creative destruction” of capitalism is what made America the envy of the world. We’d be well advised not to lightly abandon that model. Just ask Japan.