Building Entrepreneurial Economies

Carl J Schramm. Foreign Affairs. Volume 83, Issue 4. July/August 2004.

Poor Imitation

The United States, using its own direct-aid programs and its influence over development agencies, has encouraged other nations to adopt the features and institutions of post-Cold War American capitalism. But this approach—the so-called Washington consensus—has often yielded disappointing results. Many economies in Latin America, eastern Europe, and elsewhere are stagnant or backsliding, and most of the world’s poorest economies show few signs of new life. Going forward, the American economic model should not be abandoned, as some development economists advocate, but it must be improved. The current template is incomplete. In particular, it fails to reproduce a vital element of the U.S. economy: support for entrepreneurship.

Not only does the United States have a high rate of new business starts, it breeds a constant flow of new high-impact firms—the kind that create value and stimulate growth by bringing new ideas to market, be they new technologies, new business methods, or simply new and better ways of performing routine tasks. These firms do not appear automatically, as a natural by-product of having free-market institutions. Nor are they the result of any single factor. Rather, the United States has evolved a multifaceted “system” for nurturing high-impact entrepreneurship—a system that, with the right development policies, might be cultivated in many other countries as well.

Such an approach has been missing so far. The Washington consensus focuses on macroeconomic issues such as finance and trade, along with general institution building. Nations are urged to create good banking systems, reasonable interest and exchange rates, and stable tax structures. They are expected to privatize, deregulate, and invest in infrastructure and basic education. Entrepreneurship, meanwhile, is considered only as an afterthought and in piecemeal fashion. Some policymakers, for instance, have suggested that venture capital firms should be added to the list of financial institutions that developing countries ought to have. But venture capital will do no good without ventures to support. Micro-enterprises are not sufficient either. Existing programs to support small businesses, such as those promoted by the U.S. Agency for International Development and nongovernmental organizations, offer livelihoods to many people. But these ventures tend to involve cottage industries that add little to the economy in terms of productivity or growth. Even micro-entrepreneurs with great potential cannot succeed without national mechanisms to feed and sustain them. Nor can a developing nation prosper in the long term only by attracting outsourced work, which has a disturbing tendency to migrate to still lower-cost locales. Real opportunities arise only when a nation is the initiator: a breeder of new firms, based on new ideas that add unique value.

Start-Ups’ Starring Role

The system that generates and supports entrepreneurship in the United States is surprisingly unappreciated. Perhaps this is because when modern economic thought first took shape in the early and middle decades of the twentieth century, the West already had a mature industrial economy. With a universe of large corporations and modern equity markets already in place, economists were preoccupied with impersonal market forces, business cycles, capital markets, and government stimuli via fiscal and monetary policy. Microeconomic thinking also focused on big-firm behavior, rather than on the start-up process.

Few people realize how many Americans today still make their living in entrepreneurial settings. More than 500,000 “employer firms” (businesses with employees) are started in the United States every year. The latest Global Entrepreneurship Monitor (gem) survey, funded by the Ewing Marion Kauffman Foundation, found that in 2003, approximately 11 of every 100 working adults in the United States were engaged in entrepreneurial activity, either starting a business or playing a lead role in one less than three and a half years old. That rate is higher than any in Europe and roughly twice that of Germany or the United Kingdom. And although most Americans work in large or mid-sized firms, research for the U.S. Census Bureau and others has found that most net new jobs are created either by start-up activity or by firms in a rapid-expansion phase. Among other benefits, this relieves the nation’s mature companies from being hobbled by guaranteed-employment practices. Instead of maintaining jobs artificially, they can trim staff as needed to stay competitive, with the entrepreneurial base cushioning the blow by providing a steady supply of new jobs.

The United States is also unusual in that many of its big, strategically important corporations were created very recently. Dell and Cisco Systems, for example, were started in 1985 and 1984, respectively. New firms have been national leaders in creating wealth and raising living standards: Charles Schwab has pioneered low-cost securities trading, enabling more people to participate in equity markets, while large retailers such as Wal-Mart have reinvented business models, reducing the cost of consumer goods.

Overall, new firms play two essential roles in the U.S. economy. First, they are engines of innovation. Although large, established firms innovate, they tend to do so only in certain ways, wary of straying too far from their existing lines of business. Compare the birth of two industries: nuclear power and software. Innovation in the first was driven mainly by big companies such as Westinghouse Electric that were already in the power-generation business. By contrast, there was no software industry in the early days of computing. Computer programs were either custom-written or sold along with the machinery; writing and selling them separately, for widespread use, was not seen as a viable business strategy. People such as John Swanson, an engineer who left Westinghouse in 1969 to become an entrepreneur, turned this conventional wisdom on its head. Realizing that the kind of design work he was doing could be greatly enhanced by writing a general-purpose computer simulation program, he started a company now called Ansys. Its software has been used to help design goods ranging from automobiles to shoes. Thanks to the efforts of thousands of similar entrepreneurs, the software industry has done what nuclear power was once expected to do: benefited every sector of the economy and spurred tremendous growth.

The second essential role that new firms play in the U.S. economy is smoothing the exigencies of the business cycle. Time and again, the breeding of new companies, new jobs, and new industries has helped pull the economy out of a slump and fuel a rebound—as occurred after the recession in the early 1990s. Japan, in contrast, has many innovative large firms but the lowest per-capita rate of entrepreneurial activity of 37 countries studied by gem—a possible explanation for its prolonged stagnation.

Entrepreneurship is thus what enables American-style capitalism to be generative and self-renewing. The problem confronting policymakers is to model the entrepreneurial dimension of the U.S. economy in a way that is comprehensive enough to capture all the important dynamics and is also transferable to other economies. Such a model is proposed here.

The Four-Sector Model

The American entrepreneurial system involves four sectors of the economy: high-impact entrepreneurs, large mature firms, the government, and universities.

The first sector is inhabited by new firms. The people who start them need not be scientists or inventors of new products themselves. Henry Ford did not invent the automobile and Michael Dell did not invent any computer technology. Both built their firms largely around production and marketing ideas, freely borrowing from existing concepts.

New companies require more than just ideas, however: money, skilled people, and other resources are also needed. In the United States, entrepreneurs often obtain these things from large, mature firms—the second sector. Business mythology portrays new firms as adversaries of established ones, with the nimble newcomers trying to outwit lumbering dinosaurs who are in turn trying to flatten the upstarts. Something like that may occur at times, but a powerful symbiotic relationship is more common.

There are several ways in which new and established businesses work together. First, and most obvious, established firms often become customers of the new firms. U.S. corporations have learned to use new companies as reliable sources of innovation, buying from them, for example, specialized software and business services or components that can be embedded in their own products. Second, large U.S. firms today effectively “outsource” much of their research and development to start-ups. Rather than take on all of the effort and risk of developing an idea internally, they help a new firm do so, via strategic investments or working partnerships. There are many twists on this strategy. Intel, for example, tries to build markets for its chips by investing in companies that develop new systems and products that will use the chips; it has invested in more than a thousand such start-ups. Third, once a new company has developed a good product, a larger outfit often simply buys the start-up, thus acquiring a complete package of proven technology and expertise. This practice is now common in the pharmaceutical and health care product industries. Finally, mature firms support start-up firms by providing human capital. Bright young people often develop their skills and learn about a particular industry by working at a big corporation, and then leave to start or join a new one.

The third important contributor to entrepreneurship is the government, which, in the United States, uses some of its tax revenues to foster new businesses. One way it does this is by funding large programs that traffic in innovation, such as defense and space exploration. The Department of Defense is always in the market for new systems and technologies, not only for weaponry, but also for communications, intelligence, logistics, and support. Government agencies also invest directly in new firms through channels such as the Small Business Innovation Research Program and the Central Intelligence Agency’s In-Q-Tel venture fund. More indirectly, the U.S. government promotes entrepreneurship by funding research in fields of knowledge from information technology to medicine and the physical and human sciences. Total federal spending on research and development equals about one percent of U.S. GDP. Although some of this funding goes to the government’s own laboratories (such as Argonne and Sandia) or to private firms and industry consortia, much of it flows into the fourth sector of the U.S. entrepreneurial system, the nation’s universities.

U.S. universities generate a constant flow of ideas for new businesses. Since the 1960s, the number of faculty members and students doing university research has expanded greatly, due to investment from both the federal and the state governments. An invention or discovery moves out of a university into the entrepreneurial sector when investors and businesspeople help to form a company that commercializes the idea. Typically, universities own a share in any patent developed on their premises and will then license these rights in exchange for an equity share of the new company. (The Bayh-Dole Act of 1980, which allowed this process to be followed even for discoveries and inventions derived from federally funded research, greatly accelerated the transfer of technology from universities to the U.S. economy.)

The resulting economic growth has been tremendous. It has been estimated that the companies spun out from just one university, the Massachusetts Institute of Technology (MIT), would constitute a nation with the twenty-fourth largest GDP in the world. Returns to the universities also have been significant. Earnings from just one spinoff company, Lycos, enabled Carnegie Mellon University to construct a new building and create three endowed faculty chairs. Research professors often take leaves to help start a new company, typically holding a title such as “chief technology officer” while an experienced businessperson manages the firm.

Practical Steps

The four-sector model of the U.S. economy provides a useful framework for guiding policies to promote entrepreneurship in the developing world.

With respect to the first sector, developing nations must establish certain underlying conditions that allow the entrepreneurial process to flourish: favorable business policies and regulations, and access to investment and human capital. U.S. laws make it easy to start, fund, grow, and sell a company. An American citizen can incorporate a new business under state law and obtain all the federal identity needed from the Internal Revenue Service in an afternoon. U.S. tax laws encourage private investment in new firms, and bankruptcy laws provide an orderly end to a failed business, reducing the risk for creditors and allowing entrepreneurs to start anew.

In many developing countries, by contrast, starting a business is fraught with expensive and time-consuming red tape. The Peruvian economist Hernando DeSoto notes that entrepreneurs and property holders in such countries will often adapt by setting up a complete parallel economy outside the law, with its own complex rules and written contracts. An oft-cited drawback of this approach is that the government does not get tax revenue. But perhaps the greater cost is that the entrepreneurs involved are seriously constrained by the resources and horizons of their underground world, finding themselves unable to attract major investments, recruit skilled managers and technicians from outside, or legally protect, convert, and transfer their assets. The “official” economy, meanwhile, remains the province of a select few: privileged insiders, existing firms, and state-related enterprises.

Another important factor in the first sector is sources of capital for new firms. Development experts tend to focus on replicating the U.S. venture capital system. The system is a powerful one, but many entrepreneurs do not even want venture capital, since they would have to give up a great deal of ownership and control in exchange for the investment. Most of the firms on Inc. magazine’s list of the 500 fastest-growing small companies in the United States have not used venture capital. And despite the common misconception, venture capitalists do not usually provide start-up money. In 1996, according to the National Venture Capital Association (nvca), 77 percent of venture-capital-funded companies were at least three years old when they received their first round of investment. That changed during the Internet start-up frenzy, but normal patterns have returned since then. In the first quarter of 2004 (again, according to NVCA figures), only 17 percent of venture-capital dollars in the United States were invested in “early stage” companies, with the rest going to “expansion stage” and “later stage” firms.

Entrepreneurs in the United States get early-stage capital from a variety of sources. Many take second mortgages on their homes, as the founders of Cisco Systems did. Many make liberal use of credit cards for short-term operating funds. Virtually all solicit investments or personal loans from family and friends. Some find wealthy individuals called “angels”—frequently successful entrepreneurs themselves—who provide advice and contacts along with money. And once they are started, many entrepreneurs “bootstrap” their firms, reinvesting revenues or obtaining bank credit.

In countries where personal wealth is not as widespread as it is in the United States, emulating this diversity of financial resources will not be easy. But the process might be started by persuading wealthier individuals to invest in new ventures (perhaps through tax incentives), or encouraging banks and pension funds to commit a portion of assets to such ventures. Moreover, countries’ labor policies should not tie economic security to long-term employment. Americans have many close-at-hand ways to obtain support for starting a company, and at the same time they have little incentive to stay with a big firm for job security.

The Washington consensus approach to development—which stresses privatization of state-owned companies and the freeing up of local business environments to help existing firms—already has a positive impact in the second sector, that of large firms. But more needs to be done to induce a real symbiosis between established firms and entrepreneurs. First off, developing countries must ensure that there is a level playing field between old and new firms. The United States tries to achieve this in a variety of ways, such as by protecting intellectual property and discouraging monopolies and unfair trade practices. Developing nations must resist pressures from existing businesses to preserve markets and prevent innovation. And the “treaty” between large and small firms must be built on an understanding that large firms benefit from entrepreneurial activity. The most promising entrepreneurs should be helped to find big corporations as partners—which, in today’s global economy, can include corporations based in the United States or elsewhere. Developing countries’ own large firms and government agencies also could be given incentives to “farm out” and support employees who have good ideas for starting spinoff companies.

In the third sector—the government—nations should do as much as possible to invest in infrastructure that supports entrepreneurship. South Korea offers a good example with its efforts to promote end-user connectivity to the Internet. An estimated 60 to 70 percent of the country already has high-speed broadband access. One rationale for this investment has been to make government more efficient and responsive by moving citizens’ interactions online. But the policy is also helping to build a countrywide platform for entrepreneurship: every South Korean will soon be linked to massive online flows of knowledge and to online markets.

Another infrastructure investment that can help entrepreneurs is subsidizing laboratories and testing facilities for shared use, which young technology firms often need but cannot afford on their own. Shared facilities also encourage entrepreneurs to cluster geographically, as they do in the United States—gathering in certain cities or around research universities—thereby gaining a dense network of peers for partnering and mentoring.

In the fourth sector, the Washington consensus rightly calls for countries to invest in education, but it emphasizes primary education. Higher education should be made a priority, too. Consider India: in 1951, shortly after gaining independence, it launched the Indian Institute of Technology (IIT), modeling it on world-class universities such as MIT. This may be one of the best decisions a newly liberated nation ever made. The IIT now has seven campuses across India. Its alumni make up part of India’s formidable and growing professional class (the group from which many high-impact entrepreneurs emerge), and it has fueled interest in primary education by giving young Indians and their parents a great university toward which to aim. A similar approach has also benefited older industrial nations with stalled economies. In recent decades, the government of Ireland has invested heavily in higher education, which has helped produce a period of rapid growth, accompanied by a dramatic increase in high-tech business start-ups, that has been dubbed the “Irish miracle.” Universities not only train skilled people; they also attract them. In the United States, for example, about one-fourth of the new businesses in Silicon Valley since 1980 have been started by immigrants, many of whom were first drawn to the region to study or teach at its universities.

High-impact entrepreneurship will thrive most in countries that pay proper attention to all four sectors of the entrepreneurial system. China is an example of a developing nation that currently does this. While adopting policies that actively encourage entrepreneurship, Beijing is pushing to have more of its college-age population enrolled in higher education, for example. And it is developing high-skill, high-tech business in tandem with low-wage contract manufacturing, steelmaking, and other basic industries. China seems to understand that the commodities it currently manufactures can be obtained from less developed countries—and that many of the world’s highly sought-after goods will come from laboratories, skilled people, and entrepreneurs. As a result, it may well arrive at its post-industrial stage very quickly.

The Culture Chimera

Critics may object that the four-sector approach does not give enough weight to cultural factors. It is often argued, for instance, that whereas “individualistic” cultures such as that of the United States are conducive to entrepreneurship, more “collectivist” cultures are not. Yet the example of China, with its communist cultural legacy, suggests that this objection is weak. The cultural argument also looks flimsy in light of U.S. history. American culture in the 1950s was by no means favorable to entrepreneurship. Bright young men of that era were expected to join an established firm and climb the ladder while their wives stayed home taking care of the children. William Whyte’s book The Organization Man warned that the United States was becoming a “nation of bureaucrats,” with a “conspiracy of the mediocre” threatening to stifle innovation. Yet by the 1980s, a potent new generation of entrepreneurs had emerged, and people such as Steve Jobs and Bill Gates quickly became national icons.

Developing countries and development agencies, then, should not worry too much about cultural intangibles. They should try to emulate the practical features of the U.S. entrepreneurial system, as expressed in the four-sector model, with the knowledge that culture can change as incentives and conditions change. Encouraging entrepreneurship may do developing countries more good, in terms of long-term growth and gains in productivity, than policies aimed at accelerating near-term growth. And as individuals step into the market, assume risk, and work to turn their aspirations into businesses, they will insist on political and economic liberalization—the very goals prioritized by the Washington consensus. Ironically, entrepreneurs, who are by nature agents of change, may prove to be among the most important forces for global stability.