Government Waste Archives - Hunter Hastings

Governments would like to take credit for the level of entrepreneurship in their countries. Entrepreneurship leads to value creation (happier voters) and economic growth (more to tax). But, as Per Bylund points out in the Seen, The Unseen And The Unrealized, governments’ actions restrain entrepreneurship.

Dr. Samuele Murtinu joins the Economics For Business podcast to explain both how and why governments fail in their best efforts to help entrepreneurial businesses succeed.

Key Takeaways And Actionable Insights

Europe has an entrepreneurship problem.

European economies exhibit lower growth rates than the US. At the firm level, there are fewer unicorns, and fewer new technology-based firms or innovative startups and innovative ventures in general. Venture capital markets are very thin, and most venture financing is debt, which is (as Sergio Alberich described in Episode #123: Mises.org/E4B_123), a poorer choice for startups and young firms than equity.

Consequently, European countries see a lower level of innovative startup behavior. Existing firms have low levels of R&D spending. And, generally, there is an inability to turn the innovative inputs that are available into innovative outputs — new markets and industries tend not to emerge in Europe first.

And the European mindset tends to favor the idea of the entrepreneurial state — the state is thought to be where good ideas and good initiatives come from.

Governments see launching their own venture capital funds as a new means.

The key idea of the entrepreneurial state is deep involvement in economic affairs, including funding basic research, financing, shaping and directing R&D investments, and thereby creating new markets. The centrally coordinated state is seen as the driving force for the development of innovation and technological progress. For this mindset, government venture capital seems to be an available means. So governments start and implement venture capital funds — the terminology is Public Venture Capital.

These are companies and funds that are fully owned, fully funded (no limited partner structure) and fully managed by government bureaucrats, with the purpose of investing in innovative startups.

Firstly, Governments get the concept wrong at a fundamental level: they have the wrong goals.

Private venture capital funds and even hybrids like sovereign wealth funds have clear goals: rapid, high-level capital appreciation by investing in startups at an early stage and exiting as quickly as possible in a liquidity event such as a commercial sale or an IPO.

Government venture capital may have “social” goals such as encouraging industry sectors, favoring regional technological development, boosting economic growth, and providing jobs. These are vague and unclear, and may contradict individual company business plans (such as automation and minimization of labor costs). With the wrong goals, it’s impossible to succeed.

For example, the selection process for private VCs choosing firms for fund portfolios is rigorously goal-directed and VC firms have honed their candidate identification and due diligence processes in order to maximize their chances of winning from the very first steps in the investment process. Government funds lack this clarity and therefore can’t develop the requisite expertise.

Governments have difficulty letting go of control.

Private VC’s have also honed the role of the contract between them and the firms in which they invest, and with the limited partners who provide the investment capital. The contract with the startup firms is as “hands-off” as possible (see, for example, the SAFE contract — Simple Agreement For Future Equity — available for free download and free use from the Y-Combinator website: YCombinator.com/Documents) and the contract with Limited Partners gives them no role in the management of the fund. Private VC’s understand that high levels of control are not appropriate to the adaptive management of immature firms in rapidly changing environments.

Government bureaucrats directing investments in startups are averse to this kind of hands-off management.

Governments can’t get incentives right, and consequently can’t hire the best executives.

Private VC managers are highly incentivized. In the largest and most successful funds, they receive high salaries and a 20% participation in fund appreciation. The best individuals from the most prestigious business schools are hired to compete with their peers for promotions and partnerships. The most successful funds attract the most capital from the deepest pocketed sources, and the cycle of success rolls on.

Public VCs can’t attract the same quality of human capital. Typically, managers are paid a fixed salary, which can’t be seen as out-of-bounds from the perspective of bureaucratic rules and standards. If there are bonuses, they are calculated in what Professor Murtinu called a “gloomy” way. No-one is going to break any income-equity norms.

Professor Murtinu’s rigorous data-rich analysis proves beyond any doubt the failure of Public Venture Capital.

In order to analyze Public Venture Capital performance, Professor Murtinu utilized the VICO database, a comprehensive data set about venture capital backed companies in high tech industries in seven European countries. He reinforced it with additional data sources, and was able to run a comparison of the performance of firms that received public venture capital backing and those that received no venture capital. The data sets covered 25 years.

The result: no statistical difference between the performance of the two sets of firms. Public Venture Capital had no effect. It was a waste. This was true across all possible variables: productivity, whether total factor productivity or partial factor productivity like labor or capital, sales growth, employment growth, innovation outcomes, exits.

The opposite is the case for private venture capital backed firms. In the same kind of analysis, private venture backed firms are statistically superior on every dimension. The overall impact of private venture capital is very clear and highly positive.

There is one possible step in the right direction: government becomes a limited investor.

Public venture capital can syndicate with private venture capital, and so long as the investment is less than 50% of the fund total, and has no say on selection of investments, on due diligence, on governance, on monitoring, and on timing or type of exits, it is possible that the investment outcome can be positive. The European Commission is currently considering this role for Public Venture Capital.

Additional Resource

“Public vs. Private Venture Capital” (PDF): Download PDF

The concept of economic cost seems to confuse people. It is not the price you pay for a good, but the reason you pay it. The cost of one action is the value you could otherwise have gained, from taking another action. In other words, if you have $100 and you have the choice to buy two goods, each at a price of $100, you’ll naturally choose whichever is more important (valuable) to you. The cost of it is not the $100, which you give up to purchase it, but the value of the other good, which you can no longer purchase.

That other good is the opportunity foregone by your action, the ‘true’ cost of your action–the economic cost. Why does this matter? Because our actions are intended to create value, and we always aim to maximize that (subjectively understood) value. The economic cost concept brings to our attention what we *actually* give up to get a value, and thus why we choose a certain course of action.

An economy, which is a system of economizing on scarce resources, is the systematic allocation of resources to maximize value. It is not about minimizing price paid, which is something different. It is about value. While this may seem like an academic point, the implications are enormous. Those who are ignorant of this concept focus on the outcome of action only–the “net gain”–rather than the cost. Doing so means we end up wasting enormous resources while not getting the value that was well within reach.

Examples of this include arguing that there were massive gains from, for example, World War II or the US space program in the 1960s. Both were enormously wasteful, but also generated tangible benefits. WW2 led to the discovery of artificial rubber, freeing us from costly and time-consuming rubber production. Yes, that’s a benefit. And there were plenty of technologies developed as part of the space program. Those were also benefits. But at what economic cost? That’s the real issue: what *other* benefits did we never see because we instead pumped in enormous resources into war and the space race? What other discoveries and innovations were within reach had those resources been used differently?

The WW2 example should be obvious, since the war itself was hardly productive. But the space program is exactly the same issue: what opportunities did we, as a society, forego because the government preferred to invest billions of dollars into the prestige program of beating the Russians to the moon? We don’t know what we didn’t get, of course. But this doesn’t mean we cannot say whether it was the right thing to do. The fact is that in a market system entrepreneurs compete with each other not to minimize cost, but to produce value. Naturally, this means *net* value: what actual benefit is provided in the eyes of the consumer. The entrepreneurs don’t know what consumers will value, but they bet their livelihoods on what they think will benefit consumers most. The result is a variety of goods and services from which consumers can choose, and they will choose what is the best option from their point of view.

What is not produced cannot be chosen. But what is not produced also does not seem to be worth it to the numerous entrepreneurs engaging in value facilitation for consumers. Note that this is not a matter of whether entrepreneurs can “afford” the capital investment needed. It is about the rate of return: whether the value is high enough above the outlays necessary to produce the good/service (the production cost). With a sufficiently high ROI, relative to other possible and attempted projects, entrepreneurs can always find the funds needed: investors are looking for a return on their funds, after all. So the argument that “only the government can” invest in something because it requires capital is bogus. It asserts problems that don’t exist, and often fails to properly apply the concept of economic cost (as in the examples above).

Economic cost tells us what is expectedly most important to people, regardless of the capital investment magnitude. Higher ROI means greater value, which means a higher price can be charged–and more profit earned. This is where economic cost is essential to understand the workings of the economy. Because if a project envisioned by an entrepreneur appears to be highly profitable, regardless of initial investment needed, s/he will pursue it. This means, at the same time, that other entrepreneurial projects, which are expected to provide a lesser return on investment, will *not* be pursued.

What matters for society and the economy is that the greater value is pursued, because it makes all of us better off. This is why, through competition, the swift weeding out of entrepreneurs with projects that do not actually produce much value is important: they literally waste our resources because the value foregone–the projects that were not undertaken because the resources were bound up in these lesser projects–is higher than the value produced. It is an economic loss regardless of what benefits came out of it.

Consequently, we can conclude that the space program, just like war, was a wasteful act. The government stepped in because no entrepreneur was willing to undertake it, which is because its expected ROI (if any) was much lower than other projects entrepreneurs could pursue. We don’t know what we lost, but it could have been cures for nasty diseases, doing away with poverty, or whatever. The fact that consumers were not expected to spend their own money on the space program, and the fact that no entrepreneurs expected that they would, at

least not to the extent necessary, means it was not considered valuable enough. Its economic cost was expected to be higher than the economic value!

Now, does this mean that nothing good came out of the space program? Of course not. There were innovations and technologies discovered that have served us well. But they were, at the time of investment, either not expected (at all) or not expected to sufficiently serve people. There are certainly examples of flukes that ended up creating beautiful things (like Arpanet becoming the Internet), but who in their right mind would argue that we should waste resources on grand government projects because there might be unintended consequences that we’d benefit from? Considering the economic cost, what we could have gained from that investment was expected (by everyone!) to be higher than the project pursued by the government.

That’s the reason the government did it: Government is in the business of wasting scarce resources at high economic cost, i.e. without sufficient expected value. No matter how one looks at it, this is wasteful.

Unless, of course, one ignores the concept of economic cost: the higher-value opportunities that are foregone–lost–because we’re instead pursuing the lower-valued ones.

To simplify, it is a matter of picking the low-hanging fruits first, because there is much higher return–greater “bang” for the buck–from doing so. It makes no sense climbing to the top branches “in case” there is some other and unexpected benefit from putting in the extra effort.

Posts

129. Samuele Murtinu on How and Why Governments Fail in Venture Capital