Financing Innovation in the United States: 1870 to the Present

Published by EH.NET (July 2009)

Naomi R. Lamoreaux and Kenneth L. Sokoloff, editors, Financing Innovation in the United States: 1870 to the Present. Cambridge, MA: MIT Press, 2007. xii + 503 pp. $45 (cloth), ISBN: 978-0-262-12289-4.

Charles W. Calomiris, Columbia Business School, Columbia University.

Innovation has played a central role in the economic ascendance and continuing economic dominance of the United States. It gave a distinctive form to America?s first and second industrial revolutions (including, for example, the development of the unique U.S. patent system, the use of interchangeable parts, and the development of the moving assembly line), as well as to America?s leadership in the current information age. Strangely, despite the well-deserved emphasis on the evolving processes of technological change and its consequences for industrial organization, productivity and growth by economic historians, and the attention given by business historians to the activities of inventive geniuses like Edison and Ford, the literature on the financial history of innovation is scant.

This volume is thus a welcome addition to an under-researched area. It consists of eleven original contributions and a wonderfully cohesive editors? introduction by two of the most prominent contributors to the history of innovation and its financing. The editors bring together the very best scholars in the area, who offer a balanced mix of breadth and depth, which also covers a broad swath of time.

Some of the chapters analyze broad tendencies in innovation. For example, one chapter reviews the experience of the most innovative industries of the second industrial revolution, showing a common pattern of a lack of reliance either on formal financial intermediaries or on financial markets to provide early stage financing to innovative firms; instead, partnerships and other personal relationships, as well as retained earnings, were the primary means of financing innovation in the U.S. The 1920s ? not the pre-World War I period ? saw the first departure from that pattern (as stock market investors for the first time played an active role in financing innovative start ups, especially the utilities). After the 1960s, venture capitalists offered a new source of financing focused on the mobilization of funds for new technologies. One chapter shows that intangible capital (proxied by patent citations) was priced in the stock market boom of the 1920s, which demonstrates that fundamental technological value underlay much of the boom in growth stocks prior to the Great Depression. A related investigation in another chapter exploring more recent events shows that the modern venture capital industry has been quite successful in identifying and valuing productive innovations.

Three of the chapters (covering different periods and employing an impressive array of datasets and empirical methods) identify the determinants of differences over time and across locations in the industrial organization of invention (the extent to which innovation occurs within specialized firms or within large integrated firms) and show how that industrial organization implied important differences in the means of financing innovation.

Another chapter reviews the IT revolution, emphasizing the important role of government in promoting basic research, ensuring competitive diffusion of the fruits of that research, and hastening beneficial learning through procurement policies that created critical demand at early stages of development. Still another explores the ways that complex contracting structures evolved in similar ways across different countries to solve information problems inherent in financing early-stage enterprises.

More narrowly focused chapters make similarly important general points by focusing on particular examples. The chapter on the evolution of the automobile industry in Detroit shows the crucial role of early inter-firm relationships and the history of linkages in production among firms in creating productivity-enhancing innovations via spin offs, and in promoting interpersonal relationships that helped to diffuse technology and spur the development of informal financing networks. There is also a chapter on the development of Cleveland as a hotbed of industrial innovation which similarly points to the crucial role of informal personal connections in financing the most important innovations of the second industrial revolution there.

Perhaps the most gripping story in the volume is the chapter on Corning?s decision to pursue its path-breaking fiber optic technology despite daunting financial challenges, which contains compelling general lessons about the problems of managing breakthrough technologies in firms with limited resources (and no scarcity of enemies), the helpful role of strategic alliances in overcoming some of those barriers, and the crucial importance of developing a corporate culture conducive to rewarding entrepreneurship in research.

Another chapter helpfully qualifies the earlier discussion of the government?s helpful role in the IT sector by pointing out that the market, not the government, played the central role in identifying and shaping winners among specific products ? that is, defining the most productive specific form that technological progress in computing should take, once the government had helped promote the production and diffusion of basic science.

My only complaint about the volume is the conspicuous absence of any attempt to integrate the industrial organization of finance into the discussion of the financing of innovation and its industrial organization. There is one chapter in the volume that properly identifies important reforms in New York Stock Exchange clearing and listing requirements (in the late nineteenth century), which undoubtedly were somewhat helpful to the eventual usefulness of the stock market for financing innovation in the 1920s. But the second industrial revolution was unable to take advantage of those improvements for several decades and the posited causal connection between changes in trading and listing rules and stock market access for innovative firms is not convincing.

That same chapter, and others in the volume, simply ignore important changes in financial structure (changes after World War I in the structure and size of banks and the connections between commercial and investment banks), which played a crucial role in the new access to stock financing for growth firms in the 1920s. The discussion also exaggerates the U.S.?s superiority to other countries in its ability to finance technology during the second industrial revolution. German banking structure, operating under a nationwide banking system that integrated commercial and investment banking operations from an early date, was much more conducive to the financing of growth firms, and was far ahead of the U.S. in the amount of stock issues by utility companies and other industrial innovators prior to World War I. Other subsequent changes in the structure of U.S. intermediation are also ignored ? most importantly, the growth of institutional investors (pensions and mutuals) after World War II, which was crucial in financing the growth of venture capital and investing in IPOs for start ups in the 1970s and afterward.

Anyone interested in the organization of innovation, and the nexus between finance and the organization and process of innovation, must read this book. All of the chapters are original, scholarly, and packed with insightful gems (truly a font of inspiration for Ph.D. students), and the analysis manages to be both sophisticated (theoretically and statistically) and accessible to a broad audience. While the volume is too rich to boil down to a single theme, the editors? introduction does point to a common thread that runs through many of the essays: ?… perhaps the most striking aspect of the record of innovation over American economic history is the flexibility that technologically creative entrepreneurs have exhibited in adjusting their business and career plans so as to obtain financing for, and extract returns from, their projects.?

One can only hope that this impressive volume will inspire other scholars to take up the mantle and help to fill the numerous remaining gaps in our knowledge about the history of the financing of innovation. Sadly, one of the editors, the late Ken Sokoloff, will not be able to continue to provide us with such inspiring examples.

Charles W. Calomiris is Henry Kaufman Professor of Financial Institutions at Columbia Business School and a Professor at Columbia?s School of International and Public Affairs. His recent edited volumes include Sustaining India?s Growth Miracle, 2008 (co-edited with Jagdish Bhagwati) and China?s Financial Transition at a Crossroads 2007, both published by Columbia University Press.