In the latest Harvard Business Review, Edmund S. Phelps and Leo M. Tilman have a short essay calling for government action to better fund innovation. In “Wanted: A First National Bank of Innovation,” they paint a picture that agrees with what we describe in Conquering Innovation Fatigue, where we review some of the “innovation fatigue” problems we are observing in the United States and elsewhere:

Dynamism has been in decline over the past decade. Venture capitalists bemoan a dearth of innovative ideas, and investors bewail a precipitous drop in their rates of return. IPOs of venture-capital-backed firms have steadily declined from the levels of the 1990s. Total venture investment is now running at less than $20 billion per year. Institutional investors and equity analysts now pressure CEOs of public companies to hit steadily growing earnings targets. That pressure distracts from long-term value creation. And the patent system, which at first encouraged invention, now threatens inventors with a tangle of infringement suits.

The current financial system is choking off funds for innovation. It lacks transparency, and incentives for risk takers at financial firms are fundamentally misaligned with the interests of stakeholders. Outdated accounting conventions and inadequate disclosures make it impossible to evaluate the business models and risks of financial firms. Excessive resources are allocated to proprietary trading, to lending to overleveraged consumers, to regulatory arbitrage, and to low-value-added financial engineering. Financing the development of innovation takes a backseat. Whatever self-reforms and regulatory reforms are now in the works, we do not believe they are likely to restore the rollicking times of old, when banks lent to and invested in businesses, steering the economic transformations of the late nineteenth and early twentieth centuries.

In the next decade, the inadequacy of the financial system will become only more glaring. Opportunities in clean technologies and nanotechnology require large-scale, long-term investments. Unfortunately, most financial firms lack the expertise to invest in business ventures on a sufficient scale, now that a generation of financial professionals has been trained to focus elsewhere. Unless something changes, the gap in funds for business innovation will keep widening.

The solution the authors propose is a government program to provide additional funds that could be loaned to entrepreneurs. The system would be designed to “foster judicious business decisions, competent risk management, and well-aligned incentives.” Recognizing the possibility of politicians doing the things that politicians do, they make this statement: “Of course, every effort should be made to keep FNBI (the First National Bank of Innovation) free of political patronage and popular pressures.”

It’s a valuable idea, one that could really help if done properly. Unfortunately, government programs often have unintended consequences (the bigger the program or policy shift, the bigger the surprise), and any program created and guided by politicians could suffer from political distortions. Could it be done fairly? Is there a risk that money might be misallocated or ultimately diverted from healthy to unhealthy regions of the economy? Crafting an organization that fosters judicious business decisions may not be a reasonable expectation for politicians, so many of whom are unfamiliar with the challenges and rigors of running a business. With the right help and understanding of the challenges and needs innovators face, it could help. But is it solving the right problem? Would there be new unintended negative consequences?

The financial barriers to innovation that many entrepreneurs are facing today can, in my opinion, be largely traced to the failures of previous government efforts to help the economy. Even overlooking the role of the Federal Reserve Bank, Fannie Mae, Freddie Mac, Congress, and other government organizations in creating the housing bubble, the present tightness in credit, in spite of all the misallocated billions of bailout money, can be at least partially traced to the artificially low interest rates created by the Federal Reserve Bank, which allows banks to borrow money for almost free and get safe, lucrative returns by investing in treasuries, whereas loans to entrepreneurs are high risk.

The government actions and policies that have made credit very tight for innovators and people like you and me are discussed in a recent (Dec. 30, 2009) article at Motley Fool, “The Real Reason Banks Aren’t Lending” by Chuck Saletta. Here’s an excerpt:

For one thing, there’s an interesting “carry trade” going on right now that only banks can access. The Federal Reserve set the Federal Funds Rate at around 0%, giving banks an opportunity to borrow at essentially no cost. But 10-year Treasury yields — the typical proxies for mortgages — are around 3.8%. As a result, banks can earn an essentially risk-free 3.8% borrowing from the Fed system and lending to the Treasury, rather than lending to risky borrowers like you and me.

That’s easy money if you’re a bank. With the Federal deficit ballooning, the Treasury is certainly offering the banks plenty of opportunity to buy government bonds, rather than take a risk on traditional lending.

Theft by government fiat
And speaking of risk, several other government policies are dramatically adding to lenders’ risk. . . .

In essence, these policies have diminished the property rights of lenders. In effect, they turn every loan otherwise secured by a change of ownership in bankruptcy into the equivalent of an unsecured credit card. When banks and bondholders lose their ownership rights in bankruptcy proceedings, they lose much of their incentive to loan to anybody that needs the money. That doesn’t make lending impossible, but it certainly makes it tougher and costlier.

Hitting banks particularly hard is the concept of mandatory mortgage modification. Such enforced after-the-fact contract changes make it perfectly clear to lenders that they don’t have the same rights to foreclose they thought they had when they made the loan. Bank of America (NYSE: BAC), for instance, had to set aside $8.4 billion in a mortgage modification settlement with various states.

Without a credible threat of foreclosure, banks have no protection against speculators leveraging up with the banks’ money if those speculators can simply demand a sweetheart deal when their gambles don’t work out.

Other lenders have been hit hard by bad government policy as well. Some of the more pernicious examples include strong-arming bondholders into accepting deals whereby …

•Chrysler was handed over to its unions, Fiat, and the U.S. and Canadian governments, while its bondholders were given a few dimes on the dollar.
•General Motors was also handed over largely to its unions and the U.S. and Canadian governments, with its bondholders getting only about a 10th of the company. . . .

In fact, every time Uncle Sam dictates that lenders have to adjust the terms of their loans, or that bondholders do not deserve their seat at the table when an indebted company files bankruptcy, it threatens to weaken the debt market further. As President Obama’s feckless plea to banks to lend more money underscores, no amount of jawboning will really get banks to widely open their lending spigots again.

Government programs often cause unintended problems that are “fixed” by new government programs, which . . . In this case, I suggest that instead of giving politicians another hand at directing the flow of money to where they think it should go, let’s let the market do that. Let’s restore market rates rather than creating a source of free money for banks, at the expense of the rest of the economy. Let’s let banks compete, along with the rest of us, and let them fail, no matter how big, so that failure will not be subsidized by the rest of us. It was the free market, with the inherit ability to reap reward or failure in taking risk, that made the United States so successful in innovation. That track record of success was not due to government funding or programs, apart from generally appropriate efforts to help people protect their property rights (with some abuses, to be sure, from politicians and barons). Now that there is innovation fatigue in many quarters, the best solution may not be another government program, but perhaps the dismantling of programs or policies that are the source of current innovation fatigue and related barriers.