Cover story on high technology

My latest Fund Strategy cover story, looking at the high technology sector and innovation, can be read here. There follows an extract from the final section.

Apart from the debate about productivity there is another important aspect of the new economy discussion that is often neglected. That is a fundamental shift in the way that innovation is generated within the American economy. This has coincided with the emergence of what has been called the New Economy Business Model (NEBM), with Silicon Valley as the prototype, from the 1970s onwards. With its high technology start-ups, venture capitalists and collaboration with universities it is a model that many others have tried to emulate.

Whereas technological innovation used to happen largely within large companies, it has become a more diffuse affair. The Old Economy Business Model (OEBM) was centred on the substantial research laboratories run by large firms. These included the likes of Bell, Du Pont, Eastman Kodak, General Electric and General Motors.

Today the emphasis has shifted towards small firms, which often end up being bought by larger ones, coming up with innovative ideas. This is a shift that Henry Chesbrough, a professor at the Haas School of Business at the University of California, Berkeley, has called the move from closed to open innovation.

For the supporters of open innovation within the NEBM it has brought many advantages. The key innovations discussed above, from Skype to smartphones, are often attributed to this model. Without Silicon Valley and other smaller clusters of innovation it is argued that the world would be a much less technologically advanced place.

However, there are several reasons to question the benefits of this model. For a start, risk aversion and the lack of innovation by large companies seems to be its driver. The hefty cash balances held by many of the industry giants seem to confirm this fact. Indeed, anxiety about risk-taking seems to be a defining feature of this business model.

Since it is impossible to avoid risk-taking entirely, one way round the problem for large companies is to shift the responsibility to small firms. The few start-ups that are successful are then bought by large companies for a hefty sum while the many unsuccessful entrepreneurial initiatives disappear without trace.

William Lazonick, a professor of economics at the University of Massachusetts, Lowell, criticises the model on several grounds. In social terms he associates it with greater inequality and job insecurity. Those who are successful are remunerated extremely well but wages for many Americans have stagnated, while job tenure is less certain. Such an economy is, in his view, poor at using the human capital of many of its citizens.

He also criticises the model for its slavish devotion to the financial markets. “This is a system that is value extracting rather than value creating,” he says. For instance, chief executives have become obsessed with short-term equity returns, to which their remuneration is linked, rather than long-term development of the business.

Even leaving aside the social criticisms it is true that problems within the financial markets are having a damaging knock-on effect on smaller companies. Orna Berry, a veteran Israeli venture capitalist and entrepreneur, points out that the weakness of the Nasdaq in recent years has hit the venture capital industry: “The Nasdaq is the single most important factor in predicting valuations and it has been slow moving [over the past decade]. Consequently the whole ecosystem is not doing well”.

Perhaps the biggest indictment of the NEBM is that it is not producing nearly as much innovation as is often assumed. The fact that there is so much talk about the internet only underlines how little innovation there is elsewhere. Even within IT it should be remembered that the origins of the internet go back to the 1960s and it was initially a government creation rather than a start-up.