The entrepreneurial state
The only way to make growth ‘fairer’ is for policy makers to have a broader understanding of the role played by the state in the fundamental risk-taking needed for innovation.
Across the globe we are hearing that the state has to be cut back in order to foster a post-crisis recovery, unleashing the power of entrepreneurship and innovation in the private sector. This feeds a perceived contrast that is repeatedly drawn by the media, business and libertarian politicians of a dynamic, innovative, competitive private sector versus a sluggish, bureaucratic, inertial, ‘meddling’ public sector. So much so that it is virtually accepted by the public as a ‘common sense’ truth.
For example, in his budget speech of June 2010, a month after taking office, the Chancellor, George Osborne, stated that the public sector was ‘crowding out’ the private sector, providing an additional justification, beyond the need to reduce the deficit, for a relative contraction of the state (Osborne, 2011). Both in the documentation that supported that emergency budget, and subsequently, the Coalition Government has repeatedly called for a more ‘balanced’ economy, with private activity taking up a greater share of the total so that the economy can be more ‘competitive and innovative’.
The Prime Minister, David Cameron, adopted a more polemical tone in a speech given to the Cardiff Conservative Spring Forum in March 2011 when he promised to take on the ‘enemies of enterprise’ working in government, which he defined as the ‘bureaucrats in government departments’ (Wheeler, 2011). This is a rhetoric that fits with the government’s broader theme of the ‘Big Society’, where responsibility for the delivery of public services is shifted away from the state to individuals operating either on their own or by coming together through the third sector. The Big Society is in fact based on the idea that the state should recede not only to reduce the deficit but because the state impedes innovation and dynamism. By allowing local communities to have more control of their resources and decisions, free from the heavy hand of big government, initiatives under the Big Society programme – including ‘free schools’ which are run by local parents and self-help groups – will lead to higher quality, more dynamism and more choice. Without this assumption, the Big Society is only about cuts, something the government has insisted it is not.
And it is not a view that is unique to the UK government. The Economist, which often refers to government as a Hobbesian Leviathan (The Economist, 2011a), recently argued that government should take the back seat and focus on creating freer markets and creating the right conditions for new ideas to prosper, rather than taking a more activist approach (The Economist, 2010). The established business lobby groups have long argued for freedom from the long arm of the state, which they see as stifling their ability to succeed through the imposition of employee rights, tax and regulation. The right-wing Adam Smith Institute argues that the number of regulators in the UK should be reduced to enable the British economy to ‘experience a burst of innovation and growth’ (Ambler and Boyfield, 2010). In the USA, supporters of the Tea Party movement are united by a desire to limit state budgets and promote free markets.
While business as a whole may not see the virtues of anything that does not have a clear and positive impact on its bottom line, and nor arguably should it, there is a danger when a general desire to reduce the size of the state translates into weak and non-ambitious economic policy. When that happens, we are all losers: policy is not as effective as it could be and the potential to create greater prosperity is not fulfilled. There is now a real danger of that happening in the field of innovation policy, greatly limiting its impact on economic growth.
A secret history
The view of the current government – shared by its predecessor – is that the role of the state in spurring innovation is simply to provide the ‘conditions for innovation to flourish’ (BIS and HM Treasury, 2011). The UK government states that if it invests in skills and a strong science base, ensures a strong legal framework within an amenable macroeconomy, and supports entrepreneurial clusters, then the market will do the rest through the incentive of the profit motive.
In The Entrepreneurial State I present evidence that challenges this minimalist view of the state in the field of economic policy, and argue that a far more proactive role is required (Mazzucato, 2011). The case can be made that the role of the government, in the most successful economies, has gone way beyond creating the right infrastructure and setting the rules. It has been a leading agent in achieving the type of innovative breakthroughs that allow companies, and economies, to grow, not just by creating the ‘conditions’ that enable innovation. Rather the state can proactively create strategy around a new high growth area before the potential is understood by the business community (from the internet to nanotechnology), funding the most uncertain phase of the research that the private sector is too risk-averse to engage with, seeking and commissioning further developments, and often even overseeing the commercialisation process. In this sense it has played an important entrepreneurial role.
Of course there are plenty of examples of private sector entrepreneurial activity, from the role of young new companies in providing the dynamism behind new sectors (for example Google), to the important source of funding from private sources like venture capital. But this is the only story that is usually told. Silicon Valley and the emergence of the biotech industry are usually attributed to the geniuses behind the small high tech firms like Facebook or the plethora of small biotech companies in Boston or Cambridge in the UK. Europe’s ‘lag’ behind the USA is often attributed to its weak venture capital sector. Examples from these high tech sectors in the USA are often used to argue why we need less state and more market: to allow Europe to produce its own Googles.
But how many people know that the algorithm that led to Google’s success was funded by a public sector National Science Foundation grant? Or that molecular antibodies, which provided the foundation for biotechnology before venture capital moved into the sector, were discovered in public Medical Research Council (MRC) labs in the UK? Or that many of the most innovative young companies in the USA, including Apple, were funded not by private venture capital but by public funds, including the Small Business Innovation Research (SBIR) programme?
Lessons from these experiences are important. They force the debate to go beyond the role of the state in stimulating demand, or the role of the state in ‘picking winners’ in industrial policy, where taxpayers’ money is potentially misdirected to badly managed firms in the name of progress, distorting incentives as it goes along. Instead it is a case for a targeted, proactive, entrepreneurial state, able to take risks, creating a highly networked system of actors harnessing the best of the private sector for the national good over a medium- to long-term horizon. It is the state as catalyst, and lead investor, sparking the initial reaction in a network that will then cause knowledge to spread. It is the state as creator of the knowledge economy.
It cannot be called ‘new’ industrial policy because it is in fact what has happened, though in a ‘hidden way’ to prevent a backlash, over the last three decades in the development of the computer industry, the internet, the pharma-biotech industry, and many more including today’s nanotech industry (Block and Keller, 2011a). None of these technological revolutions would have occurred without the leading role of the state. It is about admitting that in many cases, it has in fact been the state, not the private sector, that has had the vision for strategic change, daring to think – against all odds – about the ‘impossible’, creating a new technological opportunity, making the large necessary investments, and enabling a decentralised network of actors to enable the risky research, and to allow the development and commercialisation process to occur in a dynamic way.
Entrepreneurship and risk
Entrepreneurship, like growth, is one of the least understood topics in economics. What is it? According to the Austrian economist Joseph Schumpeter, an entrepreneur is a person, or group of people, who is willing and able to convert a new idea or invention into a successful innovation. It is not just about setting up a new business (the more common definition), but doing so in a way that produces a new product, or a new process, or a new market for an existing product or process. Entrepreneurship, he wrote, employs ‘the gale of creative destruction’ to replace in whole or in part inferior innovations across markets and industries, simultaneously creating new products including new business models, and in so doing destroying the lead of the incumbents (Schumpeter, 1942; 1949). In this way, creative destruction is largely responsible for the dynamism of industries and long-run economic growth. Each major new technology leads to creative destruction: the steam engine, the railway, electricity, electronics, the car, the computer, the internet have all destroyed as much as they have created but led to increased wealth overall.
For Frank H. Knight and Peter Drucker, entrepreneurship is about taking risk (Knight, 1921; Drucker, 1970). The behaviour of the entrepreneur is that of a person willing to put his or her career and financial security on the line and take risks in the name of an idea, spending much time as well as capital on an uncertain venture. In fact, entrepreneurial risk-taking, like technological change, is not just risky, it is highly ‘uncertain’. Knight distinguished risk from uncertainty in the following way:
The practical difference between the two categories, risk and uncertainty, is that in the former the distribution of the outcome in a group of instances is known … While in the case of uncertainty that is not true, the reason being in general that it is impossible to form a group of instances, because the situation dealt with is in a high degree unique.(Knight, 1921)
John Maynard Keynes also emphasised these differences:
By ‘uncertain’ knowledge, let me explain, I do not mean merely to distinguish what is known for certain from what is only probable. The game of roulette is not subject, in this sense, to uncertainty … The sense in which I am using the term is that in which the prospect of a European war is uncertain, or the price of copper and the rate of interest twenty years hence, or the obsolescence of a new invention … About these matters there is no scientific basis on which to form any calculable probability whatever. We simply do not know! (Keynes, 1936)
Technological change is a good example of the truly unique situation since R&D investments not only take years to materialise into new products, but most lead to failure. In the pharmaceutical sector, for example, innovation takes up to seventeen years from the beginning of an R&D project to the end; it costs about $403 million per drug; and the failure rate is extremely high: only 1 in 10,000 compounds reach market approval phase, a success rate of 0.01 per cent. When successful, often the search for one product leads to the discovery of a completely different one. The process is characterised by serendipity. This of course does not mean that innovation is based on luck. Far from it, it is based on long-term strategies and targeted investments. But the returns from those investments are highly uncertain and thus cannot be understood through rational economic theory.
Beyond market failure
The high-risk and serendipitous character of the innovation process is one of the main reasons why profit-maximising companies will invest less in basic research and more in applied research, because of the greater and more immediate returns from the latter. Investment in basic research is a typical example of a ‘market failure’ where the market alone would not produce enough basic research so the government must step in. This is why there are few people, on all sides of the political spectrum, who would not agree that it should be (and is) the state that tends to fund most basic research.
But a key reason why the concept of market failure is problematic in understanding the role of government in the innovation process is that it ignores a fundamental fact about the history of innovation. Not only has government funded the riskiest research, whether applied or basic, but it has indeed often been the source of the most radical, path-breaking types of innovation. To this extent it has actively created markets not just fixed them.
While economists agree that innovation is an important factor leading to growth, not all innovations lead to economy-wide growth. This is only true for new products or processes that have an impact on a wide variety of sectors in the economy, as was the case with the rise of electricity and computers. These are what economists call general purpose technologies (GPTs) characterised by three core qualities:
- they are pervasive in that they spread to many sectors;
- they get better over time and, hence, should keep lowering the costs of its users;
- they make it easier to invent and produce new products or processes.
In fact, large scale and long-term government investment has been the engine behind almost every GPT in the last century. Vernon Ruttan analysed the development of six different technology complexes (the US ‘mass production’ system, aviation technologies, space technologies, information technology, internet technologies and nuclear power) and concluded that government investments have been important in bringing these new technologies into being, and that nuclear power would, most probably, not have been developed at all in the absence of large government investments in development (Ruttan, 2006). In each case it was not just funding innovation, and creating the right conditions for it, but also envisioning the opportunity space, engaging in the most risky and uncertain early research, and overseeing the commercialisation process. This has also been the case for the recent development of nanotechnology, which many believe is the next GPT.
At a more micro level, Fred Block and Matthew Keller find that, between 1971 and 2006, 77 out of the most important 88 innovations (rated by R&D Magazine’s annual awards) were found to have been fully dependent on US federal government support, especially, but not only, in the early phases (Block and Keller, 2011b).
In different sectors, it has often been the state that has funded the most radical innovations, with the private sector focusing on the less risky, more profitable innovations. For example, in the pharmaceutical industry, it is state-funded research that has been responsible for producing 75 per cent of the most innovative drugs (‘new molecular entities’ with priority rating), with private pharma preferring to focus on the less risky, hence often more profitable, ‘me too’ drugs, that is, slight variations of existing drugs such as Viagra with a different colour and different dosage (Angell, 2004).
These examples are fundamental for understanding the impact of publicly funded research.It is not just about funding blue sky research but creating visions around new important technologies. Ironically, the state has played this entrepreneurial role the most in the USA, which is usually described in European policy circles and in the media as one in which the economy is mainly driven by the market, with many European politicians pitching the need to learn from the market-driven Silicon Valley experiment. Silicon Valley was in fact built upon decades of state-led vision around the power of the internet, decades of investment in the riskiest research, and decades of nurturing regional innovation systems and new company start-ups – a lesson that is, ironically, being ignored by the UK and being followed by China. Block and Keller describe how due to political pressure it has done so in a ‘hidden’ way through a decentralised network of state agencies such as the Defense Advanced Research Projects Agency (DARPA, which invented the internet), the National Institute of Health (NIH), the National Nanotechnology Initiative (NNI), and SBIR (Block and Keller, 2011a). It is in fact this very decentralised, nimble, and active approach that has been so dynamic and successful, contrary to the usual depiction of the large, slow, bureaucratic state. A full account of this story, and its implications for understanding the economics of growth and innovation, can be found in The Entrepreneurial State (Mazzucato, 2011).
The entrepreneurial state and ‘good’ speculation
The state can be far more proactive in spurring industrial innovation at the forefront of knowledge than is currently understood by policy-makers. The state welcomes and engages with Knightian uncertainty for the exploration and production of new products which lead to economic growth. It has done so not just by funding basic research. More importantly, it has taken the lead by formulating a vision of a new area (for example the internet or the genetic sequence); investing in the earliest-stage research and development which the private sector is unable or unwilling to do (for example when the market prefers to invest in safe ‘me too’ medicines rather than risky new molecular entities); identifying and supporting multiple new paths and adjusting rules to promote them (for example changes in regulation that allow publicly funded research to be patented); creating and funding networks that bring together business, academia and finance (for example SBIR in the USA); and being constantly ahead of the game in areas that will drive the next decades of growth (for example nanotechnology and green technology today).
It will also, at a time when the economic crisis has given risk and speculation a bad name, distinguish between good speculation and bad speculation. Speculation is needed when the probability of failure is so high. The state has in fact been an important source of Schumpeterian risk and speculation – the bold courage required to delve into the world of uncertainty needed to create new products and processes that can transform long-run economic growth. Thus good risk is the speculation needed for the sake of innovation and structural change rather than speculation for... the sake of speculation – profit on short-term price changes. This ‘entrepreneurial’ risk-taking role is something that neither the economics of Keynesian stimulus nor the policies behind the Schumpeterian national systems of innovation have elaborated. And this is one of the reasons why the current international debate about post-crisis recovery and growth is often so full of rhetoric about the private–public divide, on both the conservative and progressive sides of the spectrum.
The history of technological change suggests that the key role of government is not about fixing market failures, but rather about actively creating the market for the new technologies by envisioning the opportunity space and allowing the right network of private and public actors to meet in order for radical innovation to occur. The role of government has, in this sense, been more about fixing ‘network failures’ than about ‘market failure’. It has also been about preventing ‘opportunity failures’ – government’s willingness to think big and take risks has created new opportunities and markets, whereas the private sector has shied away because of the long time horizons and the high failure rates.
An article in The Economist recently claimed that the ‘government has a terrible record at picking winners’ (The Economist, 2011b). A look at the massive impact that government’s targeted large investments in industries such as steel, railways, air travel, silicon microchip manufacturing, automotive manufacturing, computers, biotechnology, the internet, and nanotechnology shows this is just not true. Without the government pursuing a targeted investment strategy, none of these industries would have come into being. And being first matters because of the dynamic increasing returns to scale and path-dependency associated with innovation.
In this respect, Britain has got its innovation policy all wrong, with negative implications for growth in the long run. Taxpayer support is misdirected and opportunities are being missed. Innovation policy needs to focus on creating the conditions that allow innovation to flourish, but also, and perhaps especially, on directly commissioning and procuring innovative solutions. History tells us that these will not happen without a strong push by the state.
Risk-taking in innovation: who gets the return?
In finance, it is commonly accepted that there is a relationship between risk and return. However, in the innovation game, this has not been the case. Risk-taking has been a collective endeavour while the returns have been much less collectively distributed. Often, the only return that the state gets for its risky investments are the indirect benefits of higher tax receipts that result from the growth that is generated by those investments. Is that enough?
There is indeed lots of talk of partnership between the government and private sector, yet while the efforts are collective, the returns remain private. Is it right that the National Science Foundation did not reap any financial return from funding the grant that produced the algorithm that led to Google’s search engine? (Battelle, 2005). Can an innovation system based on government support be sustainable with such a system of rewards? The lack of knowledge in the public domain about the central entrepreneurial role that government plays in the growth of economies worldwide, beyond Keynesian demand management and ‘creating the conditions’ for growth, is currently putting the successful model in major danger.
This contrast is well depicted by the example offered by Steve Vallas, Daniel Kleinman, and Dina Biscotti:
A new pharmaceutical that brings in more than $1 billion per year in revenue is a drug marketed by Genzyme. It is a drug for a rare disease that was initially developed by scientists at the National Institutes of Health. The firm set the price for a year’s dosage atupward of $350,000. While legislation gives the government the right to sell such government-developed drugs at ‘reasonable’ prices, policymakers have not exercised this right. The result is an extreme instance where the costs of developing this drug were socialised, while the profits were privatised. Moreover, some of the taxpayers who financed the development of the drug cannot obtain it for their family members because they cannot afford it. (Vallas, Kleinman and Biscotti, 2010)
The socialised generation and privatised commercialisation of biopharmaceutical – and other – technologies could be followed by withdrawal of the state, if private companies used their profits to reinvest in research and further product development. The state’s role would then be limited to that of initially underwriting radical new discoveries, until they are generating profits that can fund ongoing discovery. But private-sector behaviour suggests that public institutions cannot pass the R&D baton in this way. And that the state’s role cannot be limited to that of planting seeds that can be subsequently relied on to grow freely.
Many of the problems being faced today by the Obama administration are indeed due to the fact that US taxpayers are virtually unaware of how their taxes foster innovation and growth in the USA, and that corporations that have made money from innovation that has been supported by the government are neither returning a significant portion of the profits to the government nor investing in new innovation (Mazzucato, 2010). They are sold the idea that this growth occurs as a result of individual ‘genius’, or Silicon Valley ‘entrepreneurs’, or venture capitalists, to what they think is a ‘weak’ state compared with the European system. These battles are also being played out in the UK where it is argued that the only way for the country to achieve growth is for it to be privately led and for the state to go back to its minimal role of ensuring the rule of law.
An implication of this article is that the only way to make growth ‘fairer’ and for the gains to be better shared is for economists, policy makers, and the general public to have a broader understanding of which agents in society take part in the fundamental risk-taking that is necessary to bring on innovation-led growth. As has been argued, risk-taking and speculation are absolutely necessary for innovations to occur. The real Knightian uncertainty that innovation entails is in fact the reason that the private sector, including venture capital, often shies away from it.
Understanding the dynamics of innovation must be brought in line with our understanding of the dynamics of inequality. These areas of economic thought have been separated since David Ricardo’s study of the effect of mechanisation on the wage-profit frontier/distribution. Recently, the relationship has come back in vogue with studies on how skill-biased technological change affects wages. This work explains inequality through how wages are affected by technologies like IT that favour skilled over unskilled labour by increasing its relative productivity and, therefore, its relative demand and wages. Inequality is thus explained here as a result of how economic incentives shaped by relative prices, the size of the market, and institutions create biases in factors of production, which then affect their returns (Acemoglu, 2002). While this work provides some important insights, it does not explain many dynamics of inequality, including why within a sector, the different agents that take part in production and innovation reap such different benefits from the innovation. Inequality is indeed just as high within sectors as it is between (Perrons and Plomein, 2010).
The idea of an entrepreneurial state suggests that one of the core missing links between growth and inequality (or to use the words of the European Commission’s ‘Europe 2020’ strategy, between ‘smart’ and ‘inclusive’ growth) lies in a wider identification and understanding of the agents that contribute to the risk-taking required for that growth to occur. Bank bonuses, for example, should not be criticised using arguments against the greed and underlying inequality that is produced (even though these generate powerful emotions). Rather they should be argued against by attacking the underlying logical foundation on which they stand.
The received wisdom is that bankers take on very high risks, and when those risks reap a high return, they should in fact be rewarded – they deserve it. The same logic is used to justify the exorbitantly high returns that powerful shareholders have earned in the last decades, which has been another prime source of increasing inequality. The logic here is that shareholders are the biggest risk takers, since they only earn the returns that are left over once all the other economic actors are paid (the ‘residual’ if it exists, once workers and managers are paid their salaries, loans paid off, and so on). Hence when there is a large residual they are the proper claimant – they could in fact have earned nothing since there is no guarantee that there will be a residual.
However, an understanding of risk that gives credit to the role of the public sector in innovative activities immediately makes it logical for there to be a more collective distribution of the rewards that should exist. Central to this question is the need to better understand how the division of ‘innovative labour’ maps into a division of rewards (Lazonick and Mazzucato, 2011). The innovation literature has provided many interesting insights on the division of innovative labour, for example the changing dynamic between large firms, small firms, government research and individuals in the innovation process (Pavitt, 1984; Arora and Gambardella, 1994). But there is very little understanding on the division of returns from innovation. This is a problem since governments and workers also (and perhaps more so) invest in the innovation process without guaranteed returns (Lazonick, 2007).
The critical point is the relation between those who bear risk in contributing their labour and capital to the innovation process and those who appropriate rewards from the innovation process. As a general set of propositions on the risk-reward nexus, when the appropriation of rewards outstrips the bearing of risk in the innovation process, the result is inequity; when the extent of inequity disrupts investment in the innovation process, the result is instability; and when the extent of instability increases the uncertainty of the innovation process, the result is a slowdown or even decline in economic growth (Lazonick, 2010). A major challenge for the UK and for ‘Europe 2020’ is to put in place institutions to regulate the risk-reward nexus so that it supports equitable and stable economic growth.
To achieve this it is essential to understand innovation as a collective process, involving an extensive division of labour that can include many different types of contributors. As a foundation for the innovation process, the state typically makes investments in physical and human infrastructure that individual employees and business enterprises would be unable to fund because of a combination of the amount of fixed costs that investment in innovation requires and the degree of uncertainty that such investment entails. The state also subsidises the investments that enable individual employees and business enterprises to participate in the innovation process. Academic researchers often interact with industry experts in the knowledge-generation process. Within industry there are research consortia that may include companies that are otherwise in competition with one another. There are also user–producer interactions in product development within the value chain. And within the firm’s hierarchical and functional division of labour, there is the integration into the processes of organisational learning of the skills and efforts of large numbers of people involved in the hierarchical and functional division of labour.
Identification of who bears risk cannot be achieved by simply asserting that shareholders are the only contributors to the economy who do not have a guaranteed return – a central, and fallacious, assumption of financial economics based on agency theory. Indeed, in so far as public shareholders simply buy and sell shares, and are willing to do so because of the ease with which they can liquidate these portfolio investments, they may make little if any contribution to the innovation process and bear little if any risk of its success or failure. In contrast, governments may invest capital and workers may invest labour (time and effort) in the innovation process without any guarantee of a return commensurate with their investments. For the sake of innovation, we need social institutions that enable these risk-bearers to reap the returns from the innovation process, if and when it is successful (Lazonick and Mazzucato, 2011).
A fairer and more dynamic relationship between risk and return requires a more informed understanding of the state’s leading role in taking on risk – and the often parasitic role of the private sector which, through riding the waves created by the state, reaps all the profits.
When SITRA, the Finnish government’s public innovation fund, provided the early stage funding for Nokia, it later reaped a significant return on this investment – a fact accepted by the Finnish business community and politicians. The reason why the US government has not reaped a return from its early stage investments in companies like Google (which benefitted from a state-funded grant for its early algorithm) and other such success stories including Intel, Compaq and Apple (which received public SBIR funding), is due to the lack of understanding in the USA of state-led growth-inducing investments, which allow conservative forces to portray the state as only a menace in the economy.
Governments all over the world are fighting hard to put their finances in order, while simultaneously needing to find the funds and opportunities to make the necessary growth-inducing investments (in education, research, infrastructure, and so on). Finding ways to reap a return from such investments when they are made – so that funds can later be re-plugged back into the economy, helping to assure a virtuous cycle, rather than the current vicious one – is more important today than ever. Both the Democratic Party in the USA, and the Labour Party in the UK, could make this an essential part of their ‘fight back’.
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