TCS Daily

State Venture Capital?

By Meelis Kitsing - September 8, 2005 12:00 AM

The prime minister of Latvia recently abolished the Absurdities Prevention Bureau inherited from his predecessor. At first read that might produce a grin, yet the PM's decision seems immature as the biggest absurdity has yet to be tackled: the desire of Latvian policy-makers to involve their state in venture capital. Latvia will spend €15 million of public money to set up venture capital funds, 75 percent of which would come from the EU structural funds. The remaining 25 percent would come from Latvian taxpayers.

Perhaps this absurdity would be difficult to stop for one bureau alone, albeit one reporting directly to the prime minister. The mistaken notion that the state, in order to promote a knowledge economy, must be directly involved in venture capital is not contained within the Latvian border. The idea has become widely accepted by policymakers in the new member states of EU.

In Latvia's neighboring Estonia, a program put forth by the new government that took office this year sees the establishment of state venture capital (VC) as a priority. Estonia plans to have €32 million reserved in the state budget for government venture capital. In a meeting held last summer in Bratislava, a representative of the Slovak National Agency for Development of Small and Medium Size Enterprises pointed out the necessity to set up a government-backed venture capital fund and business angels network in Slovakia.

For free marketers, the idea of "government venture capital" is an oxymoron. However, one does not need to be a small-government maverick to see the absurdity of state venture capital. Even in the eyes of those who support extensive public sector expansion, venture capital should be the last place to spend taxpayers' money. Launching high-tech ventures is a high-risk undertaking. Considering the possible outcomes, the government has no business entering into the field of venture capital; such high-risk undertakings are for private financiers. The 1999 study by Harvard University professor F.M Scherer demonstrates that of 670 U.S. venture capital investments, 50 percent lost money, 5 percent earned returns of 10 times the initial investment, 30 percent earned returns of 1-5 times, and 7 percent broke even. At worst the money will be completely lost. At best, it will help one enterprise, instead of being spent on a public undertaking such as education, where benefits are widely diffused.

Even so, the best scenario is highly unlikely to occur because government officials have different incentives than private investors. Even if this disparity could be somehow fixed by rewarding performance as the Latvian project aims to do, government officials lack what F.A. Hayek called "useful knowledge." While useful knowledge is localized and tacit, government through its centralized decision-making process does not know who the winners and losers are in the market. Thus the government is at an obvious disadvantage when in attempting to successfully allocate funds for the projects.

In their eagerness to clone Silicon Valley and catch up with the United States in venture capital financing, European officials fail to understand that they cannot achieve these goals by direct government intervention. First, the emergence of high-tech clusters, such as Boston Route 128 and Silicon Valley, were not achieved through deliberate governmental design, but rather an unintended consequence of government action. Seeing these clusters mainly as a public policy success and thinking that the same outcome can be achieved through public policy simply demonstrates the vested interests of European policymakers. This bias is inherent as every social group overemphasizes its role in a particular process and creates protective ideology to serve these purposes. Naturally, policymakers have developed their own version of the factors behind Silicon Valley's success; in it, public policy plays an instrumental, if not the most important role.

Second, policymakers are anxious to learn from successful cases but are quick to ignore failures. This selection bias creates a methodological problem. Reasons for success are interdependent and complex in cases like Silicon Valley. Hence, the probability of picking and choosing wrong factors for explaining certain successes is high. The failure to replicate Silicon Valley in New York's capital region can be much more helpful in drawing public policy implications. Why is it that Silicon Valley emerged in California while clever public policies, including public sector financing of enterprises, implemented by many smart people in the state of New York state failed? Simple answer: Social engineering does not work.

Third, there is a great deal of confusion concerning the unit of analysis. On a very general level, many characteristics of Silicon Valley and outcomes that Europeans aim for are also more typical characteristics of the United States when compared to Europe. It is obvious that the U. S. has more entrepreneurs, its universities are more entrepreneurial, technological innovation is higher, technologies are more diffused and spending on research and development is higher than in Europe in general. Thus, with such great differences between the U.S. and Europe in general terms, it is impossible to draw policy lessons for cloning Silicon Valley.

Basically, Europe should change a vast amount of policies. Most importantly, despite its general policy framework some regions thrive and grow in the United States and others do not. Logically, it follows that regions must be the units of analysis. To understand the factors behind the rapid growth of Silicon Valley, policymakers should compare Silicon Valley to Utah, and Boston to Colorado -- from the global perspective these regions operate in very similar policy environments.

Recent academic research has demonstrated that the Valley's success is not explained solely by the presence of venture capital, large high tech companies, and numerous high-tech start-ups but by a broader institutional framework and social phenomena that have evolved over time. "The complex information channels developed in the Silicon Valley to realize the potential of the computer revolution go far beyond the formal structure of firms and markets developed in standard economics," writes Douglass North, Nobel prize winner in economics, in his new book Understanding the Process of Economic Change (Princeton University Press 2005).

The evolution, role and characteristics of the Valley's entrepreneurs in the overall ecosystem differs from the rest of the United States, and it has been difficult for large banks, law offices and other firms from New York and San Francisco to enter this market due to their different culture and understanding of their role in the system.

In their book Understanding Silicon Valley (Stanford University Press 2000), Urs von Burg and Martin Kenney state bluntly that "it has been difficult to duplicate the organic, path-dependent evolution of replete with learning-by-doing, learning-by-example, and most especially, learning-by-failure."

If policymakers want to clone the Valley, they should not only set-up venture capital, attract high tech companies and create incentives for start-ups, but basically design a broad institutional framework -- both formal and informal -- that creates a self-reinforcing ecosystem similar to that of Silicon Valley. Any policymaker sensible enough to realize he or she does not have the power of God realizes the impossibility of the complex task of social engineering.

The notion held by European policymakers that considers a lack of venture capital financing to be "a market failure" that blocks new enterprises from taking off and that can be fixed by government venture capital fund is doomed to have the opposite effect. Venture capital is an entrepreneurial activity. Government meddling may become a substitute for this entrepreneurial undertaking. As always, government actions have unintended consequences -- in the name of encouraging one entrepreneurial activity, another one will inadvertently be killed. In other words, over-eagerness to fix something that is seen as "market failure" will lead to government failure.

It is important to note that the willingness to finance enterprises by private means is already present. At a meeting in Bratislava last year, Juraj Poledna of the National Agency for Development of Small and Medium Size Enterprises presented a 2003 statistical survey that showed two-thirds of current entrepreneurs in Slovakia launched their own businesses based on their personal savings. Fifteen percent of the 2000 respondents had taken informal loans from relatives or friends; 59 percent had indicated a willingness to lend money to relatives and friends to start business. Estonia has had private venture capital funds operating since the 1990s. The most successful of Estonian start-ups have also attracted financing from Silicon Valley. If start-ups from a tiny, relatively unknown nation that does not have direct flights to California can do it, then the concept of market failure has no meaning.


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