Arnold Kling  

Finance, Risk and Growth

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A reader of my piece on math and economics connected me to this 1998 Forbes cover story on Reuven Brenner.


Forbes Global: Finance is central to your view of creating wealth. Why is it so important?

Brenner: Because finance is what stops persistent mistakes. Competitive financial markets will not provide capital indefinitely to entrepreneurs whose ideas persistently lose money.

Finance also shows you why neoclassical economics is so wrong. Suppose, in the real world, you want to start a new business. For me to finance your business you must show me that you have something unique -- otherwise I won't finance you. Because only your uniqueness will give me a chance to cover the losses on all the other mistakes I will inevitably make. Neoclassical economics says entrepreneurs enter markets with homogenous products. But no one would ever finance a homogenous product.


Brenner was an early proponent of the view that trial-and-error learning produces economic growth, and of the view that entrepreneurial risk-taking is central to this process.

Brenner sees entrepreneurs as motivated by threats to their relative standing. For example, suppose that you have just been fired. You want to restore your position in society, and at this point you have nothing to lose by taking a risk.

Entrepreneurial risk-taking requires finance. In Brenner's view, well-developed capital markets facilitate easy entry and exit for entrepreneurs. Without finance, entrepreneurs have ideas that cannot be implemented. As David Warsh put it,


According to Brenner, prosperity is the consequence of one thing and one thing only, he writes: "matching talent with capital, and holding both sides accountable." When capital markets are open, he says, "so-called angels, venture capitalists, banks, investment banks, leveraged buy-out firms and asset-management firms make these matches, betting on the visions of entrepreneurs and managers" and keeping their feet to the fire.

When capital markets are closed, he says, governments, family members and criminal elements decide on the matches, with considerably less salubrious results.


My own decision to become an entrepreneur, when I started Homefair in 1994, somewhat fits Brenner's model. My status was reduced at my employer, Freddie Mac, because a project that I had struggled for years to launch was taken away from me in a very insulting way just as it earned corporate approval. Also, as I became aware of the Internet, I felt that there would be opportunities there that, if ignored, would leave one even further behind. So I had the "little to lose, a lot to gain" mindset that Brenner associates with entrepreneurialism.

For Discussion. According to Brenner's view, individuals and firms that have achieved their aspirations become complacent and risk-averse. This means that innovation is less likely to come from large, successful companies. It is easy to think of examples where large firms failed to implement innovations that seemingly were close at hand, such as Xerox's failure to market the personal computer and networking inventions of its PARC geniuses. Are those typical stories, or man-bites-dog stories?


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COMMENTS (12 to date)
spencer writes:

David makes an interesting point that I would like to see more discussion about. The entrepreneur normally does not have the capital from his savings to finance his idea. So he goes to sources of business capital to get the financing for his business. This again points out that personal savings has essentially no impact on investments. Consequently, while change in personal tax rates can have a big impact on consumption, it has no impact on investment -- capital spending or investment even in the case of new firms is not financed by personal savings. That is why there is no relationship between personal tax rates and economic growth. All of the discussion of personal tax cuts and economic growth is essentially discussing two points that have no interaction. For a quarter of a century we have created numerous ways to shelter savings from taxes and the result has been almost a complete elimination of personal savings. So the idea has failed. Yet the disappearence of personal savings has had no impact on capital spending or innovation as both have contiued at high levels.

Randy writes:

Most innovation is not "big idea" innovation. Walmart is a perfect example. No big idea, just lots of innovation in the details leading to massive profits. Or my new new Jeep Liberty which is a much improved vehicle over my old Cherokee. Its the little things. Innovation does not have to assume the form of risk - though the big ideas usually involve both - and make for great stories.

Bob writes:

Randy, I disagree that Walmart wasn't a big idea innovation. Any process innovation that fundamentally changes how an industry works is capital BIG if it is not trivial to implement and works. This is how Walmart links to Arnold's ideas - you're right that their innovations were sequential and, consequently, not terribly risky (in a "bet the company" sense). But that's the best way (for the company and the economy) because you maximize learning potential and minimize the damage from the inevitable mistakes. And when Walmart strays from their roots it hasn't worked well - they blew a lot of cash on internet initiatives (along with everyone else, of course) because they didn't hold to their successful incremental (slow but steady) innovation strategy.

Lawrance George Lux writes:

The major factor in obtaining Finance lies in proven Product, whether upscale R&D, or small shoestring operations which are co-opted by large entity business or Bank finance. The real new factor in the American economy stands as the Corporate recognition that outsourcing R&D allows for new talent recognition, with a higher Bottom line. The worst element of it is that much R&D cannot be funded by 'Mom and Pop' stores. lgl

Lawrance George Lux writes:

The major factor in obtaining Finance lies in proven Product, whether upscale R&D, or small shoestring operations which are co-opted by large entity business or Bank finance. The real new factor in the American economy stands as the Corporate recognition that outsourcing R&D allows for new talent recognition, with a higher Bottom line. The worst element of it is that much R&D cannot be funded by 'Mom and Pop' stores. lgl

Bob Knaus writes:

Spencer - it's a pretty big leap from saying that the average entrepreneur does not have enough personal savings to finance his ideas, to saying that personal savings has no impact on investments. What do you think the bank, or brokerage, or public company, does with the personal savings you entrust to them? They pool your savings with lots of others, and invest them in productive enterprises.

In small-town America (where most of my stories come from) the links were pretty obvious. So obvious that a common name for the local bank was "Farmers and Merchants Bank of Anytown". Farmers got paid once a year for their crop. Merchants got paid monthly on their accounts with the farmers. The bank existed to synchronize these credit needs over the course of the year. Often, the banks were capitalized by the railroads that hauled the farm goods out and the merchandise in.

In such a small system it is easy to see how pooled personal savings finance new ideas. Farmer Jones walks into the bank, says "I want to buy one of those newfangled combines" and walks out with the money. The money came from the merchants and farmers, just like the bank sign says out front.

Am I belaboring the obvious?

Barry P. writes:

Slight sidetrack here:

Concerning the importance of trial and error learning: I entered the econ profession fairly late in life (started a doctorate in my mid-30s) after a previous career as an engineer, in both the petrochemical and mining sectors. Engineers are taught a lot about the value of learning from our mistakes, thus it becomes ingrained that trial and error is sort of a default learning mechanism - it is very rare that a theory is hatched fully formed and implemented as-is without significant revision. Indeed, we expected some unforeseen thing to go wrong with a new installation or experiment.

Hence, I was rather surprised to see the total absence of this way of thinking in economics. Of course, this is only one of the several flaws in modern theoretical economics that are only revealed to people upon study of the field in depth. I find it sad that Econ has come to be dominated by utterly obtuse game-theoretic mathematics, that econometrics is an ever-more-convoluted obsession with improving the behavior of the information matrix, and that modern empirical finance is about finding more obscure probability distributions form-fitted to past events. The people who propogate these ideas and attitudes are seriously missing the point, IMHO.

Lucidity of ideas and their expression is no longer important.

Dezakin writes:

Well, I suppose its only anecdotal, but in relation to Arnold's question, its very typical.

Small companies that get big run out of steam and start behaving differently. The one I work for certainly did. Oh there's still innovation going on, but the stockholders expect big company stability now. That means that you don't throw half your staff at a problem thats only got a 50% chance of turning a profit, even if the profit is probably huge.

You let some other company try to do it, and if they lose, its someone elses money. If they win, you buy them out and do the big company management that you've learned to do.

I don't expect the dominance of WalMart to last forever either. Everyone can see how they rose to the top, and some of the little or medium sized chains will try to copy it with their own additions, while WalMart proceeds more cautiously trying to preserve market share.

Barry P. writes:

I have heard, anecdotally, that many pieces of consumer electronics (VCR, CD, cell phones) got their technical genesis in the US, but were more successfully commercialized by companies from other countries.

GM and Ford stonewalled on airbags through the 80s and early 90s while BMW and Mercedes happily adopted them. The net effect of that set of actions may have been detrimental to the US firms.

Is there any research on risk-taking and innovation at privately-held versus publicly-traded companies? I'd think that it's easier to get the necessary concensus for risk-taking acts amongst a small group of owners (or with a single owner) versus an ownership of many shareholders.

There are also agency problems: bureaucrats are famously risk-averse, and are more in abundance at the old blue chip firms.

Bob writes:

I think Barry has almost right - but bureaucrats don't spontaneously appear to stifle innovation, they appear because the risk-taking calculus changes for large, successful firms. When there is a lot to lose (losts of resources to be wasted on bad ideas), it is rational to focus more on preventing mistakes than making great leaps. A small company that makes the wrong call is forced to recognize its mistake quickly (or go out of business). A big company is, sadly, likely to pursue the mistake for years because it can afford to and most of us are not good at recognizing and admiting out mistakes (without the proper incentives).

another bob writes:

There are useful innovations and useless innovations. There are large companies and there's Arnold moping in front of his computer. There are innovations tried and innovations ignored. There are successes and there are failures.

There are hundreds, thousands, of stories about every possible combination of these factors.

Scott Peterson writes:

I beg to differ with Spencer's comment that "personal savings has essentially no impact on investments." The majority of investment capital from domestic US sources is in the form of pension funds, life insurance companies, and mutual funds whose source of capital is the individual contributions of corporate employees and IRA's of individuals and the policy payments of life insurance holders.

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