Quantitative Finance Review

Quantitative Finance, 2014
Vol. 14, No. 6, 959–960, http://dx.doi.org/10.1080/14697688.2014.911415

Doing Capitalism in the Innovation Economy, by William H. Janeway, Cambridge University Press (2012), Hardback. ISBN 978-1-107-03125-8.

After his doctorate at Cambridge University, William H. Janeway entered the world of investment banking and venture capital in 1970. Over the next three decades he experienced the financing of innovation first-hand in a career that culminated with signal successes in the dotcom boom. Along the way, he sought to make sense of his expe- riences through the writings of political economists as diverse as Joseph Schumpeter, John Maynard Keynes, Karl Marx, historian Fernand Braudel and—well before his recent, posthumous celebrity—Hyman Minsky.

In this book, a fascinating blend of memoir and analysis, Janeway presents an overarching paradigm for how capitalist economies finance technological innovation and cope with the resulting detritus of failed experiments. Rejecting neo- classical formulations, Janeway sees innovation as the result of a complex ‘three-player game’ between the state, financial

capitalists and entrepreneurs who organize the commerciali- zation of new technologies. Public capital markets play a piv- otal, if somewhat controversial, role in this formulation. According to Janeway, it is the tendency of equity markets to froth into ‘speculative excess’ with some regularity that ulti- mately emboldens venture capitalists to finance nascent tech- nologies and to explore the myriad opportunities suggested by a new technology before the market’s Darwinian forces ultimately select lasting applications. ‘In all their wasteful excess’, he writes, ‘bubbles have been necessary drivers of economic progress (Janeway 2012)’.

The foundation of Janeway’s theory of innovation is his view that innovation is marked by ‘inescapable, irreducible uncertainty’ that is beyond the reach of measurement. Not only is there no scientific basis for calculating the probabilities of possible outcomes, says Janeway, but these outcomes themselves cannot be fully enumerated. This ‘ontological’ or ‘Knightian’ uncertainty makes it impossible to allocate capital on traditional assessments of risk and expected return.

960 Book review

Nowhere is this ontological uncertainty greater than in the primary research that can spawn new industries or reshape existing ones, such as automobiles a century ago, the internet in our generation and perhaps green energy in the next. Jane- way believes that with returns so far beyond quantification, primary research is best undertaken by entities that do not need the chimera of performance forecasts to rationalize their deci- sions. The state can play a critical role in advancing primary research through its political mandate, as evidenced by the transformational work on semiconductors, microcomputers and the internet sponsored by the Department of Defense, and on human genome research and biotechnology sponsored by the National Institutes of Health in the post-war US economy. Firms with entrenched market power can also create such research, with facilities like AT&T’s Bell Laboratories and Xerox PARC incubating fundamental science in computing and networking technologies.

But primary research creates only possibilities, not products. It is the role of ‘financial capitalists’ (e.g. venture capitalists today), working with entrepreneurs, to identify attractive appli- cations of nascent technology and manage the perilous passage from possibility to product. This is the nexus Janeway occu- pied for three decades as a venture capitalist, and he captures its challenges wonderfully through detailed narratives of his own experiences. Echoing Schumpeter’s warning that the entrepreneur ‘loses other people’s money’, Janeway writes feelingly of his two Laws of Venture Capital: (1) All entrepre- neurs lie and (2) No news is never good news. The key to con- trolling the hazards of this relationship, says Janeway, is not diversification but a deeper engagement in the venture’s out- comes through ‘cash and control’.†

For all the clarifications brought by primary research, venture capitalists continue to face forbidding ‘ontological uncertainties’ as they seek to bring products to life. The venture capitalist’s reward is an occasional success that punctuates his myriad trials and errors. To make venture capital inviting in the face of large, unquantifiable uncer- tainties, these occasional successes have to be spectacular. It is here, as Janeway sees it, that public equity markets play a crucial role. Equity markets, says Janeway, are sus- ceptible to regular outbursts of speculative excess; so regu- lar that Janeway, in a play on Hannah Arendt’s memorable phrase, talks of the ‘banality’ of bubbles. But bubbles, in his view, are not evil. They incentivize innovation by creat- ing the periodic liquidity and reward that compensates financial capitalists for all their unsuccessful risks and sus- tains new rounds of innovation financing.

In a world of ontological uncertainty, Janeway defines a bubble as a state where ‘the price of the financial asset is separated from any concern with the underlying cash flows’.‡ This is subtly different from mainstream definitions of a bubble, which would have prices deviating from the present value of underlying cash flows, or ‘fundamental value’. In a world of ontological uncertainty, where funda- mental value may be hard to measure, Janeway believes bubbles, in his sense of the word, can be a blessing because they enable investors to look past the paralyzing immeasur-

†See, for example, Janeway, pp. 6 and 115 among others. ‡Janeway, p. 2. [emphasis added].

ability of risk and take a leap of faith on an emerging inno- vation. By doing so, public investors assume the ontological uncertainties hitherto borne by venture capital- ists, freeing them for the next round of innovation. Through the transfer of downstream risk, the venture capitalist also captures the compensation for bearing upstream risk.

Of course, leaps of faith can end badly. Many of the exper- iments facilitated by an exuberant equity market end in fail- ure, causing significant short-term harm to investors and workers in the innovation economy. The resilience of the economy is determined by how well it can absorb this cost and exploit new opportunities arising from it. Flexible prices and entrepreneurial agility help to create new opportunities from over-supplied technologies and deploy them produc- tively again. And when the economy recovers, it will resume from a higher level of technology than it had before the bub- ble. The state could re-appear in the innovation game by adopting expansionary monetary and fiscal policies that miti- gate the bust but Janeway appears to regard this prospect with suspicion. He notes Hyman Minsky’s warning that such measures serve only to delay and magnify the ultimate reck- oning, with each rescue signalling an implicit guarantee of similar future risk-taking.

Many elements of Janeway’s paradigm are individually familiar from earlier writings but his synthesis of these ele- ments into an overarching model for the economics of inno- vation is both novel and insightful. He develops each element, and its many subtleties, in great detail and while readers may not agree with every conclusion—I don’t—they will surely be richer in knowledge or under- standing for having placed themselves in Janeway’s hands.

This book addresses more issues than I can cover in this review. In the process of laying out his paradigm, Janeway gives interesting insights into the evolution of investment banking, the emergence of the venture capital industry, why credit bubbles (potentially terrible, in his view) are different from equity bubbles (often good, in his view), why market leaders are better at creating new technologies than in exploiting them commercially and how well-meaning financial regulation can have dire, unintended consequences. Running through this narrative is a thoughtful and entertaining record of his own experiences in venture capital and the illustrations they offer for his understanding of the innovation economy.

‘Some books’, said Sir Francis Bacon, ‘are to be tasted, others to be swallowed and some few to be chewed and digested’. From a lifetime of reflection and experience, Janeway has produced a book that should be chewed and digested thoroughly.

Reference

Janeway, W.H., Doing Capitalism in the Innovation Economy, 2012 (Cambridge University Press: New York).

Sanjay Unni

Berkeley Research Group, Emeryville, CA, USA