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I went undercover last week at the New Zealand Association of Economists conference to see what they had to say about innovation.  Not so incognito was the Undercover Economist, Tim Harford, Financial Times columnist and author of several highly entertaining popular economics books, who delivered the opening keynote address at the conference.  In this post I will touch on some of the ideas that Harford covered in his talk.

Harford made his name with 2005’s Undercover Economist, an account of the effects of markets in our everyday lives.  Via a deft deconstruction of the factors that govern the price you pay for your morning espresso, he delivers an orthodox expose of the inner workings of the marketplace:  markets are good for you, except when they aren’t, in which case there are straightforward interventions that will correct most failures.

The trouble with markets

Yet the Harford of 2011 is not the Harford of 2005.  The recent global financial crisis gave many economic commentators pause for thought, and Harford’s response comes in his most recent book, Adapt: Why Success Always Starts With Failure*.

Harford’s new world view is a tad less orthodox, although it stands firmly on the shoulders of the old.  The Undercover Economist told us of three ways in which markets can fail:  externality, information asymmetry and monopoly.  To this list, argues Harford, we must now add a fourth cause of market failure:  complexity.

Harford’s original faith in markets was vested in their ability to tell the truth.  In a market economy, bad ideas will ultimately be shut down by the bankruptcy court, whereas good ideas will spread as they are copied by competitors.  In a centrally planned economy, bad ideas can become Great Leaps Forward.

Nonetheless, Harford sees the financial crisis as an example of where complexity may have overwhelmed the ability of the market to sift the good from the bad.  The bewildering variety of complex financial hedges that were in place to manage risk instead ended up concealing that risk; at least for a time, markets were unable to tell the good loans from the bad.  This was not so much an information asymmetry as an information deficit.

Beyond efficiency

Harford has not abandoned his confidence in markets altogether.  Rather, he draws a lesson from the fact that markets seem to work at all in the face of complexity, and applies this wisdom to the broader swathe of institutions that advanced economies rely on to regulate, to innovate and to govern.

Beyond the efficient allocation of goods, Harford celebrates the ability of markets to explore new ideas, experiment with them and eliminate those that fail.  In contrast, governments, bureaucracies, and even most companies are not good at taking risks or experimenting.  It is an unusual political career than can survive more than a few failures, and middle managers in a hierarchical corporate or government structure have little incentive to report failure up the chain.  This generally results in organisations that struggle to filter good from bad.

Yet some institutions have learned to flirt with failure.  The scientific method, for instance, formalises the procedure for proving ideas wrong.  Peer review, the double blind trial and the requirement for repeatability in any experiment, are all tools the scientific community use to weed out the ill-founded ideas from the sound.  Companies like Google expect 90% of their projects to fail, relying on the 10% that succeed to keep the company ahead of its competitors.

Picking winners?

So what can the rest of society learn from the way in which markets explore and scientists experiment?  Imagine a government, Harford muses, that had the confidence to experiment, that was able to run properly controlled trials of new initiatives, and that above all was ready to accept failure.  Such thoughts sit quite nicely along side those of Sir Peter Gluckman, regarding evidenced-based policy making.  A government that could properly trial and refine educational, social or correctional initiatives would get my vote.

There are also lessons for how New Zealand should spend its innovation dollars.  It is frequently argued that New Zealand is doomed to choose; our resources are too limited to fund a full portfolio of science.  We must put our resources where we think they will do best.  We must pick our winners.

Yet much of Harford’s talk was spent busting the myth that this is possible.  Fonterra today seems as good a bet to Kiwis as US Steel must have to Americans at the beginning of the twentieth century:

This was a company with everything going for it:  it was the market leader in the largest and most dynamic economy in the world; and it was in an industry that has been of tremendous importance ever since.  Yet US Steel had disappeared completely from the world’s top one hundred companies by 1995; at the time of writing, it was not even in the top five hundred.

So if we can’t pick winners, what do we do?

An entrepreneurial government

Harford argues for an entrepreneurial approach to funding science and innovation:  governments should intervene in research and development as if they were entrepreneurs rather than investment bankers.  When pressed for an example of what this might look like, Harford suggested that innovation prizes were one way in which governments were being more entrepreneurial.

Harford is not alone in holding this point of view.  I recently read a very interesting evaluation of the human genome project, which concluded:

… that reframing science policy around the notion of conducting entrepreneurial experiments — experiments that increase the diversity of technical, organizational and institutional arrangements in which scientific research is conducted — can provide policy makers with a wider repertoire of effective interventions.

…  policy makers can use the levers of entrepreneurial experimentation to transform scientific progress, much as entrepreneurs have transformed economic progress.

Huanga and Murray, Research Policy 39  567—582 (2010).

To attempt this would entail a radically different approach to funding science in New Zealand.  It would demand a commitment by government to maintaining a diverse set of scientific and technical capabilities.  It would require new methods for evaluating the effectiveness of these experiments.  It would require an acceptance of greater risk and a tolerance of failure by our policy makers.

But the pay-off could be huge. Do we have the courage to rise to the challenge?

*The talk I saw on June 29th was largely based on the first chapter of this book.

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