Monday, November 29, 2010

Scale, Innovation and the Role of Intellectual Property (Properly Understood)

I've spent far more time on the blog today than I'd planned, but I might as well embrace that fact and use the blog to develop my theory of the historically imporant role of IP in creating competition, in being the catalyst in all modern cases that led to Schumpeter's "Creative Destruction." 

The paper that I'm working on (I did not win the competition, but I'm still working on it) attempts to counter the pernicious influence of the neoliberal doctrine of "law and economics," which is acting to undermine the long-standing classical liberal foundations of law and equity by replacing "equity" with "economics."  Historically, courts in equity would act when common law courts could not so as to perfect and protect property rights.  The old saying is "equity protects property rights, not personal rights,"  but neoliberal Law and Economics stands equity on its head to protect the "personal" economic rights of corporations over the property rights of individuals.  The Supreme Court has already taken a major step to codify this doctrine in the law, much as they did to make corporations "persons" entitled to civil rights under the Constitution.  It may take a couple of generations to achieve this goal, but it will happen, if unchecked.  We are firmly placed on the road to where only corporations and individuals who exploit property economically will truly have property rights.  When the status of something as property depends on who owns it, that thing is not truly property.

My insight to the financialization of the real economy forms the basis of several policy arguments against this trend, particularly as it relates to intellectual property (by which I mean only patents and copyrights). 

In addition to the history of economics and finance, I've been studying up on the history of IP and the rationales for IP's existence.  The problem is that, of the three or four historical rationales, the one that has the most coin in modern times-- thanks in part to the Law and Economics movement-- is the utility argument, i.e., that IP's primary function is to create an incentive for people to innovate and share their innovations with the commons. 

While this utilitarian rationale makes a lot of sense in theory, it does not hold water in view of practical reality.  Here's why: the theory of intellectual property as currently understood came to maturity in the 18th century, just as the financial markets did.  In the beginning, IP and financialism went hand-in-hand.  As Paul Romer stated better than I ever could (as did Thomas Jefferson), an idea once shared with the public can be replicated at no additional marginal cost.  What this means in financialist terms is that scale would always trump innovation, that an incumbent controller of a particular commercial channel always would be able to "win" in the marketplace because its returns to scale swamped the ability of a small competitor to compete.  The true function of IP as initially instantiated in its modern form was to allow innovators to compete against the scale of incumbent industries in a manner that allowed them, if successful, to achieve their own scale unmolested by anyone other than fellow innovators who provided a non-infringing alteranative.  The alleged rewards to the innovators and the incentives for capitalists to invest in those innovations are both derived from the opportunity to compete against market incumbents in generating cash flow, which is all that financialism really cares about.

The problem is that financialism requires firms to demonstrate perpetual exponential growth, which requires two things: (1) keeping the cash flow you already have and (2) creating additional cash flow that meets the shareholders' expectations of growth.  I've previously explained how the illusion of perpetual growth is achieved through the four basic mechanisms (organic growth, acquisition, cost arbitrage, and rule arbitrage aka "cheating").  The problem is that IP affects the ability of different industries to meet growth demands differently.  For industries where a particulare IP asset and the product are synonymous (e.g., publishing and biotech), the way you keep the cash flow you already have is by making the IP right in question effectively perpetual, which explains why Disney has attempted (and succeeded) in continually extending the term of copyrights and why Big Pharma has accomplished essentially the same thing for its patented lock on biologic drugs through a little talked-about giveaway in the Obamacare law.  On the other hand, for industries that aggregate the innovation of several players (e.g., the semiconductor and software industries), incumbents seek to do away with IP rights (in this case, patents) altogether.  I'm not joking: companies like Intel and Apple would be more than happy if patent rights were abolished because they know that their scale will stamp out any competition that innovators may bring to the table.  I've been in the room.  Their preference, however, would be for the patent laws to work only for them and not against them.
The history of economics and IP bear out this thesis.   "Free trade" is, in fact, an emotional label attached to a policy that is always a bad idea for the nation that is asked to embrace it, as "free trade" is merely propaganda perpetuated to enable firms to continue to scale past the size that domestic markets inherently allow them to achieve.  As part of any strategic planning process, a firm considers its ability to maintain the illusion of perpetual exponential growth in view of its existing markets.  If you go back to the 1850s in the UK, when the cries for "free trade" and against patents first rose to a fevered pitch, you'll find that the firms shouting the loudest were members of innovation aggregator industries that broke free of the feudal land rentiers through the use of IP, but they were finding it progressively more difficult to maintain maintain their margins and growth when they had to pay for using somebody else's innovation.  Google Books has a fantastic collection of historical documents that demonstrate this dynamic.  The anti-patent fervor of the mid-19th century was beaten back due to the long global depression triggered by the collapse of the U.S. railroad bubble: once it became clear that globalism was no longer possible in view of nationalist sentiments brought on by economic hard times, patents became vogue again.   For a time.  They came under attack again in the U.S. shortly before WWI, but the Great Depression ultimately put an end to that effort.  I predict that the current attack will end as th ereality of the current and Greater Depression becomes clear.

Unfortunately, given how broken our government is, I don't know if the damage to U.S. competitiveness can be undone without great pain and greater realization of the fact that IP, properly understood, is critical to enabling competition unders capitalism in the presence of scale.  An "Innovation Economy" is impossible under financialism because true competition is not allowed in deference to scale.  Again, competition is bad for business under financialism.

Ralph Gomory, current NYU professor emeritus and former IBM SVP recognized the problem in this op-ed, although he did not truly understand that financialism is the source of the "Innovation Delusion."  Scale always trumps innovation, which is why large scale companies like Disney, Monsanto, Intel and Apple don't really innovate any longer: they don't have to.  In the case of the IP-qua-Product industries like publishing, biotech, and "seed" companies, the government has agreed to make their IP rights perpetual.  In the case of Product-as-Aggregation-of-IP industries like semiconductors and consumer electronics, the government (this time through the court systm) has agreed to eliminate those IP rights unless they're owned by a direct competitor. 

The role of IP, as properly understsood, is to afford new market entrants a reasonable opportunity to compete in the marketplace against large-scale market incumbents.  This means that IP rights must (1) have a limited term and (2) be treated exactly the same as real property rights during that limited term.  This is, in fact, what U.S. courts determined in the mid-19th century after several decades of a purposefully weak patent law penned by Thomas Jefferson to avoid meeting the Constitutional mandate of "securing" innovators' rights in their inventions and works of authorship.  Jefferson ultimately lost the argument when his position proved to be an abject failure. 

(FYI - I've come to the conclusion that, in spite of his wonderful words about liberty and freedom, Jefferson was just as duplicitous as Hamilton, albeit in his own way.  Any man who can talk so eloquenty about liberty and freedom as a moral imperative and yet keep (and procreate with) slaves has a massive ethical and moral blindspot.  I don't blame the man, who was a product of his times, but I don't have to worship his memory as if he were not deeply flawed by modern standards.)

Update: I have modified the discussion of IP aggregators to reflect that the abolition of patents is viewed by them as an acceptable to alternative to having the patent laws stacked in their favor.