Mariana Mazzucato is a professor in the Economics of Innovation program at the Science Policy Research Unit of the University of Sussex. Her widely acclaimed book, The Entrepreneurial State: Debunking Public vs. Private Sector Myths, reveals the critical role that we, the taxpayers, play in the creation of the most exciting innovations of our time through publicly funded investment. (The new U.S. edition hits the shelves October 27.) Mazzucato debunks common myths about how innovation works and shapes a new narrative on how to grow a robust and inclusive economy. Think that iPhone in your pocket is simply a product of Silicon Valley magic? Think again! (This interview was originally posted on the blog for the Institute of New Economic Thinking.)

Lynn Parramore: We constantly hear that anything to do with government is incompetent and inefficient. Yet as you show, many of the industries and products that make our lives better wouldn’t exist without government-funded research. The whole process of economic growth is hugely interdependent with governmental action.

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What about something like the iPhone? Is it a product of Silicon Valley magic and the genius of Steve Jobs? Or is there more to the story?

Mariana Mazzucato: Economists have recognized that government has a role to play in markets, but only to fix failures, like monopolies, for example. Yet if we look at what governments have done around the world, they have not just stepped in to address failures. They have actually actively shaped and created markets. This is the case in IT, biotech, nanotech and in today’s emerging green economy. Public sector funds have not only supported basic research, but also applied research and even early-stage, high-risk company finance. This is important because most venture capital funds are too short-termist and exit-driven to deal with the highly uncertain and lengthy innovation process.

I often use the iPhone as an example of how governments shape markets, because what makes the iPhone ‘smart’ and not stupid is what you can do with it. And yes, everything you can do with an iPhone was government-funded. From the Internet that allows you to surf the Web, to GPS that lets you use Google Maps, to touchscreen display and even the SIRI voice activated system —all of these things were funded by Uncle Sam through the Defense Advanced Research Projects Agency (DARPA), NASA, the Navy, and even the CIA.

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These agencies are all mission driven, which matters to their success, including who they are able to hire. The Department of Energy was recently run by Steve Chu, a Nobel Prize-winning physicist, who wanted the Advanced Research Projects Agency-Energy (ARPA-E) to do for energy what DARPA did for the Internet. Would he have bothered leaving academia to join the civil service just to "fix" markets? Surely not. That’s boring.

LP: So what Steve Jobs and his team did was not central to the greatness of Apple?

MM: It’s not that Steve Jobs was not a genius—of course he was! But the problem is that the narrative we tell around entrepreneurs like him, Bill Gates or Elon Musk is so unbalanced. We pretend that government at best was important for some infrastructure and basic science behind their empires. We see the new Steve Jobs film, which is based on a 600-page book where not one word mentions any of the public funding behind Apple’s empire.

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But the real iPhone story — or the story behind biotechnology — reveals a very different narrative in which government-funded research made the most exciting innovations possible. The same could be said of Elon Musk today —Tesla and Space X not only benefit from government-funded basic research through agencies like the DoE and NASA, but they have also, as companies, received high-risk investments by the public sector. Just one example is the $465 million guaranteed loan received by Tesla by the DoE. As recently shown by an LA Times article, the entire Musk empire has received close to $5 billion in direct and indirect support.

Do we hear about that? No. Is that "story" helpful for future innovation? No.

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LP: You make the case that if taxpayers fund research responsible for the success of many private sector enterprises, we deserve something back. What might a fairer system of the distribution of rewards look like? Have any countries done better at this than others?

MM: Government support is not only investing in upstream areas like basic research, but also in downstream areas like applied research and early-stage financing for the companies themselves. This means there are great risks.

When government provided Tesla with that guaranteed loan, it was a success. On the other hand, Solyndra got roughly the same amount ($500 million to Tesla’s $465 million), but it was a failure. Any venture capitalist will tell you that this is normal: for each success there are many failures. But what the venture capitalist has that the government does not have is the ability to use some of the upside to cover the downside and the next round of investments.

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Economists argue that the government gets that upside through taxes paid by the companies benefitting from the investments; and by economic growth, which should generate higher tax receipts more broadly; and also through the spillovers from the investment into other areas, which helps the economy. But those mechanisms are limited, because of decreased corporate tax rates (and abundant loopholes), as well as the fall in what the top 1 percent pays. Also, patents are increasingly blocking the ability of spillovers to happen since the upstream tools for research are being patented (this is a new trend as patents used to be mainly for downstream products, not the science itself). And of course the globalized nature of production and innovation means that the benefits don’t necessarily stay in the country where the investments are made.

So yes, I’ve been arguing for a more realistic approach to the risk-reward problem. Once we admit that the public sector takes an immense amount of risk along the entire innovation chain, it becomes crucial to find ways to share both risks and rewards. This can be done through retaining a golden share of the intellectual property rights; through equity stakes or shares; through income-contingent loans (we do it with students, why not with business?); or through the price mechanism itself. Prices we pay for a product could reflect the public contribution.

Some countries are more courageous about this than others. In Israel, the very successful public venture capital fund Yozma retains royalties. In Finland, the public innovation fund Sitra, which backed Nokia, retains equity. And let’s not forget the obvious way to also get a return: insist that company profits generated from such investments are reinvested into production and innovation, and not spent on share buybacks or hoarded.

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LP: Let’s look at pharmaceuticals. If I want a breakthrough drug to treat cancer, which is more likely to deliver it to me, the National Institutes of Health or a multinational pharmaceutical company? What do you think the role of the companies is likely to be in such cases?

MM: In 1980, the Bayh-Dole Act allowed publicly funded research to be patented. The idea was to facilitate the ability of science to affect commercialization—getting it out of the ivory towers. The act says that the government should have the right to control the prices for those drugs that it funds. We know that most radical new drugs (such as those with new molecular structures) are funded by the NIH, which continues to spend about $30 billion a year on pharmaceutical innovation. Yet the government has never exercised this right of price control.

This is because the narrative is so skewed toward the "value" and innovation produced by Big Pharma (or small biotech), that even when the government funds the innovation, it does not have the confidence to go the whole way and strike the right deal. We socialize the risk but privatize the gains. Recentscandals on the way that hedge fund managers like Martin Shkreli have gotten in this rotten game—making drug prices rise exponentially overnight—shows just how bad things are getting. We need to build innovation eco-systems that are more mutualistic and less parasitic.

So how should things work ideally? I think it’s only to be expected that it will be mainly public funds that invest in the research part of R&D, but if Big Pharma mainly invests in the development part, that’s fine as long as they don’t pretend that they are the main innovators and charge crazy prices for that reason. The actual division of labor must be reflected in the division of the rewards (and prices, which is the way the consumer gets rewarded).

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Companies cannot have it both ways! It’s also important that public funds be spent in research directions that are pushing market frontiers rather than working in existing areas. This means funding research not only on drugs but also on areas like life-style changes, even if the profit potential is lower for Big Pharma as you cannot sell that change as you can sell a medicine.

LP: Six years past the financial crisis, we find ourselves with a sluggish economy. Can more public sector investment help? How do you evaluate claims that innovation has slowed down in the U.S. in recent years? Do you think large firms enhance or work against innovation on balance now?

MM: The economic crisis that followed from the financial crisis is still being felt strongly across the world. There’s an insinuation that somehow the lower growth is inevitable or due to factors out of our control. But look at the increasing financialization of business (seen in the high rate of share buybacks emphasized by economist William Lazonick) and the fact that companies are hoarding profits at record levels — that points to a serious investment crisis.

It’s not about lack of opportunities. It’s because businesses are choosing to hoard profits or to use them to simply prop up stock options (and hence executive pay). That is bad for innovation and there is nothing inevitable about it. At the same time, governments are being asked to cut back with the austerity craze that continues to plague many nations. So we have a crisis of investment on both the private and public side.

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But it’s not only New Deal-type investment programs that we need, but also better deals between government and business. Where did Bell Labs come from? It came from pressure by government on AT&T, which was a (government-granted) monopoly, to reinvest its profits back into the real economy — back into innovation and big innovation. And they did. Where is that pressure today?

Innovation policy itself should be seen as part of the deal: the NIH could say: look, we will continue to spend on innovation, but only if you, Big Pharma, also increase your investments along the whole chain. Instead, Big Pharma gets its way and is able to do record-level share buybacks while lobbying for regressive tax policies, falling regulation, and a parasitic patent system which is blocking future innovation.

LP: Why are countries so slow to learn the lessons of the entrepreneurial state? Have things improved or gotten worse since the first edition of your book?

MM: Unfortunately, things are getting worse. Companies are increasingly financialized and spending less on basic research; governments are increasingly cutting back and becoming less able to do long-term thinking and be mission driven; and the vicious narrative around public debt is stronger than ever. It was private, not public debt that produced the financial crisis, yet while governments saved the day, they were then blamed! Politicians and policy makers did not have the vocabulary, and the courage, to defend themselves. Very little was done to explain to people how public debt rose after the crisis precisely due to the bailouts, and also due to the fall in tax income caused by the crisis and foolish austerity programs.

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Even when government does make wise investments, it does not know how to talk about them. We have to change the frame of the debate from ideology to evidence about how markets are created — as a collective process. The mission of my book is to not only tell the history of Silicon Valley as it really was, so as to create more intelligent policies in the future, but also to enable policy makers to have a new vocabulary through which to talk about their own role—and more courage to strike the right deal. So that smart, innovation-led growth can also be inclusive growth.