Entrepreneurs, Innovation, and Rent-Seeking

Schumpeter (1934), Kirzner (1973), and Baumol (1990) have all made significant contributions to our understanding of the role of the entrepreneur in socioeconomic development. In their theories the concept of the entrepreneur refers to an economic actor who performs the entrepreneurial function in the economy, rather than to specific individuals and their part in the course of events.¹

According to Schumpeter (1934; [1942] 1976), the entrepreneur’s role is to drive innovation in the economy. Innovation is the introduction of new combinations in the market—for example, the use of new technology, the opening up of new markets, or changes in industrial organization. Innovations disrupt the equilibrium in the economy and are the precondition for new value creation and profit. Through innovation, entrepreneurs compete in a manner that is difficult for incumbent companies to match, as innovation is directed at the very nature of their products and processes and simply reducing the price is not an effective response. After an innovation, the market becomes flooded by imitators, moving the economy back toward equilibrium and thereby diminishing profits. Controlling companies and even industries, which have often secured their position in a cartel-like manner, are unable to respond. As a result, industries rise and fall in a process Schumpeter ([1942] 1976) termed “creative destruction.” Even though the short-term effects can be problematic for less competitive companies, the overall results are positive for the economy and a necessary precondition for renewal and long-term economic development and growth.²

Although entrepreneurs drive innovation, they do not do so in isolation or in a straightforward way, that is, by the application of new scientific knowledge. Innovation is a chain-linked and path-dependent process involving a large number of actors and shaped by institutional context and historical circumstances (Kline, and Rosenberg 1986; Nelson 1992).

Entrepreneurs aiming for novel innovations have a difficult time finding financing due to the high level of uncertainty of outcomes. However, in the wake of innovations—for example, major technological changes—there is less uncertainty and profit expectations may rise, making it easier for imitators to fund their activities. Numerous imitators take advantage of these opportunities, increasing the capital in circulation and the expectations of future profits, resulting in overinvestment and inflation. The result is a bubble economy that is based on expectations that cannot be met in the real economy and must eventually be corrected (Perez 2002).

Kirzner (1973; 1997) gives the entrepreneur a different but similarly important role in the development of the economy and the prosperity of society. To Kirzner, the entrepreneur is an alert person who is willing to exploit opportunities that arise due to disequilibrium in the economy. For a variety of reasons, such as its participants’ different knowledge and access to different information, the economy is constantly moved out of the balance predicted by economic theory. Because of the imbalance, those things that contribute to the cost of production, or production factors, are not priced according to their value, creating an opportunity for profit (Baumol, Robert, and Schramm 2007). However, through his activities, the entrepreneur sends out information about the value of those production factors, and as a result the economy moves toward equilibrium, leading to better utilization of resources and improved welfare. Kirzner’s analysis is somewhat consistent with Schumpeter’s ideas about the entrepreneur as a change agent but ignores the importance Schumpeter assigns to radical change brought about by innovation and the role of investors. While Schumpeter emphasizes the role of entrepreneurs in creating imbalance in the economy, Kirzner emphasizes their role in establishing balance.

According to Baumol (1990), the entrepreneur performs both the role of the innovative agent who promotes change and disequilibrium in the economy and the one who is alert to changes and, through entrepreneurial action, drives the economy toward equilibrium. Thus, Baumol combines, to some extent, the views of both Schumpeter and Kirzner. However, unlike Schumpeter and Kirzner, Baumol does not regard the entrepreneur’s impact on economic development as always positive. Baumol (ibid.) argues that entrepreneurship at any point in time depends on the structure of payoffs in the economy. In general, profit motive leads to innovation and prosperity, but in some cases entrepreneurial activity can become destructive.

He mentions, for example, rent-seeking, an effort to gain by changing the rules, whether that be creating a license for a service like cutting hair or giving financial advice or privatizing fishing quotas, where the entrepreneur benefits without a corresponding benefit returning to the society. This is not necessarily through illegal activities, such as drug dealing or blackmail, but rather through lawful activities, such as a company buying out a shareholder who has threatened a takeover or big investment funds manipulating the markets by legal maneuvers.

The government both directly and indirectly influences the structure of economic payoffs, through legislation, policies, and administrative rules and actions, but it is also dependent on the prevailing culture in society that broadly defines right and wrong. Thus, according to Baumol, the institutional setup determines whether or not overinvestment following radical innovation is economically productive. Although such overinvestment does not profit the entrepreneur and investors directly, as a whole the economy may benefit from the activity, for instance, through increased technical knowledge and “sectoral” networks. This can hardly be said of innovative rent-seeking, both because it does not lead to prosperity and because it can be made less attractive or impossible through changes in the law.

Development of the Icelandic Economy

In the twentieth century Iceland evolved from one of the poorest countries in Europe into one of the richest (Jónsson 2002). As we have discussed before (Jónsson and Sæmundsson 2006), this development occurred over several periods of initiative and development with government participation.

Throughout most of the twentieth century, there was a worldwide conviction that a gradual move toward modern society could be navigated through socioeconomic planning. Despite recurring fluctuations and economic downturns, the major players in Icelandic politics more or less agreed with this view. The Icelandic version was that, as latecomers, Icelanders could learn from the mistakes of those who had gone before. Although the “rules of the game” are significantly similar in an ever more globalized world, historical determinants (North 1990), structural and organizational settings, and new “social technologies” are difficult to transfer abruptly from one economy to another (Eggertsson 2005).

In Iceland the fishing industry was operating under several specific conditions: its geographical embeddedness (fishing communities were located close to the most productive fishing banks); Iceland’s relatively strong civil society, based on positive freedom (“freedom to” rather than “freedom from” [Berlin 1969]); and the cartelized organization of the fisheries sector.

The basic idea, until World War II, was that Icelanders should “work themselves into prosperity” in their own time and under their own terms. The driving force should be the household—farmers, fishermen, and wage laborers. In Karl Polanyi’s terms, the system should be based on reciprocity. Icelanders enforced this through an emphasis on local community and local initiatives achieved through the absence of outside capital and several protectionist measures, including limiting the number of players allowed to import goods (Polanyi [1944] 1968). Icelanders regarded the savings as collective earnings to be either redistributed internally or used to pay for collective goods.

The result was an entrepreneurial economy based on a trial-and-error approach to innovation, wherein the basic actor was the “practical man” or “collective entrepreneur” rather than the “optimizing capitalist” (Hansen and Serin 1997). In addition to the rationality of the system, policies sought to extend the workday and encourage a wide-ranging participation in wage work rather than household provisioning. The country’s industry was predominantly a cottage industry, with commerce dominated by craft-based corner shops operating, more often than not, from coastal fishing villages.

World War II fundamentally changed this situation. The occupying Allies built basic infrastructure with Icelandic labor, and a consequent influx of money via widespread wage work led to the long-awaited monetization of the economy. In the postwar era of the early fifties, the government emphasized the creation of a mixed economy built on the Nordic model and the promotion of main structures and organizations necessary for a successful welfare system.

Innovation was defined as a political initiative with an emphasis on adopting foreign technology and practices. Private funding for entrepreneurs was locally induced through incremental initiatives. The need for change and nation-building was obvious and visible; the challenge was to prioritize. The government took on the role of the innovative entrepreneur by way of its investments in infrastructure and efficient production processes in the fisheries—investments made possible through savings accumulated during the war and development aid from friendly allies.

The organizational principles of the Icelandic economy’s two main sectors, fisheries and, later, aviation, were not capital-intensive after the initial start-up phase. The two fundamental technological innovations, the jet engine in aviation and the move from side trawlers to stern trawlers in fisheries, were financed by soft loans from the state banks, which meant that, in general, only working capital was required in the industries themselves. The nation’s two largest business conglomerates were both at their core mercantile but relied heavily on political redistribution of the return from ever-increasing fisheries efforts, on a local as well as state level. The larger of the two clusters, aviation, adhered to capitalistic optimization; while the other was a diversified grouping of fisheries co-ops.

Both business clusters were based on rapidly increasing pension funds and trade, transport, insurance, and the importation of oil. Their networks abroad were, for the most part, confined to the sphere of imports and relied more on pension funds as their central source of capital.

Iceland’s economy developed into a comprehensive, more or less closed system driven largely by political governance in which market forces had only a marginal influence. The two reigning business groups were small in scale, confined to Iceland, and unable to reap the benefits of the liberalization they themselves designed. Their governance was grounded in organic growth protected by a favorable regulatory system. Financial capital played an insignificant role. In Kirzner’s sense, the Schumpeterian disruptions were leveled out via informal contractual relationships between the two businesses.

In the early 1970s the pioneers in export tied to the fisheries sector saw the opportunity to exploit rapid technological developments, like the introduction of microprocessors and the increased expertise in materials technology. In Schumpeter’s (1934) sense, they were innovative in that they developed new ways around the obstacles that had slowed productivity. Along with other changes, including the introduction of a new fisheries management system, they created the foundation for a revolution in the industry by changing work methods and making associated changes in the power structure within the industry.

It soon became apparent that the innovations in fish processing could also be applied to other types of food processing and markets outside Iceland. Efficient fish-processing methods and equipment were used for chicken production. The insulated containers used to preserve fresh fish were useful in hot countries, and product development initially aimed at fresh seafood became useful in the market for high-quality convenience food. At the same time, internationally competitive innovation, such as prosthetics and generic pharmaceuticals, appeared in other industries.

Despite the emergence of internationally competitive innovation and free trade treaties, such as the EFTA agreement, the activities of Icelandic entrepreneurs were still limited to the seafood industry for several reasons. First, seafood trades, which were about 90 percent of total exports, were controlled by two industry groups. Second, expertise, skills, and networks were difficult to transfer from the fishing industry to other industries, even in related fields.³ Third, the economy was relatively closed, and there was limited access to funding. For example, there were severe limitations on currency exchanges; there was no stock market; and the major banks were run by the government and historically tied to the industry, farming, and fisheries sectors. Furthermore, each sector had its own funding structure and numerous local “Savings and Loans” located around the country.

Attempts had been made to create a public stock market in Iceland, but such a market did not become firmly established until 1990 when the first shares were listed on the Icelandic Stock Exchange (Kauphöll Íslands). The Icelandic stock market grew slowly at first. In the beginning, one-third of the companies listed on the exchange belonged to the fishing industry, and in 1997 their relative value reached its peak of 40 percent (Kristinsdóttir 2009). These companies, which previously raised funds with the help of political relationships within the state-owned banking system, were able to take advantage of market mechanisms to grow. Innovative companies related to fisheries were also able to finance their growth with expansion into foreign markets and other industries, such as meat processing. Lack of raw materials, however, limited the growth of industries associated with agriculture.

Despite the emergence of capital markets, reduction of tariffs, and further opening of foreign markets through membership of the European Economic Area (EEA) in 1993 and GATT in 1995, these factors as a whole did not have much impact on the diversification of exports, at least initially. Exports of products, as opposed to exports of raw material being processed abroad, increased steadily in the 1980s as a result of advances in fisheries management and fish-processing equipment.

The Advent of Crisis

The privatization of the banking system (between 1998 and 2003) created more opportunities for Icelandic entrepreneurs. Access to domestic and, later, foreign capital investment improved, and the investment capability of the economy multiplied. Following the privatization, three banks emerged, all of which grew very rapidly through increased activity abroad. They became related to the boom-bust cycle, which proved to have a logic very different from that of the import-export model that liberalization was expected to facilitate.

Expansion and the size of the banks had a major impact on the Icelandic economy. The market value of the companies listed on the Icelandic Stock Exchange grew from ISK 100 million in 1996 to ISK 2.5 billion in 2006, and banks and financial institutions dominated the market.⁴ More and more companies had become investment companies, or even hedge funds, without changing their names. Most manufacturing companies in the fishing industry had been taken off the stock exchange, and few businesses that practiced international innovation had been added. Registered profit from the banks had become several times greater than the value obtained from seafood exports.

The factors behind the underlying crisis were inexperience in banking; political favoritism when the banks were privatized; and strong ties between economy and politics (Danielsson and Zoega 2009). Transforming the three major banks from saving banks into investment banks transformed savings into investment capital, and, to the surprise of almost everyone, new players or outsiders took hold in a matter of two to three years.

The development can be characterized as a three-step move:

1. a successful diversification and strengthening of exports along with an overall liberalization of trade,

2. the shift of governance from the Reykjavík stock exchange to the City in London, and

3. the systematic and opportunistic exploitation of Icelandic ties by newly created business groups operating in London.

New business groups, which had existed in 2002 only in embryonic form, took on the role of the risk-takers on the stock exchange in London and, to a lesser extent, in the Nordic markets. The Icelandic “entrepreneurs” in the City became alliances of three to four groups deriving their mandates from the Icelandic banks.

The meltdown had much to do with leveraged takeovers by the clustered Icelandic groups that financed themselves with foreign funds that were relatively easy to obtain at the time. Icelanders were attempting to become players in the world of the superrich—high yield and risk on a massive scale. A bunch of amateurs were able to seize opportunities in the wake of the privatization of the Icelandic banks. In the process, they indulged in conspicuous consumption on an unprecedented scale, buying an English football club, a Formula One racing team, a yacht formerly owned by Armani, and England’s most prestigious bank, Singer & Friedlander.

In order to create such vast, complex, and conflated webs, these groups needed international accounting firms (such as KMPG and PricewaterhouseCoopers). This design was deliberately opaque in order to avoid accountability, which was one of the main characteristics of the bubble internationally. In less than five years, a simple, enclosed, and transparent economic universe had been transformed into an infinitely complex and fuzzy one.

Instead of strengthening the economy, the privatization and expansion of the banks had the opposite effect. Increased opportunities for investment were used only to a limited extent to strengthen economic sectors already in place, such as fisheries, or for international innovation in Schumpeter’s and Kirzner’s sense. Instead, conditions and strong incentives were created for rent-seeking and asset price inflation (Rannsóknarnefnd Alþingis 2010, 1:31–47). The size and type of business agreements were not in accordance with former practices or the size of the Icelandic economy, which formed the basis of the credit ratings of the Icelandic banks. Despite their radical innovation, the pioneers became the destructive force that Baumol warns against.

The “real economy” based on the four main economic sectors—fisheries, energy-intensive production, tourism, and high-tech innovative companies—has reemerged following the collapse of the banking system and the associated meltdown of the economy. These sectors have regained their significance, characterized by stable fisheries and growing utilization of hydro- and geothermal power.

Fisheries, energy production, and tourism are all examples of industries that utilize limited resources for value creation. Since return on the investments themselves is limited in the long term (because they all depend on finite natural resources), it is necessary to build in the capacity for future innovation. The focus on fisheries, energy production, and tourism is likely to be at the expense of knowledge-based businesses.

Conclusion

In the 1980s Icelanders were in a very favorable position: they had built up a Nordic welfare model and ruled over the fishing grounds surrounding the country. Growing technical skills increased both productivity and product quality in fisheries, but the turning point came when it was possible to transform knowledge of fish processing into knowledge to develop and produce fish-processing equipment. When it was later discovered that the solutions developed within fishing were applicable to many other industries, new possibilities opened up. It was not the increase in the value of the catch that was decisive but the more extensive usage of manufacturing technology and the organization that had been developed for the fishing industry.

Innovative entrepreneurs had created new opportunities for expansion into foreign markets, and one can say that this was a natural extension of knowledge, skills, and international networks that had been accumulating for some time. Privatization and improved access to foreign markets increased these opportunities but also created opportunities for rent-seeking of unknown proportions more appropriately scaled to London than Iceland.

The Icelandic financial crash was first and foremost the result of neoliberal economic policies and unscrupulous investment backed by foreign banks and funds. The Icelandic banks were allowed to go bankrupt, making some people millionaires and others debtors. A simple and transparent economic universe had been transformed into a vastly more complex and inscrutable one.

Following the crash, the “real economy” has reappeared. Companies have again become the foundation for the economic well-being of the country. In addition, a new generation of knowledge-intensive companies has been created. These companies may provide a potential backbone for future development, given the opportunity to prosper. Unlike before, when innovation was localized and focused on adopting technology and practices from abroad, knowledge-intensive companies are likely to create work for the primary sector and not vice versa. Therefore, it is appropriate that policy makers reduce the weight of support for basic sectors and focus on strengthening the innovation capacity of the nation. It is important that the future backbone is not sacrificed for short-term solutions based on the further utilization of almost fully used resources, no matter how tempting it may be.