Whether it’s direct equity investments made by government-backed venture funds at DoD or the CIA, loan guarantees to established small and medium-sized SME manufacturers, export credit financing assistance to U.S. exporters, loans to rural broadband providers, bailouts of large banks or automakers, or loans to solar energy companies, the U.S. government makes direct or indirect investments in hundreds of enterprises annually. Moreover, state and local governments engage in business financing as well. And notwithstanding the Solyndra kerfuffle, given the serious challenges the U.S. economy faces, these types of government interventions to support individual firms could very well increase, not decrease, in the future.
In fact, in many cases, these types of government investments are critical to boosting American innovation, economic growth, international competitiveness and job creation. Nonetheless, the potential benefits of government investments in firms shouldn’t give policymakers carte blanche ability to invest in any and all enterprises. Policy should be nuanced enough not to reflexively reject on strictly ideological grounds an appropriate and constructive role for the U.S. government in supporting individual enterprises, yet also must be much more sophisticated than the current, seemingly ad-hoc approach.
Therefore, we need to articulate a clear framework grounded in a set of core principles that guide government agencies when making decisions about using taxpayer funds to support individual firms. Such a framework should think about distinct and clear principles at five hierarchical levels: 1) What core principles should guide all activities? 2) What are the types of situations and the types of firms in which government should be investing? 3) What’s the level of risk-tolerance for those investments? 4) What are the deal terms with the firm? (e.g., what are the rules of the road? What’s the quid-pro-quo with the firm?); and 5) What are the procedural/structural elements?
1) Core principles for the Types of Situations and Firms Government Should be Investing In
There are three core principles that should guide all kinds of public investments in all kinds of firms. The first is that the firm should ideally be in a traded sector of the economy (that is, a sector that faces foreign competition). This is important because if firms in industries that do not face foreign competition (think retail trade, electric utilities, etc.) do not thrive, domestic demand will create the conditions for their replacement by more robust competitors in the United States. In contrast, for firms in traded sectors, if they go out of business or lose market share because of a lack of financial support their domestic sales can easily be replaced by production from other nations that is imported, worsening the trade deficit and reducing jobs. In this sense, a not insignificant share of the SBA 7(a) loan guarantee portfolio is misdirected, going as it does to firms in non-traded sectors such as retail and personal services.
The second principle is that the health of the firm should have clear significant positive spillover effects for society/the broader economy. This can either be in the form of significant domestic supply chains that would be disrupted if the firm were to go out of business, beneficial impacts on other firms’ financial balance sheets, or direct benefits to society (e.g., more broadband in rural areas).
The third principle is that the firm should pay above the median wage and provide benefits for workers. There is little logic for government support to firms that pay little or do not provide workers with a decent standard of living and benefits.
This does not mean that all firms meeting these criteria should be candidates for funding. Rather, these criteria should represent a first screen that all investment decisions go through. Firms that make it through this first screen should then be evaluated for other criteria.
2) What types of government intervention?
There are three types of government intervention that can be legitimate. The first is crisis/bailout intervention. These are episodic interventions made in response to particular crises, such as the loans to GM and Chrysler and the TARP funds to banks. When making bailout investments the firm must be critical to the broader economy, and saving the firm must be predicated on doing so having sizeable positive externality effects upon large supplier/value chains, workers, and communities/regions broadly. The firm must also be salvageable, but because of imperfections in capital markets (e.g. insufficient scale of potential private sector investment or inability to make desired level of private market returns, even when the ROI to society is positive), markets fail to make needed investments. A case in point is General Motors. Failure of GM would have meant much more than the loss of economic activity at GM, it would have trickled down through GM’s supply chain and to the communities dependent on this activity. Moreover, as we have learnt, GM was salvageable but no one was willing to fund it because of risk aversion and other problems in capital markets.
The second is supporting operations of established firms. Here the financing is provided on a regular basis to firms to have them perform activities of benefit to society, such as providing export credit financing through Ex-Im Bank or some activities of the SBA loan programs. The key consideration here is to ensure that the principles below are followed.
And the third is investing in new start-up, technology-based entrepreneurial companies. Here the level of risk taking should be higher than on supporting operations of established firms in large part because the rewards to society can be larger.
3) Principles for the Level of Risk-Tolerance Government Investment Should Have
Government investments in enterprises should not duplicate or substitute for private market investors. They should be filling gaps. These can be where the risk levels are too extreme and/or the returns too uncertain for private investors, but still likely to be positive for society as a whole. In addition, there can be a role for public financing if the public (societal) rate of return is high but the private rate of return is not sufficient to attract private investors. This can happen if there are significant “externalities” to the investment.
As such, governments shouldn’t invest in areas where the risk is low and the marketplace would easily provide funding. In this sense, government investments shouldn’t be duplicating the marketplace, but finding gaps in the market. For example, historically a large share of DOA’s Rural Utility Service broadband loans have gone to places that already have broadband because these are places where the economic return is more secure. But these are also places where public financing duplicates private activity. At the same time, the level of risk should be tolerable and bear a strong relationship to the expected rate of return. For example, if the expected failure rate is 50 percent and the return to society is low this would be finding more than a gap in the marketplace, it would be finding a gaping hole, and as such would be an unwise investment.
Related to this it should be determined that the firm would have a difficult time receiving financing from existing private sector sources. In addition, is this financing necessary to match investment/subsidies from trade competitors? If the competitors of traded firms receive investments from foreign nations, then not giving support to domestic firms confronting that competition can mean that U.S. economic activity and jobs will suffer. This is particularly the case with Ex-Im Bank financing, where other nations provide significantly more financing to their exporters and a failure to have export financing would represent “unilateral disarmament.”
There is one final aspect of evaluating risk. Risk needs to be evaluated at the portfolio level, not the deal level. To take a prominent case in point, Solyndra and the DOE loan guarantee, to find that Solyndra defaulted on the loan is in and of itself relatively meaningless. The real question is how did the overall portfolio of DOE clean energy loans perform. If Solyndra was the only failure (which it wasn’t) then arguably DOE was too risk averse. If, however, a large share of loans defaulted, then they were not risk averse enough.
4) Principles for Terms of the Deal With the Firm
While government must do its due diligence to ensure high societal benefit and relatively low government risk, it must be required that the firm have significant skin in the game. Firms should have a significant financial stake in any public-sector initiative that involves them. This is one way to ensure that the government level of risk is not unnecessarily high and that there are incentives for firms to effectively manage the government support.
One way of doing this is to implement a cap on the level of government investment relative to the private market capitalization of the firm. (Though caps may vary depending on the type/category of investment.) In no case should the level of government investment exceed the level of private capitalization of the firm. Investments should also have a recapture and repayment element. In other words, if the investment fails, taxpayers get at least some of their money back. This is particularly important in the first two kinds of interventions (crisis and support of ongoing firms). In addition, the financial interest of taxpayers should not be subordinated to private investors in the event of firm bankruptcy or liquidation; taxpayers by principle should be repaid before private investors. This is particularly true during crisis interventions.
In addition, firms must use the predominant portion of investment to fund activities (whether R&D, manufacturing production, etc.) that occur within the United States. This doesn’t mean government policy should discriminate against foreign companies, but instead that it’s understood that any company that receives government support, domestic or foreign, is receiving it to expand operations, production, and research in the United States. This requires government investment policy to explicitly state the purpose of the funds going to a company as well as the company to explicitly agree to invest those funds in an agreed upon way.
5) Core Principles for Procedural Elements of Government Investments in Firms
To the extent possible, government investments in individual enterprises should be made through a quasi-independent agency with specific and deep expertise and experience in making such investments (such as Ex-Im Bank, OPIC, or a potential National Scaling Bank, as Andy Grove has called for). Investment decisions should be made on the basis of expert analytical review and be shielded from political influences. The advantage of this is that the investing will be managed by professionals who know how to judge firm activities and require the right disclosures.
In addition, the evaluation process and decision-making criteria should be fully transparent (and subject to public review and comment). All investments must be fully transparent and fully disclosed by government agencies to the legislature and to the general public. Toward that end we should consider a requirement that in exchange for receiving federal financing executives at firms are prohibited from making campaign contributions to any government elected official at the level of government making the investment for the following 3 or 4 years.
In the wake of “Solyndra,” the debate over government financing of enterprises has intensified, but in many ways has become less informed – being essentially a Manichean debate over whether government financing is good or bad. Yes it is. It can be bad. It can be good. The task for policymakers and managers of government programs for financing is to ensure that they are good, and one place to start is by following these five principles.
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