Nurturing the creative roots, improvements that promote growth

Robert J. Shiller, Professor of Economics, Yale University, Project Syndicate

Governments all over the world try to encourage economic growth. But growth -- with the high employment and rising living standards that politicians crave -- results from creativity. As people pursue new directions in business, science, and the arts, they develop innovations and improvements that drive the economy forward. So how, beyond mere rhetoric, can governments promote creativity?

Intellectual property law -- patents and copyrights -- is the clearest example of a government policy designed to stimulate creativity. The idea dates back to renaissance Italy, but modern patent law originated in England, where, in 1624, the Statute of Monopolies was enacted to grant a 14-year exclusive right to the "true and first inventor" of any manufacturing method. The law benefited inventors in a way that tied an invention's reward to its economic dividends.

This approach can result in large rewards for important inventions -- precisely what is needed if maximum incentive is to be given to people to develop bold new concepts -- and has served us well over the centuries since 1624. But until recently, patent law was based on a rather narrow definition of creativity, usually the kind embodied in the invention of devices or industrial processes.

In recent years, however, patent law widened enormously with the acceptance, in the United States, Australia, Japan, and Korea, of business-method patents -- that is, patents not on a technological process but on a way of doing business. The turning point in the US came in 1998, when a federal court decision upheld a patent on an accounting system, which launched a flood of business-method patents -- over a thousand a year in 1999 and 2000.

The expanding scope of patents increases their value as a tool to promote creativity. While previously most patentable inventions were produced in laboratories, with business-method patents the rewards for creativity can now motivate all kinds of people throughout a business organization. Indeed, countries that do not allow business-method patents -- even though some of their citizens apply for patents in the US -- run the risk that their businesses will lose some of their creative edge.

One area where business-method patents promise to spur innovation is financial markets. Despite dramatic theoretical advances, financial institutions were, until recently, slow to develop and expand new instruments allowing people to exploit many risk-sharing opportunities. Yet, as I argued in a recent book, financial instruments that increase our ability to manage risks that are now regarded as "non-diversifiable" would be of great economic importance.

Introducing such instruments, however, is likely to be costly. People will probably not buy and sell them unless the markets for them are liquid, which means that a lot of traders must be there at the same time. But generating enough liquidity implies huge expenses: the public must be educated to understand the concept of risk management and overcome serious psychological barriers before it can be persuaded of the usefulness of the new instruments. Financial innovators might not incur these costs if they expect that others will copy their ideas at little or no cost to themselves as soon as they are shown to work.

The harm of inadequate patent protection in the financial world before 1998 was clear. In 1993, the American Stock Exchange (AMEX) expended considerable resources to develop and promote its new concept of an exchange-traded fund (ETF), with its first embodiment as Standard & Poor's Depository Receipts (SPDR's). The ETF was a key innovation that made it possible for investors to hold an instrument that effectively tracked the value of a specified portfolio, such as the S&P index, with low trading costs.

But once the idea was proven successful, it was widely imitated by other organizations, depriving the AMEX of a big share of the returns on its innovation. The recent expansion of patent protection is designed to prevent these problems and to bring a faster pace of innovation.

Of course, there are downsides to patent law expansion, prime among them the increased incidence and cost of litigation. Firms are discovering that their competitors with business-method patents may seek to block them from improving their business strategies. For example, Amazon.com sued Barnes & Noble.com for offering to its customers Amazon's patented "one-click shopping" method. The matter was made worse by the fact that one-click shopping seemed to be an "obvious" idea that shouldn't have been granted a patent in the first place. (The case was settled out of court last year, with royalties paid to Amazon.com)

The lesson is that whenever patents are extended to a new domain, we must be attentive to whether their positive incentive effects are outweighed by the main disadvantage of granting what is in essence a monopoly to the inventor: slower adoption by others.

Patents work well to promote creativity when innovation involves high costs for the innovator and low adoption costs for everyone else. In such cases, the innovation would never be implemented without patent protection, because no inventor could ever recoup costs. But patents work poorly when an invention depends on many small sequential innovations. In these cases, too many patents can drive up licensing and legal costs prohibitively, lowering the payoffs to inventors and discouraging them from innovating.

It should be a top priority for policymakers to ensure that patent offices have the financial and human resources needed to grant business-method patents judiciously, and that they do not award patents to obvious or merely incremental ideas. If correct patent policies are followed, business-method patents have the potential to boost dramatically business creativity -- and the economic growth that goes with it.