Why Innovation Needs Regulation

A ban on advertisement of healthcare drugs on national television in The Netherlands. Free public phone calls in Singapore, just a one-time 10 cent connection charge. Mandatory health inspections in restaurants in North Carolina, with regularly updated door-posted scores. Those are great examples of how government regulations provide a better quality of life for its citizens.

But in the United States, we generally balk at any form of government regulation as if it is poised to erode the freedom we set out to create. It makes for good press to publicly support a free world and anarchy rather than the opposite. Being a freedom fighter is good karma.

Regulation is not an option, but a requirement

But regardless of government involvement, our world is riddled with self-imposed regulations. We stop when pedestrians cross the road (irrespective of whether they should), and show more respect to the elderly than we are often given in return. We raise kids as best as we know how and send them to the best schools we can afford. Most of us are decent people who respectfully comply with our interpretation of the definition of decency; with a set of self-imposed regulations.

Regulations, self-imposed or governed, are the foundation of free-market principles (see our extensive coverage of free-market principles). And free-markets only function well when they stimulate or enforce behavior that builds transparency and trust, pulling in new participants and thereby allowing the marketplace to grow itself.

Everything in life is a marketplace (in the macroeconomic sense of the word). And we have the option to grow those marketplaces based on a meritocracy or create excessive walled gardens that, when the impact on our economy becomes too big, risk the enforcement of regulations by our government.

Innovation is a marketplace

In large part early-stage innovation in The United States is fueled by the investment dollars from Limited Partners (LPs), allocating their money to invest in the ideas of the entrepreneurs, using Venture Capitalist (VC) as their conduit and decision-maker. In the marketplace of innovation, the LP and the entrepreneur represent supply and demand, with the VC acting as the arbitrator of the marketplace.

The preponderance of evidence makes for a lousy marketplace in which the VC acts as the Emperor with no clothes:

  • Less than 10% IRR of the venture sector in the last ten years
  • Few genuinely disruptive innovations are born
  • The number of entrepreneurs is declining (according to Kauffman)
  • The number of LPs and investment dollars are declining

The VC as the systemic risk to innovation

It is ironic that so many VCs who are vehemently against government regulation (and put their efforts at attempting to stave regulation off) are themselves the ones that aggressively use arbitration to regulate (with their peers) the restrictions that are put upon the entrepreneurs. They collectively set standards on deal intake, technology focus, valuations, syndication, geographical proximity, etc., and allow for minimal deviation that is inherent to a marketplace meritocracy.

Simply put, VCs are the ones that violate any of the free-marketplace rules (stay tuned for a detailed deep-dive) and prevent the innovation marketplace from prospering, thereby inhibiting the creation of disruptive innovation.

Why we need new regulations

Frankly, we messed up, and we should be ashamed of ourselves.

Innovation is a crucial ingredient to our economy, as explained in my previous blog entry The Systemic Risk of Venture Capital. We need to remain at the forefront of innovation for our immediate benefit and how we set an example for (not arbitrate) the rest of the world. The right innovation plays a significant role in optimizing the strength of human renewal.

We, marketplace participants and the government should do our part in fixing the innovation marketplace that is so sorely broken. Our government should force VCs to exhibit transparency (one aspect of marketplace rules). LPs should do a better job of hiring VCs with relevant early-stage operating experience to create more trust. The integrity of the new marketplace we create together will improve the integrity and quality of entrepreneurs it attracts.

We are responsible

The point I am making is that every marketplace requires the same amount of rules and regulations to instill transparency and trust. No matter what you apply that marketplace construct to. The owners of the marketplace, by their adherence to the law, get to decide how much of those regulations they deploy themselves. Government intervention will punish a lack of governance reaching significant economic impact.

So, rather than blame the government for their interference, we as marketplace participants should instead preempt the need for self-governance in support of free-market principles to promote the meritocracy, spirit, and entrepreneurial capacity that this country was founded upon. And thereby prove that we are deserving of keeping the government off our backs.

Let’s lead the world by example with new rigors of excellence we first and successfully apply to ourselves.

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