The Case for Another GSE

Many think the U.S. needs another government-sponsored enterprise like it needs another Katrina. The Freddie Mac and Fannie Mae debacles and the ongoing capitalization worries in the Federal Home Loan Bank system have seemingly exhausted the risk-tolerance of taxpayers and lawmakers. But venerable economic theorist and 2006 Nobel laureate Edmund Phelps believes there's room for the government to create a new entity that could help revive the country's storied knack for "ideas, experimentation and exploration."

Phelps, along with Columbia University economist colleague Leo Tilman, argued in a recent paper published in the Harvard Business Review that the U.S. needs a "First National Bank of Innovation" - a federally chartered GSE that could help reverse what they see as a critical decline in private-industry investments in entrepreneurism and "bottom-up" economic dynamism.

"Business innovation ought to be declared a public policy objective - one at least as important as boosting home ownership and agriculture," write Phelps and Tilman.

They point out that venture capital investments have shriveled to under $20 billion a year (compared to a dot.com-era peak of $100 billion) and contend that banks have become too driven by short-term profit goals in trading or consumer lending to support long-term incubation of groundbreaking companies.

So why a GSE? As Tilman explains it, a Bank of Innovation would obtain the lowest-cost capital for making loans to start-ups and other companies.

Initially seeded by taxpayer money, the bank would eventually fund itself by securitizing and selling its loans. Investors would flock to these securities, thanks to the implicit government backing. (And they would have to be in the range of "tens, if not hundreds of billions" of dollars to meet the level of investment Tilman says is necessary for bank's mission).

Decisions on which projects to approve and finance would be made at the regional level, by independent merchant-bank members, a structure Tilman and Phelps compare to the modern Farm Credit System.

As can be expected, the proposal is drawing skepticism.

"When I was a graduate student, I read [Phelps'] textbooks and I have a lot of respect for him," says Bob Davis, the American Bankers Association's GSE and mortgage market expert. "But frankly, this proposal could only have come out of an academic institution."

The underlying premise that market forces or banks lack long-term investment horizons is flat-out wrong - instead, markets are judicious and "may have a tendency not to over-invest in a variety of new technologies, with the expectations that many of them would fail," Davis says.

And the falling venture capital volume is not from a lack of interest in innovative companies, says Mark Heeson, president of the National Venture Capital Association, but the end of scattershot strategies that permeated Web company investments a decade ago.

A $20 billion to $30 billion market isn't "a bad place to be," he says.

Venture capitalists aren't opposed to competing with the government to back companies - even if it might cherry-pick the market, Heeson says. His group actually endorses a proposal for a new independent agency to fund clean-energy alternatives.

But he worries such federal intervention might lead to government representatives choosing winners and losers, influenced by political, not business, factors. Plus, a string of initial investment failures could easily raise hackles on Capitol Hill.

"Members of Congress might say, why did we sink money down this rat hole?" says Heeson.

Tilman acknowledges the proposed structure is theoretical, but insists that the need for a Bank of Innovation is not. "The vast majority acknowledges the need for substantive debate and new solutions that mitigate the deficiencies of the current system."