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Rebuilding America's job machine

Industrial policy isn't dead. It's thriving in the states — and may be the start of a U.S. comeback strategy
/ Source: Business Week

As staff at the College of Nanoscale Science & Engineering wait patiently in a conference room, a loud rumble shatters the silence. "Must be him," someone says. Alain E. Kaloyeros has just pulled into a parking lot at the State University of New York's Albany campus in his $220,000 red Ferrari F430 F1 Spider, the one with the "Dr. Nano" license plates. Minutes later, Kaloyeros, 52, the school's $696,000-a-year CEO, strides into the room talking into his BlackBerry and wearing a white long-sleeve cotton shirt and faded jeans. He apologizes for being late. "I can't understand why some people think they're saving money driving 15 miles an hour," he fumes.

Fast and flamboyant, Kaloyeros epitomizes a new breed of entrepreneurial public servant. He has helped persuade the state of New York to inject $900 million in taxpayer money into research and development facilities, including one of the world's most advanced clean rooms for making prototypes of next-generation chips.

Kaloyeros earns his high salary by running an operation that employs 2,200 researchers and has drawn $3.5 billion in R&D investment from the likes of IBM, Advanced Materials, Tokyo Electron and the government-industry chip-research consortium Sematech, for whom mastering materials at the atomic scale is vital for future products. The effort helped persuade IBM to build a plant nearby to make silicon wafers, the material used to manufacture chips. In October, struggling chipmaker Advanced Micro Devices said it will build a $4.5 billion wafer facility near Albany with help from Abu Dhabi. New York is contributing $1.2 billion in tax breaks and cash rebates to help cover construction and equipment costs.

SUNY Albany's nanotech push marks a daring new direction in economic strategy sweeping U.S. states — one that is now being severely tested. States have lavished perks on private industry for decades. In recent years, though, some have brazenly crossed the line between the public and private sectors, designing strategies that look a lot like industrial policy. They have been targeting specific businesses and technologies and, alongside companies, investing big bucks in elaborate research centers, plants to test new technologies and industrial parks whose occupants receive a special boost. States from Pennsylvania to Oregon have become increasingly important sources of early startup capital to technology companies.

Now many states face vast budget shortfalls and must choose between protecting public-private R&D programs that could create jobs in the long term and slashing public education and health benefits. Kansas Governor Kathleen Sebelius, for instance, has proposed cutting $35 million for a bioscience initiative and shutting an agency that offered financial and managerial help to promising tech companies. Indiana plans to slash $20 million for life sciences research and development, while budget cuts are forcing the Maryland Technology Development Corp. to close an incubator program for startups. "Since states can't print money like the feds, programs that encourage private and university partnerships are under stress," says Brian Darmody, associate vice-president for research at the University of Maryland.

The natural partners of these experiments also are hurting. University endowments have shrunk, and corporations are hard-pressed to raise funds for ongoing operations, let alone risky new ventures. Such financial pressures are sure to mount in 2009. To add to the pain, a forceful advocate of these public-private partnerships, Governor Bill Richardson of New Mexico, had to turn down the job of Commerce Secretary in the Obama administration because of an investigation linking him to possible campaign finance abuses.

So far, though, most states are holding firm, saying these efforts are critical to creating new industries amid intensifying global competition. New York's nano initiative remains largely unscathed — a $150 million corporate-funded research center just opened at the Albany campus. And even though IBM is eyeing layoffs at its chipmaking operations around the U.S., Kaloyeros says it is talking about expanding its R&D collaboration at SUNY Albany.

Eyeing a long-term payoff
The Obama Administration's $900 billion economic stimulus package now being debated in Congress raises new hopes that states can tap Washington's funds to support their industrial policies. Some Obama appointees, such as incoming Small Business Administration chief Karen Gordon Mills, a venture capitalist, believe that more federal dollars for research and development, workforce training, and business promotion should be channeled through successful public-private collaborations in the states.

Mixing taxpayer money and private industry is risky, of course. Public officials can be bad at picking winners. State intervention can lead to cronyism and market distortion. Costly bidding wars rage for companies and elite labs in biotech, an industry poised for a shakeout. These are some reasons Harvard Business School competitiveness guru Michael E. Porter preaches caution. "The grassroots model, where regions get on with it without waiting for Washington, is one of America's great strengths," Porter says. But he calls many state interventions unrealistic. "Subsidies are usually a sign you have no underlying advantage in an industry."

Many state officials insist they are becoming more sophisticated about economic development. Rather than woo plants that could relocate to Mexico or China in five years, they are trying to build new industries in fields such as renewable energy, nanomaterials and biomedical devices that could generate high-paying jobs for decades. That means first training the local workforce, supplying venture capital, and nurturing research and development. San Diego offers a promising model. There, government and local entrepreneurs have methodically cultivated a top biotech hub, now boasting some 700 companies. The effort began in the 1960s with investments in research institutes and the Torrey Pines Science Park.

San Diego-like partnerships are proliferating. DuPont, Oak Ridge National Laboratory and the University of Tennessee have formed a long-term R&D tie-up to refine switchgrass into biofuel. The state is investing $40 million of the $170 million needed for a pilot plant. California has allotted $400 million for institutes in biomedicine, nanotech and other areas that aim to raise $800 million from corporations. Ohio, Michigan, Arizona and Massachusetts have built huge public-private research war chests. "The rise of collaboration is the biggest shift in development thinking I have seen in decades," says Mary Jo Waits, who has studied the trend for the National Governors Assn. and the Pew Center on the States. "I'm surprised at how tightly governors are trying to hang on to investments in R&D, given budget constraints."

Some advocates contend governments are now one of the few sources of patient capital. Unlike info tech, where $25 million could launch a Google or, plants for building next-generation solar cells, digital lighting or electric-car batteries can cost billions. Startup A123 Systems of Watertown, Mass., for example, has lined up $10 million in aid from Michigan and is seeking a $1.8 billion federal loan to manufacture lithium-ion batteries for cars. "The old VC model that worked for IT won't work for clean technologies," says Chicago venture capital attorney James J. Greenberger, a specialist in renewable energy. "The scale and the risks are much greater."

Corporate welfare?
That's why America's semiconductor industry is relying more on state funds for plants that can cost $4 billion. Since the '90s, most U.S. chip companies have abandoned manufacturing and hired Asian companies to make chips designed in U.S. labs. As the challenge of making ever more powerful chips rises, some analysts worry, it will be harder for designers to collaborate with factories half a world away. The same nanotechnologies used in chips are also vital to everything from photovoltaic cells to superthin TV displays. And though they are highly automated, a silicon wafer plant can support 5,000 jobs — from engineers and robotics technicians to laundry staff.

To critics, New York's subsidies for AMD's wafer factory and other plants by IBM are corporate welfare. Greg LeRoy, head of watchdog group Good Jobs First, has faulted such state efforts. He figures most of the $50 billion or more states spend annually on industrial incentives goes to "smokestack chasing" — courting companies that shrewdly play states off against each other to win subsidies for factories, offices and even retail stores.

Kaloyeros says such criticism is misplaced. New York has invested steadily since 1995 in the research, labs and manpower needed to make Albany a viable hub for nanotech, which designs systems at the molecular level. The state and IBM built an R&D center at the University of Albany to develop the next generation of computer chips. It is part of a consortium that includes Samsung, Freescale Semiconductor and Singapore's Chartered Semiconductor. The university then built a silicon wafer plant that IBM Research Director John E. Kelly calls "by far the most advanced research center in the nanotech world" and saved jobs that probably would have gone offshore. Dozens of chipmakers and equipment vendors have opened major labs on campus. In an old armory, Hudson Valley Community College in Troy, N.Y., started a program that has graduated 600 clean-room technicians. "States are stepping up and doing what the federal government should be doing," says Kaloyeros.

New Mexico has been even more ambitious in its partnerships under Governor Richardson. Soon after his election in 2002, state planners sought to identify new industries that would create high-paying jobs that could not be outsourced. They chose film production, renewable energies, financial services and aerospace. To lure companies, New Mexico tapped multibillion-dollar trust funds set up by the state to invest the royalties on oil, gas and minerals extracted from public lands. It set aside $600 million in venture capital for startups and has invested in everything from feature films to an aircraft maker and a $250 million "space port" for commercial space travel. New Mexico reimburses companies for 10 percent of the wages and other costs incurred for each new job they create that pays at least $50,000 a year. Film studios recoup 25 percent of the costs they incur in the state.

Hits and misses
Despite the recession and controversy surrounding Richardson, who denies any wrongdoing, the strategy is holding up. Hewlett-Packard, Fidelity Investments and Germany's Schott Solar are going ahead with new manufacturing and services facilities in Albuquerque that will employ more than 1,000 each. Before 2003, one or two major movies or TV series were shot in New Mexico each year. In 2008 there were 30, including Warner Bros.' “Terminator Salvation.”

The state's 5 percent equity stake in Eclipse Aviation looks like a loser, though. The Albuquerque-based maker of light, six-seat aircraft, founded in 2003, filed for Chapter 11 protection in November after being beset by production delays and canceled orders. Analyst Richard Aboulafia of aerospace consultant Teal Group calls Eclipse "a case study in why governments are bad at making investment decisions."

Eclipse spokesperson Alana McCarraher counters that the state's $30 million investment so far has led to $100 million in taxes and local spending. "New Mexico has earned a substantial return from Eclipse Aviation," she says. On Jan. 20, Dutch firm ETIRC Aviation acquired Eclipse's assets and says it will keep some production in Albuquerque. Whatever happens with Eclipse, New Mexico Economic Development Secretary Fred Mondragón contends that the state's aerospace cluster, which includes an Air Force research lab, avionics companies and the White Sands Missile Range, will flourish. In other areas, Mondragón says many U.S. and foreign renewable-energy companies are exploring investments, drawn by the brainpower at the state's three research universities and the national laboratories Sandia and Los Alamos. The strategy is creating jobs. A decade ago, New Mexico's unemployment rate was the nation's highest. As of December, it was 4.9 percent, well below the national average of 7.2 percent. And while film subsidies have been assailed as wasteful around the U.S., Ernst & Young says New Mexico's film industry employs more than 2,000 and contributed $811 million to the economy in fiscal 2008.

To residents of Bethlehem, Pa., the rusting Bethlehem Steel Works offers a daily reminder of the city's decline. The plant once employed 30,000 and furnished much of the steel for the World War II naval fleet. It closed in 1995. Yet within walking distance, office parks are filled with the headquarters of such companies as medical device maker Orasure Technologies, semiconductor-materials maker IQE and business outsourcer PeopleForce. They are among hundreds of startups launched with the aid of Ben Franklin Technology Partners, a state investment vehicle.

Founded in 1982 by then-Governor Dick Thornburgh, Ben Franklin began with grants to help local universities spin off technologies. Today it's one of America's biggest state-owned venture capitalists, parceling out sums ranging from $25,000 to $500,000 to help entrepreneurs develop prototypes, refine business plans and expand production.

Such programs now exist in every U.S. state. The National Association of Seed & Venture Funds (NASVF) counts $2.3 billion in state seed capital, from Michigan's $109 million 21st Century Jobs Fund to Texas' $290 million Emerging Technology Fund. States account for a tiny portion of all U.S. private equity and venture capital. But in Pennsylvania, Oregon, New Mexico and elsewhere, notes NASVF President James A. Jaffe, "the states have become crucial sources of early-stage capital."

Do they work? Paul Kedrosky, a senior fellow at the Ewing Marion Kauffman Foundation, which focuses on entrepreneurship, notes that no truly independent studies of U.S. state venture funds have been done. Another question is whether states could generate more economic activity investing in other areas, such as education. "If you put $100 million into a bunch of businesses, you will create a bunch of jobs," says Robert E. Wiltbank, an entrepreneurship professor at Willamette University who is a partner in a VC firm. "That doesn't say you will do better than anyone else."

Defenders of the funds counter that in most states, an ecosystem for tech startups has never evolved. Two-thirds of American venture capital is invested in California, Massachusetts, Texas and New York. That strands thousands of potential companies in other states in the so-called Valley of Death, the five or more years it takes to turn an idea in a lab into a working prototype.

Ben Franklin says the $140 million it invested from 2002 to 2006 in hundreds of companies has yielded $517 million in new state taxes and generated $8 billion in economic activity. Successes include Garland, a Freeland maker of high-end kitchen ovens, and Bethlehem's Orasure, an $83 million supplier of kits to detect HIV by testing human saliva. "It's impossible to say the state has not benefited financially and economically," says Chadwick Paul, CEO of Ben Franklin's Northeast Pennsylvania arm.

When Innovative Control Systems in Wind Gap wanted to develop new computer controls for car washes in the mid-'90s, "banks wouldn't talk to us, and VCs said we weren't sexy or large enough," says President Kevin Detrick. Ben Franklin injected $236,000. When Detrick changed strategic direction in 2004, Ben Franklin organized a "tiger session" where local businessmen punched holes in his business plan. They persuaded Detrick to focus not just on hardware but also on services to help car washes manage everything from credit-card payments to reminding customers when their cars need a lube job. In 2008, Interactive Controls says it posted sales of $16 million and served 2,000 car washes. Without Ben Franklin, "I don't think we'd be here now," Detrick says.

Even if there are pockets of public-private success, are these experiments big enough to make a difference, especially in competition against China, Japan or South Korea? Well-planned assistance from Washington could have an impact, but such coordination has been weak. "There is a lot of great experimentation in commercializing new technology at the state level," says CEO Dan Berglund of State Science & Technology Institute (SSTI) in Westerville, Ohio, a nonprofit that advises regional governments. "But at the federal level, there is little funding and no strategy." Incoming SBA head Mills led a 2008 Brookings Institution study that found that 14 U.S. agencies spend $76 billion a year on economic development. But these efforts are not "linked, leveraged, or aligned," Mills said in an interview prior to her nomination. "The federal people don't talk to the state people or to industry."

If the Obama administration can blend the states' and Washington's efforts, states that invested early in strategic industries could be the best positioned to land federal backing. That's part of Kaloyeros' thinking — to make Albany the place where "anyone who wants to demonstrate any concept in nanotechnology will have to be." His goal, he jokes, is to expand his R&D campus so he can walk to the nearest Starbucks without going outside. That Starbucks is a mile away.