A  version of this article first appeared in Business Horizon Quarterly.

As the national economy has emerged from the Great Recession, growth has been more sluggish than businesses and policymakers would like. To jump-start growth, the country needs an innovation boom that will raise productivity.

Established companies that do not innovate, be they large or small, will lose market share to competitors that do. High-growth startups are built upon innovations that they want to force into the marketplace.

So how do we get more innovation, and how do we harness it? That is the challenge we face.

A Free Market Innovation Machine

Economist William Baumol described a healthy, thriving system of capitalist enterprise as a kind of “free-market innovation machine.” When it is operating smoothly, it cannot help but create innovations that raise living standards over time. So it’s worth studying how the machine operates.

That machine has several components. At its center are large, thriving corporations, often multinational in scope. These big firms develop enormous markets and establish platforms for innovative devices and business practices.

Consider a company such as Wal-Mart, which used innovations in information technology and supply management techniques to revolutionize global retailing.

Or think of Minnesota-based 3M, which makes everything from Post-it Notes® to digital imaging equipment. Its engineers are making advances in material and other sciences and developing new products that scale to become multimillion-dollar or billion-dollar businesses.

Or take Microsoft, Intel, and AT&T, the software and telecommunications giants. These firms cultivate and accumulate the human and industrial capital required to satisfy rapidly advancing global demand for information services.

Large businesses are uniquely able to provide a crucial market for entrepreneurs creating new tools and innovations for the enterprise sector. As American Enterprise Institute economist Alan Viard noted, “Economies of scale enable large firms to purchase more sophisticated capital.” This helps explain how big firms drive innovation, and how this, in turn, prompts them to “hire more skilled workers who receive higher wages.”

Small companies also play a critical role. They are often indispensable suppliers of goods and services to multinational firms. And their smaller size means that they are nimble enough to experiment with new technologies, business models, and strategies that, if successful, can ultimately be adopted by other firms to boost productivity throughout the economy.

Capital Markets

America’s varied capital markets play a critical part in the innovation ecosystem. When large firms need to invest to create products or services to satisfy enormous market demand, they can turn to America’s vast pools of investment capital.

Likewise, when small firms need risk capital to develop an innovative idea, they can turn to America’s venture and angel investment communities or to local banks and credit unions.

Robust capital markets play an important role in the discovery of knowledge and as drivers of innovation. They also facilitate trade and mobilize resources in new ways. They enable a process of trial-and-error discovery that leads to new business practices, new industrial techniques, and innovative enterprise activities.

Entrepreneurial Culture

When we think of harnessing innovation, we must pay special attention to America’s business and entrepreneurial culture.

By its nature, culture is hard to define. While specific metrics are hard to come by, an innovative culture will be recognizable by several characteristics:

• It will be open to change.
• It will embrace risk.
• It will be tolerant of failure. (Indeed, it will acknowledge that failure is a part of progress.)
• It will be at the technology frontier.

America has been fortunate to have a culture long hospitable to innovation. Among the many reasons for our culture is that our nation was founded by immigrants—and is perpetually renewed by them.

Think of the character of people who choose to migrate. They accept the hazards of moving to a strange new place, risk their own private capital and resources to move a long distance, and accept that there is no guarantee of ultimate success and comfort.

This embrace of the unknown and the untried is essential to innovation. It is hardly surprising then that a “nation of immigrants” would generate a culture that makes innovation an imperative.

The Role of Government and the Private Sector

Government can be a significant force for advancing innovation in at least two key ways. First, it can support basic scientific research as opposed to targeted and politicized investment that creates industrial winners and losers. Advances in life sciences, prompted by decades of government research budgets, have become critical tools used by private sector scientists and engineers to develop innovative treatments, drugs, medicines, and devices for the health care marketplace. The dip in government research investment relative to GDP in recent years is cause for concern, and economist Michael Mandel rightly argues that research investment should certainly be higher than it was in the 1980s and 1990s.

Second, government must establish good rules of the road upon which the private sector operates and flourishes. These include establishing the rule of law, enforcing contracts, protecting intellectual property, maintaining peace and security, building critical infrastructure, maintaining a sound and stable currency, and establishing and maintaining a predictable system of fair rules and regulations. If government is seen to act capriciously, or is hyperactive with respect to tax and regulatory policy, this can gum up the gears.

Economists Scott Baker, Nicholas Bloom, and Stephen Davis created a “policy-related economic uncertainty” index to “estimate uncertainty’s dynamic relationship to output, investment, and employment.” The economists conclude that their index “reinforce[s] concerns that policy-related uncertainty played a role in the slow growth and fitful recovery of recent years.”

The private sector can play its role in the innovation machine by competing fiercely. To do this, companies must attract top talent, train their workers, respond quickly to changing customer demands, adopt and develop new technology that boosts efficiencies and creates wealth, deploy risk capital in the interests of shareholders, and expand into new markets.

Nick Schulz is the DeWitt Wallace Fellow at the American Enterprise Institute and Editor-in-Chief of American.com.