Driving around Youngstown, Ohio, can feel eerily like exploring a decimated city in a war-torn nation. Brick buildings downtown look like hollow, bombed-out shells. Houses abandoned by blue-collar workers sit empty. Bruce Springsteen’s ode to the Rust Belt city sang of the steel mills that “built the tanks and bombs that won this country’s wars.” But those factories were shuttered long ago, their idle smokestacks looming over a crime-ridden town that for decades was better known as "Bomb City" and "Murdertown, USA."

But there’s life emerging beneath these hardened scars. In the shadow of the iconic 1919 Home Savings and Loan Company building downtown, a managed cluster of high-tech startups is injecting new energy into the city. It’s the Youngstown Business Incubator (YBI), a nonprofit corporation, and it’s not only redefining the industry of this hardscrabble valley on the eastern edge of Ohio; it’s changing the notion of what cities and states can do to spur innovation and investment. In the past decade, CEO Jim Cossler, who also refers to himself as “chief evangelist,” has revamped the model of an incubator from a klatch of unrelated businesses to a targeted group of niche entrepreneurs—in this case, business-to-business software firms. Unlike traditional business incubators, Cossler doesn’t “graduate” successful companies and send them packing. Instead, he keeps the portfolio companies on a single, mixed-use campus that promotes open source collaboration. He provides them with cheap or free rent, utilities and Wi-Fi to help them convert IT ideas into dollars and, in turn, jobs.

Bringing Silicon Valley into the Mahoning Valley was a hard sell at first, Cossler says. “When we announced to the world in 2001 that we were going to launch world-class software companies in the global market, the kindest thing that was said to us was, ‘You’re kidding, right?’” But in 2002, the Ohio Department of Development backed him up, pumping $375,000 per year into the incubator from the Ohio Third Frontier, a 10-year, $1.6 billion project designed to support innovation ecosystems around the state with early-stage equity investment capital. The gamble has been paying off. The YBI now boasts eight onsite companies with a total of 320 employees, many in highly skilled technical jobs. In 2010, Cossler says, the entire portfolio made about $65 million in global sales. One of the businesses, Turning Technologies, which makes audience response systems, was ranked by Inc. magazine in 2007 as the nation’s fastest growing software company.

The YBI is definitely a crown jewel in Ohio’s push to cultivate small businesses, but it’s only one piece of the state’s venture capital efforts. Since 2002, the Third Frontier has created more than 60,000 jobs in Ohio. It has helped create, attract and capitalize more than 600 businesses and leveraged more than $5 billion in private investment. Last May, voters overwhelmingly approved a $700 million bond issue to extend the program for another four years. “It’s helped create companies and careers that didn’t exist in Ohio, or anywhere, just a few years ago,” then-Gov. Ted Strickland said following the renewal. “They are inventing the cure for the Rust Belt.”

Now more than ever, states are playing the part of venture capitalist -- and despite the recession, it turns out they’re uniquely suited for the role. As the recession froze private-sector investment, venture capital firms began avoiding early-stage deals, saving their money for less risky, later stages of development. That created a void. Governments began to realize they could fill the gap by providing seed money to new startups in all sorts of emerging industries, from biotech and health care to nanotechnology and solar power.

The idea isn’t to supplant private-sector firms, but to plug a hole in the marketplace by funding new companies during the high-risk early stage frequently referred to as the “valley of death.” It makes for riskier deals, but it also means that relatively small amounts of cash could bring a big payoff to governments that invest. “Many states are saying ‘We see that valley of death, and we think we can fill it and create jobs for our residents,’” says Robert Atkinson, founder and president of the Information Technology and Innovation Foundation, a Washington, D.C.-based technology policy think tank. “It’s something government knows how to do: They just write a check or give a tax break.”

The idea of government as venture capitalist isn’t exactly a new one. Around the globe, governments have been experimenting with that role for decades. Some efforts have produced positive results, while others serve as cautionary tales on how to blow billions of taxpayer dollars on a bad idea. Decades ago, Norway squandered some of its oil wealth on sketchy business ventures, and recently the Dubai government’s investment in real estate projects led to massive deficits as the financial crisis hit. According to The Economist, Canada’s venture capital experiment flopped because the Canadian Labor Fund Program had so much money that it scared off private venture capitalists. And in 2005, the Malaysian government opened its huge $150 million complex, called BioValley, prematurely, and it became mocked as the “Valley of the BioGhosts.”

The United States, especially in recent years, is no stranger to tech incubation and venture capital efforts. As part of his State of the Union pledge to “win the future” by boosting innovation, President Obama in February launched a national campaign to provide mentorship and funding to help cultivate new businesses. Dubbed “Startup America,” the program will eliminate the capital gains tax on some small business investments and speed up the patent process. The U.S. Small Business Administration will direct $2 billion over the next five years to match private-sector investment capital for under-the-radar startups and firms with high-growth potential.

The modern venture capital industry goes back to the 1970s. Private-sector capital firms set their sights on electronic, medical or data-processing technology, and began investing in the startups that soon would populate Silicon Valley. As the number of firms grew, leading venture capitalists formed the National Venture Capital Association and by 1978, the industry experienced its first major fundraising year, with venture capitalists raising about $750 million. At the same time, states were getting into the venture capital game. In the earliest approaches, state governments set up quasi-public corporations and made direct investments in companies, according to Dan Berglund, president and CEO of the State Science and Technology Institute (SSTI), a nonprofit organization that helps states build tech-based economies. “For more than 30 years, states have put money into programs to encourage access to capital,” he says. “Over time, it’s shifted. Now, more investment decisions are being made by private investors and states play a more passive role as a limited partner.”

During the 1980s and ’90s, the venture capital wave rose and fell and rose again, leading up to the boom in 2000, followed by the dot-com bust and a decade in recovery mode. Today, in the face of an unstable market, state governments, desperate for jobs, are aiming to capitalize on untapped potential with seed money, investment programs, partnerships and economic development funds to nurture new businesses and create innovation clusters. California and Massachusetts dominate the country in earlier-stage per capita growth and deals. But several states, including Colorado, Connecticut, Maryland, Ohio, New York and Washington, are boosting capital opportunities for early- stage entrepreneurs, according to the SSTI.

In New York state, for instance, Empire State Development joined forces with the University of Rochester Medical Center to help high-tech startups commercialize their ideas through a $2 million pilot seed fund project. In February, Maryland Gov. Martin O’Malley announced plans to spur job creation in cutting-edge industries by unlocking $100 million in venture capital through InvestMaryland. Various other states, from Oregon to Georgia to Connecticut, have been setting up similar programs to advance innovation in emerging fields. “We know these kinds of programs do work and make a difference,” Berglund says. “In a down economy, now is the time when you really have to invest in the future. It’s even more critical at this point.”

While state-funded venture capital efforts promise payoffs around the country, they’re particularly valued in the Rust Belt and Midwest, where the recession has exacerbated the existing hardships of the shift to a post-industrial economy. In addition to Youngstown, cities such as Ann Arbor, Mich.; Madison, Wis.; and Pittsburgh have powered forward with business acceleration strategies that have attracted up-and-coming entrepreneurs and generated millions from venture capital firms, not to mention the cash coming in from individuals who invest in startup businesses, known as angel investors. For example, Ann Arbor Spark, a nonprofit and business acceleration organization, serves as the administrator over the Michigan Pre-Seed Capital Fund. As of January, 52 startups had received investments from the fund, which have totaled more than $11.6 million.

“The West Coast and Boston and Texas, they don’t need money the same way that the Midwest states do,” says Jim Jaffe, president and CEO of the National Association of Seed and Venture Funds. “There is an emphasis in some of these areas and some money is starting to flow.”

But the key for a successful state venture capital program, Jaffe says, comes down to how much money governments can afford to put on the table. Not all states can invest on the level of Ohio Third Frontier. And places that can’t put up enough capital run the risk of handicapping all their venture capital efforts. “The states have to be willing to invest enough money in this process to make it worthwhile,” Jaffe says. “If you’re investing $500,000 or you’ve got $20 million over a few years, you can’t make enough of a difference at that rate to create a lot of jobs.”

That lack of sufficient investment is what usually undermines government efforts to spur innovation, says Harvard Business School professor Josh Lerner. In his book, Boulevard of Broken Dreams, Lerner examines the history of government venture capital activity. True, he says, government investments helped create success stories like Silicon Valley. “But for each effective government intervention,” he writes, “there have been dozens, even hundreds, of failures, where substantial public expenditure bore no fruit.”

In addition to underinvesting, Lerner says states that set up capital programs tend to rush to give away cash. “In their eagerness to jump-start entrepreneurial activity, governments frequently race to hand out capital,” he writes. “This is equivalent to serving the main course before setting the table and unlikely to lead to a successful dinner party.” Expecting quick results can torpedo a state’s venture capital program.

That was part of the problem with a program in Florida designed to attract biotech firms to the state. In January 2010, news media made hay of a state report showing that Florida’s hefty investment in biotech firms hadn’t had much of an impact. According to the report from the Florida Legislature’s Office of Program Policy Analysis and Government Accountability, titled Biotechnology Clusters Developing Slowly; Startup Assistance May Encourage Growth, the $1.5 billion in state and local taxpayer funds to turn the state into a biotech hub had so far only generated some 1,100 jobs. Lacking proper private-sector venture capital funds, the Legislature in 2007 set up the Florida Opportunity Fund to direct public money to biotech startups. But the massive investment of cash, according to last year’s report, “has not yet resulted in the growth of technology clusters in the counties where program grantees have established facilities.”

Some deals in Ohio haven’t worked out as well as others, Third Frontier officials say, but the overall default rate is only one-tenth of 1 percent. The new voter-approved extension of the program shows the public’s support for the job-creating potential of the program, says Norm Chagnon, executive director of the Third Frontier Commission. “Most people say they want to stay in Ohio and want to raise families, but they can’t find the jobs,” he says. “This signals our commitment.”

Between 2004 and 2008, total venture capital investment in Ohio grew by 13.2 percent per year, from $243 million to $445.6 million, according to a 2008 report published by Michael Camp, academic director of the Center for Entrepreneurship at the Ohio State University’s Fisher College of Business. That’s more than double the annual growth rate of total U.S. venture capital investment during the same period. And the state continues to invest in startups through the Third Frontier, as well as its Technology Investment Tax Credit Program and the Ohio Venture Capital Authority. Gov. John Kasich, who took office in January, brought in longtime friend Mark Kvamme to run the Ohio Department of Development and analyze the state’s capital investment programs. Kvamme, a Silicon Valley venture capitalist, took the interim development director job for $1, and by midyear he plans to complete the transition of the state agency into a new public-private partnership, JobsOhio. “We’re evaluating programs to figure out where we want to double down,” Kvamme says. “We want to fund entrepreneurs who have intestinal fortitude.”

Back in Youngstown, Cossler says he truly believes technology has the power to change the local landscape. “We’re not Palo Alto,” he says. “We don’t have indigenous tech companies here. But no one wants to know the origin of software.”

In other words, unlike the massive steel factories of the past, a Web-based company can deliver products from anywhere with a computer and an Internet connection. Now Cossler’s on a mission to bring home “the Youngstown diaspora” and grow the tech campus to support 5,000 jobs. The incubator currently occupies three buildings in downtown Youngstown, a mix of renovated historic structures and a modern glass addition. Cossler plans to expand into a fourth building soon, putting to use a long-dormant brick warehouse next door, where a weathered sign still reads, “Furnitureland of Youngstown.”

“This is a city that essentially was dying,” says the SSTI’s Berglund. “And they’ve taken a really innovative approach with their incubator program.”

While some may consider it a waste of taxpayer money to heap funds on luring high-tech firms to the Rust Belt, Cossler says Ohio’s venture capital investment is critical. And, he says, it’s not even all that different from the industry that built Youngstown in the first place. “If you reduce software to a common denominator, it’s a steel company,” he says. “You’re taking raw materials and blending them together to create a value-added product. It’s all manufacturing.”