When Innovation Is Not Enough

8 January, 2015 / Articles

China’s State Council recently kicked off work to update the five-year plan that targets “strategic” industries. Narendra Modi has called for India to become “self-reliant” in electronics. Meanwhile, other major emerging markets have designated their own business sectors for preferential treatment. All of these schemes aim to promote domestic innovation, which policy makers believe can drive prosperity.

Yet there is ample evidence that the greatest benefits from innovation can’t be captured by state policies. Rather, they come from the application and adoption of technical breakthroughs, regardless of where those breakthroughs were achieved.

Innovation is important because it is the key to raising worker productivity. Productivity is, as former U.S. Federal Reserve Chairman Ben Bernanke once said, “perhaps the single most important determinant of average living standards.” When innovative new products or services come to market, productivity goes up and a country becomes wealthier.

The dramatic rise in living standards over the past two centuries is largely a byproduct of innovation. Tools ranging from the cotton gin to the computer, coupled with improved health care and public-health practices, have enabled people to produce more and live longer. Nobel laureate Robert Solow found that 35% to 40% of all productivity and growth gains achieved by the U.S. from 1900 to 1950 could be traced to new ideas.

But the broad understanding that innovation drives higher productivity and greater economic growth often leads to an incorrect conclusion: That in order to achieve productivity gains, a government should create national technology champions. While there are gains for countries that generate new technologies, the biggest benefits from innovation come from companies that use these innovations effectively.

Consider the World Wide Web: It was invented in 1989 at CERN, a particle-physics lab near Geneva. While it was a breakthrough innovation, the biggest beneficiary wasn’t Switzerland, but rather the companies throughout the world that learned to harness its power for many different uses.

Government policies affecting the use of innovations can be as important as any investments in new technologies. From the 1990s to early 2000s, firms in Europe’s largest economies invested in new IT hardware and software. As a share of gross domestic product, those investments were on par with the investments made by American businesses. But the European investments did not translate into the same gains in productivity achieved by American firms. From 1995 to 2000, annual productivity increases averaged 1.1% in France and 1.5% in Germany, but 2% in the U.S.

Why? A McKinsey study concluded that, “the key inhibitor to the diffusion of innovation [in Europe] is a distorted competitive environment resulting from inappropriate sector-specific regulation.” Citing the road-freight industry, McKinsey found that price regulation and market-access restrictions in France and Germany minimized competition, discouraged consolidation and led to industry fragmentation. “As a result, there was little use of IT-based network optimization tools that were instrumental in improving productivity performance in the U.S.”

Government policies can also be counterproductive when politicians and bureaucrats fixate on national champions, as if economic growth were like winning Olympic medals. The likelihood is high that officials will target the wrong sectors and products, leading to misallocated capital and economic distortions. Think of that fabulously expensive Franco-British government hobby, the Concorde supersonic aircraft—great diplomacy, terrible business.

One of the lessons from the U.S. is that being an innovation leader doesn’t arise from having a national industrial policy. The U.S. government does play a catalytic role in funding basic research, but the country also provides a flexible labor market and skilled workforce, unobtrusive business regulation, strong property rights, efficient capital markets and a large domestic market with many early adopter consumers. Together these factors create what Tufts University economist Amar Bhidé has aptly called the “venturesome economy.”

With similar policies, emerging markets can benefit even more than the rich countries. China, for instance, has profited handsomely from investment from industry leaders in Europe, Japan, Korea and the U.S., which have introduced new technologies and business practices to help modernize the wider Chinese economy. Rather than coddle local firms with discriminatory “indigenous innovation” policies, China and other emerging markets would be wiser to focus on creating the policy and commercial ecosystem to attract foreign direct investment and the world’s best new ideas. That means providing robust protections of intellectual property, coupled with rigorous investor protections, a modern infrastructure and an educated workforce. It also means abstaining from the state-sponsored industrial espionage that keeps some of the best technologies offshore.

Innovation will continue to be the key driver of productivity gains throughout the world, but policy makers need to stay focused on the regulatory and business environment that encourages companies and consumers to use these innovations—and not place undue emphasis on where the innovations come from.

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