(This essay was published in Hong Kong Economic Journal on 11 November 2015.)

 

Should governments intervene in the capitalist free market to promote economic activities? Economists have debated this issue at considerable length on two occasions. The first time was over industrial policy and the second time over innovation and technology policy. The old and new debates are related in some areas, but are fundamentally different in nature.

 

The old industrial policy debate concerned the most efficient way of allocating scarce resources – an issue central to Hong Kong’s positive non-interventionism. Should governments pick winners or should the task be left to the market? The market system and the price mechanism were seen by most economists to be the most efficient institution for allocating resources efficiently. Public intervention was justified only when markets failed and because the social rate of return was higher than the opportunity cost of providing funds.

 

The more recent debate about technology saw wealth production as the result of transforming new ideas into new products that could be profitably supplied. Economics has always viewed resources – labor, capital, and human capital – to be subject to scarcity and therefore the law of diminishing returns. If ideas could be nurtured through policy measures, then one could overcome diminishing returns and unlock the Holy Grail of continuous productivity growth. What is the best approach of nurturing ideas to foster growth and productivity? Whether it is the government or the market is central to the technology debate.

 

Economic policy in the industrial debate revolved around the issue of scale economies and market failure. It was argued that the survival of new national industries required government protection to shield them from larger and more competitive foreign companies that had achieved scale economies. A new national industry needed time to learn and grow before it could compete with foreign companies. This was the famous infant industry argument.

 

Its central logic is that companies are unable to raise enough capital for the long duration that allows them to learn and grow to the scale necessary to survive competition in the world. The source of the market failure is therefore capital market imperfections, meaning the infant firm is handicapped when raising funds. It was argued that government intervention in the form of subsidies and protectionist policies could correct such market failure.

 

Unfortunately, infant firms often do not grow up. Once accustomed to living in a protected environment, they prefer to avoid adult competition. Infants often became highly skilled at rent-seeking by lobbying government. Politicians and officials of course seldom admit to having made a policy mistake in the first place. So the umbilical cord is never cut.

 

Protectionist import substitution policies were introduced in many developing countries based on the infant industry argument. Prestigious organizations like the World Bank once recommended this for many developing nations that were its clients. Its failure became well recognized when the export-oriented manufacturing economies of Japan, South Korea, Taiwan, Hong Kong and Singapore sped past the rest of the developing world to become first-world economies.

 

Another reason why the old industrial policies tended to fail was that once government decided to pick industries and support them through protection, there were many willing clients that wanted to be the chosen ones. Insulating the selection process from political lobbying is almost impossible. Hong Kong’s positive non-interventionism has been both an argument that the free market could pick winners better than the government and a strategy to insulate government decisions from rent-seeking lobbies.

 

The more recent debate about innovation and technology policy has concerned how to raise productivity growth in both existing and new industries. It emerged out of work at the University of Chicago in the late 1970s and early 1980s by two economists, Paul Romer (then a graduate student) and Professor Robert Lucas (Nobel Laureate 1995), who began separately to develop two different but related models of economic growth.

 

Does government have a role in promoting economic growth – that is, keeping economic growth rates positive so that a continuously increasing amount of output can be produced from the same amount of input? The new models of economic growth purported to show that the source of this productivity growth comes ultimately from new ideas.

 

Both Romer and Lucas took the view that outputs are “things” and so are labor, capital and human capital, and “things” are different from ideas. Human beings possess an infinite capacity to reconfigure “things” by creating new recipes for their use. By coming up with new ideas on how to increase, say, the power of a processor or the efficiency of a supply chain, humans can boost productivity, spawn new opportunities for profit, and ultimately drive economic growth. And the great thing about ideas is that they are nearly limitless.

 

The two economists also saw ideas as having consequences. In their view, output is driven by the stock of ideas, in addition to the usual inputs of labor, capital, and human capital. Investing in human capital enhances the chance for discovering new ideas (or learning the ideas of others), and learning new ideas augments the stock of human capital. Their complementarity magnifies each other’s effect so that ever more output can be produced from the same amount of input.

 

The iterative interaction between the stock of ideas and the stock of human capital produces a positive dynamic that is behind all technological progress. It allows us to overcome the law of diminishing returns that “things” like output, labor, capital and human capital are limited by scarcity. Ideas, unlike “things”, can be invented by human ingenuity without limits. Ideas unlike “things” are not scarce.

 

New ideas lead to new products, new markets, and new possibilities to create wealth. The world is no longer defined by scarcity and limits on growth. The number of ways one can rearrange “things” to create something of greater value is vast and the prospect for economic growth is far greater than can be imagined.

 

Still, scientific discoveries – a major source of new ideas – are serendipitous in nature and fraught with uncertainty. The transformation of scientific ideas into technological products and services is a risky market undertaking and requires an appropriate level of protection of intellectual property rights – not too much and not too little – for otherwise it would not be possible to attract commercially viable investments.

 

Taking a product or service to market requires further innovation in marketing to meet the requirements of diverse clients in different markets. The entire process starting from scientific discovery to meeting client needs at the end requires numerous supporting institutions and participants that must all come together for the benefits to be realized.

 

Silicon Valley and Route 128 emerged on their own accord and succeeded when all these factors came together naturally. Few subsequent attempts to clone Silicon Valley and Route 128 by government policy have been successful. It is simply not easy to assemble all the factors crucial to success at a cost that would make the investment worthwhile in the end.

 

But if government wants to encourage innovation and technological progress, are there conditions it can create that would encourage knowledge creation and profit making businesses to feed on each other so that each generated positive spillovers for the other?

 

The standard view based on Michael Porter’s thesis of the competitive advantage of nations argues that competitive firms within a concentrated single-industry cluster are more conducive to the spread of knowledge among similar firms to maximize the gains from knowledge spillovers. For example, concentrating a lot of competitive textile and garment firms in a single location provides the best structure for industry growth.

 

Romer and Lucas, however, had different conceptions of how knowledge and business can generate positive spillovers for each other.

 

Paul Romer believed that there were fewer incentives to produce knowledge among competitive firms than among monopolists or near-monopolists, and he was not averse to some form of protection or subsidies. He saw government as having an active role in building hard and soft infrastructure and a supportive regulatory environment. He became the moving force behind the Charter Cities initiative to work with governments in rapidly urbanizing countries, focusing on the potential for startup cities to fast track reform. While Romer’s strategy is not targeted at specific industries, its bold vision counsels governments to embrace fundamental reforms to adopt better rules and institutions.

 

Robert Lucas endorsed urban writer and activist Jane Jacobs’s notion that new ideas and knowledge spread about most readily in cities with competitive, not monopolistic, businesses and with a diversity of businesses. More ideas and different ideas generate more useful spillovers. Unlike Porter or Romer, diversity, not single-industry clusters, is considered important.

 

Lucas emphasized making cities attractive for the skilled and talented to want to live and work there. This would attract a diverse population pool to agglomerate and raise families in the cities, which would in turn attract a diverse pool of companies to come.

 

Two recent success stories are Singapore and Israel, which have developed as bases for innovation and technology. Beginning around 1990, Singapore embarked on an aggressive policy to attract skilled immigrants notably from China. Israel benefitted from the opening and subsequent collapse of the former Soviet Union that allowed massive numbers of Soviet Jews with high skills in science and engineering to migrate there. The 1990-91 wave of immigration increased Israel’s population by 7.6% in two years. The chart below shows the massive growth of population these two countries experienced compared with Hong Kong.

 

 

Closer to home we have Shenzhen, a city identified as one of the newest leading innovation and technology centers. It is the most pleasant city for people on the Mainland to live, thanks to its openness, and it has attracted massive numbers of skilled and entrepreneurial people from all over the Mainland. The population is now believed to exceed 20 million when the migrant population is included.

 

Empirical work comparing cities in the US supports the view that competition is more conducive to growth than monopoly and that a diverse city economy is better than one with a concentration of a few industries. The evidence is thus negative on Romer and consistent with Lucas and Jacobs. Porter is not entirely wrong because for a period of time a single-industry cluster can work, as in the example of Detroit, but sustainability of the city requires a greater diversity of industries.

 

The lessons one takes away from the old and new debates are that government has a role to play in building up the soft and hard infrastructure to facilitate innovation activities, in investing in the skills of the population and in attracting diverse talents from overseas, and it must allow industrial diversity to thrive, not suffocate it.  Industry targeting should be avoided, while attention should be paid to developing and maintaining rules and institutions.

 

At the end of the day, skilled and talented people are the most important element of success in fostering innovation. Population policy should be the central focus of the government’s strategy to promote innovation in Hong Kong. One must not forget Hong Kong’s economic miracle was also built on the massive wave of immigration in 1945-51. Positive non-interventionism alone would not have been sufficient.

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