(This essay was published in Hong Kong Economic Journal on 16 December 2015.)

 

The Innovation and Technology Bureau has just been established. This is no small achievement as it is the first major government administrative reform initiative in years. To be brought to life, it had to first break free from the clutches of partisan political interests in the legislature. But if the newly-minted Bureau is to make an impact on future economic growth, then it will have to produce a policy strategy anchored in a deep understanding of how business opportunities are created.

 

A successful policy strategy for promoting economic growth must begin with the recognition that regulatory obstacles have been the most important failure of government decision-making in the past two decades. Government has failed to deregulate and to liberalize an increasingly ossified regime that is preventing economic growth through innovation and technology. This is reflected in three interrelated factors.

 

First, technology only creates market value when it is adopted by business for profit. Technologies without a present-day market do not create economic value, even though some may later do so at some time in the future. Companies like Lenovo, Huawei, Baidu, Alibaba, Tencent, China Shipping, Cosco and many others have all harnessed technology to create economic value.

 

For years businessmen in Hong Kong chimed: “High-tech hi-yeah, low-tech lo-yeah!” (or “high-tech get beaten, low-tech be prosperous!”) The real meaning of their message was clear: we will only use the appropriate technology that allows us to create economic value in the market. Many companies prospered by applying cutting-edge technology in such areas as finance, shipping, container ports, air cargo terminals, and supply chain management to seize market opportunities. But there were many others who prospered without having to adopt new technologies. They innovated in other ways, but not primarily in technology.

 

Second, the most important technology today by far is digital and information technology. Unlike other technologies, it impacts all industries and is not limited to any specific industry or set of industries. Historically, the only other all-pervasive enabling technology has been electricity, which was used initially for heating and lighting purposes, but through further application became indispensable for every activity. Like the discovery of electricity, new technology has a very long way to go.

 

In view of the significant spillover effects, there is a justifiable case for government to play an important role to ensure the proper incentives are in place to encourage appropriate infrastructure investment in digital and information technology. The Digital 21 Strategy and the Government Cloud Environment initiatives are relevant examples.

 

Third, a liberal regulatory regime to create platforms that can be accessed by all with ease and without barrier, will be essential to the development of new innovative and technology companies. Many entry barriers still exist today for companies wanting to use technology because the regulatory regime was established for a previous age.

 

These need to be reviewed and many have to be dismantled to make room for a more enlightened and liberalized regulatory regime. The old regime unfortunately covers hundreds and thousands of specific industries. Inevitably, the task of taking down barriers will be daunting and will require years if not decades of hard work.

 

This also means that a great deal of the economic value that could be created by digital and information technology will not be unlocked unless the new Bureau works with other Bureaus to liberalize and deregulate the old regulatory regime. For example, digital media and information technology have converged, yet many of our regulatory regimes are focused on ownership control in narrowly-defined businesses. Finance is one of the most innovative areas and a great user of technology, but future innovation will be held back unless the regulatory regimes too are liberalized. The list is literally endless.

 

There is a very compelling reason why old regulatory regimes need to be reformed. The most frequently-cited reason for why technology driven innovation fails is that regulatory barriers prevented it from getting to market. The new Bureau will have to work closely with other bureaus and departments in government to tackle this problem.

 

The new Bureau could look to the example of the Independent Commission Against Corruption (ICAC) for inspiration. The ICAC has three arms: (1) the investigative arm that goes after criminal cases, (2) the research arm that examines existing rules, regulations, and practices to identify and modify them in order to remove the opportunities and incentives for corruption, and (3) a community relations arm that drums up community support for its mission.

 

The ICAC’s research arm is particularly relevant because it reviews the regulations of other bureaus and departments to  identify rules and regulations that encourage market corruption, and targets them for modification. The new Bureau should likewise focus on identifying, liberalizing and deregulating those rules and regulations that act as barriers to economic value creation by innovating firms.

 

Inevitably there will be overlapping jurisdictions between bureaus and departments that also need to be identified, some quite urgently. Consider the situation of Hong Kong’s rapidly ageing population, which will also soon start to appear in Mainland China. In both places there will be enormous demand for trained medical and healthcare manpower in the decades ahead. But the current regulatory regime holds back solutions and also the development of technology to meet an ageing society’s needs.

 

There is a compelling case not only for investing in local manpower, but also liberalizing the regulatory regime to allow trained personnel from abroad to work here. Once a critical stock of professional and scientific manpower can be put in place, it will spawn the rise of biomedical and related technology industries. Population dynamics will drive opportunities in the medical and healthcare markets.

 

This situation illustrates how an issue can straddle policy bureaus – in this case the portfolios of the Food and Health, Education, and Security Bureaus. Each must be involved in finding a solution.

 

Regulatory barriers are easily the greatest enemy of innovation and technology for another important reason – the political economy of rent-seeking activities.

 

Rent-seeking is a redistributive activity that works through political processes – lobbying, stealing, taxation, corruption, etc. It is economically unproductive because it takes up resources, but adds no economic value to society. It is enormously costly to economic growth because it not only wastes resources, but is detrimental to innovative activities.

 

Businesses normally profit by creating economic value through market competition, but they may sometimes choose to compete politically by lobbying government for special treatment or protection, in other words to engage in rent-seeking activities. This is often identified with crony capitalism. But rent-seeking is actually much more widespread in communist and socialist economies because more resources are channeled through economic planning; rent-seeking is more profitable for businesses when there is a big government.

 

Why is rent-seeking so enormously detrimental to economic growth? There are three reasons: increasing returns to unproductive activity, the crowding out of productive activities, and discouragement to innovation.

 

On the first point, rent-seeking activities exhibit very natural increasing returns, which makes them more (rather than less) attractive relative to productive activity. When rent-seeking activity accumulates, an economy can be stuck in massive amounts of unproductive activity that stifles economic growth.

 

This can happen through three mechanisms. First, while there is usually a fixed cost to setting up a rent-seeking system, such as a legal code, once it is set up then lawyers can cheaply sue each other’s clients, which they could not do if the code did not exist.

 

Another mechanism is that offense creates a demand for defense, which makes rent-seeking self-generating. If a customer hires a lawyer, his supplier must do likewise; and so on. This, too, is a form of increasing returns.

 

And the third mechanism is that rent seekers have strength in numbers. If only a few people steal or loot, they will get caught; but if many do, the probability of any one of them getting caught is much lower, and hence the returns to stealing or looting are higher. Stealing or looting is here used in the sense of unproductive resource redistribution, as opposed to productive value creation.

 

The second way in which rent-seeking activities are detrimental to the economy is that even when they do not exhibit increasing returns, they can still harm economic growth. When rent-seeking expands, more of societies’ productive resources are allocated to this activity which then drives down not only the returns to production but also the returns to rent-seeking. How does this happen?

 

Rent-seeking activities are profitable because they steal or loot the returns of other productive economic activities. This ends up driving entrepreneurs away from highly productive economic activities where returns can be readily expropriated, into those that cannot be so easily confiscated. Very often the latter are less productive activities.

 

When rent-seeking crowds out highly productive activities, the economy suffers because rent-seeking is inherently a non-productive activity. Eventually everyone is driven into low productivity activities that are less vulnerable to the grabbing hand. When this stage is reached even rent-seeking is unprofitable, but the economy is now so underdeveloped that everyone is engaged in low productivity activities. This condition is characteristic of underdeveloped economies where property rights are poorly protected.

 

Finally, rent-seeking is particularly detrimental to economic activities that require innovation and technology. In this case it is useful to distinguish between private and public rent-seeking. Private rent-seeking takes the form of theft, piracy, litigation and other forms of transfers between private parties. Public rent-seeking is either redistribution from the private sector to the state (such as taxation), or alternatively from the private sector to government officials and politicians who affect the fortunes of private businesses.

 

Private rent-seeking attacks primarily the productive sector rather than the innovative sector of the economy because it crowds out highly productive businesses. Private rent-seekers go after existing stocks of wealth, such as land, output, capital, and the like. Bandits steal goods, lawyers sue deep-pocket corporations, and armies invade resource-rich countries.

 

In contrast, public rent-seeking attacks innovation, since innovators need government-supplied goods, such as permits and licenses to set up business, import quotas, and so on, much more so than established businesses. The innovators’ demand for government-supplied goods is high and inelastic, and very often requires government to be flexible and supportive. The rapid rise of Baidu, Alibaba and Tencent owes much to the protection they received from the state in preventing the entry of foreign companies.

 

Permits and licenses for newly-created products and services may not exist in the existing regulatory framework. There is a law regulating the import of apples and another the import of mangoes, but none exists for a new fruit that is a genetic cross between apples and mangoes. If such permits cannot be obtained or are delayed for a long time, then innovation and technology is negatively impacted and economic growth suffers. This could even provide an opportunity for public corruption.

 

New producers are almost always more vulnerable to public rent-seeking. Innovators have no established lobbies and are not part of the government elite. Whereas the established producers are often part of the government, innovators are outsiders and hence are subject to particularly heavy bribes and expropriations. This problem becomes even worse when the interests of new and established producers are opposed, in which case the government may even stop innovators altogether.

 

Innovative projects are typically long-term and risky, which makes them particularly vulnerable to rent-seeking. If a project succeeds, the returns are expropriated, whereas if it fails, the innovator bears the cost. The long-term slow accumulation process provides rent-seekers plenty of opportunities for future expropriation. For this reason, investing effort in short-term trading with less likelihood of expropriation is often preferred when rent-seeking activities are more rampant.

 

These arguments suggest that public rent-seeking can be a severe disincentive to innovation activities and thereby will result in more resources being channeled into established production or the public rent-seeking sector. The result would be a reduction in economic growth.

 

The enemies of innovation and technology need not be government officials and politicians or established businesses, they can be broad and loose coalitions of interests that possess a shared purpose or ideology. For example, local professionals are opposed to an immigration policy that brings in foreign talents, educated elites are opposed to expanding education opportunities that create competition for themselves. Immigration policy is also a form of entry barrier.

 

The Innovation and Technology Bureau will succeed if it focuses attention not only on a narrow set of scientific and technological issues, but also on lowering the barriers of market entry for new innovative businesses and increasing the supply of new talents and skills in the workforce. The successes of Singapore and Israel as innovation and technological hubs were kicked off by large influxes of talented manpower that set in motion a virtuous circle of supporting policy initiatives. Pulling oneself up by one’s bootstraps is not a winning strategy, building a virtuous circle is.

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