China’s latest Five-Year Plancalls for an economic shift from export toward domestic consumption as an engine of growth. The key to achieving this is an economy that is conducive to innovation. China’s spending on research and development (R&D) rose to 1.7% of GDP in 2009, from 0.90% in 2000, a period during which GDP also increased dramatically.

Some observers in advanced nations are worried that their economies could become less competitive as China and India harness their growing scientific and engineering expertise to their large low-wage labor force. These observers call for more protectionism and urge more spending to promote cutting-edge science and technology in their own countries.

IAs far as national prosperity is concerned, the origins of scientific discoveries and technological breakthroughs is irrelevant. The important factor for national prosperity is who commercializes them. And that is the race. Prosperity often leads to the development of cutting-edge science and technology, but the reverse is not necessarily true. The obsession with the notion that national prosperity relies on dominance in the fields of science and technology is misguided.

How Innovation Creates Value

Innovation involves the development of new products, or processes, and the know-how that begets them. Professor Amar Bhidé has deconstructed the innovation process into three levels.New products can take the form of high-level building blocks, or raw materials, mid-level, the intermediate goods, and ground-level, the final products. All levels of innovation contribute to economic prosperity as they all play necessary and complementary roles. Innovations that sustain prosperity are developed and used in a huge game involving many players working on multiple levels over many years (see Table 2).

Technological innovations, especially high-level ones, are usually of limited economic importance, unless complemented by innovations at lower levels. Breakthroughs in general principles have value for industry only if accompanied by mid-level technologies, which themselves may be largely useless without plant-level solutions, like context-specific rules of thumb that make it possible to produce in-demand final products.

Take the traditional combustion-engine used in cars. The relevant science was developed over a century ago. Cars have been in service since Ford started manufacturing them in 1903.  Combustion engine technology is mature by any measure, yet plant-level context-specific rules of thumb continue to evolve. New solutions and innovations at that level continue to emerge. But this is proprietary knowledge owned by manufacturers and their production teams, and that is not easily acquired from public sources.

Where Obsession with Science and Technology Goes Wrong  

Almost everyone oversimplifies innovation by equating it with discoveries announced in scientific journals and with patents for cutting-edge technologies developed in universities, or commercial research labs. They rarely distinguish between the different levels and kinds of know-how, and routinely ignore the contributions of other players that don’t generate publications or patents.

The presumption that nations must invest in science and technology in order to promote economic prosperity requires an implicit assumption that high-level ideas and know-how rarely, if ever, cross national borders. Only the final goods do. This is grossly inaccurate. In fact, ideas and technologies move from country to country with ease, but much final output, especially in the service sector, does not. The findings of science are made publicly available in learned books and journals. And although advanced technology can be patented because it has commercial value. B patent owners do not generally charge higher licensing fees to foreigners.

In a world where breakthroughs travel easily, their national origins are fundamentally unimportant. It doesn’t matter that Google’s search algorithm was developed in California, or that the World Wide Web’s protocols were invented in a Swiss lab by an Englishman. Skype, for example, was started by a Swede and a Dane in Estonia. Mid-level technology has become truly global. More than a decade ago the pharmaceutical company Eli Lilly was already outsourcing R&D on a global scale through the internet. Researchers from Russia, Eastern Europe, and India were eagerly providing solutions to the R&D problems posted on Lilly’s website.

Globalization has greatly expanded the trade of final products, procurement of intermediate goods through global supply chains, flow of equity investments, and the use of immigrant labor. But most services remain untraded. Of the many activities in the innovation process only some can take place in remote locations; many mid-level innovation activities are best conducted close to potential customers, and this is particularly so in the services.

The willingness and ability of innovators to create new know-how and products at lower levels is at least as important to an economy as the scientific and technological breakthroughs on which they rest. Without lower level innovations, locally on the ground, an economy will simply fail to prosper. Economists have long recognized that economic growth can be easily impeded by excessive research, by committing too high a percentage of scientific manpower to the task of increasing knowledge, and too small a percentage engaged in using it. Will this be the situation in China?

The point is: it is not enough to have only great scientists and research labs; one must also have the many types of innovators that can exploit high-level breakthroughs, regardless of where they originate. Does China have these types of innovators?

China’s R&D spending now accounts for 12 percent of global R&D spending while its GDP is only 8% of world GDP.  R&D as a percentage of GDP this may still lag behind South Korea, Japan, and the US, but these latter nations are at a more advanced level of economic growth, and can afford more R&D investment. But is this level of investment necessary to catch up? One must draw a distinction between catching up with the rich nations, in terms of per capita incomes, and in terms of R&D spending. The two are not synonymous, even though they may be related. Over-spending in R&D can be wasteful and can negatively impact long-term economic growth.

An economically backward country is at an advantage in that it can leverage on the scientific and technological developments of more advanced economies to propel its growth. Indigenous breakthroughs made at the frontiers of science and technology are great for national prestige, but rather than serving the nation they may well end up helping foreign companies that are better prepared to exploit such discoveries. Without sufficient innovators to take advantage of these breakthroughs at the lower levels, their value will be lost to others, or wasted.

Consider the successful trio – iPod, iPhone, and iPad. All the high- and mid-level know-how required to develop these products was available for quite some time before Steve Jobs turned it into a huge economic success. Many companies had produced different versions of some features of the trio. Apple’s breakthrough was essentially ground level innovations – new designs, new packaging, new applications (like iTunes), and marketing success. The science and technology used were available in many countries, but the trio was created at Apple.

R&D in services is often different in character from R&D in manufacturing. It is less oriented towards technological developments and more towards developing new applications. It requires fewer resources and an adequate science and technology workforce that is motivated towards innovation in the work place. The workers and consumers reap the rewards because, in contrast to manufacturing, most services generated in the local economy are also consumed locally.

We have discovered that companies operating in relatively free market economies have a tendency to adopt new technologies sooner than those working in markets that are less open. For example, when IT researchers create an application that helps retailers to cut inventories, we find retailers in the US are more likely to adopt them than, for example, those in Germany, where regulations to protect inefficient small-scale shops discourage companies from taking a chance on anything new. A less heavily regulated service sector explains why, since the mid-1990s, productivity and incomes have grown faster in the US than in Europe and Japan.

China desperately needs to deregulate its services sector to help promote domestic consumption. Innovations that apply technology to meet consumer demands require a more flexible service sector. Such innovations will shift the economy towards domestic consumption. But an obsession with innovation at the high-levels of science and technology will not. As prosperity spreads, China will naturally make a greater contribution to humanity’s stock of high-level knowledge capital, but getting too quickly ahead of the game is not sound policy.

In the 1980s, many people in the US attributed the problems of the US economy to the proliferation of lawyers and managers, and to a shortage of engineers and scientists; Germany and Japan were praised as countries with a better occupational ratio. Yet in the 1990s, their economies slackened while the US prospered because of its flexible and innovative service economy, which exploited its scientific and technological advances. During this period, math and science education in US high schools did not greatly improve. Enrollment in law schools remained high, and managers accounted for a growing proportion of the workforce. The US share of scientific articles, science and engineering PhDs, and patents continued to decline, and manufacturing employment stagnated, but still the innovative service sector expanded.

The US medical sector illustrates the high-level bias of public policy. US investment in health care R&D, as a proportion of GDP, is many times higher than the other OECD countries, but their innovations are restricted to medical technologies. As a consequence, the US has a higher infant mortality rate and lower life expectancy than other OECD countries. Almost all experts agree that the solution for US health care is not more, or better, medical research, but a fundamental shift in the rules to ensure that hospitals are better managed, that IT is more widely and effectively utilized, and that insurance schemes are better organized. Unfortunately, willing entrepreneurs have difficulty attempting to provide care at lower costs because status quo providers, abetted by legislators and insurance companies, have made it virtually impossible for them to succeed.

In coming years China’s R&D funding will increase substantially and investment in bio-medical technology will top the list. Scientifically this is highly laudable, given the prospective potential of this area. Yet how will these breakthrough scientific findings be transformed into medical and health care benefits for China’s population under the present medical and health care systems? Perhaps the findings could be licensed overseas thus benefitting the rest of humanity. An obsession with staying ahead in research diverts money and attention away from health services reform, which could provide far greater pay-offs that would remain largely in China.

China’s Challenges Ahead

The point is not that China should not be making investments in R&D. Of course it should. But it would be a mistake to believe that this is both necessary and sufficient. Chinese policy makers have learned some important lessons from earlier innovation failures, when they tried to impose innovation from the top down. An early attempt to develop an indigenous technological standard (TD-SCDMA technology) for mobile telephony found few takers in China, or elsewhere. Alternatives already existed, and those were preferred.

China has made some progress toward becoming a more innovative economy thanks to a freer market.  In some areas, such as telecommunications and pharmaceuticals, innovation is clearly evidentm while local companies and universities have discovered multiple chemical compounds in China.  Huawei’s ( 华为技术) and ZTE’s(中兴通讯)glocal gains in market share have been achieved in part through innovation.

Beijing is also identifying new opportunities and creating incentives for market participants to innovate. It plans to make R&D investments in electric vehicles at a number of companies, and has committed to guaranteeing demand for the cars by requiring official fleets to purchase them and providing incentives for consumers to use them. The actual innovation will be left to the private sector.

The shift of R&D spending from government-controlled research institutes to large- and medium-sized enterprises, which now account for 65% of total R&D spending, is a positive move. It is worth noting that foreign-invested companies account for as much as 17% of this spending, and despite their frequent complaints about lax intellectual-property protections this is a sign that the market is working.

Catching up allows China to leap ahead in some areas, for example, in building advanced mobile-phone networks and high speed rail. But, there is still the question of whether policy makers will consistently pick the sensible areas for innovation. China has decided to support the innovation of electric cars, but not traditional combustion-engine cars. Time will tell whether this is a wise choice. If central planning has not worked in the past, then a central plan for innovation today makes even less sense. Central plans are not plans; they are simply the negotiated outcomes of political lobbying by powerful interests where success is not determined by economic considerations alone.

In state-dominated service sectors, there has been limited product or service innovation. Banking is a good example. The most urgent task in China is to liberalize the service sector, to foster an environment that allow entrepreneurs to develop new business models, and incentivize innovators to make use of the available technology—domestic and foreign—to stimulate consumption. Innovation, based on careful studies of consumer preferences, is rare in China, but sorely needed.

Much of the best innovation in China today is developed around creative business models. For example, Alibaba (阿里巴巴) has successfully built a new business around an online platform to connect smaller Chinese producers with overseas buyers, while. Broad Air Conditioning (远大空调) has developed a way to commercialize gas-powered air conditioning systems for large buildings.

Excelling in the overall innovation game demands a great and diverse team, and this cannot be achieved overnight. Japan began to modernize itself in the late 1860s, yet nearly 150 years later it remains behind the United States in its overall capacity to develop and use those innovations. South Korea and Taiwan, which have enjoyed truly miraculous growth rates since the 1970s, are still further behind. And to a large measure this is because its service sector remains over-regulated; a fate from which many European economies also suffer.

Excessive investment in R&D may well become counterproductive if the benefits cannot be realized, and this is more likely if the service economy remains shackled as it is now. Chinese companies today place too much focus on expanding global market share with just-good-enough products. The drive to create 100 world class brands is laudable, but will this foster prosperity at home and jumpstart domestic consumption?

Innovation does play a major role in nurturing prosperity, but China must carefully formulate policies that sustain rather than undermine it by favoring one form of innovation over another. Innovations in high-level science and technology are not more important than the ability to use them locally in mid- and ground-level applications. To truly prosper China’s Five Year Plans should adopt policies that award equal importance to all levels of innovation.

References:

Amar Bhidé, The Venturesome Economy: How Innovation Sustains Prosperity in a More Connected World, Princeton University Press, 2008

Gordon Orr,“Unleashing the Chinese Inventor”, The Wall Street Journal – Asia, December 28, 2010

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