Innovation Economics

Stephen DeAngelis

September 30, 2008

When the cloud of economic dust created by the implosion of large U.S. financial institutions finally begins to settle, some optimistic analysts believe that the U.S. economy that will emerge from the debris will be quite different than the economy that faltered. They believe that the U.S. will innovate its way back to health [“Can America Invent Its Way Back?” by Michael Mandel, BusinessWeek, 11 September 2008]. As readers of this blog know, innovation is one of the topics to which I continually return. Creativity not only fascinates me, but as an entrepreneur I see it as the engine that powers the future. That is exactly what the “innovation economists” are counting on. Mandel writes:

“Will 2009 be the year of innovation economics? Pessimism about America’s future is growing. People worry about the long-term impact of the housing crisis, global competition, and expensive energy. And the policy solutions offered by Republicans and Democrats—mainly tax cuts and government spending programs—seem insufficient. Yet beneath the gloom, economists and business leaders across the political spectrum are slowly coming to an agreement: Innovation is the best—and maybe the only—way the U.S. can get out of its economic hole. New products, services, and ways of doing business can create enough growth to enable Americans to prosper over the long run.”

Mandel reflects on the fact that both John McCain and Barack Obama have made innovation a central theme of their campaigns and they see innovation as a way to address energy problems and create jobs. Mandel then offers up some sobering statistics.

“Here’s the conundrum: If money alone were enough to guarantee successful innovation, the U.S. would be in much better shape than it is today. Since 2000, the nation’s public and private sectors have poured almost $5 trillion into research and development and higher education, the key contributors to innovation. Nevertheless, employment in most technologically advanced industries has stagnated or even fallen. The number of domestic jobs in the computer and electronics sector continues to plunge while pharmaceutical and biotech companies lay off as many workers as they hire. And even the industry category that includes Google — Internet publishing and Web search portals — has added only 15,000 jobs since 2003.”

For years futurists like Francis Fukiyama have been predicting that new fields like nanotechnology and biotechnology will become huge economic sectors employing significant numbers of people in well-paying jobs. Mandel’s underlying question is: what happened? The answer to that question, he asserts, is what innovation economics is supposed to provide.

“The new field of innovation economics addresses this gap between spending and results. Economists are increasingly studying what drives successful innovation to learn how companies can get more bang from the bucks spent on R&D and higher education. At the same time, they’re collecting new data on American R&D initiatives to understand what’s working in the U.S. and what’s not. And most important, economists are making concrete proposals about how to turn smart ideas into jobs and growth.”

The big difference between innovation economists and traditional economists, Mandel explains, is that the former is more results-oriented and the latter more policy-oriented.

“This focus on innovation as a crucial way to develop a competitive edge is a big change from the past. While a handful of economists have studied technological change, the main focus of policy-minded economists has, until recently, been on traditional topics such as taxes, government spending, and trade. Now some of the brightest minds in the field, including Daron Acemoglu of Massachusetts Institute of Technology, winner of the 2005 John Bates Clark Medal for the top economist under 40, are paying a lot more attention. His work examines how government and business decisions such as outsourcing can influence the direction of technological change.”

It’s hard to be result-oriented, however, without having good measures of effectiveness by which results can be judged.

“That’s why government statisticians such as Lynda Carlson of the National Science Foundation are trying to find new ways to quantify innovation and its impacts on business. In January [2009] the NSF will launch an annual survey of 40,000 companies asking how much they spend on R&D in the U.S. and overseas, by type of business and country. ‘For the first time, we’ll have a clear picture of what kind of research companies are doing globally and what benefits they are getting from their spending,’ says Carlson, who is spearheading the survey.”

I’m not sure how Mandel defines innovation, but it must be similar to the way I define it. Innovation involves both the conception and the implementation of creative ideas. There have been lots of good ideas that have never been implemented. As a result, those ideas cannot be defined as innovations. On the other hand, there have also been a lot of bad ideas implemented (people like to recall Ford’s Edsel model and Coca-Cola’s New Coke as examples). They weren’t innovations either. Mandel goes on to discuss how innovation can be fostered and supported.

“Economists are also suggesting how to use new tools to boost innovation. They’re studying when prizes for technological advances make sense. They’re proposing ways state and local governments can best encourage innovation-based economic development. And they’re exploring how to make optimal use of the billions of dollars’ worth of research conducted in government-funded national labs. It’s possible the longstanding partisan debate over tax rates and budget deficits may soon become a sideshow. ‘The main purpose of economic policy should be to spur innovation and growth,’ argues economist Robert Atkinson, head of the Information Technology & Innovation Foundation (ITIF), a nonpartisan think tank in Washington. ‘This is not an issue either party owns.'”

The world has reason to be concerned with the latest financial crisis but has no reason to be forlorn. Mankind has managed to create more wealth in the last two hundred years than in all of the rest of history combined. One reason, of course, is that the explosion of knowledge and technology has made mankind more productive than ever. There is little reason to believe such progress will end — even if it has been slowed down for the moment. Mandel continues:

“Historically, technological change has been the biggest force for productivity growth in the U.S. The latest figures show that ‘multifactor productivity’ — a category that includes technological change and other improvements in business processes — accounted for 45% of productivity gains between 1987 and 2007. ‘Ninety-five percent of economists agree that innovation is the most important thing for long-run growth,’ says Acemoglu of MIT. What’s more, the best way to keep the U.S. competitive is to bank on promising new ideas. America still is a leader in resources devoted to innovation, as measured by the share of gross domestic product spent on R&D and higher education. But it can’t compete with China, India, and other developing countries on labor costs. And it’s unlikely the U.S. can depend on cheap capital because it borrows so much money from overseas. Indeed, personal, corporate, and government savings combined total only 14% of GDP in the U.S., vs. an average 22% among other industrialized nations.”

American’s should certainly understand by now that their lavish spending habits (mostly on credit) and poor saving habits contributed to America’s current financial woes. They helped feed corporate greed and corruption by trying to live beyond their means. The fact that wages stagnated while investment bankers and corporate executives filled their personal treasuries using questionable, if not criminal, practices certainly were contributing factors. Because jobs in new sectors didn’t develop to replace the manufacturing jobs being lost to globalization and automation, people began pointing to free trade as the culprit. Mandel, however, wonders why innovation failed to create the brave new world that futurists predicted.

“While some info tech corporations are still thriving, other sectors that were supposed to drive growth have faltered. Biotech companies have produced new drugs, but so far no real breakthroughs. And nanotechnology has been slow to generate commercial products. Worse, the historic link between jobs and innovation seems to have vanished, at least for now. In the past, pioneering industries such as automobile manufacturing and aerospace were big job creators. Today, jobs in cutting-edge sectors are down 12% since their 2001 peak. (Those industries include computer and communications hardware, software and computer-systems design, aircraft, drugs and medical devices, telecom, and Internet outfits such as Google and Yahoo!) Until recently, economists had few good remedies when innovation stopped producing enough tangible benefits. Thats because technological progress — the discovery of penicillin or the invention of the laser — was viewed mainly as the product of science and serendipity, and therefore not very responsive to economic forces. As a result, economists had only one blunt tool for stimulating innovation: larger government research grants and tax breaks for businesses. Economists for the most part treated R&D spending as an investment in a physical asset, just like an office building or truck.”

Mandel believes that the inability of mainstream economists and policymakers to understand the underlying connection between innovation and economic growth is what has caused the unexpected lack of growth in new sectors. He points out, however, that there have always been a few visionaries around who did understand the connection.

“In the 1940s, Joseph Schumpeter of Harvard University coined the phrase creative destruction to describe the necessary turmoil caused by innovation. Robert Solow of MIT won a Nobel Prize for economics for his work on technological progress and growth. And Dale Jorgenson of Harvard and William Baumol of New York University have been mentioned as potential Nobel laureates for their work in areas such as technological change and entrepreneurship. Economists began taking a broader interest in innovation during the New Economy boom of the 1990s, which was driven by breakthroughs in information technology. At the same time, economist Paul Romer, now at Stanford University, showed how spending on innovation was different from the usual sort of capital investment because the gains from new ideas and discoveries could be shared by everyone. Today, researchers are focusing on ways to make those undertakings more efficient. ‘Innovation is not just exerting effort and spending money, it’s problem-solving,’ says Karim Lakhani, a professor at Harvard Business School. Lakhani has been studying what is called distributed innovation, in which solutions to a business or technical problem are solicited from a wide variety of people. Open-source software or companies like InnoCentive, which encourages outside researchers to work on corporate problems, are good examples. By contrast, most companies are unwilling to draw on outside expertise. ‘It’s the broadcast of the problem that is important,’ argues Lakhani. ‘By publicizing a problem, we can get access to better ideas.’ Lakhani is encouraged by the growing number of prizes for innovative products, such as the Progressive Automotive X prize ($10 million for a car that gets 100 mpg). However, offering more—and smaller—prizes would allow a wider range of people to take on a challenge, he argues. ‘We want diversity of eyeballs.'”

I am a big fan of getting a “diversity of eyeballs” focused on problems. This is centerpiece of an approach I’ve discussed before — an approach that Frans Johansson calls the “Medici Effect.” If you want to read a bit more about the other approaches Mandel discusses see my posts entitled A New Approach to Innovation, More Prizes for Innovation, Dating Game for Innovation and Participatory Innovation. The flow of ideas has become one of the important flows of globalization (along with the flows of capital, resources, and people). Mandel picks up on this theme.

“One way to attract broader attention to a problem is to conduct more R&D overseas. In part, that’s because scientists and engineers in India, China, and Eastern Europe are cheaper than their American counterparts. In addition, global collaboration can improve results by bringing in more diverse perspectives. But globalizing research and production can also alter the direction of technological change — with potentially negative effects on U.S. prosperity. MIT’s Acemoglu, who holds dual American and Turkish citizenship, argues in his work that in the past U.S. companies directed their research to take advantage of the well-educated American workforce. Now, as more multinationals move operations overseas, they are developing technologies adapted for their less skilled foreign workforces. In other words, offshoring is affecting the direction of innovation in ways that are more favorable to countries such as China and India. In particular, says Acemoglu, ‘China is going to have a major effect on technology.’ Measuring the impact of outsourcing and other factors on innovation will require far better statistics than are now available. That’s why the NSF is pushing hard to collect greatly improved data on R&D and innovation, a tough task.”

I’m a little surprised that MIT’s Daron Acemoglu discusses innovation as though it were a zero-sum game (i.e., “globalizing research and production can also alter the direction of technological change — with potentially negative effects on U.S. prosperity”). Globalization has been a driver of prosperity that has lifted all nations. There have certainly been winners and losers in certain industries, but billions have risen out of poverty to become productive middle class consumers. It is those very emerging market consumers who have helped keep the U.S. economy in better shape than it would have been during the current financial crisis and who have helped reduce America’s trade deficit. Any innovation that helps create more middle class workers will, eventually, be good for everyone — including the United States. Mandel concludes his article by examining how the U.S. Government can help foster innovation.

“What kinds of policies can improve the performance of U.S. innovation? Since 2000, the Bush Administration has boosted spending on nondefense R&D by roughly 40%, after adjusting for inflation. Still, more could be done. Democrat Obama wants to double federal funding for basic research, which in real terms is up just about 20% since 2000. Both the GOPs McCain and Obama want to boost support for the development of less polluting technologies. But a big point of innovation economics is that money alone is not enough. Atkinson, of the think tank ITIF, argues that the R&D tax credit needs to be reworked to encourage collaboration. He suggests giving companies credit on their tax returns for 40% of the money they spend on research partnerships with universities and government laboratories, not just for their increased spending, as the current law allows. Atkinson also advocates creating a national foundation, similar to the NSF, with the mission of promoting innovation. The idea has some support: In June, Senators Hillary Clinton (D-N.Y.) and Susan Collins (R-Maine) introduced legislation to set up a National Innovation Council. One of the hottest areas in the field is the use of government aid to cultivate ‘innovation clusters,’ or collections of local companies and academic institutions working together to create new products and processes. Ideally, those alliances would build on existing expertise in a region. Last November, for example, Maine voters passed a $50 million bond issue to help finance groundbreaking local business initiatives. In early August, grants totalling $29 million were announced, including funds to renovate a commercial pulp mill by adding a pilot plant to produce ethanol—without reducing the mill’s usual output. Will innovation economics keep America growing? Proponents are upbeat about the long-term technological possibilities, despite the current pullback. ‘Like the 1970s, people are going to assume that a short-term slowdown means the trend is slower as well,’ says Stanford’s Romer. ‘But the arguments for long-run optimism are as strong as they have ever been.'”

I have noted before that entrepreneurs are optimistic by nature. They believe in the future or they wouldn’t be entrepreneurs. I’m certainly no different. I see opportunities everywhere I travel. I get invigorated being around other entrepreneurs who also see a bright future and are working to make it happen. Innovators, whether found in established or entrepreneurial organizations, share a common bond of hope. I suspect that the reason that McCain and Obama have embraced innovation as part of their campaigns is that hope is in short supply at the moment. It remains to be seen whether the U.S. can invent its way out of the current financial downturn, but my gut tells me it can.