The Good, the Bad, the Ugly, and the Self-destructive of Innovation Policy:

bridges vol. 28, December 2010 / Feature Articles

By Stephen Ezell



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Innovation has become the central driver of economic growth and thus a key focal point of countries' economic development strategies as they seek to gain global competitive advantage. In fact, no fewer than three dozen countries have now created both national innovation agencies and strategies designed specifically to link science, technology, and innovation with economic growth. These countries' innovation strategies seek to align their policies toward skills, scientific research, information and communications technologies (ICTs), tax, trade, intellectual property (IP), government procurement, standards, and regulations in an integrated and coordinated approach designed to drive economic growth through innovation.

However, countries' focus on innovation creates both global opportunities and threats, because countries can implement their innovation strategies in either constructive or destructive ways. As Figure 1 shows, countries can implement their innovation policies in ways that are either: 1) "Good," benefiting the country and the world simultaneously; 2) "Ugly," benefiting the country at the expense of other nations; 3) "Bad," appearing to be good for the country, but actually failing to benefit either the country or the world; or 4) "Self-destructive," actually failing to benefit the country but benefiting other countries.  

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Figure 1: The Good, the Bad, the Ugly, and the Self-destructive of Innovation Policy



For example, "Good" innovation policies include countries' increasing investments in basic scientific research, openness to high-skill immigration, effective science, technology, engineering, and math (STEM) education practices, and promotion of ICT deployment and adoption. Countries' "Good" innovation policies are positive for the world, as discoveries, inventions, and innovations made in one nation ultimately spill over to the benefit of citizens worldwide. Countries' "Ugly" policies include those, such as forced IP transfer or domestic sourcing of production as a condition of market access, designed to benefit themselves to the detriment of others. "Bad" policies are those such as import substitution industrialization or restrictions on foreign direct investment (FDI), that a country believes will help it, but that in fact do more harm than good to the country's economy. Finally, "Self-destructive" innovation policies, such as a country turning away high-skill immigrants or raising corporate taxes so high that multinational corporations relocate elsewhere, are those that hurt a country while actually benefiting others.

Yet notwithstanding the fact that countries can readily implement a range of "Good" innovation policies, there is disturbing evidence that the global economic system has become increasingly distorted as a growing number of countries embrace what might be called "innovation mercantilism" (or "technology mercantilism"), as they seek to realize innovation-based growth through a negative-sum, beggar-thy-neighbor, export-led approach. These countries' approach is based on the view that achieving economic growth through technology exports is preferable to achieving economic growth by raising domestic productivity levels through genuine innovation. Such nations, of which China is the most prominent, are not so much focused on innovation as on technology mercantilism, specifically the manipulation of currency, markets, standards, IP rights, etc., to gain an unfair advantage favoring their technology exports in international trade. Their goal is not to increase the global supply of jobs and innovative activity, but rather to induce their shift from one nation to another. They accomplish this by using their trade and innovation policies to help their manufacturing and ICT sectors move up the value chain toward higher-value-added production by applying a number of trade-distorting measures.

Ideally, countries' innovation policies should address all points along the innovation value chain: These include products, services, business and production processes, organizational models, and business models, as well as different points in the innovation process, from conception, R&D, transfer (the movement of the "technology" to the production organization), production and deployment, and marketplace usage. But far too many countries place the vast majority of their innovation focus on supporting the manufacturing and export of internationally tradable technology products, while giving short shrift to their domestic services industries. Indeed, building their economies around high-value-added, export-based sectors, such as high-tech or capital-intensive manufacturing, appears to be the path that nations such as China, Germany, Indonesia, Malaysia, Russia, and others are following, as did Japan and the Asian tigers (Hong Kong, Singapore, South Korea, and Taiwan) before them. These countries place a dominant focus on tradable goods exports - often abetted by mercantilist practices - as their path to economic growth.


Countries' innovation mercantilist practices

Indeed, a number of "Ugly" and "Bad" innovation practices pervade countries' currency, trade, tax, IP, government procurement, and standards policies. Perhaps the most pervasive and damaging mercantilist practice is the rampant and widespread currency manipulation many governments engage in today. Countries manipulate their currencies, either by pegging them to the dollar at artificially low levels or by propping them up through government interventions, in an attempt to shift the balance of trade in their favor. Mercantilist countries' artificially low currencies are a vital component of their export-led growth strategies, making their exported products cheaper and thus more competitive on international markets while making foreign imports more expensive; the overall intent is to induce a shift of production from more productive and innovative locations to less productive and innovative ones.

For example, the Peterson Institute for International Economics argues that China undervalues the renminbi by about 25 percent on a trade-weighted basis and by about 40 percent against the US dollar. This subsidizes all Chinese exports by 25-40 percent, while placing the effective equivalent of a 25-40 percent tariff on imports. China's government strictly controls the flow of capital into and out of the country, as each day it buys about $1 billion in the currency markets, holding down the price of the renminbi and thus maintaining China's artificially strong competitive position. Such currency manipulation is a blatant form of protectionism. Nor is China alone. Hong Kong, Malaysia, Singapore, South Korea, Taiwan, and even Switzerland - in part in an effort to remain competitive with China - also intervene in currency markets and substantially undervalue their currencies against the dollar and other currencies.

Despite the substantial focus placed by the international trading system over the past several decades on removing tariff barriers, a number of countries, including signatories to landmark agreements such as the World Trade Organization's (WTO's) Information Technology Agreement (ITA), continue to place onerous tariff barriers on high-tech products and services. For example, India imposes tariffs of 10 percent on solid-state, non-volatile storage devices; semiconductor media used in recording; and television cameras, digital cameras, and video camera recorders. Malaysia imposes duties of 25 percent on cathode ray tube monitors and the Philippines imposes tariffs of up to 15 percent on telephony equipment and computer monitors. Countries that have not acceded to the ITA place even higher tariffs on ICT products. China - despite its massive trade surplus with the rest of the world, and although it has entered into an ITA-accession protocol - places 35 percent tariffs on television cameras, digital cameras, and video recorders; 30 percent tariffs on cathode ray tube monitors; and 20 percent on printers and copiers. Even the European Union (EU) moved to advantage its domestic ICT producers when it sought to rewrite the description of certain ICT goods to circumvent their coverage under the ITA with its 2005 announcement that it would apply duties on LCD TVs larger than 19 inches, a move since overturned by the WTO.

One of the most insidious forms of innovation mercantilism concerns outright intellectual property theft. Yet many countries continue to pilfer others' IP because it's easier than making expensive investments themselves and because, at least in the short term, IP theft works. Research from Gene Grossman and Elhanan Helpman shows that IP theft actually does help countries in the short run. However, IP theft stifles incentives to embark on home-grown technology development, thus hurting countries over the long run. (In other words, IP piracy or forced transfer is an "Ugly" strategy in the short run, but a "Bad" strategy in the long run.) For example, in 1999 Brazil passed its Generics Law, which allowed companies to legally produce generic drugs that are perfect copies of patented drugs, a clear violation of the WTO's Trade-Related Aspects of Intellectual Property Rights (TRIPS) Agreement. While Brazil's policy has nominally helped its consumers by forcing foreign pharmaceutical companies such as Abbott Laboratories to sell drugs significantly below market prices, not only do the countries producing the drugs suffer, but the rest of the world suffers because less pharmaceutical R&D is conducted and, therefore, fewer drug discoveries made. Moreover, Brazil's insistence on tampering with intellectual property rights has damaged the development of its pharmaceuticals industry and discouraged FDI in the country, redirecting it to other countries such as Mexico and South Korea - an example of a "Self-destructive" innovation policy. Likewise, evidence shows that the lack of effective protection for IP rights in China has limited the introduction of advanced technology and innovation investments by foreign companies.

Standards have become increasingly important because they directly affect at least 80 percent of world trade and because they are ubiquitous in ICT products and services. Yet nations are increasingly using mandatory standards as a mercantilist tool to block or limit foreign companies' access to their markets and to support domestic industries, especially ICT industries. For example, despite the growing number of international ICT standards that most countries have adopted through a regular, open, industry-led standards-setting process, China is currently trying to establish its own domestic standards, several of which the country is seeking to make compulsory for products sold in China. Such practices are unfortunate, because the OECD estimates that complying with country-specific technical standards can add as much as 10 percent to the cost of an imported product.


Why countries employ mercantilist practices

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Countries employ mercantilist policies because they hold one or more of the following beliefs: 1) that goods, particularly tradable goods, constitute the only real part of their economy; 2) that moving up the value chain, particularly through innovation, is the primary path to economic growth; 3) that they should become autarchic, self-sufficient economies; or 4) that mercantilist policies actually do work.

Many nations believe that goods constitute the only real part of their economy through which they can drive a growth multiplier, and therefore view exports and large trade surpluses as good in and of themselves (and imports bad) as targets of economic policy. Furthermore, these nations believe that the primary path to economic growth lies in moving up the value chain from low-wage, low-value-added industries to high-wage, high-value-added production. Many of these countries are willing to engage in what is essentially predatory pricing on international markets, accepting short-term losses in order to grow long-term production. By so doing, they hope to erode the production base of advanced industrial nations, with the goal of ultimately knocking industry after industry out of competition in order to reap long-term job gains.

Some countries pursue mercantilist strategies out of a desire to realize national economic self-sufficiency. China's current economic strategy could perhaps best be described as autarky - a policy of becoming fully economically self-sufficient and free from the need to import goods or services, especially high-technology ones. Chinese policy appears to be to identify every flow of money exiting the country and shut off the spigot, an ambition evident in China's efforts to establish a domestic base of commercial jet aircraft production and in its desire to establish indigenous standards across a range of technologies so it need not make royalty payments on IP embedded in foreign technology standards.

But the primary reason countries pursue mercantilist strategies is their belief that they work. Some, including many in Western capitals still subscribing to a neoclassical economics-based view of the world, argue that mercantilists only hurt themselves. But the reality is that while some mercantilist policies do backfire and end up hurting the countries using them (the "Bad" and "Self-destructive" policies), many mercantilist practices actually work (the "Ugly" ones) and help these countries gain a competitive advantage - at least temporarily. China's "Ugly" practices, such as currency manipulation and forced IP transfer, have clearly boosted the country's exports, moved productive activity to its shores, and hurt foreign producers. The "success" of China's mercantilist practices is reflected in the country's share of world exports jumping from 7 percent to 10 percent between 2006 and 2010, the country's $400 billion and $426 billion current account (trade) surpluses in 2007 and 2008, respectively, and its accumulation of $2.65 trillion of foreign currency reserves. This creates a vicious cycle. Seeing the success of some countries' mercantilist practices, others are enticed - even compelled - to introduce similar practices.

 
Why innovation mercantilism is a fundamentally flawed strategy

Yet mercantilism is a fundamentally flawed strategy, healthy neither for the countries that practice it nor for the rest of the world. The flaws in technology mercantilism policies are:

  • They are fundamentally unnecessary and counterproductive; countries have much more effective means to drive economic and employment growth at their disposal;
  • They look to the wrong place for economic growth; neglecting the far greater and more sustainable opportunity to drive economic growth by raising productivity across-the-board, particularly in non-traded sectors, and particularly through the application of ICTs. In fact, mercantilist policies often imperil the health of these sectors;
  • They are unsustainable, both for the country and for the world;
  • Many, especially those distorting ICT and capital goods sectors, are "Bad" and fail outright;
  • They contravene commitments countries have elected to accept in participating in global trade agreements and undermine faith in the international trading system;
  • They lower global innovation and productivity.

Mercantilist countries - and the apologists who defend them - argue that the only way they can grow is through high-value-added exports that run up massive trade surpluses as if they were collecting gold bullion, but the notion that the only way to achieve a full employment economy is by manipulating the trading system to run ever-growing trade surpluses is flat wrong. It contradicts basic macroeconomics, which observes that a change in GDP equals the sum of the changes in consumer spending, government spending, corporate investment, and net exports (exports minus imports). In other words, mercantilist countries could grow just as rapidly, probably even more so, by pursuing a robust domestic expansionary economy that drives growth through increased domestic consumption and greater business or government investment.

Moreover, large sustained trade surpluses do not leave a nation's citizens better off; rather they leave citizens poorer. For example, China ran up a $426 billion global trade surplus in 2008. But this surplus hurt, not helped, China's living standards because it represents $426 billion of value that China transferred outside its borders; thus, China's residents are actually poorer by this amount. In fact, if China hadn't run up this trade surplus, the average Chinese household would have seen a 17 percent increase in its disposable income. In aggregate, this is an enormous figure; China could produce a dramatic increase in its citizens' standard of living if only it invested its surplus on products and services such as medical devices, construction equipment, and ICT products and services, which could increase the quality of life of its citizens. This would simply require that China spend its would-be surplus on imports instead of on US Treasury bills.

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Productivity growth is the most important measure and determinant of a nation’s economic performance.

In effect, mercantilist countries mistakenly believe that promoting exports rather than increasing productivity across-the-board is the superior path to economic growth. Yet it is productivity growth - the increase in the amount of output produced by workers per a given unit of effort - that is the most important measure and determinant of a nation's economic performance. Indeed, the lion's share of productivity growth in most nations - especially large- and medium-sized ones - comes not from altering the sectoral mix toward higher-productivity industries, but from all firms and organizations, even low-productivity ones, boosting their productivity. Put succinctly, the productivity of all of a nation's sectors matters more than a nation's mix of sectors, which means that mercantilist countries could grow more reliably and sustainably if they focused on raising the productivity of all sectors of their economy, not just propping up their export sectors.

Yet perhaps the greatest weakness of countries' mercantilist-based, export-led growth strategies is that they are unsustainable - for the world and for the country itself. First, the international economic system just can't sustain these strategies any longer. Neither markets in the United States nor Europe (minus Germany) - nor even both combined - are large enough if nations such as Brazil, China, Germany, Japan, and Russia continue promoting exports while limiting imports as their primary path to prosperity.

Second, a predominantly export-led growth focus is unsustainable for the countries themselves. For example, Japan boasts many world-leading exporters of manufactured products (e.g., Sony, Toyota, Toshiba, etc.) but because it has never really focused on the non-traded sectors of its economy, only about one-quarter of its economy is growth-oriented:  It can't boast any world-class service firms, it trails badly in the usage of ICTs, and it conspicuously lacks its own eBays, Amazons, and Googles. What  countries such as Argentina, China, Japan, India, and South Korea, who have been far more concerned with ICT production than ICT consumption, have missed is that the vast majority of economic benefits from ICTs  (as much as 80 percent) comes from their widespread usage across a range of industries, while only about 20 percent of the benefit of ICTs comes from their production. As MIT's Erik Brynjolfsson has eloquently noted, it's about how firms like Wal-Mart use ICT to revolutionize their industries, not where those ICT products were manufactured, that truly drives countries' productivity and economic growth. Yet most mercantilist countries have been more concerned with manufacturing and selling ICT (and other high-value-added) products than applying them to make their own domestic service industries more productive and competitive. Ultimately, countries relying predominantly on export-led strategies risk being a one-trick pony. They may reach the technological frontier and boost growth for a while, but they are liable to languish there or perhaps even decline, if global export markets become saturated and countries with more robust service sectors pass them by. Japan, with its current stagnation, is the poster child for this phenomenon.

For these reasons, mercantilist policies placing high tariffs or other import restrictions on general purpose technologies (GPTs) such as ICTs are purely "Bad" and fail outright. Such policies have the effect of raising the cost of domestic ICTs and making local industries that need to leverage ICTs less competitive. For example, as part of its import substitution industrialization strategy, India placed high tariffs on ICTs for many years in an effort to keep out foreign ICT products in order to spur creation of a domestic computer-manufacturing industry. But research has found that for every $1 of tariffs India imposed on imported ICT products, it suffered an economic loss of $1.30. Such policies only served to raise the price of ICTs for domestic players, inhibiting the diffusion of information technology throughout domestic service sectors such as financial services, retail, and transportation,  causing productive growth in these sectors to languish.  

Finally, mercantilist strategies are flawed because they contravene the established rules of the international trading system and because they undermine confidence in trade's ability to produce globally shared prosperity, thus reducing global consumer welfare. Moreover, these strategies retard growth in global innovation and productivity. For example, by stealing IP, countries reduce revenues that could have been invested in innovation. And by investing in technology transfer, rather than basic and applied sciences, countries fail to expand the global pool of scientific knowledge. Further, by forcing or providing incentives for firms to locate where they otherwise would not, mercantilist innovation policies raise total global production costs.

If an export-led growth strategy predicated on technology mercantilism is not the path to sustainable economic growth, what is? The answer is "innovation economics," which holds that the path to higher incomes lies in raising productivity by boosting innovation in all firms in all sectors. Indeed, raising the productivity of domestic non-traded sectors such as retail is not trivial and can have profound economic impacts. For example, even despite some extremely productive and innovative multinational firms, Japanese productivity overall is just 70 percent of US rates, while South Korea's productivity is just 50 percent of US rates. The gap is even greater for developing nations. Overall productivity in India is only 8 percent of US rates, while Chinese productivity is just 14 percent of US rates. India's retail goods sector productivity is just 6 percent of US levels, and the productivity of its retail banking sector just 9 percent of US levels. If India could raise productivity in those two sectors to just 30 percent of US levels, it would raise its standard of living by over 10 percent. Thus, attracting more high-value-added export firms is not likely to be the major path to growth in the long run; more benefit would be derived from boosting productivity in the vast swaths of the economy that are not traded internationally.


Getting innovation policy right

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Competition according to the rules of the international trade established by the global community.

To be sure, there is nothing sinister about countries engaging in fierce innovation and economic competition, and there is nothing wrong with countries competing to win - so long as they are competing according to the rules of international trade established by the global community. In fact, when a county intensely competes to win, within the rules of the system, doing so benefits both itself and the world. This is because fair competition forces countries to put in place the right policies on support for science and technology transfer, the right tax policies on R&D tax credits, the right corporate tax policies with lower tax rates, the right education policies, etc. So when the United States expands its R&D tax credit, or France trumps the United States by offering an R&D tax credit six times more generous, or Denmark creates innovation vouchers for small businesses, or the Netherlands and Switzerland tax profits generated from newly patented products at just 5%, or a country lowers its corporate tax rates because its public sector is so efficient, this is all tough, fair competition that forces other countries to raise their games in kind by enacting many "Good" policies of their own. The problem comes when countries start to cheat and contravene the global economy's established rules. These "Ugly" practices can indeed help countries win. But not only do such policies harm other countries, they then cause the system to devolve into a competition where every country has the incentive to cheat, and to beggar-thy-neighbor. And so the overall system decays, the competition becomes worse, and the global economy suffers as all countries fight for a slice of a smaller pie.


Implications for policy makers

Accordingly, it's time for the world collectively to move beyond perceiving the pursuit of economic growth through innovation among nations as a zero-sum game to embracing a perspective that views mutual global prosperity as the goal. A new approach to globalization is needed, one grounded in the perspective that markets drive global trade; that countries should adhere to their trade agreements; that genuine, value-added innovation drives economic growth; and that constructive competition forces countries to ratchet up their game by putting in place "Good" innovation policies that leave all countries better off.

At the end of the day, countries committed to "Good" innovation policies are going to have to abandon the notion that countries using mercantilist policies are going to play by the rules if we just play nice with them. The only way to stop countries' systematic manipulation to gain innovation-based competitive advantage is if the nations that engage in it less than others - principally the United States, the Commonwealth nations, and most European countries - along with international organizations such as the World Bank and the International Monetary Fund (IMF), agree to cooperate to fight it, not just to talk about it. There are several implications for policy makers.

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Countries committed to “Good” innovation policies are going to have to abandon the notion that countries using mercantilist policies are going to play by the rules…

First, policy makers - both in US and European capitals - must recognize that mercantilism constitutes a threat to the global trading system, which undermines public confidence in globalization's ability to deliver shared and sustained long-term prosperity. That's why it's critically important that policy makers are able to distinguish the "Good" innovation policies from the "Ugly" and "Bad" ones - so they can promote those that benefit countries and the world simultaneously, while pushing back against those that benefit some countries at the expense of others.

Second, it's imperative that the global economy be put on a more balanced and sustainable growth footing. This will require policy changes both from consuming and from producing nations. China, India, and most of the East Asian tigers, along with South American countries such as Brazil and Argentina, are too export-oriented and need to focus much more on raising their domestic sector productivity. For its part, the United States must begin working to balance its debt, curb its consumption, and raise the competitiveness of its traded export sectors, which have long withered without Washington caring. But the US proposal at the November G-20 summit in Seoul, South Korea, that sought to arbitrarily limit countries' trade surpluses to 4 percent of their GDP is not the right solution. Rather, the United States should: 1) field better innovation policies to compete more effectively, and 2) insist that markets, not governments, set currency rates so they can play their intended role of facilitating effective balance of payments adjustment. In that regard, it is good that the G20 summit reaffirmed its existing language on exchange rates, calling on countries to refrain from "competitive devaluation" and urging nations to move "towards more market-determined exchange-rate systems, enhancing exchange-rate flexibility to reflect underlying economic fundamentals." Nevertheless, given the continuing perilous state of the global economy, it is disappointing that the G20 summit did not result in a greater accord about addressing trade and exchange-rate imbalances, or any concrete movement beyond a loose timetable through 2011 for nations to agree on "indicative guidelines" on how to rein in growing current account surpluses and deficits.

Third, developed countries need to work alongside international development organizations to reformulate foreign aid and development assistance policies to use them as a carrot (and stick) to push countries toward the right kinds of innovation policies. Developed countries should insist that international development organizations both stop promoting export-led growth as a solution to development and also tie their assistance to steps taken by developing nations to move away from mercantilist policies, thereby rewarding countries whose policies are focused on spurring domestic productivity. Blatantly mercantilist countries engaging in IP theft, manipulating currencies, imposing significant trade barriers, etc. should have their foreign aid privileges and development assistance withdrawn by the international community.

At the same time, developed countries should do a much better job of supporting those countries wanting to field "Good" policies. Thus, the G20's failure in Seoul to offer the poorest countries duty and quota-free access to their markets (a proposal that was in the draft but not final communiqué) was a disappointment. However, the announcement at the summit of a "Seoul consensus for shared growth" that would update the erstwhile Washington Consensus with a renewed growth-related focus and emphasis on mobilizing domestic savings for infrastructure investment was a step in the right direction. Western countries should also continue trade-liberalization talks and push towards completion of the Doha trade round.

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Click here to download the full report of “The Good, the Bad, and the Ugly of Innovation Policy”.

At the same time, US and European trade policy must become more seriously geared to combating nations' systematic innovation mercantilism. One of the biggest challenges for US and EU trade policy is that it is structured to play "whack a mole." The US and EU expend enormous resources in the time-consuming process of identifying, responding to, and combating particular instances of foreign countries contravening international trade agreements to the detriment of their businesses (the actual harm from which must also be legally established). But US or European trade policy rarely rises to the level of broader principles, e.g., insisting that other countries "desist with this generalized practice." As a consequence of US and European trade policies being organized in a legalistic framework to combat unfair trade practices on a case-by-case basis, it becomes difficult for them to implement a comprehensive trade strategy designed to stimulate competitiveness and innovation.

If these measures prove insufficient, it may be time to think about establishing a new trade regime outside of the WTO, which would exclude nations that persist in the systematic pursuit of mercantilist policies that violate the principle of free trade. The Trans-Pacific Partnership could provide a model for how to organize such a new trade zone. The Trans-Pacific Partnership represents a vehicle for economic integration and collaboration across the Asia-Pacific region among like-minded countries - including Australia, Brunei, Chile, New Zealand, Peru, Singapore, Vietnam, and the United States - that have come together voluntarily to craft a platform for a comprehensive, high-standard trade agreement. The door would be open for all countries to participate, but those wanting to do so would have to fully renounce mercantilist practices and demonstrate genuine commitment to free trade principles.

Enough is enough. The stakes are too important for humankind. Trade, globalization, and innovation remain poised to generate lasting global prosperity, but only if all countries share a commitment to playing by the rules and fostering shared, sustainable growth. It's time to end innovation mercantilism and replace it with good innovation policy.

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Stephen Ezell (sezell[at]itif.org) is a senior analyst at the Information Technology & Innovation Foundation (ITIF), in Washington, DC, and coauthor, with ITIF President Robert D. Atkinson, of the October 2010 report, "The Good, The Bad, and The Ugly (and The Self-Destructive) of Innovation Policy: A Policymaker's Guide to Crafting Effective Innovation Policy."