The Innovation Delusion

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This is a guest note by Ralph Gomory, one of the nation’s leading thinkers about technology, innovation, and the productivity health of national economies. Gomory previously served as IBM’s Senior Vice President for Science and Technology and subsequently as the immediate past president of the Alfred P. Sloan Foundation.
This essay first ran on The Huffington Post.

In the United States, innovation has become almost synonymous with economic competitiveness. Even more remarkable, we often hear that our economic salvation can only be through innovation. We hear that because of low Asian wages we must innovate because we cannot really compete in anything else. Inventive Americans will do the R&D and let the rest of the world, usually China, do the dull work of actually making things. Or we’ll do programming design but let the rest of the world, usually India, do low-level programming. This is a totally mistaken belief and one that, if accepted, will consign this nation to second- or third-class status.
The latest offender to advance this line of thought is Thomas Friedman, who has prominently displayed this familiar and entirely incorrect line of thought in the New York Times. Unfortunately, this idea is one that is widely accepted without careful thought about either its truthfulness or its consequences.
Truth and Consequences
Cheap labor abroad is cited as the incurable handicap that explains why the United States cannot compete. But cheap labor doesn’t explain the fact that Japan and Germany, both high-wage countries, are successful in the automobile industry. Nor does it explain how semiconductors, a model of a high investment, low-labor content industry, are mainly made in Asia. The premise that the inescapable burden of competing against low wages means failure is simply not correct.
Perhaps even more disturbing than the lack of truthfulness is the fact that we are not addressing the consequences of not competing. There are some inescapable truths about any economic good, be it a manufactured good or a service: (1) you either produce it in your own country, (2) you trade something you do produce for it, (3) you do without it, or (4) you import it and promise to pay later.
We are moving steadily away from producing what we need in this country. We are also moving away from producing on a scale that enables us to trade for what we do need. Rather than do without, we are increasingly importing things with a promise to pay later. This cannot go on. When our trading partners, especially China, no longer want to loan us hundreds of billions of dollars a year to be paid later, we will have little productive capacity left and we will be a poor nation.
Friedman is only the latest to assume that we can avoid this fate by emphasizing designs, ideas, and R&D and trading them for the items we need. This is an attractive idea; we often hear about innovation parks and university research centers and often their work is both exciting and good.
But the chasm-sized flaw in this otherwise alluring proposition is scale. Balancing trade on ideas and R&D simply cannot be done. The most elementary analysis shows that the scale is entirely wrong. As one who spent many years as the head of research of a large corporation, I know how much R&D matters; I also know how small it is. Eight percent is a very large percent of revenue to spend on R&D. Even in manufacturing, which is relatively R&D intensive, 4 to 5 percent is typical. It is really wrong to think that you can scale up R&D to be big enough so we can trade it for the huge quantity of things we need but don’t make in this country.
A Strange and Unworkable Strategy
Ignoring the issue of scale, Tom Friedman goes on to quote authoritative Chinese sources who say that by the end of the decade China will be dominating global production of the whole range of power equipment. To Friedman’s approving eye this just means that China is going to make clean power technologies cheaper for itself and everyone else. Friedman says that Chinese experts believe it will all happen faster and more effectively if China and America work together with the United States specializing in energy research and innovation, at which, he asserts, China is still weak, while China will specialize in mass production.
It is probably true that all this will happen faster with the specialization Friedman describes, but where will we be at the end of that process? China will be making power equipment cheaply, but the chasm is still there, so what will we have to trade for it? Power equipment will be cheap in China, but if we adopt this approach it may well be unaffordable in the United States.
Meanwhile the Chinese wisely welcome our nascent innovations and turn them into products. They are building plants, making things manufacturable, and adding them to their growing GDP. Friedman’s article contains an excellent example of this. He describes a U.S. developer with a new approach to solar-thermal power, whose proposal to the U.S. government asking for small scale support was easily outbid by a Chinese offer that was far larger and was aimed at much larger scale plants.
Specializing in R&D, but sending its fruits on to others is a strange and completely unworkable strategy for a nation.
Other Issues
Thinking of innovation as a standalone activity without production has other major flaws. First, our global corporations, understanding that innovation and production are in fact closely tied, are rapidly moving not only production but also R&D overseas. Intel’s CEO made this very clear when he said that the goal of Intel’s new plant in China is to support a transition from “manufactured in China” to “innovated in China”.
In addition, the standalone innovation approach leaves most Americans entirely out. After all, only a very small portion of Americans are engaged in R&D. At a recent meeting I heard “The only thing that matters is innovative and passionate people.” These people do matter, but they are very far from being the only ones. This attitude misses the point that it was all our people, working in many different work settings, that made this country prosper. And all of them will all be needed in any viable future for our country.
What We Must Do – The Role of Trade
We need successful industries and we need to innovate within them to keep them thriving. However, when your trading partner is thinking about GDP rather than profit, and has adopted mercantilist tactics, subsidizing industries, and mispricing its currency, while loaning you the money to buy the underpriced goods, this may simply not be possible.
The ability to compete in a world that is half-mercantilist, half-free is inescapably tied to effective trade policy. Our present policy is to beg. We ask countries like China to stop the subsidies and currency mispricings because they are creating a one-way flow of underpriced goods; goods that are destroying jobs on a large scale in many of the most productive sectors of our economy. But why should they stop? It’s working for them.
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We must move to balanced trade. With balanced trade every dollar of imports is matched by a dollar of exports of goods or services produced here in the U.S.A. We are fortunate that there are in fact ways to balance trade. One very attractive way is to adopt some version of Warren Buffet’s Import Certificates plan, which Buffet has described in a remarkably insightful Fortune article.
We should act now to balance trade. We should not continue to beg while jobs disappear and our productive ability erodes.
What We Must Do – Motivating our Companies
Today our companies are motivated to take innovations abroad, produce there and import the goods into the United States. Increasingly we can expect services also to go overseas. We must produce here in the U.S.A., to employ the people of this country, and we must keep their activities effective by a steady stream of innovations in design and production. While other countries roll out a welcome mat of tax breaks and subsidies for our companies because their common sense tells them that their people being employed in productive work is the road to being a rich country, we provide no incentive for U.S. companies to produce here.
We cannot continue to have our corporations, faithful only to the interests of their shareholders, engage in a one-way flow of jobs, technology, and innovation out of the country. We need to realize that with globalization the interests of our country and of our global corporations have diverged. We can realign the interests of corporations with those of our country by rewarding companies that are productive here. And that can be done in ways that are consistent with our history and with the limited capabilities of our government.
Conclusion
Specializing in innovation is an attractive idea, but a misleading one; an idea that blinds us to what we really need to do.
We need to do more than produce exciting new ideas; we must also be able to compete in large productive industries. This requires us to both balance trade and to motivate our corporations not only to innovate, but also to produce in this country. While this is hard to do, it can be done. Specializing in innovation, though often recommended, is in fact a delusion, an alluring path that in reality will lead us straight downhill.
— Ralph Gomory

Comments

10 comments on “The Innovation Delusion

  1. Jerry says:

    Amen. Excellent piece. Too bad nobody in Washington, DC, has the least intention of acting on recommendations like these.

    Reply

  2. tom fitzsimons says:

    Thank you. Adam Smith is rolling over in his grave
    at what we are calling the new wealth of nations.
    In the developed world, the primary export is money
    and no one talks about the fact that money is NOT a
    natural resource, or that we are selling our
    national soul and future well being for a cheaper
    today. We have become a nation of brokers hoping
    to take our piece before everyone else gets theirs.
    I don’t mind lifting others up, but not if I have
    to drown to do it. We are drowning in the debt we
    are creating for $7.99 tee-shirts. It’s dumb

    Reply

  3. Dirk says:

    All very good points, thank you for this article. Trade is good but only when it is fair trade that benefits both/all parties in multiple ways.
    A few of my own thoughts on the subject:
    A country that doesn’t manufacture goods will eventually be unable to sustain innovation because of lack of interest in engineering in that field.
    Trade agreements should include a core quotas which a country produces itself before any imports are allowed, for both security and to maintain knowledge of the production process.
    When the currency is high or overvalued it should be the industrial policy to import raw materials that can then be used to produce goods for export when the currency is lower in value. We should not be trying to lower the value of our currency but ride the waves of valuation.
    Germany does job sharing or lowering of hours to prevent layoffs in down times. This keeps people sharp and sustains them simultaneously. Additionally Germany sometimes has labor representatives on company boards which lowers ignorance of fiscal situations and lowers hostility in labor negotiations.
    Completely agree with Carroll’s point on wage differential being part of trade negotiations.

    Reply

  4. JohnH says:

    As Wigwag says, “there’s plenty of demand in the world for American debt.” Problem is that there’s not near enough demand for anything else American.
    And, since a huge chunk of China’s exports are generated by rogue American corporations, it’s time for the government to start using its powers of dissuasion to reign them in. But, as Don Bacon notes, it’s those same rogue corporations that have bought and paid for Congress.

    Reply

  5. Don Bacon says:

    Isn’t it difficult for a be-kind-to-corporations government to “get tough” with the countries who manufacture cheap goods for those same corporations? Getting tough with China means getting tough with Michael Dell’s principal manufacturing source.
    It seems to me that the uS government has actually done the opposite of getting tough, and that is to facilitate US job losses with trade, treaty and military sales offset policies. Now we’re asking these bought-and-paid-for politicos to do the opposite? Put jobs over corporate profits? Threaten their campaign contributions? Antagonize Dell and WalMart?

    Reply

  6. WigWag says:

    “However, when your trading partner is thinking about GDP rather than profit, and has adopted mercantilist tactics, subsidizing industries, and mispricing its currency, while loaning you the money to buy the underpriced goods, this may simply not be possible. The ability to compete in a world that is half-mercantilist, half-free is inescapably tied to effective trade policy.” (Ralph Gomory)
    This essay gets it precisely right; it’s time for the United States to get tough with China while we still can.
    At this point, vis a vis China the United States is holding all of the cards. There’s plenty of demand in the world for American debt; if China decided to shoot itself in the foot by diversifying its currency portfolio, there would still be lots of folks lining up to buy Treasuries. Besides, if China decides it wants more Euros, we should let them be our guest; we know that there will be a dollar five years from now; we don’t know that about the Euro.
    If China decided to look elsewhere what would that mean for Chinese exports? If the dollar declined in value because of Chinese actions what would that mean for China’s accumulated wealth? Even more importantly, wouldn’t a dollar that declined in value be a tremendous net plus for the American economy, especially for the manufacturing sector?
    While the U.S. may be holding most of the cards right now, that may not be true in the intermediate or long term. That’s why the time to get tough with China about its mercantalist trade policies and its currency manipulation is now.

    Reply

  7. JohnH says:

    “About time someone wrote this…” Yes, indeed.
    This problem has been around for more than 30 years. It’s only gotten worse as more goods, and especially services, can be produced overseas.
    The words “industrial policy” come to mind. And it will probably strike terror into the hearts of the corporatists.

    Reply

  8. Nigel says:

    About time someone wrote this, though I’d add I think there are
    hidden incentives, for instance for a corporation to outsource IT
    overseas it could be headcount. For manufacturing after hearing
    horror stories, it sounds accountant driven & often not looking at
    the full picture, but by the time it’s happened it’s to late.
    Where I think the article goes wrong, is by suggesting more
    regulation is a solution, I think it’s case examples, showing the
    real financial impact of these decisions, along with the emergence
    of facilitators like Cargill who work to help local industry survive,
    by exploiting local knowledge & distance to market.
    This is not just a US problem, I’d argue a extreme example is the
    UK & that should be a very sobering warning for US policy makers
    on where the US economy is heading.

    Reply

  9. Carroll says:

    Totally agree.
    BUT….I see nothing in Buffet’s IC plan that does anything to help create markets or buying ability for US products among those consumers in importing countries.
    Also in his certs plan ..you export one billion to us we export one billion to you….what’s the real deal? We export/sell a $100 million plane or two to VietNam A/L Inc. and other high end products and they export to us a
    billion in low priced consumer goods? What does that do? It may help the ‘deficit’ but it doesn’t do anything to spread or create jobs across the USA.
    Basically if we don’t create consumers who can afford whatever we would export on the IC’s…then what’s the point in terms of jobs in the US? We send expensive stuff to a few, they send billions in stuff for the masses.
    Nope, disappointed this is all Buffet has to offer in the way of ideas. IC’s are a lot like trading off pollution allowance certificates. It limits the pollution over all but does nothing for the areas getting the pollution.
    We need to stop wage and labor shopping by multinationals and raise wages in importing countries so they can buy our products. Give us a tarrif that pentalizes multinational, not native industry, importers based on the average wage and income re standard of living in the offshore countries the multinational operates in and perhaps we can raise their wages and their buying power for US goods. The higher their wages overseas the lower the tarrif goes.
    While also making the consumer choice between domestic and imported no more than 10 to 20% in cost in the US.

    Reply

  10. Don Bacon says:

    Excellent points on The Innovation Delusion. My son had a lucrative consulting business writing software for computer chip manufacturing machines — but the whole thing went East.
    Professor Gomory: “We are already using the corporate tax rate to spur R&D — why not use it to encourage directly the creation and retention of productive jobs? For example, the corporate tax rate could be scaled by the value added (a measure of productivity) per full-time employee in the United States.” — from linked article
    Paul Krugman wrote a classic article on value-added in 1994 entitled “COMPETITIVENESS- A DANGEROUS OBSESSION”. extracts:
    “. . .[The assumption is that] high value-added is more or less synonymous with high technology. .
    “It turns out [however] that the U.S. industries with really high value-added per worker are in sectors with very high ratios of capital to labor, like cigarettes and petroleum refining. (This was predictable: because capital-intensive industries must earn a normal return on large investments, they must charge prices that are a larger markup over labor costs than labor-intensive industries, which means that they have high value-added per worker).
    “Among large industries, value-added per worker tends to be high in traditional heavy manufacturing sectors like steel and autos. High-technology sectors like aerospace and electronics turn out to be only roughly average.”
    http://www.pkarchive.org/global/pop.html
    Any value-added incentive program has to done with care. Dell Computer has revenues of $61bn with 76,000 US employees, or nearly a million dollars of productivity per employee, a figure that is increasing as Dell continues to close US plants and move production overseas.

    Reply

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