Is China outstripping the West at innovation?

Conventional economic theory does a poor job of explaining the growth eruptions that transformed Western Europe during the 19th century and parts of Asia during the late 20th century, the Nobel Laureate Edmund Phelps argued in his 2013 book Mass Flourishing (Princeton, £19.95). Phelps’s book drew positive reviews but not enough thoughtful consideration. It challenges many of our prized assumptions about what makes economies succeed.

It is not scientific discovery, nor engineering skill, nor education, nor the astuteness of entrepreneurs that generates economic transformation, Phelps observed, although all of these elements are important. Rather, it is the willingness of the whole of society to plunge into “the topsy-turvy of creation, the frenzy of development” — to pull up stakes and move, to abandon old ways of doing things and try new ones, to abandon the safe harbor of the familiar and embrace novelty.

Phelps is closer in spirit to Paul Johnson’s 1991 study The Birth of the Modern than to any of the economic theorists. What he calls “mass flourishing” in contrast to ordinary economic growth stems from a radical change in attitudes and ideas through the whole of society. 

“The advent of the modern economy,” Phelps writes, “brought a metamorphosis: a modern economy turns people who are close to the economy, where they are apt to be struck by new commercial ideas, into the investigators and experimenters who manage the innovation process from development and, in many cases, adoption as well. In a role reversal, scientists and engineers are called in to assist on technical matters. In fact, it turns all sorts of people into ‘idea-men,’ financiers into thinkers, producers into marketers, and end-users into pioneers.”

Like Paul Johnson, Phelps dates Europe’s growth take-off from 1815. The scientific revolution and the Age of Navigation produced no dividends for ordinary folk until modernity enveloped Europe and turned whole societies into innovators. “The modern economies were not the old mercantile economies,” Phelps writes, “but something new under the sun.” 

The living standards of ordinary Europeans in 1800 were not much different from those of Roman or medieval times. But modernity brought “a cornucopia of material benefits”, Phelps observes. “By 1870, total domestic output per capita in Western Europe as a whole had risen 63 per cent above its 1820 level. By 1913, there was a further rise of 76 per cent.”

What was it about that unprecedented epoch of economic expansion that we have lost in what Phelps calls a “structural slump” in the mature industrial economies? Can we observe a comparable mass flourishing anywhere else in the world today? And can the industrial world accomplish this great transformation once again?

Economic policy, Phelps contends, suffers from bad theory. He disputes “the classic account by Arthur Spiethoff and Joseph Schumpeter of entrepreneurs jumping to make the ‘obvious’ innovations suggested by discoveries of ‘scientists and engineers’.” 19th-century determinism took economics down the wrong path, he believes: “The two pied pipers, Schumpeter with his scientism and Marx with his historical determinism, profoundly misled historians and the general public.” 

It wasn’t the scientists who made the industrial revolution, but humbler, enterprising men with grand ideas. “Nearly all the inventors, even the headliners, were not trained scientists, nor were they even particularly well educated. Watt was the exception, not the rule. Arkwright [who co-invented the water-powered spinning frame] was a wigmaker turned industrialist, not a scientist or engineer.” 

A nation’s potential to flourish comes first of all from its culture at the grass roots of society. It should be no surprise that Israel displays an exceptionally high degree of economic dynamism, with twice the venture capital investment per capita of the United States and 30 times that of Europe. Between 2002 and 2012, investors paid some $42 billion for 772 Israeli start-ups, and that was before Google bought Waze for $1.3 billion and Mobileye’s IPO raised the firm’s market capitalisation to $7.8 billion. Israel is poised for a wave of wealth-creation considerably greater than its success of the past decade. It is hard to meet an Israeli who does not have a business plan, and the country’s venture capital industry encourages entrepreneurs to compete for seed-capital funding.
 Many things make Israel prone to innovation. It thrives in a part of the world where first prize is the chance to compete for first prize next year, and second prize is, you’re dead. It is a nation of immigrants, and immigrants are innovators, in Palo Alto as well as Haifa. It absorbed nearly a million Russian immigrants during the 1990s, of whom 57,000 had worked as engineers-double the number of engineers in Israel before they arrived. With a population of seven million, Israel is a hothouse for startups. But it is hard to project Israel’s unique experience onto much larger economies.

America was the great engine of innovation during the 1980s and 1990s, home to most of the world’s cutting-edge technology firms. Between 1980 and 2000, it created 40 million jobs, mostly in startups. But total employment fell slightly between 2000 and 2010, and only regained its pre-recession peak in May 2014. What happened to America’s capacity to innovate? The problem, Phelps argues, lies in a shift to what he calls corporatism: the suppression of individual initiative and self-expression in favour of the social concerns now bundled together under the rubric of inequality. Excessive regulation, the taxation of emerging business through Obamacare, and other government-imposed burdens on enterprise stifled America’s animal spirits.

Part of the answer lies in slow but insidious change in the character of the technology sector itself. To an increasing extent, America’s technology firms are not innovators, but investors in patents whose purpose is to stifle innovation. According to William J. Watkins, Jr, author of Patent Trolls: Predatory Litigation and the Smothering of Innovation (Independent Institute, £10.49), many of America’s best-known tech firms have spent more money on acquiring and litigating patents in recent years than they have on research and development. In this view, shortening the tenure of patents is a critically-needed regulatory reform.

America’s technology companies today look and act like mature consumer franchises rather than innovators. A simple but robust gauge of their descent into stasis is equity price volatility, finance theory’s classic measure of market risk. Innovative firms trade with greater volatility than the overall market, which is to say that they have more upside as well as more downside than mature franchises. That was true of the technology subsector of the S&P 500 Index during the late 1990s and early 2000s: the volatility of this S&P sub-index was typically double that of the overall equity index, just what we would expect to observe.

By the late 2000s, though, the volatility of the tech sector is indistinguishable from that of the overall index. Microsoft and Cisco, the disruptive entrants of the 1990s, now bear the risk profile of a Procter & Gamble.

The internet promised to open new horizons for the market entrant with an unusual idea. The most successful internet companies in today’s America settle their users into familiar patterns of behaviour: Facebook, for example. Startups still proliferate, to be sure, but they accommodate themselves to the social-media giants like barnacles on a supertanker. There are many possible explanations for the dearth of disruptive innovation, from the technological to the demographic — ageing populations take fewer risks than younger ones — but the facts are indisputable.

Of all the world’s economies, China has seen the most disruption in the past generation. But China is at a crossroads, Phelps cautions: “While the world sees world-class dynamism, the Chinese discuss how to acquire the dynamism for indigenous innovation, without which they will be hard pressed to continue their fast growth.”

Between 1987 and 2013, household income in China rose 16-fold as the country’s population migrated from low-productivity rural employment to industrial jobs in the cities. China could not perpetuate a growth model dependent on exports fed by cheap labour even if it wished to: its reserves of rural labour are shrinking and wages are converging on the low end of the industrial world.

China has to innovate. How likely is it to succeed? To Westerners, Chinese culture appears conformist rather than individualistic, prone to copy rather than invent. When Deng Xiaoping began his industrialisation drive in 1978 China was better served by acquiring Western technology than inventing its own.

As a proportion of GDP, China’s R&D spending is now close to that of Western Europe, and the country has made impressive advances in dual-use technologies with military as well as civilian applications: computation, missiles, satellites, telecommunications and high-speed rail. If we follow Phelps’s logic, though, science and engineering are not the springboard for mass flourishing. We have to look to the character of society itself. The Western consensus leans towards pessimism about China.

It is true that the China of the Cultural Revolution was the most all-encompassing totalitarian state of which we know, where independent thinking bore with it existential risk. Precisely because China is emerging from an era in which conformity was imposed in the most brutal fashion, into a period where entrepreneurship is not only tolerated but encouraged, the change in China’s character is perhaps the most radical of any society in the world. The reforms undertaken by the new government of Xi Jinping may sink into a bog of cultural conformism. But they also might release the pent-up entrepreneurial energies of the most educated and confident generation in Chinese history. 

A dozen years ago Jack Ma, founder of Alibaba, a business-to-business trading platform, was teaching English at a government university. Entrepreneurs like Tencent’s Ma Huateng and Huawei’s Ren Zhengfei have created firms that are shaking the foundations of the Chinese economy, with the blessing of its government. Chinese universities may not produce as many prospective innovators as their Western counterparts, but Chinese firms are now hiring Western scientists and engineers by the thousand.

China has the benefit of the late adopter. Rather than laying fibre-optic cable into individual homes, China will provide free public wi-fi in every city and half its rural areas by 2020. The internet is becoming a free public good. China has showrooms rather than shopping centres: young people window-shop while ordering products on their smartphones. 

By 2017 China will have a national electronic system to track every citizen’s credit history, allowing internet finance to compute credit scores and grant retail credit in real time. The marginal cost of acquiring bank deposits will fall to zero. Jack Ma hailed internet banking as a disruptive innovation in the financial system. The Chinese authorities will slow but not stop the financial transformation — the existing state banks are an important source of employment — but the authorities support these changes. That is one way that China can move up the value-added spectrum and avoid stagnation.

Strewn around the periphery of the industrial city of Shenzhen is the detritus of the last wave of China’s growth, the remains of factories where migrant workers toiled 12 hours a day to fill Walmart’s shelves with cheap goods. In its centre, though, stands a science park that looks like Silicon Valley on steroids, full of new firms built by returning graduates of doctoral programmes at Western universities, intent on producing world-beating innovations. It’s impossible to gauge the macroeconomic impact of these challengers. But Chinese universities now turn out twice as many science and engineering PhDs as the US, not counting the tens of thousands trained abroad. The probability is that some of them will strike pay dirt. 

Nothing like China’s transformation has ever occurred in economic history, so there are no precedents from which to venture forecasts. But the grand sweep of social transformation now under way in China creates the preconditions for the kind of mass flourishing that Phelps describes. One example stands out: by 2025 China will have moved 600 million people from the countryside to cities, the equivalent of the whole population of Europe from the Urals to the Atlantic. It will build the equivalent of all of Europe’s cities to house them — another Seville, Dortmund, Kiev, Liverpool, Florence, Helsinki and so forth in little more than a generation.

It is a great migration of people hungry for wealth and eager to work for it unlike anything the world has seen. It has torn out the roots of traditional China and given hundreds of millions of people the impulse to innovate. We in the West chronically underestimate Asian competitors, as the Russians did at Port Arthur in 1904 and the British at Singapore in 1942. China may collapse of its own internal problems, as some Western analysts believe. Or it might become the prime case study in a future edition of Phelps’s book. The West should prepare for the latter eventuality rather than the former, and look towards reviving its own wellsprings of innovation.

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