Back in February, Commerce Secretary Gary Locke claimed that America needed to reduce its “innovation deficit” if it was going to spur job creation and reduce unemployment [“Erasing our innovation deficit,” by Eric Schmidt, Washington Post, 9 February 2010]. Schmidt, who is chairman and CEO of Google, asserts that Americans “have been world leaders in innovation for generations. It has driven [the U.S.] economy, employment growth and [America’s] rising prosperity. But much of the cutting-edge research and development in key areas such as renewable energy now takes place outside the United States.” Schmidt’s company, Google, was recently ranked the second most innovative company in the world (see my post entitled Innovative Companies). If it exists, erasing the innovation deficit won’t be easy because countries around the world aren’t standing around waiting for the U.S. to catch up. I’ll return to Schmidt’s recommendations for closing the deficit later.
Two articles in a recent edition of The Economist add weight to Schmidt’s concerns. The first article discusses new management trends originating in emerging market countries [“The new masters of management,” 15 April 2010]. The article reports:
“Management gurus are always glibly proclaiming revolutions. What happened [30 years ago] in Japan[‘s automobile industry] qualified, as did the advent of mass production in America a century ago. Now something comparable is taking place in the developing world. It is hardly news that the world’s center of economic gravity is shifting towards emerging markets. Buy a mobile phone and it will almost certainly have been made in China. Use it to phone a customer helpline and your call may well be answered by an Indian. … Emerging countries are no longer content to be sources of cheap hands and low-cost brains. Instead they too are becoming hotbeds of innovation, producing breakthroughs in everything from telecoms to carmaking to health care. They are redesigning products to reduce costs not just by 10%, but by up to 90%. They are redesigning entire business processes to do things better and faster than their rivals in the West. Forget about flat—the world of business is turning upside down.”
The Economist is not the National Enquirer. It doesn’t make bold statements like “the world of business is turning upside down” lightly. It explains why this statement is not hyperbole:
“The rich world is losing its leadership in the sort of breakthrough ideas that transform industries. This is partly because rich-world companies are doing more research and development in emerging markets. Fortune 500 companies now have 98 R&D facilities in China and 63 in India. IBM employs more people in developing countries than in America. But it is also because emerging-market firms and consumers are both moving upmarket. Huawei, a Chinese telecoms giant, applied for more international patents than any other firm did in 2008. Chinese 20-somethings spend even more time on the internet than do their American peers. Even more striking is the emerging world’s growing ability to make established products for dramatically lower costs: no-frills $3,000 cars and $300 laptops may not seem as exciting as a new iPad but they promise to change far more people’s lives. This sort of advance—dubbed ‘frugal innovation’ by some—is not just a matter of exploiting cheap labor (though cheap labor helps). It is a matter of redesigning products and processes to cut out unnecessary costs.”
Some of those innovations are finding their way into the developed world through a process that has been dubbed “reverse innovation” [for more information, read the article “The Joys and Perils of ‘Reverse Innovation,’ BusinessWeek, 5 October 2009 print issue]. The Economist article continues:
“Just as Henry Ford and Toyota both helped change other industries, entrepreneurs in the developing world are applying the classic principles of division of labour and economies of scale to surprising areas such as heart operations and cataract surgery, reducing costs without sacrificing quality. They are using new technologies such as mobile phones to bring sophisticated services, in everything from health care to banking, to rural communities. And they are combining technological and business-model innovation to produce entirely new categories of services: Kenya leads the world in money-transfer by mobile phone, for example.”
The article notes that this is particularly “good news for the billions of people who live in the BRICS and other developing countries.” Such innovations, the article concludes, are replacing fear with hope in emerging market countries. Since an emerging global middle class is essential for economic growth, innovations that create jobs, wealth, and hope are good for the rest of the world as well. Just because the developing world is starting to achieve some victories, it doesn’t mean that the developed world is losing; but, as Schmidt pointed out above, developed countries need to wake up to new realities. The BusinessWeek article continues:
“What about the slow-growth rich world? … Many of globalization’s most vocal supporters have justified the loss of manufacturing jobs in the West on the ground that the rich world will maintain an edge in innovation; the clever jobs will stay at home. Emerging economies are not merely challenging that lead in innovation. They are unleashing a wave of low-cost, disruptive innovations that will, as they spread to the rich world, shake many industries to their foundations. All sorts of chief executives will scream for protection. Change will indeed be painful for incumbents, as disruptive innovation always is. But cheaper goods and services will be a blessing for Western consumers, who are likely to face years of slow income growth. It could also be good news for rich-world governments, which are plagued with deficits even before the baby-boomers begin to retire. Frugal innovation may well prevent America’s health-care system (which already consumes 17% of its GDP) from swamping the rest of the economy. Clever ways of applying economies of scale and scope in new ways could boost public-sector productivity.”
The Economist concludes that emerging market innovation is a good thing because it “will encourage, rather than undermine, innovation in the rich world.” A second article attempts to explain why “countries that were until recently associated with cheap hands now becoming leaders in innovation” [“The world turned upside down,” The Economist, 15 April 2010].
“The most obvious reason is that the local companies are dreaming bigger dreams. Driven by a mixture of ambition and fear—ambition to bestride the world stage and fear of even cheaper competitors in, say, Vietnam or Cambodia—they are relentlessly climbing up the value chain. Emerging-market champions have not only proved highly competitive in their own backyards, they are also going global themselves. The United Nations World Investment Report calculates that there are now around 21,500 multinationals based in the emerging world. The best of these, such as India’s Bharat Forge in forging, China’s BYD in batteries and Brazil’s Embraer in jet aircraft, are as good as anybody in the world. The number of companies from Brazil, India, China or Russia on the Financial Times 500 list more than quadrupled in 2006-08, from 15 to 62. Brazilian top 20 multinationals more than doubled their foreign assets in a single year, 2006. At the same time Western multinationals are investing ever bigger hopes in emerging markets. They regard them as sources of economic growth and high-quality brainpower, both of which they desperately need.”
The article goes on to note that many emerging market countries have been spending their money on their most important resource — people. China and India continue to crank out graduates in science and engineering. As a result, “the world’s biggest multinationals are becoming increasingly happy to do their research and development in emerging markets.”
“Both Western and emerging-country companies have also realized that they need to try harder if they are to prosper in these booming markets. It is not enough to concentrate on the Gucci and Mercedes crowd; they have to learn how to appeal to the billions of people who live outside Shanghai and Bangalore, from the rising middle classes in second-tier cities to the farmers in isolated villages. That means rethinking everything from products to distribution systems.”
While there are enormous upsides to all of this activity in emerging market countries, there are also challenges.
“Anil Gupta, of the University of Maryland at College Park, points out that these markets are among the toughest in the world. Distribution systems can be hopeless. Income streams can be unpredictable. Pollution can be lung-searing. Governments can be infuriating, sometimes meddling and sometimes failing to provide basic services. Pirating can squeeze profit margins. And poverty is ubiquitous.”
Nevertheless, the article notes, “no visitor to the emerging world can fail to be struck by its prevailing optimism, particularly if his starting point is the recession-racked West.”
“The 2009 Pew Global Attitudes Project confirms this impression. Some 94% of Indians, 87% of Brazilians and 85% of Chinese say that they are satisfied with their lives. Large majorities of people in China and India say their country’s current economic situation is good, expect conditions to improve further and think their children will be better off than they are. This is a region that, to echo Churchill’s phrase, sees opportunities in every difficulty rather than difficulties in every opportunity. … This combination of challenges and opportunities is producing a fizzing cocktail of creativity. Because so many consumers are poor, companies have to go for volume. But because piracy is so commonplace, they also have to keep upgrading their products.”
The article continues with a reprise of the kind of concerns expressed by Eric Schmidt above.
“Until now it had been widely assumed that globalization was driven by the West and imposed on the rest. … This is changing fast. Muscular emerging-market champions such as India’s ArcelorMittal in steel and Mexico’s Cemex in cement are gobbling up Western companies. Brainy ones such as Infosys and Wipro are taking over office work. And consumers in developing countries are getting richer faster than their equivalents in the West. In some cases the traditional global supply chain is even being reversed: Embraer buys many of its component parts from the West and does the assembly work in Brazil. Old assumptions about innovation are also being challenged. People in the West like to believe that their companies cook up new ideas in their laboratories at home and then export them to the developing world, which makes it easier to accept job losses in manufacturing. But this is proving less true by the day. Western companies are embracing ‘polycentric innovation’ as they spread their R&D centers around the world. And non-Western companies are becoming powerhouses of innovation in everything from telecoms to computers. The very nature of innovation is having to be rethought. Most people in the West equate it with technological breakthroughs, embodied in revolutionary new products that are taken up by the elites and eventually trickle down to the masses. But many of the most important innovations consist of incremental improvements to products and processes aimed at the middle or the bottom of the income pyramid: look at Wal-Mart’s exemplary supply system or Dell’s application of just-in-time production to personal computers. The emerging world will undoubtedly make a growing contribution to breakthrough innovations. … But the most exciting innovations … [will include] smarter ways of designing products and organizing processes to reach the billions of consumers who are just entering the global market.”
Schmidt argues that it is time to compete not concede. He offers five recommendations to help the U.S. reduce the so-called innovation deficit:
“First, start-ups and smaller businesses must be able to compete on equal terms with their larger rivals. They don’t need favors, just a level playing field. Congress should ensure that every bill it passes promotes competition over protecting the interests of incumbents.
“Second, encouraging risk-taking means tolerating failure — provided we learn from it. If we want to be a leader in new industries such as green energy, we have to accept that some of our investments won’t pan out. Show me a program with a 100 percent success rate, and I’ll show you one with 0 percent innovation.
“Third, we need to invest more in our knowledge base. The decision by Congress to double science funding last year was a big step in the right direction. Now we need to extend the R&D tax credit so businesses can confidently invest in their future.
“Fourth, information must become even more open and accessible. Government-funded research should be made public through ‘a Wikipedia of ideas,’ so entrepreneurs can harness ideas commercially. High-speed Internet access must be much more widely available. Broadband is a major driver of new jobs and businesses, yet we rank only 15th in the world for access. More government support for broadband remains critical.
“Finally, we need to hang on to talented people. The best and brightest from around the world come to study at U.S. universities. After graduation, they are forced to leave because they can’t get visas. It’s ridiculous to export such talent to our competition.”
None of Schmidt’s ideas are really new. The fact that he has to reiterate them, however, is telling. If the government and/or companies were actually acting on these and other recommendations, Schmidt wouldn’t be so concerned and The Economist wouldn’t be focusing on innovation in developing countries. America is by no means a wasteland when it comes to innovation; but, it also can’t rest on past laurels. I’ve averred in the past that America’s future depends on fostering a climate of innovation and entrepreneurship. This is more true today than ever. If the U.S. is going to avert a debt meltdown like the one affecting Greece, it must focus on creating a sustainable and growing economy that can pay that debt down.