The Two Innovation Economies: Frontier and Follower

INET Conference
Hong Kong, April 4, 2013


For 250 years, technological innovation has driven economic development. But the economics of innovation are very different for those at the frontier versus the followers who are striving to catch up.

At the frontier, the innovation economy begins with discovery and culminates in speculation. From scientific research to identification of commercial applications of new technologies, progress has been achieved through trial- and error and error.  In between, the strategic technologies that have repeatedly transformed the market economy – from railroads to the internet – required construction of networks whose value in use could not be known at the outset of their deployment.

Consequently, innovation at the frontier depends on sources of funding decoupled from concern for economic value. The other side of that speculative coin is that these processes cannot be reduced to the optimal intertemporal allocation of resources. The conventional production function of neoclassical economics, that is to say, offers a dangerously misleading lens through which to read the processes of frontier innovation. They cannot be reduced to the optimal intertemporal allocation of resources.

Financial speculation has been, and remains, one of the required sources of finance.  Investment bubbles have arisen wherever liquid markets in assets have existed. The objects of speculation challenge the imagination: tulip bulbs, gold and silver mines, real estate, the debt of new nations, corporate securities. 

Occasionally, decisively, the object of speculation has been one of those fundamental technologies – Canals, Railroads, Electrification, Radio, Automobiles, Micro-electronics, Computing, the Internet -  for which financial speculators have mobilized capital on a scale far beyond what “rational” investors would provide. And from the wreckage that inevitably followed, a succession of new economies emerged.

Complementing the role of speculation, activist states have played multiple roles in encouraging innovation.  They have been most effective when pursuing politically legitimate missions that transcend narrow economic calculation: national development, national security, conquering disease.

In the U.S., the state variously constructed transformational networks (the interstate highway system), massively subsidized their construction (the transcontinental railroads) or played the foundational role in their design and early development (the internet).   Activist states around the world have funded upstream science and served as early customers for the novel products that result. For one crucial example, the U.S. Department of Defense combined both roles over a quarter of a century, starting in 1950, to build the foundations for the digital economy that the entire world is still learning to explore and extend

For those nations following the innovative leader, the path is clear.  Mercantilist policies of protection and subsidy have been the effective instruments of an economically active state, deployed in support of private exercises in the economics of imitation.   Through the nineteenth century, America’s multi-generational effort to catch up with Britain began with the appropriation of British intellectual property: the first profitable American textile mills blatantly violated British patents. And ferociously entrepreneurial private enterprise was supported by a broad array of state investments, guarantees, and protective tariffs in accord with the “American System” advocated by Alexander Hamilton and Henry Clay.

The great, neglected German economist, Friederich List, laid out an innovation road map for his own country in his National System of Political Economy. It has been put to repeated and successful use: by Japan beginning in the last decades of the nineteenth century, then by the emergent Asian Tigers in the second half of the twentieth century and now by China. 

List actually reached back to record how Britain’s emergence as “the first industrial nation” at the end of the eighteenth century depended on prior state policies to promote British industry, from the sixteenth century Tudors through the seventeenth century Commonwealth. As List wrote: “Had the English left everything to itself…the Belgians would be still manufacturing cloth for the English [and] England would still have been the sheepyard for the [Hanseatic League],” exporting wool to Flanders and buying it back in the value-added form of woolen textiles.

Coherent programs to accelerate economic catch-up are relatively straightforward.  But the transition from follower to leader at the frontier of the innovation economy is more challenging and elusive.  The U.S. managed the transition between roughly 1880 and 1930, combining the professionalization of management with a speculative taste for new technologies – electrification, automobiles, radio – and state tolerance of the great industrial monopolies spawned by the second industrial revolution that invested their excess profits in scientific research.  The post-World War II invocation of national security as the legitimizing rationale for an economically active state extended America’s leadership.

It is not yet clear whether the economic powerhouses of East Asia will succeed in making that transition from follower to frontier.  First of all, the same “national champions” that were the vehicles for economic development during the catch-up phase must be rendered accessible to competitive assault.

More generally, the role of the state must shift from executing well-defined, proven programs to funding upstream research and supporting trial-and-error experimentation, while tolerating entrepreneurial failure. And the debilitating “corruption tax” that seems inevitably to accompany economic revolutions must be curbed, as it was in Britain during the nineteenth century and America during the twentieth.

So we have arrived at a moment of strategic uncertainty.  The digital new economy that was “made in America” exhibits ample momentum in the private sector.  But leadership of the next new economy – the low carbon economy – is open.  America is suffering the consequences of a generation-long effort to render the state illegitimate as an economic actor.  Europe is mired in its self-contradictory commitment to “expansionary fiscal austerity.” 

Can China manage the economic, cultural and political transitions necessary to assume and hold the leadership role now up for grabs? I find it intriguing to reach back almost two hundred years, to consider the state of Britain’s political economy when the First Industrial Revolution was gathering steam, as one might put it.

England in 1820 was governed by a corrupt oligarchy whose authority was exercised across the country in intimate collaboration with a national religious establishment.  Political legitimacy was validated by the fear of anarchy, the terrifying reality of which had been observable across the Channel within living memory.  Arbitrary, draconian repression was the rule: under the “Bloody Code” of criminal justice, more than 100 felonies were definitionally punishable by death or transportation.  And the patent system was notoriously expensive and inaccessible.

Those who ruled England were seeking to hold the lid on the greatest explosion of economic energy and financial wealth in human history.  And, over a long generation from the 1820s, England was transformed in multiple dimensions, from the “Old Corruption” derided by William Cobbett to the High Victorian order celebrated by Anthony Trollope.

From the Great Reform Act of 1834 to repeal of the Corn Laws in 1846 and on to the Northcote-Trevelyan civil service reforms initiated in 1853 and the radical Representation of the People Act of 1867, Britain followed its own unique path towards a relatively stable and sustainable democratic capitalism that could survive the disruptive consequences of successive waves of Creative Destruction.

No doubt China’s own path forward will be as distinctive and path-dependent as were the processes through which it reached this extraordinary time of opportunity and challenge.  Will that path prove to be as constructively progressive as was England’s those long generations ago?  Leadership of the Frontier Innovation Economy turns on the answer.