What Innovation Advantage?

In our current don’t-worry-be-happy mode of economics, the tendency is to shrug off the growing competition from China, India and others. The story line goes like this – yes, they are low cost producers, but we’re the innovators and designers. Not so says Roger Martin, Dean of the Rotman Business School at the University of Toronto, in a provocative essay in the most recent issue of Business Week – “What Innovation Advantage?”:

There is a romantic notion in North American business that its future lies in design and innovation, while India and China will be the home of less skilled, lower-paying operations churning out the products and services the U.S. comes up with. It is a nifty twist on David Ricardo’s seminal 19th century theory of “comparative advantage,” which explained why cloudy and cool England exported woolen goods to sunny and hot Spain, which in turn exported wine to England.
The problem is that the theory didn’t ring true when I rode through the streets of Hyderabad, Bombay, and Bangalore on visits to major Indian companies. At Tata Consultancy Services’ 23-acre campus in Bombay, for instance, I learned about its central goal of providing customers with not just an acceptable-quality service but also a user experience that delights and surprises. To accomplish this, its tech professionals also are taught how to manage client change.
. . .<br
These globally oriented outfits are not entrusting all creativity, design, and innovation to "first world" opponents while they huddle over their workstations. True, they have staggering cost advantages over traditional competitors. But that doesn't mean they are incapable of design and innovation. (Their North American rivals just wish they were.) The Ricardian logic, based on so-called natural endowments, simply doesn't apply.
. . .
Assuming that capabilities are static and advantages are permanent is a mistake. Natural endowments of climate, location, and mineral resources may be enduring, but company-generated capabilities are quite fluid. It is as much an error to assume that competitors won’t attempt to develop a capability because it seemingly conflicts with an existing one — in this case low cost vs. innovation expertise. The general rule: If the opposite of a capability sounds stupid, competitors won’t try to acquire it — they’ll pursue the reasonable one. For example, the opposite of choosing to be “customer-oriented” is to elect to ignore your customers, a truly daft proposal.
Since lackluster design and staid conformity are obviously bad ideas, it is safe to assume that compelling design and potent innovation are going to be almost universally sought. So North American companies, many of which have pretty dreary design, are wrong if they assume their Asian rivals will pay no attention.

Professor Martin is right on target. While the future of competitiveness is in innovation and design, the US is not necessarily winning that fight. Nor is that high-end/low end division of labor turning out in our favor. Every month I publish in this blog an analysis of trade data in intangibles (which includes high-end professional services, royalties, fees, etc.). That data shows the US with a modest surplus of $6.9 billion – but one that has been essential flat. In other words, our small surplus in high-end services is not growing to cover our huge deficit in low-end goods. And the US has not had a surplus in advanced-technology goods since June 2002.
Policy makers need to wake up and understand that the future of the US economy is in serious jeopardy.

Changing economics of knowledge – a top 10 trend

The consulting firm McKinsey & Company has just released its Ten trends to watch in 2006. The trends are a thoughtful look at macro and micro changes occurring in the economic environment:

1. Centers of economic activity will shift profoundly, not just globally, but also regionally. The story is not simply the march to Asia. Shifts within regions are as significant as those occurring across regions.
2. Public-sector activities will balloon, making productivity gains essential.
3. The consumer landscape will change and expand significantly with almost a billion new consumers entering the global marketplace
4. Technological connectivity will transform the way people live and interact. More transformational than technology itself is the shift in behavior that it enables. We work not just globally but also instantaneously. We are forming communities and relationships in new ways.
5. The battlefield for talent will shift, with a focus toward importance and scarcity of well-trained talent.
6. The role and behavior of big business will come under increasingly sharp scrutiny.
7. Demand for natural resources will grow, as will the strain on the environment.
8. New global industry structures are emerging with nontraditional business models flourishing. In many industries, a barbell-like structure is appearing, with a few giants on top, a narrow middle, and then a flourish of smaller, fast-moving players on the bottom. Similarly, corporate borders are becoming blurrier as interlinked “ecosystems” of suppliers, producers, and customers emerge.
9. Management will go from art to science.
10. Ubiquitous access to information is changing the economics of knowledge.

While all of these are of significance, I found the last especially interesting:

Access to knowledge has become almost universal. Yet the transformation is much more profound than simply broad access. New models of knowledge production, access, distribution, and ownership are emerging. We are seeing the rise of open-source approaches to knowledge development as communities, not individuals, become responsible for innovations. Knowledge production itself is growing: worldwide patent applications, for example, rose from 1990 to 2004 at a rate of 20 percent annually. Companies will need to learn how to leverage this new knowledge universe — or risk drowning in a flood of too much information.

Many of these trends are part and parcel of our shift into the I-Cubed (Information, Innovation, Intangibles) Economy: technological connectivity, the role of talent and the new industry structures. However, learning how to manage information and knowledge is the underpinning of the entire transformation. It is not just the danger of drowning in information, it is also the problem of not being able to utilize the key information and intangibles. The easiest way to prevent drowning is to stay away from the water. Unfortunately, that may be the reaction of many — to shut out the flood and fall back on the old ways (and the old industrial age paradigms). That will be the road to disaster for some.
The other reaction to managing information will be to filter based on narrow criteria. However, narrowing the information flow is a sure-fire way of stifling innovation. A rich flow of diverse information is needed for the creative process. The old saying of separating the wheat from the chaff is only partly applicable. What is need are ways to think creatively about what to do with both the wheat and the chaff.
Key is the word “leveraging” — the ability to leverage knowledge will determine the success stories of the I-Cubed Economy. What that means, however, is yet to be completely revealed. We are still in the transformation — with most of us trying our best not to drown. As we learn to swim in — and then sail over — this sea of information, creativity, innovation and productive economic growth will flourish.

A positive indicator of New Orleans’ future – Tulane

After Katrina devastated New Orleans, I observed that how Tulane University responds will be a leading indicator of the city’s economic future:

For the Fall semester, Tulane students will be dispersed across the nation. How many return (either in January if that is possible or next Fall) will determine New Orleans’ future as a dynamic creative city.

Well, it’s January and the new term is starting — and the news is good! According to a story in this mornings Washington Post –
“Interrupted by Hurricane, Tulane’s Orientation Resumes for Freshmen”:

Nearly 90 percent of Tulane’s 6,700 undergraduates are returning, the university said, and more than 80 percent of freshmen — a significant accomplishment considering college officials initially wondered if they would break 60 percent. It is also a big boost for the city, where Tulane is the largest private employer and returning students will amount to a noticeable population increase.

The return of Tulane’s students, along with the earlier announcement of keeping their medical research programs while cutting back in other areas, keeps alive the hope that the University can spark an innovation and creativity-led economic revival of the city. Only time will tell, but the signs are good. As they say, stay tuned.

November trade in intangibles

This morning’s BEA trade data contained some good news as the overall trade deficit declined slightly. However, the surplus in our balance of trade in intangibles remained flat at $6.9 billion in November. The intangibles surplus is almost exactly what it was a year ago in November of 2004 and is still below the peak surplus of almost $7.5 billion in December 2004.
Even with the improvement in this month’s deficit, the total deficit for the first 11 months of 2005 ($661.8 billion) is already significantly above the total for all of 2004 (at a record setting $617.6 billion). At this rate, the deficit for 2005 could run as high as $720 billion.
The deficit in Advanced Technology Products declined slighly in November to $4.8 billion, as exports grew slightly while imports were basically unchanged. The last monthly surplus in Advanced Technology Products was in June 2002 and the last sustained series of monthly surpluses were in the first half of 2001.

Intangibles trade-Nov05.gif

Note: we define trade in intangibles as the sum of “royalties and license fees” and “other private services”. The BEA/Census Bureau definitions of those categories are as follows:

Royalties and License Fees – Transactions with foreign residents involving intangible assets and proprietary rights, such as the use of patents, techniques, processes, formulas, designs, know-how, trademarks, copyrights, franchises, and manufacturing rights. The term “royalties” generally refers to payments for the utilization of copyrights or trademarks, and the term “license fees” generally refers to payments for the use of patents or industrial processes.

Other Private Services – Transactions with affiliated foreigners, for which no identification by type is available, and of transactions with unaffiliated foreigners. (The term “affiliated” refers to a direct investment relationship, which exists when a U.S. person has ownership or control, directly or indirectly, of 10 percent or more of a foreign business enterprise’s voting securities or the equivalent, or when a foreign person has a similar interest in a U.S. enterprise.) Transactions with unaffiliated foreigners consist of education services; financial services (includes commissions and other transactions fees associated with the purchase and sale of securities and noninterest income of banks, and excludes investment income); insurance services; telecommunications services (includes transmission services and value-added services); and business, professional, and technical services. Included in the last group are advertising services; computer and data processing services; database and other information services; research, development, and testing services; management, consulting, and public relations services; legal services; construction, engineering, architectural, and mining services; industrial engineering services; installation, maintenance, and repair of equipment; and other services, including medical services and film and tape rentals.

Improving patent quality

I have to give the US Patent and Trademark Office credit for trying to improve patent quality after reading this in today’s New York Times – “U.S. Office Joins an Effort to Improve Software Patents”:

At a meeting last month with companies and organizations that support open-source software (software that can be distributed and modified freely), including I.B.M., Red Hat, Novell and some universities, officials of the patent office discussed how to give patent examiners access to better information and other ways to issue higher-quality patents.
Two of the initiatives would rely on recently developed Internet technologies. An open patent review program would set up a system on the patent office Web site where visitors could submit search criteria and subscribe to electronic alerts about patent applications in specific areas.
The third initiative is focused on the creation of a patent quality index that would serve as a tool for patent applicants to use in writing their applications. It is based on work done by R. Polk Wagner, an intellectual property expert at the University of Pennsylvania.

This is a good step forward in the type of industry-specific patent review processes we may need if we are to solve the quality problem.
Now if we can just get the legislative reforms moving as well . . .

Innovation and the environment

Yesterday, the OECD released its review of US environmental protection efforts over the past decade (the last review was in 1996). Depending on who you talk to the glass is half full or half empty. According to the EPA, the US is doing a great job: “EPA Press Release: International Panel Concludes U.S. has Improved Environmental Performance”:

The United States has significantly improved its environmental performance in the last eight years even as its economy and population have grown substantially, according to a report from the Environmental Performance Review Program of the Organization for Economic Cooperation and Development’s (OECD).

However, others, such as the Financial Times see the story differently – “US could do better on green issues, OECD concludes”:

As other nations increased their energy efficiency further in the face of rising fuel prices, the US risked falling behind in its international competitiveness if it failed to keep up, the report’s authors said. Using energy more efficiently would also help to combat climate change.

What the OECD environmental report card for the US actually said was, not surprisingly, more between this two:

A new OECD review of environmental policy in the U.S. recommends more efficient use of energy and water as a way to safeguard economic prosperity while protecting the environment and human health. Despite progress in some areas over the past decade, more effort is needed in others. The OECD recommends that the U.S. play a more proactive role in dealing with global environmental concerns.

What U.S. Ambassador to the OECD, Connie Morella, told me yesterday morning was that innovation was one of the reasons why the US came out as good as it did on the review. Many of those innovations are not new technologies, but management processes. For example, the report’s conclusions and recommendations specifically cites Massachusetts’s pesticide tax and Oklahoma’s tax credit for manure management as innovative economic instruments to reduce water pollution.
Now, manure management may not top the charts when it comes to the sexiest innovations. But given that farm run-off is one of the major sources of water pollution, manure is a major issue.
Other examples include the introduction of ecosystem management approaches for the Great Lakes, Chesapeake Bay, the Florida Everglades, the Gulf of Mexico and numerous watersheds; introduction of sustainable forestry practices on public lands; and the Government Performance and Results Act which has promoted co-ordination among government programs.
The report does tip its hat to technological innovations. But it real focus (and benefit) is on the management changes that would be useful if we are to continue to make progress. As the OECD press release concludes:

Overall, the OECD report urges the United States to increase the efficiency of its environmental management and energy use, projecting that doing so would yield economic benefits.

Innovative new technology and innovative management techniques — sounds like the classic winning approach to me.

Linking production and engineering

What is the locational link between production/manufacturing and research/engineering/product design? That is a key question underlying the I-Cubed Economy (and much of the debate on offshoring). Is product design and engineering tightly linked with the manufacturing process – as was argued a few years ago under the rubric of manufacturing matters? In other words, if production moves offshore, will product design and engineering naturally follow? Or is distance dead – and given information and communications technologies, engineering and design can be anywhere and production someplace else?
Economic history is ripe with examples of both. Clearly, the globalization of manufacturing over the past few decades (actually during the entire 20th Century) has shown that for mass produced goods, production and engineering can exist literally world apart. But a finer grain analysis of the globalization phenomena has also shown a strong local design/customization component to the process.
Far from being an academic question, this issue forms the implicit foundation of many views of our economic future and the economic growth process. Can the US economy survive as a “service” economy, where we handle the high-end engineering, research and product design portion of the production process? Or having lost the manufacturing portion, are we destined to lose the design part as well? Or, alternatively, has competition shifted from the mass manufacturing paradigm to solely a design/innovation paradigm — where the US maybe losing its competitive edge in innovation completely independent from what has happened in manufacturing?
A new study of the notebook PC industry in China sheds some light on this question:

China has become the world’s largest producer of computer hardware, driven by large scale investment by multinational and Taiwanese companies. At the same time, computer hardware production and employment in the U.S. have fallen by about one-third since 2000. A new concern is that knowledge activities such as new product development are being pulled along with manufacturing to China. Based on a study of the notebook PC industry, it is concluded that production is pulling some product development activity to China, although the shift is also driven by the availability of low cost engineering talent. While the U.S. has retained its role in marketing, concept design, and product planning, it has lost many of the engineering jobs associated with notebook design. The number of jobs affected is relatively small, but the movement of knowledge work may portend similar changes in industries with larger numbers of jobs at stake.

In other words, those parts of the process that require tacit knowledge of the market – product concept and product planning – are remaining in the US (as a major market for notebook PCs). But more and more of the activities that are related to the physical production process, including design and prototyping, are moving to China.
It is not clear whether this middle-portion of the process (design and prototyping) necessarily needs to shift to be near the production facilities. However, as the study authors explain, there are economic reasons for the shift:

Production and sustaining engineering clearly benefit from proximity to manufacturing, as production problems can be addressed immediately on the factory floor and engineering changes in existing products can be tested in production models from the assembly line. It also makes sense to move pilot production to China rather than maintain an assembly line in Taiwan just for this purpose. Then the question arises whether to move the expensive test equipment from Taiwan to China. If so, then there is more reason to relocate the design review and prototype processes as well.

The location-specific activity in this process is the front-end concept work. This is remaining in the US not because we are necessarily theoretically the best at it, but because we are a major market and it requires on-the-ground market intelligence. Other major markets, such as Japan, are also locations for this front end work. This may the future of China as well:

as China’s PC market continues to grow, and its users become more demanding, it may become the leading market at least for the Asia-Pacific region, and definition and planning of products suitable for the region may be done there.

The study ends with the following conclusion:

Product development, design, R&D and other innovative activities account for many jobs in industries such as software, IT services, electronics, aerospace, automobile, clothing, and pharmaceuticals. In some cases, these activities may be pulled along with manufacturing, or they may move to places where engineering and other creative skills are abundant and cheap. If so, our research suggests that China will attract a good share of the knowledge work associated with manufacturing industries, given its large pool of engineers and its role as a manufacturing center.

A sobering thought. But, issue might not just be how many US jobs will be shifted because of design following manufacturing. Rather it might be how many of the high-end knowledge jobs of the future will be created in other countries, rather than the US, to service those increasingly sophisticated markets.
If high-end design and product concept jobs require localized knowledge, then there is no reason to believe those jobs that service the US will leave the US. By the same logic, however, there is no reason to believe that US-based workers in these jobs will be able to service other markets. Americans will be designing for the US market, Chinese/Japanese for the Asia market, and Europeans for the European market.
This scenario completely contradicts the view that many, I suspect, have of the future of our economy. Under that view, the US will maintain its economic competitiveness by exporting design services, innovation and other intangibles. My tracking of our intangibles trade shows that this view is not sustainable. The increasing dispersion of design and innovation capacity – either following or independent of manufacturing capability – means that we need to seriously re-think our vision of the US economic future.
And the sooner we undertake that re-thinking, the better.

France rediscovers the apprentice

I recently came across this interesting tidbit in a story about the French apprentices in the International Herald Tribune:

Germanic cultures preserved the traditions and spirit of apprenticeship while revolutionary France destroyed the guilds and the apprentice system with it in the 1790s. The system was re-established in France but remains much less widespread than in Germany.

Might this fact explain Germany’s rise as an industrial power? Maybe, maybe not. As I understand it, the German apprentice system is more advanced than the British system as well the French. The US has always lagged in our apprenticeship programs.
The apprenticeship system is an important mechanism for passing on tacit knowledge. Such knowledge is key in skilled areas; less so in mass production activities. So a country whose economic development was based on precision engineering, such as Germany, is more likely to benefit from an apprenticeship system than an economy build more on the mass production of consumer goods, closer to the British and American experiences
The transfer of tacit knowledge is also important in innovation and creative activities. But in the I-Cubed economy, formal apprenticeships may be much less important that informal mentoring and networking. A formal apprenticeship passes down very specific skills in a defined context. There is also often a rigid hierarchy and an end point of learning that defines “mastery” – although in truth, the real masters of a craft never stop learning. The ability to absorb tacit knowledge from multiple sources in an ever changing context is more important in the I-Cubed Economy. Multiple mentors are common, with different sets of skills learned at different points in one’s career.
So, rather than emulate the German apprentice program, France may do better in the future by emulating the American networking model. As much as that may pain my French friends to hear.

Innovation legislation – what about design?

I have been a strong supporter of the efforts of Senator Lieberman on competitiveness, and most recently with the National Innovation Act of 2005. In fact, Athena Alliance wrote a letter of support for the legislation, calling it “a step forward in addressing this challenge [of coping with the new I-Cubed Economy].” We specifically based our support on two provisions in the bill. The first is a study on valuation of intangibles. As our study on Reporting Intangibles pointed out, we are flying blind when it come to understanding and accounting for intangibles. This study will move us in the right direction.
The second provision is the creation of a President’s Council on Innovation. We believe that, properly focused, this Council could take a broad view of innovation and knowledge diffusion to include policies to foster non-technological ingenuity and creativity as well as science-based research and development – and in all sectors of the U.S. economy, particularly those in which rates of productivity and innovation have lagged, and in U.S. companies of all sizes, particularly small and medium-size companies. As such, it could serve as an important analytical and policymaking body, similar to that which was envisioned in Senator Lieberman’s previous legislation to create a Commission on the Future of the U.S. Economy (which we helped formulate).
However, I have always felt that the bill is only a step in the right direction – not the complete answer. It addresses the S&T issues, but not the broad innovation issues.
Niti Bhan, writing two weeks ago in Business Week – “A Competitive Nation, by Design” makes a similar point:

There can be no argument against the importance and validity of these initiatives, . . .
However, one must raise the concern: What about design? Is any of the increased funding to the National Science Foundation and other basic research focused on design methodology and tools, the building blocks of innovation? We’ve all heard the success stories in which design-led innovation has directly increased existing market share, grown new markets, added value to the bottom line, and raised the visibility of brands.
Take Google’s design philosophy of simplicity or Procter & Gamble’s (PG) emphasis on user needs — both examples of global giants recognizing the value of design. Yet there is no mention of design or the design industry in the National Innovation Act.

Yes, as I have railed about only yesterday, we don’t have the government programs focused on design. And we desperately need them.
Maybe we can all work together to make that the next piece of legislation.

UK innovation and creativity report

In my essay on innovation and creativity policy (UK leads; US lags), I mentioned that Chancellor of the Exchequer Gordon Brown commissioned a study by the British Design Council on the link between creativity/design and business. That Review of Creativity in Business was released early last month. Nicknamed the Cox Review, after Sir George Cox, chairman the British Design Council who headed up the study, the recommendations from the study are expected to show up in the next government budget submission to Parliament. According to Business Week – “Renewing Britain’s Legacy of Innovation”, one recommendation is moving ahead quickly:

. . .a program to encourage businesses and design students to think and work together. The government is now helping to set up higher-education centers to create pilot courses that combine business, engineering, technology, and creative disciplines in a similar way to Finland’s International Design Business Management program or the new Hasso Plattner Institute of Design at Stanford University in the U.S.

So, where are the US programs? Where are the programs to replicate the Stanford D-School?
Sadly, the answer is that the US is still fighting the last war. We are focused on innovation as S&T – not innovation as creativity.
The Cox Review uses the following definitions:

‘Creativity’ is the generation of new ideas – either new ways of looking at existing problems, or of seeing new opportunities, perhaps by exploiting emerging technologies or changes in markets.
‘Innovation’ is the successful exploitation of new ideas. It is the process that carries them through to new products, new services, new ways of running the business or even new ways of doing business.
‘Design’ is what links creativity and innovation. It shapes ideas to become practical and attractive propositions for users or customers. Design may be described as creativity deployed to a specific end.

Technology is part of those definitions – but only part.
With the Cox Review, the UK has at least conceptually made the leap from looking at a technology-led economy to an innovation & creativity-led economy
We need to do the same.