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Innovation in the new economy
by Martin Baily, Chairman, US Council of Economic Advisers
The end-user industries of the old economy are spurring in the new.
The OECD countries are now enjoying their brightest growth prospects in more than a decade. Low inflation has become the rule even while unemployment remains low. Information and computer technologies grow by leaps and bounds and are easily transported across national borders in this era of increasing globalisation. Talk of a new economy abounds.
The Economy is Changing in Fundamental Ways
The dramatic decline in the costs of information and communication, combined with increased globalisation, is changing the nature of companies, industries, markets and economies. These forces are playing out in ways that are only partially understood and seem at times contradictory or paradoxical.
An information economy is one where there are economies of scale and first-mover advantages that can result in the growth of large companies with dominant market shares. Globalisation has led to takeovers, alliances and mergers in many industries, reducing the number of independent producers worldwide. This process is facilitated by the reductions in the cost of communications. Interaction costs are incurred as people work together to produce, exchange and distribute goods and services to final users. New technologies are sharply reducing these interaction costs, allowing productivity increases and the co-ordination of activities throughout a value chain spread around the world.
At the same time, the new economy is associated with the increased importance of small innovative companies and a widespread perception that there is more competition, not less. The reduction of interaction costs allows new entrants that have a competitive advantage at some point in the value chain to compete directly just at that point. Existing companies and industries can lose markets and profitability unless they adapt to the new competitive environment. Even those companies that have developed first mover advantages and large market shares in technology sectors may find an advantage in outsourcing their R&D and innovation activities. They scour the marketplace for small innovative startups and then buy them out or license the technology.
An important reason that a dynamic small firm sector in the US has been able to co-exist with the giant companies with their scale advantages is that financing - notably venture capital - has been made available to high-risk startups. The outsourcing of innovation to small firms could not have happened had financing not been available.
The New Economy Is Driving The Old Economy and Vice Versa
Developments in the new economy are dramatically changing old economy industries. Traditional manufacturing industries use computer-aided design and production. Retailers integrate backward into the wholesale function and develop communication channels that run from the scanner at the checkout to new orders to the manufacturer. Specialty chains operate small establishments that are linked to gain the advantages of scale. Truckers use the Internet to locate loads and avoid empty back-hauls. Farmers use satellite information on rainfall and crop conditions.
If the old economy is being affected so strongly, why have stock market values languished in so many old economy companies? One possible answer is that competition really has increased. The ability to take advantage of the new technology productively may be essential for survival but need not provide old economy companies with a unique advantage. It seems that increased market value is associated with the intangible assets of a new technology or a brand or a dominant market position. As US Treasury Secretary Summers said recently, the new economy is highly Schumpeterian. Innovation generates a temporary competitive advantage for a company, allowing it to earn strong profits for a period. Then the technology moves on, and new profits can be earned only by continued innovation.
Analysis of the new economy sometimes focuses too much on what is happening in the high-tech sector itself and suggests that the reason for the rapid growth of the new economy in the US lies only within that sector. This view neglects the role of the old economy in spurring growth in the new economy. A competitive and dynamic old economy has generated the demand for the products and services provided by the new economy. The desire of end-user industries for greatly expanding computing and communications power has created the market that has spurred innovation.
A retailing sector that is constrained by regulation or zoning laws and remains stuck in the era of traditional mom and pop stores will not create a market for state-of-the-art computing and communications. A dynamic and evolving retailing sector, on the other hand, demands powerful new tools that can enable business system improvements and new lines of business. This example is repeated over and over in the US. Germany has not achieved great success as a centre for software development across the board. But it has made a mark in one important area. Its strong, competitive export-oriented manufacturing sector created a demand for enterprise resource planning software. This software was developed in Germany and is now being used extensively in the US and worldwide.
Will Rapid Growth Continue?
The evolution in computing technology has certainly been dramatic. In 1944, the Mark I computer could carry out 3 instructions per second compared to more than 400 million instructions per second today.
In 1970 a state of the art computer cost about $4.7 million, an amount equal to 15 times the lifetime wages of the average American worker. Now, a personal computer with more than 10 times as much computing power costs only $1000, or less than 2 weeks of the average workers pay.
Microprocessors, the fundamental building block of the new technology, have made products better, cheaper, and more efficient. A single memory chip now holds 250,000 times as much data as one from the early 1970s. This is like cramming 1600 books onto one page. The cost of storing one megabit of information- the equivalent of a 320-page book- fell $5,275 in less than 25 years from $5,275 in 1975 to $0.17 in 1999. Today, fibre optics make it possible for the contents of the entire Library of Congress to move across the nation for just $40.
Can this amazing pace of advance continue and continue to yield higher productivity? We do not know, but the signs are positive. The benefits of the combination of increased computing power and increased ease of communication are only now being realized.
B2B e-commerce is expected to grow at 80% a year or more. Measuring the pace of innovation with R&D or with patent data can be problematic. But despite the limitations in these measures, both are pointing towards continued or even accelerating technological advances. Private R&D in the US has grown 11% a year over the past five years and the number of patents filed has increased by more than 50% over this period.
The US and Other OECD Countries: Some Comparisons
The OECD is preparing an important study of economic growth that is exploring the sources of growth among the OECD economies in the Eighties and the Nineties. The full results will be made available over time and I do not want to anticipate results of the work in process, so I will offer only two quick reflections on this issue.
First, subject to data limitations and inconsistencies, it appears that the sharp acceleration of productivity growth that occurred in the US after 1995 has not been observed in the other major OECD economies. This may not be surprising. After all, the new economy digital revolution has been underway for many years and it is only in the past five years that this has been reflected in the US productivity statistics. It may just be a matter of time before the surge in productivity spreads elsewhere.
Second, countries other than the US have more to gain from the new economy, but may face more barriers to achieving it. The US, on balance, has a more market-oriented regulatory structure and a more flexible labour market than other OECD countries. And this has meant that industry change and evolution is often further along in the US than elsewhere. New economy innovations can potentially yield greater gains in growth outside the US, leapfrogging inefficient traditional businesses. But the social adjustment and the labour reallocation may be much greater and much harder to accomplish. To the extent that past policies have slowed structural change and economic evolution, they may also slow the growth and development of the new economy in other OECD countries.
Policies for the new economy Combined with sound economic policy, the information revolution has provided the necessary ingredients for a new economy. Stimulating economic growth is like creating a chemical reaction. All the right elements have to be in place. The mix has to be right. Policy cannot grow the economy on its own. Growth from the private sector will not take off if the policies are not right. The key to the strength and longevity of the US expansion has been that the dynamism of the private sector has reacted with superb monetary policy, and with the Administrations policies of investing in people and technology while preserving fiscal discipline. In short, the chemistry for growth seems to have been right.
A major concern in the US during the Seventies and Eighties was rising income inequality. And the problem of inequality is still with us. But there have been some encouraging signs. Unlike the 1973 to 1993 period when real incomes stagnated and even fell for the poorest Americans, from 1993 to 1998 all of the income groups have seen solid income growth, and the lowest quintile has actually grown most rapidly. Poverty rates have declined sharply and unemployment has fallen to new lows for many groups. This experience demonstrates that growth can bring economic prosperity to all groups, even though technology is changing and globalisation is increasing. A full employment economy, education and training programmes and income support (such as the Earned Income Tax Credit) have contributed to this favourable outcome.
My final comment on policy goes back to the earlier statement about the importance of end-users. It is important to invest in technology. It is helpful to have financial institutions that can judge business opportunities and take risks on small companies. But you cannot force-feed the new economy that way. Policies in this area are not enough if the demand from end-users is not there. The best tonic for the new economy may be open and competitive markets in the old economy.