The fading lustre of clusters

The Economist - October 11, 2007

The best thing that governments can do to encourage innovation is get out of the way.

THE scene in Salzburg earlier this year was one that Joseph Schumpeter, an economist obsessed with innovation, and Mr Drucker, the management expert, would surely have approved of. Several dozen government officials and academics from around the world gathered at Schloss Leopoldskron, a spectacular rococo palace located on the shores of an idyllic lake. They came not for the fresh Alpine air, hearty Austrian fare or even the hills alive with music. It was for a conference organised by the Salzburg Global Seminar, a non-government organisation, to discuss what they could do to turn their economies into innovation powerhouses.

Holding such a meeting in the heart of Europe seemed only fitting—and not just because the two great theorists of innovation both hailed from the region. After all, it was a European, France's Georges Doriot, who invented venture capital during his time teaching at Harvard. And it was another Frenchman, Jean-Baptiste Say, who coined the word entrepreneur two centuries ago to describe the plucky upstart who “shifts economic resources out of an area of lower and into an area of higher productivity and greater yield.”

And yet the star of the show was America. Everyone wanted to learn how Silicon Valley was created and how it has managed to keep its edge despite various booms and busts. And Asia also made its mark, with innovation gurus from places like Singapore bragging about how many billions of dollars they are spending on technology parks, tax breaks on foreign investment and scholarships for their bright young things to go to MIT and Stanford.

Out of steam

So what about Europe? The blunt answer is that the European Union (EU) is something of an also-ran when it comes to innovation. That does not mean the region has no innovative companies—it certainly has them in some areas, especially retail and financial services with firms like Zara, a Spanish fast-fashion chain, and Direct Line, a British online insurer. But these tend to be exceptions. It is not much of an exaggeration to say that, aside from mobile telephony, Europe has not come up with a globally disruptive innovation in decades—although Skype, an internet-telephony firm that is now part of eBay, once looked like it might qualify.

Europe's innovation malaise is the result of a complex mix of factors. Some places, like Ireland, Finland and parts of Scandinavia, do better than others. And Cambridge, England, can reasonably claim to have created Europe's best innovation cluster, albeit one that falls far short of Silicon Valley. The main thing holding back continental Europe is that it is a lousy place to start a new company. It can cost a lot of money and it takes too long to set up a business.

Last year, venture capitalists invested only about €6.4 billion ($9 billion) in the EU, while their American counterparts splashed out some $45 billion on new ventures. The link between venture capital and innovation is a strong one. Samuel Kortum and Josh Lerner, two American academics, have shown that “a dollar of venture capital could be up to ten times more effective in stimulating patenting than a dollar of traditional corporate R&D”. They scrutinised 20 manufacturing industries between 1965 and 1992, and found that the amount of venture-capital money in a sector dramatically increased according to the rate at which businesses in that sector took out patents. From 1982 to 1992, they calculated that venture-capital funds amounted to just 3% of corporate R&D but 15% of all industrial innovations.

It is true that patents have become less important in some industries and so they may be an imperfect proxy for all innovation. And in some cases venture-capital funds will follow rather than create innovation. Nevertheless, patents are still widely used and Messrs Kortum and Lerner successfully validated their results with other measurements too.

But surely innovation and entrepreneurship are not the same thing? Following the most useful definition—that innovation brings fresh thinking to the marketplace that creates value for a company, its customers and for society at large—someone who opens yet another corner café may be a successful entrepreneur but not much of an innovator.

The ones worth paying attention to are a special type of entrepreneur who embraces new ideas. These are the people who are able to carry out the “creative destruction” that Schumpeter marvelled at. In Europe they are thin on the ground: too many Europeans opt for comfortable jobs working for Siemens or Electricité de France than the risk and bother of starting speculative new companies.

This is worrying for Europe. National champions and incumbents are not disruptive innovators: upstarts are. From 1980 to 2001, all of the net growth in American employment came from firms younger than five years old. Established firms lost many jobs over that period and dozens fell off the Fortune 500 list.

Big corporations have been dying off and disappearing from stockmarket indices. Most of the dynamism of the world economy comes from innovative entrepreneurs and a handful of multinationals (like GE, IBM, 3M, P&G and Boeing, all of whom have stayed on the Fortune 500 list for over 50 years or so) and which constantly reinvent themselves.

Carl Schramm, president of the Kaufman Foundation, which studies entrepreneurship and innovation, says that “for the United States to survive and continue its economic and political leadership in the world, we must see entrepreneurship as our central comparative advantage. Nothing else can give us the necessary leverage to remain an economic superpower.”

The trouble with dirigisme

America's economy is not a free-market paragon, to be sure. The internet and related industries have all benefited from the spill-over effects from government funding of universities and from military spending. However, it is wrong to think those factors alone explain America's dynamism. The Soviet Union spent lavishly on its military and space programmes during the cold war, but because its economic system was ossified there were few spill-over effects. The unintended beneficiary was Israel, arguably the most entrepreneurial economy on earth, because its many Russian émigré scientists now form the core of a vibrant high-tech sector.

What is more, Europe itself spends a lot of money on higher education and has a number of top universities with leading academics and researchers who produce excellent papers and win Nobel prizes. The problem is that their ideas tend to stay in their ivory towers. Part of the explanation is that innovation is still seen as being driven by government spending in R&D, when in fact most of it is now in services and business models. Companies that outperform their peers put a much bigger emphasis on business-model innovation (see chart 6).

The EU has an official target to raise government R&D spending to 3% of GDP and there is much angst over patents—an obsession that Japanese planners share. The latest edition of “Science, Technology and Innovation in Europe”, an annual report by Eurostat, the statistical arm of the European Commission, reveals exactly what is wrong. It is chock full of figures, broken down by region and industry, of research spending, patents filed, scientists employed and other important-sounding variables. The problem is that these are all inputs into the innovation process, not outputs. There is only a cursory discussion of venture capital and no attention paid at all to entrepreneurship—the most powerful way to turn ideas into valuable products and services.

The world is spiky

Another problem is that EU officials, like government bureaucrats everywhere, are obsessed with creating geographic clusters like Silicon Valley. The French have poured billions into pôles de compétitivité; and Singapore, Dubai and others are doing much the same. There are dozens of aspiring clusters worldwide, nicknamed Silicon Fen, Silicon Fjord, Silicon Alley and Silicon Bog. Typically governments pick a promising part of their country, ideally one that has a big university nearby, and provide a pot of money that is meant to kick-start entrepreneurship under the guiding hand of benevolent bureaucrats.

It has been an abysmal failure. The high-tech cluster in and around Cambridge, England, is the most often-cited counter example. Hermann Hauser, of Amadeus Capital, a leading British venture capitalist (who, curiously, also hails from Vienna), is an optimist: “Silicon Valley is still the lead cow but Cambridge is the best in Europe.” Perhaps, but that is faint praise. The main problem, argues Georges Haour, of IMD, a Swiss business school, is that Cambridge suffers from the Peter Pan complex: “inventors never want to grow up, they are happy with modest success.” One veteran of the city's start-up scene even argues that its success came “in spite of, not because of” government and university support.

Experts at Insead looked at efforts by the German government to create biotechnology clusters on a par with those found in California and concluded that “Germany has essentially wasted $20 billion—and now Singapore is well on its way to doing the same.” An assessment by the World Bank of Singapore's multi-billion dollar efforts to create a “biopolis” reckoned that it had only a 50-50 chance of success. Some would put it less than that.

Diana Farrell, of the McKinsey Global Institute, argues that the real problem holding back innovation in many developed countries is too much government in the form of red tape and market barriers. She points out that planning restrictions have prevented the expansion of Ahold and other highly efficient retailers in France. Closing hours in several EU countries also act as an inhibitor. The institute's studies of Japan and South Korea suggest the heavy hand of government is even more stifling in those countries: outside a small, highly competitive group of export industries (cars, electronic goods and steel), inefficient, coddled domestic sectors are slow to adopt new technologies or business practices.

Pedro Arboleda, of Monitor Group, summarises his consultancy's years of research into this matter thus: “Companies, not regions, are competitive. So the question for government is: how to attract many competitive firms?” That throws cold water on cluster-mad politicians. It also points to what are sensible prescriptions to promote innovation.

First of all, stop spreading money around trying to clone lots of Silicon Valleys. Steven Koonin, chief scientist at BP and formerly the provost of the California Institute of Technology, thinks EU countries anyway spread research funds too thinly. American officials, he says, “have no problem making big awards, so they can achieve scale.” His own firm has just done that, setting up a $500m research alliance run by the University of California at Berkeley to look into advanced biofuels.

However, there is an even more important factor than money: culture. Nokia's success was not the result of far-sighted planning or subsidy by the government of Finland. One Nokia executive confides: “The biggest boost to our firm was the deregulation that followed the second world war and the government's avoidance of protectionism.” One of the most innovative things Nokia did was to spot that the handset could also be a fashion accessory. And coming from such a small and open market, it was forced to think globally.

Secondly, governments keen to promote innovation need to look out for market distortions and over-regulation that can be stripped away. Entrepreneurs can face an uphill battle legally, and not just culturally, in many countries. The bankruptcy code in many places is excessively burdensome, even banning some failed entrepreneurs from running a company for years. Contrast that with America's Chapter 11 bankruptcy proceedings, which quickly re-deploy both the bankrupt firm's physical assets and the creative energies of its leaders.

In India an overbearing system known as the “Licence Raj” choked the creativity out of most sectors of the economy for decades, through a mix of over-regulation, petty corruption and centralised planning. But the bureaucrats in Delhi did not understand computer software well enough to regulate it. And by the time they cottoned on, innovators in Bangalore and other corners of India had created a world-class industry. A similar story may be unfolding in China. Adam Segal, of the Council on Foreign Relations, an American think-tank, has studied high-technology firms in Beijing, Shanghai, Guangzhou and Xian. His research shows that smaller firms in the private sector are likely to be more innovative than bigger ones reliant on government largesse.

Even in Africa, where chaotic and corrupt rule can impede growth in myriad ways, extraordinary innovators are starting to flourish wherever they are not choked off by bureaucrats or fat cats. John Dryden, of the OECD, observes that “freedom from legacy” (in the shape of stranded assets, like fixed-line telephony or centralised power grids) has liberated African entrepreneurs and allowed them to leapfrog with technology—from having no electricity to solar cells, for instance.

Stewart Brand, an internet pioneer and co-founder of the Global Business Network, a scenario consultancy, is convinced that if you want to see the next wave of consumer innovation, “look to the slums of South Africa, not Japanese schoolgirls.” So where does that leave the present Goliath of innovation, the United States?