Download The Idea-Based Economy and Trade

 The Idea-Based Economy and Trade
Robert J. Shapiro
Conference on Trade Policy and the Ideas-Based Economy
European Center for International Political Economy
Brussels, Belgium
January 29, 2014
In recent decades, we have seen an historic expansion of international trade and
investment flows, largely in response to the very rapid modernization and turbo-charged growth
of China and other large developing countries and the spread of new information and Internetrelated technologies. Consider that one third of all goods and services produced in the world are
traded across border today, compared to 18 percent in 1990. With this enormous expansion of
global markets, actions by some developing nations to maintain or even strengthen certain
barriers to trade and investment can impose large costs on their own economies as well as ours.
My remarks today focus on one critical and costly aspect of this phenomenon, the weak respect
for and lax enforcement of intellectual property rights in some developing countries.
This is not just about royalties. Intellectual property rights are a central element of the
basic process of innovation – and innovation is itself critical, because without it, growth would
slow dramatically or even stagnate. This result follows from the economic principle of
diminishing returns, which says that in any productive process, adding one more unit of a factor
of production, with everything else constant, will eventually yield lower returns. Add more and
more fertilizer to farm production, and at some point the boost to yields declines. Add more
workers to an assembly line, and at some point the increase in production tapers off.
To early, classical economists, this reflected the declining quality of the inputs. You start
by hiring the most skilled and productive workers, or buying the most fertile land; and as you
continue to expand, you have to rely on less skilled workers and less fertile land. Of course,
that’s not true of technology: The 100th computer, in itself, is just as productive as the first or the
50th.
Neoclassical economists understood this problem and still found that the principle of
diminishing returns held up. That’s because adding more workers to a fixed amount of capital –
or more workers and more fixed capital -- disrupts the production process. In effect, there are
limits to the productive size and reach of any enterprise: If it gets too big, it cannot be managed
effectively – plus its profit opportunity trails off -- so its returns begin to shrink. Socialist
countries had that experience with most state-owned enterprises – and the United States and
Europe experienced it with the large conglomerates created in the 1970s and 1980s.
Innovation provides the best way out of the law of diminishing returns, by developing
new ways to use the growing supplies of capital and labor. And societies which try to wall
themselves off from foreign innovation find themselves with stagnating economies.
Innovation largely explains why economic growth over the last two centuries has far
outpaced growth in previous centuries – it’s the broad application of science to economic tasks,
1 through new technologies, beginning with the industrial revolution. And as industrial economies
have evolved, the importance of new ideas has increased.
In the 1930s, economists first asked themselves, precisely how much does innovation
contribute to growth? In the 1950s, Robert Solow of MIT won the Nobel Prize for the answer:
His “growth accounting” model showed that some 35 percent to 40 percent of all productivity
and growth gains achieved by the United States from 1900 to 1950 could be traced to innovation
in its various forms. By contrast, improvements in workers’ skills were responsible for about 20
percent of the increases in productivity. Increases in economies of scale and shifts in the use of
labor each explained about 10 percent. Finally, increases in the traditional source of value, the
capital stock, accounted for only about 10 to 12 percent of new economic value.
The economic importance of new ideas has only accelerated since the 1950s – and we
measure it. In 1984, the book value of the 150 largest U.S. public companies – what their
physical assets would bring on the open market – was equal to three-quarters of the market value
of their stock. At that time, most of the value of large firms still came from their physical assets,
which naturally was the focus of business investment. This began to change in the 1980s with
the advent of information technologies. By 1995, U.S. companies were investing more in
intangible assets -- from research and development, and patents, to databases and brands -- than
in physical assets. By 2005, the book value of the 150 largest U.S. public companies was equal
to just 35 percent of their stock market value. Nearly two-thirds of the value of America’s public
companies came from their intangible assets.
In 2011, a colleague and I set about to refine and update those calculations. We found
that by 2009, almost 80 percent of the market value of all public companies in the United States
could be traced to their intangible assets, including their ideas. Their intellectual capital -patents, copyrights, databases, brands, and organizational knowledge – accounted for 45 percent
of their value.
Moreover, while in 2005 only a handful of industries had very high concentrations of
intellectual capital – mainly, computers, software, pharmaceuticals, and telecommunications – by
2011, intellectual capital accounted for more than half of the market value of about half of the
U.S. economy. IP-intense sectors now include -- in addition to the traditional IP-heavy sectors of
software, computers, telecom and pharmaceuticals -- media, the automobile industry, household
and personal products, the food, beverage and tobacco sector, healthcare equipment and services,
consumer services, and commercial and professional services. That’s what economists mean
when they adopt the popular concept of the “idea-based economy.”
What is it about innovation that creates so much value? Think about some of the major
innovations of the last decade, such as Google, or new treatments for HIV and Hepatitis C
developed by innovative biopharmaceutical firms . We know that Google’s expanding services
have made its shareholders richer by generating multi-billion dollar annual profits. But there’s
another kind of benefit that’s much larger. People use Google, because it makes them more
efficient or allows them to do things they couldn’t do without it. So, people and businesses can
cut their costs by using Google, or use it to help produce new goods and services. Similarly,
Gilead Sciences earns billions of dollars for its shareholders; but the millions of people who use
their treatments live longer and get many more years of being productive, generating economic
benefits that are much greater than those captured by shareholders.
2 This illustrates a central aspect of innovation: Its economic power comes mainly from its
adoption and use, not from its creation, so the economic benefits of an innovation are closely
related to how effectively it is used. Let me restate that in another way: It’s more important
economically to effectively adopt the innovations developed in other places, than to become the
generator of innovations. Of course, it’s best to do both – the position of America and a handful
of other advanced economies. Moreover, the development of those innovations depends on
incentives that are seriously weakened when other countries adopt them without respecting the
developer’s IP rights – akin the killing goose that lays the golden eggs.
These are the key lessons of this era for developing nations. They have historic
opportunities to increase their productivity and wealth by not only shifting workers from
agriculture to manufacturing and services, but also encouraging the firms in those sectors to
adopt modern technologies and business methods. It won’t make them self-sufficient innovating
economies, but it will make them richer. Indeed, this approach is a central tenet of Chinese
modernization: Instead of developing home-grown innovations, China has allowed and
encouraged the leading multinationals from advanced economies to locate major foreign direct
investments or FDI in China. Of course, China also wants it both ways, sometimes requiring that
companies transfer their technologies as a condition of their FDI, and providing large subsidies
and other advantages to domestic Chinese firms to spur what they call “indigenous innovation.”
Setting asides the strings sometimes attached to FDI, China strategy of relying on western
FDI represents an important innovation in the modernization process. For two centuries,
governments singled out a few industries – such as steel or autos, textiles and basic appliances,
aircraft and semiconductors – and granted them trade protection from foreign competitors until
they could develop. Most European countries as well as the United States used this approach in
the 19th century; and in the 20th century, so did countries such as Japan, Taiwan, and Korea.
Globalization made this approach much less effective. Rather than slowly develop the
knowledge and resources required to build up a competitive new industry, countries today can
import state-of-the-art factories and business organizations, mainly through FDI. Industries that
once took generations to take hold in developing countries can be up and running in a few years.
And the developing country benefits further as its workers learn how to operate efficiently in
modern enterprises, and how to manage modern ventures. The presence of these large, modern
enterprises also creates new demand for the goods and services that modern corporations rely on
– and that can spur the formation of new native businesses or the expansion of existing ones, to
help meet those demands.
One of the keys to modernization, then, lies in attracting FDI. Economists have
identified the criteria that influence where multinationals locate their FDI. Many are traditional
economic factors, such as the size of a country’s domestic market, its access to other neighboring
markets, the skills, quality and wage costs of domestic labor, and the quality and extent of its
infrastructure. A range of other factors, often characterized as a country’s “business and
investment climate,” also play big important roles in FDI. For example, countries where it takes
relatively little time and expense to start a new business attract more FDI, relative to their GDP.
Similarly, regulatory and bureaucratic barriers to operating an enterprise also affect FDI-location
decisions. Other political factors also can weigh heavily on FDI decisions, including a country’s
political stability, the soundness of its fiscal policies and its currency, and the government’s
respect for contracts and the rule of law.
3 Finally, when it comes to FDI in the IP-intensive goods and services that now dominate
the U.S. and other advanced economies, the security of patents and other intellectual property
rights has become crucial. When General Motors, Apple, Siemens or Samsung opens a factory
or an entire division in India or China, what they provide of value is their ideas and experience –
about how to produce a product with new technologies, how to distribute and market it, and so
on. If their property rights in their technologies or methods are not respected, they will take their
FDI elsewhere. Respecting IP rights, in short, has become a prerequisite for modernization.
One study, for example, examined 80 countries over four time periods from 1975 to
1994. The authors found that strong IP protections stimulated growth in countries with high
per capita incomes and even greater gains in countries with low per capita incomes -- by
encouraging imports and foreign direct investment from advanced countries. Other researchers
have established that every one-percent increase in the patent protections provided by a
developing country expands the stock of U.S. investment in that country by 0.45 percent.
There’s also evidence from the other direction. A survey of 100 U.S.- based multinationals
found significant reluctance among them to do business in countries cited by the Office of
the U.S. Trade Representative for failing to protect the I P rights of American companies.
With a colleague, I recently conducted new research in this area, focused on India. Using
a variety of measures, it is clear that India does not conduct itself as a responsible actor with
respect to IP rights. The widely-cited Ginarte-Park Index ranks India well behind many other
developing nations in enforcing patent rights -- 42nd in the world with a score of 3.76 out of a
possible 5.00, and so tied with Ecuador and El Salvador and behind many other developing
countries such as China, Ukraine and Turkey. Another measure, the International Property
Rights Index, ranks India 57th in the world with regard to IP rights – well below the scores of not
only the advanced countries, but also other developing nations such as China and Chile,
Malaysia, Uruguay and Rwanda, Panama and Brazil. And a recent survey of 13,000 business
leaders in 144 countries by the World Economic Forum found that among the 11 major Asian
economies, India ranks last with regard to IP rights.
As one of the world’s largest and fastest-growing economies, India’s IP regime matters
for global trade and investment. The IMF estimates that India’s GDP in 2012 was $1.9 trillion,
making it the 10th largest economy in the world. Adjusted for the cost-of-living in various
countries – that is, using “Purchasing Power Parity” or PPP -- India’s 2012 GDP came to $4.7
trillion, which made it the world’s third largest economy.
When India ignores or restricts the IP rights of western companies, those actions not only
discourage exports to the Indian market, but also reduce western investments and the
employment associated with them. In many cases, India has gone even further, by rejecting the
patents on goods developed by U.S. and European companies that are recognized everywhere
else in the world. The result is that India’s domestic producers can then appropriate the IP
protected everywhere else, and produce and sell their own versions in India and other countries.
India’s limited respect for the IP rights of American and European companies has other
adverse implications. In my recent study, we found a strong correlation between the quality of a
nation’s IP regime and flows of FDI to that nation over the period 2008 to 2012. After
controlling for GDP, we found that each unit increase in a country’s Ginarte-Park Index value –
4 equal to about one standard deviation – is associated with a 29 percent increase in its inflows of
FDI. The link between a country’s respect for the IP rights of foreign companies and its FDI
inflows is especially strong in highly IP-intensive industries, such as pharmaceuticals.
We also examined the particular impact of India’s IP regime on U.S. FDI to India in
pharmaceuticals. We found that if India improved its IP protections just to the level of China,
much less the United States, U.S. FDI to India’s pharmaceutical sector would increase
substantially. The main beneficiary would be India itself, especially as FDI flows have come to
dominate the modernization process. But it also matters for America and Europe, because recent
research has shown that the foreign and domestic investments of multinationals, as well as their
foreign and domestic employment, complement each other.
We now know that investments in a foreign market by multinationals stimulate demand
for goods and services produced by the parent company, back in the Europe or the United States.
As a result, increases in the assets and sales of foreign affiliates of multinational companies are
usually accompanied by increases in the same areas by the parent companies back home. From
1989 to 2004, a 10 percent increase in a U.S. multinational’s FDI was associated with a 2.6
percent increase in its domestic U.S. investments; and a 10 percent increase in the wages paid by
foreign subsidiaries was associated with a 3.7 percent increase in the wages and benefits paid to
the parent company’s American employees. Higher FDI by American and European companies
is also linked to higher exports by those companies and higher domestic spending on R&D.
As expected, we found that India’s current, lax IP regime has reduced the investments
and compensation paid by U.S. pharmaceutical firms in both the United States and India. We
also found that if India adopted IP rights comparable to the United States, U.S. FDI to India’s
pharmaceutical industry would increase as much as three-fold over the next four years. We do
not know how much of those increases in FDI to India would come out of FDI that otherwise
would go to other countries, and how much would represent an overall increase in FDI. If we
posit that one-fourth of the projected increases represent overall higher FDI, it implies an
increase in overall U.S. pharmaceutical FDI of more than $4 billion over four years. And this
suggests that if India adopted strict IP rights, the increase in pharmaceutical FDI to India would
be accompanied by a 1.3 percent increase in U.S. domestic investment by the industry over the
next four years. In a global economy, India’s current lax IP regime directly harms U.S. and
European domestic business investment, as well as their exports.
India is fully capable of making major improvements in its IP rights and enforcement,
which in turn would produce large benefits for India. Yet, India also has demonstrated a
persistent tendency to step backwards and even reverse course on IP rights. Since 2005, the
Indian Pharmaceutical Alliance and its member companies have challenged 81 patents of foreign
drug producers, patents recognized everywhere else, and often successfully. In recent years, the
Indian government has also considered or issued compulsory licenses for a number of important
patented treatments developed by foreign companies.
With so much at stake, the United States and the European Union should take immediate
steps to encourage the Indian government to reform its IP regime or, more directly, bring serious
pressures to bear on Delhi to respect and enforce the intellectual property rights of American and
European enterprises operating there. Thank you.
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