A Leader, a Follower, and a Competitor
States that want to achieve high standards of living and long-term GDP growth have to work on real improvements in productivity. These, in turn, are heavily reliant on innovation. What states need in order to initiate and support innovation is, first of all, a socio-economic, financial and institutional enabling environment. Innovation however does not arise by itself: it requires actors capable of driving innovation (i.e. expanding the technological frontier), and adopting innovation (i.e. actually getting on the frontier).
Taking the above factors into account, the current global picture of innovation depicts a leading United States, a European Union following with difficulty, and a rising China that could eventually compete with the US on equal terms.
Keeping it in Perspective
The current situation can be analysed in two ways: in a snapshot, and in a dynamic way. Each of these two points of view on its own would give a partial and distorted representation of the current situation: both are needed to gain the right perspective.
Among the three entities taken in consideration, the US is in fact the leader. The EU follows the US relatively closely, while China seems to be lagging behind. GDP per capita in 2015 was over $55,000 in the US. On the other hand, the EU was following with a GDP per capita of almost $38,000, while China lags behind with a value of only around $14,000. The same pattern can also be found in terms of labour productivity: the US is leading with a level of labour productivity per person of around 119 thousand dollars. The EU positions itself at almost 90 thousand dollars, whereas China stops below 27 thousand dollars. Finally, American leadership is also clear in terms of patent filing: over 1,500 patents per 1 million inhabitants have been filed in the US in 2014, while the EU follows with around 1,000 patents. Even in this case, China did not reach the competitors’ level, stopping below 800 patents.
This static representation of the state of things, however, is only partial. What we can extrapolate from a dynamic assessment is that while the US is still the leader in innovation, China is catching up with it at a very high pace. In the meanwhile, the EU follows the US with difficulty, loosing ground to the US, especially since the 2008 crisis.
In 2015, GDP per capita has grown around 1.6-1.7% both in the US and the EU. In China, it has increased by 6.4%. Even more strikingly, Chinese GDP per capita has grown fourteen-fold from 1990 to 2015, while in the US and in the EU it has only increased around 2.5-fold. The EU, in particular, has stopped catching-up with the US since the mid-80s, and since the 2008 crisis the gap between the two has been increasing. In terms of labour productivity, China’s growth has been very strong in the last decade, with peaks at almost 10% and 12% in 2006 and 2010, however slowing down since 2015 (under 4% growth rate). Over the same period, European and American rates have never been above 3%, and mainly below 2%. A very similar pattern can be found also in relation to patent filing. The US has always been the country filing more patents among the three. The EU, while catching up with the US until the late 90s, it has since then lost ground, especially since 2008. Finally, China, from virtually no patent filing in 1999, has almost reached the level of patent filing in the EU, thanks to incredibly high growth rates.
Considering the static and dynamic pictures together give us a good overall perspective: the US has always been leading the way, while the EU has transitioned from being an engaged and determined “catcher-up” to a limping follower. On the other hand, starting from a low point, China has been quickly catching up with both the EU and the US, and is now turning into a real competitor of the US in the field of innovation.
An Innovation-Friendly Environment
A high-quality human capital, efficient infrastructures, a developed financial sectors, and reliable institutions are the necessary elements to build an innovation-friendly environment.
Human capital is arguably the most important determinant of long-term economic success of a country. Human capital includes all the skills and knowledge that reside in people that can be put in productive use. The World Economic Forum (WEF) human capital composite index gives us a clear picture: both the EU and the US perform well (with scores around 78.5/100) with the US slightly ahead, whereas China lags behind by 10 points. It is interesting to mention that 14 out of the 20 top countries are EU member states. Even in terms of public expenditure on education, the US leads with 5.2% of GDP in 2014, the EU follows with 4.9%, while China spent only around 3.6% of its GDP. Moreover the US can also count on a strong private contribution, especially to higher education. Focusing on higher education shows us a similar pattern: among the world top 100 universities, 30 are American (24 when specifically looking at engineering and technology), 33 are EU-based (25), and only 4 are Chinese (6).
The development of efficient, integrated and reliable infrastructures can enable innovation, reducing costs and widening the markets for both inputs and outputs of production. A static picture of the quality of infrastructure networks reveals us again the typical pattern: the quality of American infrastructures is rated 5.9 out of 7 by the WEF; the EU networks are rated slightly below at 5.8; whereas Chinese infrastructures quality is lagging behind at 4.7. Nevertheless, a dynamic analysis shows us that both in the EU and the US, infrastructure investments rates have decreased respectively by 0.4% and 0.2% of GDP in the 2008-2013 period. On contrary, over the same period, investments in China have increased by 0.7%. Moreover, annually, China is spending more on infrastructures than Northern America and Western Europe together: China investments amount to around 8.6% of world GDP (versus the combined 5% for Northern America and Western Europe).
Innovation also depends on the capacity of the financial sector, as it provides the funding necessary for firms to invest in technology and for startups to spring up. In the world of innovation, venture capital (VC) funding is particularly relevant. VC investments in the US in the last couple of years averaged 0.2% of GDP, while in the EU it stopped to a much lower 0.03%. The gap with the US has been widening especially since the 2008 crisis, reaching almost €25 billion. On contrary, despite starting from a low point, China has experienced a stunning increase in VC, which has grown seven-fold in the last 5 years (partly because of the strong involvement of the state in VC funds). China has already overtaken the EU in terms of VC availability, and is quickly closing the gap with the US. One of the factors hampering early stage financing in the EU is the greater difficulty for VC investors to sell their shares through equity markets, due to the limited size of the latter. The total stock market capitalization in the Euro Area is around 47% of regional GDP, below total capitalization in China (48%), and far below the US’ one (146%). European exit markets are not only smaller but also fragmented along national lines, reducing liquidity and venture capitalists’ exit possibilities.
In the context of innovation, institutions also play a central role: property rights, intellectual property rights, transparency, accountability, efficiency of the legal framework and investor protections all have a strong impact on how innovation-friendly the economic environment is. There is virtually no gap between the US and the EU in any of these categories, while China scores much worse. The institutional environment might actually be one of the main challenges China will have to overcome in order to become a real competitor of the US.
An innovation-friendly environment is obviously not enough: actual innovation needs to arise. Driving innovation requires availability of scientists and engineers, high company spending on R&D, government procurement of advanced tech products, university-industry collaboration, and high quality of scientific research. In all these areas, the US is a global leader. What is most striking is that in all these fields (except for the quality of scientific research institutions) the EU has been overtaken by China, which is quickly catching-up with the US. The EU’s poor performance can mainly be explained in terms of weak industry-science links, poor commercialisation of research results, and the negative impact of the economic crisis. In particular, while business share of total expenditure on R&D in China and the US is respectively 74% and 60%, in the EU it stops at a lower 50%.
The results of innovation activity can be estimated using the number of filed patents. As already pointed out, the US is a leader even in this case, with over 1,500 patents per 1 million inhabitants. The EU has stopped in the catching-up process: in fact, since 2008, the gap with the US has been increasing. On contrary, China is rising in this sector as well, almost achieving 800 patents per 1 million inhabitants, and thus almost catching up with EU. Even in terms of innovation hubs, the US leads with 9 hubs in the world Top 20, while China stops at 2 (Shenzhen, which is 2nd overall, and Beijing, which is 4th). Even in this case, the EU performs poorly with only one hub in the world top 20: Einhoven (Netherlands), which is 19th overall.
Research and development can push forward the frontier of innovation. However, for innovation to be useful, it must be adopted by firms. The capacity of firms to absorb innovation can be analysed comparing the availability of latest technologies, the firm-level technology absorption, and technology transfer. In all these fields, the US performs best among the three, with the EU following it. Finally, China still performs significantly worse than both the US and the EU, but it has been improving in recent years. The largest gap between the EU and the US is in firm-level tech absorption, while in the case of China the largest gap is in the availability of latest technologies.
A Dynamic Economy
Once new ideas are translated into new products and services, the need of a dynamic environment becomes crucial for the above to take off. For an economy to be dynamic, old inefficient firms need to make place for younger more innovative ones: the so-called “creative destruction”. The European business environment greatly lacks such dynamism. This is partially due to the large share of static firms, i.e. firms that grow less than 5% or shrink less than 5% a year in terms of employment, and a low share of fast-growing firms.
An economy is dynamic when doing business in it is easy. This can be measured via proxies, such as the easiness of starting a business, dealing with construction permits, registering property, getting credit, enforcing contracts, and trading across borders. China performs worst in these areas, while the EU closely follows the US. The EU performs best only in trading across borders, but that could be misleading, since the statistics do not distinguish between intra-EU and extra-EU trade.
Purchasing Power Parity
Is what you can buy with $100 in the US, the EU and China going to be the same? A way to look at this is through the lens of Purchasing Power Parity (PPP) theory. PPP theory is the notion that in the long run exchange rates should move towards the rate that would equalise the prices of an identical basket of goods and services in any two countries. Since 1986 The Economist has applied this theory to reality through the Big Mac Index, which compares the price of the famous burger worldwide, to analyse whether currencies are at their “correct level”. Taking US dollars as the base currency, we find that, in July 2016, a Big Mac cost $5.04 in the US, $4.21 (€3.82) in the Euro area, and only $2.79 (18.60 Yuan) in China. What emerges, then, is that the euro is undervalued by 16.6% and the Chinese currency is undervalued by 44.7% when compared to American dollars. Furthermore, when compared to the euro, the Yuan is undervalued by 33.8%. This pattern is the same also when adjusting for GDP (although with lower percentages of over/undervaluation). Other factors apart, China has thus a great advantage over the US and the EU in attracting investments and businesses, since with the same amount of dollars you can buy much more in China than in the EU or the US.
The US still maintains a strong hold on the leadership in the innovation race: in all dimensions discussed, the US still performs better than the EU and China. On contrary, the EU is relentlessly drifting away: while it was catching-up with the US until the 90s, it has since then stopped in the process and the gaps have in fact widened since 2008. Further, the EU has been surpassed by China in fields such as venture capital availability and capability of driving innovation. In these areas, China has been experiencing amazing improvements and is on the way to eventually close the gap with the US. Even in some areas where China still performs worse than both the EU and the US (human capital and quality of infrastructures), it is improving at a very sustained pace. Moreover, China can still count on the advantaged of a strongly undervalued currency. However, while it is well on its way to become a real competitor of the US in the field of innovation, China still has to confront some major challenges, which mainly lie in the fields of institutions and easiness of doing business
A Final Note: Brexit
In this article, the performance of the EU stands for the average performance of the 28 member states, weighted by their GDP. It is important to note that the result of the British referendum on EU membership will negatively affect the performance of the EU. All top EU universities are in fact British (Oxford, Cambridge, LSE, and UCL). The Oxford-Cambridge-London area is one of the most important ones in the EU in terms of innovation. London has been the main financial hub serving the entire EU, providing financial services and venture capital. And the British economy is among the most innovative and dynamic ones in the EU.