Money Talks

By Michael Fitzgerald

Is U.S. Losing the Innovation Arms Race?

Tom Melcher saw it coming. Even back in the early 1980s, when he was an undergraduate at Yale University studying Mandarin Chinese, Melcher understood the critical role that China would someday play in the U.S.'s economic future.

He observed it firsthand while helping to found IBM Corp.'s early efforts in Beijing in the mid-1980s. And he thought about it often throughout his time at Harvard Business School and during his stints as a principal executive at five different Silicon Valley start-ups. But it wasn't until last year that Melcher made a move he had considered for more than two decades.

In July 2004, Melcher moved to Beijing with his wife and two daughters and began investing in emerging Chinese companies.

"We feel it's part of our jobs as parents to prepare our daughters and give them opportunities," Melcher explains. "They really need to learn Chinese." Asked why, he laughs. "They ask us that all the time. It seems obvious. If you fast-forward 10 years, or maybe 20 years, it is absolutely clear that the only other superpower in the world will be China, and it will be a world force in the way that the U.S. is now."

What Melcher is acting on is the growing fear in the U.S. today that the twin forces of outsourcing and globalization are working in tandem to unseat the U.S. from its lofty position as the world's only economic superpower. And in the frenzied fight to keep the U.S. on top during this perceived global leveling, innovation is the weapon in our economic arsenal most commonly being called upon to save us from an uncertain future.

It is a long-held tenet of entrepreneurialism in the U.S. that no matter what global economic challenges the world can dish out, we can innovate our way out of them. Time and again, American innovation has created new markets, built economic value and kept our citizens gainfully employed. The telephone, the semiconductor, the Internet. But what happens when innovation itself is being outsourced? "Where innovation happens matters," says Thomas Friedman, author of The World Is Flat (Farrar, Straus & Giroux, 2005), a 500-page tome on the effects of globalization. "The flat world means that you don't have to emigrate to innovate, and when you can innovate without having to emigrate, you don't have to come to the U.S."

The Council on Competitiveness, a lobbying group composed of industry and academic leaders, is so concerned about the future of innovation in the U.S. that it issued a 68-page "call-to-action" report in December 2004, urging policy-makers, universities and industry to "optimize our entire society for innovation."

There is reason to worry. In 2005, the National Science Foundation saw its R&D budget cut for the first time since 1996. And the proposed 2006 federal budget includes a meager increase of one-tenth of a percent in R&D funding, most of it earmarked for defense and homeland security.

Meanwhile, fears about the nation's faltering educational system abound. In February, Bill Gates told an audience at the National Education Summit on High Schools in Washington, D.C., that the country's schools were obsolete. "By obsolete, I mean that our high schools—even when they're working exactly as designed—cannot teach our kids what they need to know today," Gates said. And U.S. citizens pursuing graduate degrees in science and engineering declined 10 percent between 1994 and 2001, while foreign-born students upped their enrollment by 25 percent, according to the NSF.

Perhaps that's why at a biotech conference in late 2003, George Whitesides, the eminent Harvard chemist and nanotechnology researcher, answered a question about the U.S.'s prospects by noting he has three "very nice but unemployable" sons. "The future is going to be much better for India than Indianapolis," he said.

That may be a tad drastic. And while statistics indicate that the U.S. needs to till the soil from which innovation grows, historical evidence suggests that downturns of this nature are cyclical, normal and addressable.

Money Talks

Money Talks

Much of the hand-wringing over American innovation can be traced to some troubling trends in the financing of research and development. Innovation has always been a crucial driver of the country's economic engine, and as such it has always been well looked after. No other nation spends more on R&D than the U.S., which contributes 44 percent to the worldwide total. But budget deficits, a costly war in Iraq and an ongoing economic slump are all contributing to a widespread pullback.

When it comes to funding innovation today, the lion's share of the money comes from corporate R&D spending. More than 68 percent of all domestic R&D is funded by the private sector, a dramatic shift from 20 years ago, when the federal government financed the majority of it. The danger in that shifting tide is that corporate R&D spending is closely pegged to business cycles. When money is tight, as it is now, R&D budgets get slashed early and often. Over the past four years, private industry in the U.S. has issued a collective shrug when it comes to filling the R&D coffers. Even the technology companies whose lifeblood is innovation have been reducing their spending on R&D as a percentage of sales, and refocusing the money on product development, rather than basic research that may not yield marketable products. The NSF estimates that between 2000 and 2003, nonfederal funding of R&D from private industry declined 2.3 percent.

"The drumbeat pressures of quarterly results are . . . drowning out long-term management, investment and innovation strategies," write the authors of the "National Innovation Initiative," the report issued by the Council on Competitiveness. But they'll find no sympathy from the likes of Wall Street. "Who wants to invest in core R&D with no visible upside?" asks Pip Coburn, global technology strategist at UBS Warburg. He says it isn't Wall Street's job to reward companies for basic research; it's to reward them for innovation that leads to revenues.

At least part of the problem is the major spending pullback that followed the Internet bust of 2001, and there's no reason to think that R&D spending won't eventually rebound. But the numbers are down across the board. Federal funding of nondefense-related R&D increased only 1.4 percent between 2004 and 2005, while defense R&D climbed 6.2 percent, to an all-time high of $74 billion. And though it is true that many market-changing innovations, such as the Internet itself, have come from defense research in the past, almost all of the increase in defense spending is dedicated to new weapons systems.

While the federal funding of research in the physical sciences as a percentage of GDP has declined steadily in the U.S. over the past 30 years, China doubled its spending on R&D in just the last ten years—from 0.6 percent to 1.2 percent of GDP, which is currently about $1.2 trillion—and plans to boost its proportion of science spending on basic research more than 200 percent in the next ten years.

Friedman may be right that where innovation happens matters. But it is also true that where the consumer markets are also matters. And at the moment, everyone is closely watching the rapidly maturing Chinese market. More and more R&D is being sent overseas in an attempt to leverage cheap labor and address those local markets. The Economist Intelligence Unit, the research arm of The Economist magazine, published a survey in September 2004 showing that global executives plan to make more R&D investments in China than anyplace else over the next three years. The U.S. finished a distant second, followed closely by India.

Meanwhile, overseas multinational companies are happily stepping in to fill the widening void in R&D funding in the U.S. When American universities don't get enough financing from the federal government or U.S.-based companies, lines of foreign firms await with checkbooks at the ready. Arup Gupta, president of Tata Consultancy Services America, a subsidiary of Mumbai, India-based Tata Group, says that investing in American universities is part of TCS's strategy to leverage the innovation infrastructure in the U.S. In addition to investing in research centers in India, TCS spends heavily—as much as $3.5 million a year—sponsoring chairs and research centers at such schools as the Massachusetts Institute of Technology, Carnegie Mellon University and the Georgia Institute of Technology, and walks away with whatever intellectual property is created. "Today, we are not seeing enough innovation from the Indian companies," Gupta says. "But we understand that cost reduction is just a one-time benefit, and innovation is crucial to our long-term survival. We are trying to emulate the U.S. model."

Teach the Children

Teach the Children

Americans have always possessed an odd combination of fear and faith, two qualities that worked together to create a nation of stunning progress in a short amount of time. Says Stanford University historian Joseph Corn: "Americans have been very comfortable with seeing themselves going to hell in a handbasket, which goes along with a breast-beating fury about how great they are." What's different today, he maintains, is a creeping doubt about our strengths, much of which comes from the belief on the part of current students that they will not be as well off as their parents. Corn says he finds it strange that 20-year-old students are worrying about whether they'll be able to afford a house.

Part of that fear stems from the fact that Europe and Asia are graduating record numbers of science and engineering students hungry for the same jobs Americans used to feel were their birthright. In 2000, Asian universities accounted for nearly 1.2 million science and engineering degrees, compared to 850,000 in Europe and 500,000 in North America, according to the NSF. And in 2001, more than half the science and engineering postdoctoral positions in the U.S. were held by foreign-born scholars.

But does it really matter how many science and engineering students a country graduates? It does when those students stay at home and start producing. Patent applications in China, India, Singapore, South Korea and Taiwan have been ballooning, growing more than sevenfold between 1989 and 2001. During that same time, the U.S. increased its patent portfolio by only 116 percent.

Ask Paul Saffo, director of the Institute for the Future in Palo Alto, Calif., what he thinks is wrong with education in America, and you get an earful of anger. "America has a really strong anti-intellectual streak," he fumes. "We're celebrating the bubbas, the superstitious and the ignorant," he continues, citing reality TV shows like American Chopper and Kansas's mock trial of evolution as evidence.

In the academic community, the mood is decidedly dour, almost fatalistic. "It's inevitable," says Langdon Winner, a professor of humanities and social sciences at Rensselaer Polytechnic Institute, when asked whether the U.S. will be surpassed in technology innovation. "The U.S. graduates about 70,000 engineers at present, while China aims to graduate half a million a year for the foreseeable future."

Many academics complain of a lack of vision and leadership from the highest levels in the country. And most quickly point to shortsighted policy decisions, particularly in the area of embryonic stem-cell research. Since the Bush administration's ban on the use of federal funds to work with any embryonic stem-cell lines created after August 9, 2001, prominent scientists have left the U.S. to go to places like Britain and Singapore in the quest to decode the secrets of hundreds of hard-to-treat diseases. Normally, the federal government would be a major backer of this kind of early-stage research, helping to propel the U.S. to the next frontier of science and medicine. But on moral grounds, the Bush administration has limited what it will fund.

Saffo sees the stem-cell debate as the bellwether for our future. "I live in fear that the neocons are going to pass an out-and-out ban on stem-cell research," he says. "And that will be the death knell" for the U.S. as an innovator.

Take a Deep Breath

Take a Deep Breath

Is the sky falling? In the past year, at least three breathless calls to action have been issued by powerful lobbying groups, all urging the Bush administration, private industry and universities to address the dire situation. Joining the report by the Council on Competitiveness, "Innovate America," is a manifesto from the Task Force on the Future of American Innovation titled "The Knowledge Economy: Is the United States Losing Its Competitive Edge?" as well as TechNet's "Innovation Policy Agenda." All share the same concerns over the future of innovation in the U.S., and recommend similar solutions: Strengthen math and science education; increase federal funding of basic research; provide broader tax incentives for R&D, etc.

There is an avalanche of data to support the claim that the U.S. is on the precipice of innovation breakdown. But amid the panic, there is also ample evidence that the U.S. is completely in control. Despite the oft-cited recent declines in federal and private spending on R&D, the U.S. still ponies up a combined $284 billion a year, more than two and a half times the closest competitor, Japan, and more than all other G-7 countries combined.

And experts argue that at least part of the decline in R&D spending is due to more efficient use of R&D dollars. "There is some fine-tuning of R&D spending going on, and companies are developing products faster and more efficiently," says Al Delattre, managing partner in Accenture's electronic and high-tech practice. Delattre explains that U.S. firms are outsourcing parts of the development process to save on labor, but that's not necessarily a bad thing. "In a global economy, it really doesn't matter where the innovation occurs. What matters is how much value is taken from it."

There is also the matter of having an enormous head start. "America is so far ahead," says TCS's Gupta. "For a country of India's size, with the talent base we have, we still haven't been able to come up with the kind of products that Cisco Systems or Microsoft have. We don't have the capital base. You can call Bangalore the Silicon Valley of India, and I can show you fifty different start-ups there. But how many of them are funded? How many of them are successful?"

As Gupta talks, you can hear the envy in his voice. The deep base of American investment capital far outstrips anything the rest of the world has to offer. In 2004 alone, despite lingering wariness following the tech bubble, U.S. venture firms raised more than $17 billion, and buyout and mezzanine funds topped out at more than $45 billion according to the National Venture Capital Association. That's compared to $17 billion of total private equity funding for Asia during the same period. "You need a culture that supports innovation, that encourages risk and allows for failure," says Accenture's Delattre. "The U.S. does that better than anyone, and that is not a culture that is available or can be replicated."

Much of the anxiety over American innovation seems to stem from a lack of visibility into what the "next big thing" will be. "If you're waiting for the next transistor or integrated circuit or optical networking technology, you've got a long, long wait coming," says Nicholas Donofrio, senior vice president of technology at IBM. "There is no next big thing."

Of course, it's often hard to tell what the next big thing is until it is already upon us. And even if the U.S. doesn't produce the next world-changing technology or product, it's quite possible, even likely, that Americans will be the biggest beneficiaries of it. "Technical invention is not necessary to innovate," says Hervé Gallaire, CTO of Xerox Corp. and president of Xerox Innovation Group. "Many inventions come from other parts of the world. What made America different was bringing those inventions together to create the innovation."

Look no further than Austin, Texas, for proof of that. Michael Dell, a college dropout, didn't invent the PC, the modern manufacturing plant, or the Internet. Yet he brought the three of them together to redefine how PCs are built and sold. Nor did Bill Gates, another college dropout, invent the graphical user interface. And yet it would be hard to argue that Dell and Gates haven't made critical contributions to the nation's economic engine.

Even Saffo, after he calms down, apologizes for sounding alarmist. He's not alarmed—yet. Instead, he thinks it would take "a major screwup" for the U.S. to slide into the kind of complacency that could unseat it from its place atop the global economic food chain.

In the meantime, Tom Melcher and his family are committed to staying in China for at least the next three years, and quite possibly until both girls are out of high school. He's going to continue funding Chinese start-ups. Yet despite his affinity for all things Chinese, he still doesn't believe that the U.S. is losing its ability to innovate. China is simply on a faster innovation curve, and he thinks the world economy "will no longer be centered on America. It will become much more of a duopoly." That doesn't sound so bad, does it?

Michael Fitzgerald is a business and technology freelance writer based in Massachusetts.

This article was originally published on 06-05-2005