Stagnate or Innovate? That Is the Question

Our whole way of life depends on answering it correctly

We have an economic recovery of sorts. But economic growth remains weak, too many people are unemployed or in temporary jobs, there is downward pressure on wages, income inequality is high and business investment in productivity-enhancing innovation is inadequate. Could it be that the Golden Age of fast-rising productivity and significant improvements in living standards that we experienced in the last half of the 20th century is over, and that we now face a decade of slow or stagnating growth and consequently big challenges in delivering on the health care, education and social promises made by governments when the economy was doing better?

Discontent is no doubt the reason political parties are focusing on the middle class, although their solutions are less clear. And as young Canadians face tough labour market conditions, including reduced wages and more temporary or contract jobs, while boomers expect their pensions and health care, we risk intergenerational conflict. Yet we cannot blame all of this on the recent financial crisis. Trouble has been brewing for some time, as shown by adverse movements in labour participation rates and median wage levels since the 1960s, particularly for young Canadians.1 Trends in income distribution have been just as worrisome, with income growth since the early 1980s largely confined to the very top echelons of income earners.2 As a result, the middle class has seen its share of income decline significantly.

Moreover, the average annual growth rate of per capita national income after inflation, which is probably the base overall measure of how we are doing economically, has been dropping for the past half century.3 This is due to a reduction in the growth potential of the economy. Two big factors affect this growth potential. One is the growth rate of the labour force, including improvements in the skills of labour; the other is the growth trend of labour productivity, which in large measure depends on innovation and technology. Together, they constitute the potential growth rate of the economy, the rate of growth that is possible without setting off a burst of inflation. The problem is that our potential growth rate has been slowing, acting as a brake on the economy, and it has been doing so since the early 1980s.4

The growth of the labour force is shrinking and will continue to do so, so that productivity performance becomes even more important. Yet labour productivity growth rates have also been declining.5 This is why so much attention is now being focused on innovation: productivity gains and increases in living standards depend greatly on major technological advances and their rapid diffusion throughout the economy.

While the economy will not stop growing, it may not grow fast enough to create the good jobs and rising living standards we have seen in the past or fast enough to enable governments to continue to provide the health, education, pensions and other social benefits we expect it to deliver while also bringing deficits and debt under control. But is a decade or more of relative stagnation inevitable or is there something we can do?

This is not simply a debate between stimulus and austerity. It is about whether we have the new technologies and innovations that can deliver higher rates of productivity growth that ultimately are the source of sustained increases in living standards. Here the jury is still out. What does seem clear, though, is that we need to focus even harder on innovation and productivity strategies if we are to move beyond slow growth.

The American conservative economist Tyler Cowen, in The Great Stagnation: How America Ate All the Low-Hanging Fruit of Modern History, Got Sick and Will (Eventually) Feel Better, argues that the enormous gains in economic growth and living standards over more than two centuries came from living off “low-hanging fruit” in the form of lots of free land as settlers pushed westward, lots of immigrant labour and transformative new technologies. The problem today, he argues, is that “we have built social and economic institutions on the expectation of a lot of low-hanging fruit, but that fruit is mostly gone.” So his country is stuck with low growth until the next major growth revolution occurs. The Canadian story is not much different. Building condos and exporting oil sands oil will not do it.

Americans, and Canadians to a lesser extent, made a huge mistake, Cowen contends: “we thought we were richer than we were.” This belief encouraged everyone, from homeowners to governments, to take on more debt, confident that continued prosperity would make this a painless way to consume. Now that debt must be paid down. Yet Cowen describes himself as “an optimist for the longer run” because he is hopeful that new “low-hanging fruit” will emerge—although in the meantime, “we’re trying to eke out gains from marginal improvements in how we’ve done things for quite a few decades. That kind of process isn’t going to yield massive improvements in our living standards,” he says.

Cowen’s optimism is based on what he sees as favourable trends. One is the focus on science and engineering in China and India, which will mean a transition from being copycats to becoming innovators. This will contribute to global wealth creation. Second, he believes that the internet may do more for the economy in the future than it has done so far, because it will advance scientific discovery, connect people with new ideas to boost technological progress and help billions of people become better educated. Third, he sees a major effort underway in the United States to bring improved quality to K-12 education, something Canadians need to pay attention to as well. These are all positive factors for the future, but they may take some time to kick in.

Robert Gordon, an American economist and widely recognized expert on productivity also fears we face an era of slow growth. In a paper published last year—Is U.S. Economic Growth Over? Faltering Innovation Confronts the Six Headwinds—-Gordon challenges the widespread assumption that economic growth “is a continuous process that will persist forever” and suggests that “the rapid progress made over the past 250 years could well turn out to be a unique period in human history.” Gordon divides the period since the mid 18th century into three successive industrial revolutions, concluding that the second industrial revolution, which gave us electricity, the internal combustion engine, chemicals, indoor plumbing and mass communications, is the most important of the three, delivering rapid productivity growth and rising living standards over 82 years from 1890 to 1972.

Many of the gains from the information and communication technology or third industrial revolution, Gordon argues, have already been achieved, such as the role of computers in large-scale data processing and the elimination of much clerical labour, the introduction of CAM-CAD and robotics in manufacturing, the invention of the microprocessor, and the advent of the internet and wireless communications. The current array of devices, such as the BlackBerry and the iPad, while smaller, smarter and more capable than earlier devices, “do not fundamentally change labor productivity or the standard of living in the way that electric light, motor cars, or indoor plumbing changed it.” Gordon is not forecasting zero growth but slower growth. Innovation and gains in living standards will continue, but at a much slower pace, not only because of a slowdown in technology but also because of other factors such as the need to bring public finances under control and reduce household debt and the challenge from globalization pressure on wages. Yet while Gordon is right to challenge our belief in constant progress, he could be underestimating the future gains from the revolution in information and communication technologies (ICT).

Stephen King, group chief economist at HSBC, is another who fears, in When the Money Runs Out: The End of Western Affluence, that the West faces an era of economic stagnation. The baby boomers did well, he argues, calling them “the lucky ones.” But those who now follow will face a tough time, as slower economic growth and weaker productivity gains make it more difficult for governments to pay down public debt and restore their finances. So promises made in more prosperous times will have to be broken as western societies are forced to re-evaluate priorities, including entitlements and social spending. In Canada we have already had one example. In his 2012 budget finance minister Jim Flaherty announced that the age of eligibility for the old age security pension will be gradually raised from 65 to 67, the argument being that we cannot afford to maintain the 65 eligibility level.

King believes that the free market and deregulation advocates made us overconfident. “We began to believe that economies free of excessive government interference could happily expand, over the years delivering higher incomes for all … Capital markets would take care of everything.” This turned out to be a delusion. The idea that western economies could grow their way out of debt is now seen to be a false hope. Many governments in the West face difficult choices; dealing with deficits is a painful process when growth is weak. Yet restoring fiscal health is critical, King contends. Stronger growth from innovation would make it easier, although he does not express much optimism on future productivity gains.

U.S. Federal Reserve System chair Ben Bernanke is more optimistic on whether we can look to stronger economic growth from fast-paced innovation. Many factors affect economic growth, “but over long periods probably the most important factor is the pace of scientific and technological advance,” he said in a speech at Bard College in May 2013. Previous “waves of innovation” through two industrial revolutions clearly benefited and enriched societies. Now we are living through a third industrial revolution—the information technology revolution—that began in the late 1940s and is still going on.

“History suggests that economic prospects during the coming decades depend on whether the most recent revolution, the IT revolution, has economic effects of similar scale and scope of the previous two. But will it?” Bernanke asks. He answers his own question optimistically, maintaining that innovation is based on ideas, that no one can forecast what future ideas will emerge, that the long-run consequences of innovation for the economy are notoriously hard to predict and that the pessimists may be paying too little attention to the underlying social and economic forces that generate innovation in the modern world, including the vast increase in the number of scientists and engineers worldwide and the growing investment in new approaches by industry, governments and academia. Innovation is part of our DNA, he argues, and that will not change. Bernanke brings useful insights but does not express a view as to whether we can expect breakthroughs soon.

In their sweeping survey of what they called “the third globalization,” Dan Breznitz and John Zysman, American academics with a long-time interest in innovation, offer a cautiously optimistic outlook. In their edited volume—The Third Globalization: Can Wealthy Nations Stay Rich in the Twenty-First Century?—they postulate that we now face what they call a “double bind.” This arises from the desire both to unleash markets for innovation through deregulation while at the same time governments are called on to protect society to ensure market outcomes are acceptable or to accomplish a specific objective such as dealing with climate change. As they note, “simultaneous calls for often-disruptive economic growth and citizen welfare have always pulled in opposite directions.”

For the past three decades, Breznitz and Zysman contend, echoing Stephen King, that the rich countries have accepted “the neoliberal belief that ‘less’ regulated markets can achieve sustained growth, which will then ‘naturally’ enhance societies without the need for public intervention.” The financial crisis exposed the fallacy of this thinking and the debate has now shifted to a more balanced approach with a purposeful role for government. They stress that ICT is radically changing the way firms compete and markets work, which is why we need a new growth model to define what it takes for a company to compete in markets, create value and provide jobs as well as clarifying the role government plays in “sparking, sustaining, and supporting development.” A successful third globalization will emerge from the way this debate is resolved.

This third globalization, they maintain, is about change. The western domination of trade and finance has ended and the global power base is shifting so the West can no longer coerce the rest of the world to its agenda. The outsourcing of the production of goods and services to networks that make the supply of components and tools widely available, along with ICT, has changed the terms of competition and permitted rapid entry for new countries into industries that were formerly dominated by the West. China’s entry into the automotive and electronics industries and India’s entry into the software and systems industries are examples. Likewise, the third globalization has seen loss of middle class jobs and higher inequality in the West, with ICT-based automation in manufacturing and services and expansion of production from the developing world resulting in a hugely disproportionate share of the gains from growth now going to the so-called 1 percent. Growing fiscal pressures on governments are also pressing on the welfare state and the policies we have relied on to cushion society from the disruptive impacts of capitalist markets.

Yet the two authors are optimistic, they say, because there is now recognition we need to achieve a new balance between markets and governments. As they write, “this is not going to be easy, but the fact that this task is now on the agenda, because the failure of the one-size-fit-all neoliberal solution is on full display, offers a unique period of policy experimentation and innovation.” However, they admit that countries in the West are having a tough time addressing these issues and they do not provide a clear road map to finding such a balance.

Tom Brzustowski, chair of the Institute for Quantum Computing at the University of Waterloo, and for a decade the president of the Natural Sciences and Engineering Research Council of Canada, knows something about innovation and the importance of both a rich science and engineering base and the need to convert new ideas into successful innovations. Canada, he argues in Innovation in Canada: Why We Need More and What We Must Do to Get It, is a wealthy country compared to most but, “surprisingly, it is turning out that Canada is not prosperous enough. Evidence is mounting that our current prosperity is insufficient to meet all the truly important needs that are being identified across the land.”

He creates a daunting list of examples, including the health costs of an aging society and the competition for public dollars from needed education spending, the challenge of reducing child poverty, the restoration of crumbling infrastructure and the future infrastructure needs in our cities, the provision of safe water in all communities, addressing climate change and the transition to a low-carbon economy, expanding broadband access in rural Canada, acquiring modern search-and-rescue aircraft, building ice breakers for the Arctic, investing in mass transit to reduce traffic congestion and raising the standard of living of aboriginal communities. “We can’t afford to fund the necessary solutions fully, or quickly enough, or at all,” he argues, because we are not generating sufficient wealth.

The squaring of this circle, Brzustowski contends, depends on strengthening wealth creation and economic growth through an all-out effort to boost innovation in Canada. While Canada has a strong science base and abundant natural resources, it is a laggard when it comes to innovation. But while Brzustowski does an excellent job of taking us through the factors that drive innovation—such as sustained investment in education and research, support for emerging next-generation companies, adding value to our natural resources before exporting them and boosting advanced manufacturing—as well as setting out guidelines or principles for innovation policy, he provides less in the way of actual prescription. His solution is to call for an “Innovation Action Plan.” It would be led, he says, by “a small group of the top leaders of government and equal numbers of the acknowledged leading figures from business and from post-secondary education” who would “jointly develop a strategy for meeting the goal” and specify “who will do what and when.” However, this kind of national consensus-building exercise has been tried several times, with only limited success. Canada clearly needs to improve its innovation performance, as Brzustowski stresses, but it is still not clear how best to do it.

In a major study published this year, the McKinsey Global Institute sees considerable reason for “optimism about the potential for new and emerging technologies” but trepidation about the impact on employment and social structure. In Disruptive Technologies: Advances That Will Transform Life, Business and the Global Economy, it identifies major technology opportunities that it believes can bring big economic gains by 2025. However, “the nature of work will change, and millions of people will require new skills” with new technologies making some forms of human labour “unnecessary or economically uncompetitive.” The new technologies have the potential to eliminate many middle class jobs, and to continue the pattern of inequality in most western societies.

In addition, “there will be a need for sustained public and private investment in R&D and the removal of regulatory and other barriers to new technologies and new ways of doing business.” Governments will have an important role to play. “Since the Industrial Revolution, governments have played an increasingly important role in bringing disruptive technologies to life,” the McKinsey report says. An active state is vital for innovation.

McKinsey lists twelve innovations, optimistically declaring “that the technologies we identify have potential to affect billions of consumers, hundreds of millions of workers, and trillions of dollars [$14 trillion–$33 trillion per year] of economic activity across industries” by 2025. The technologies are the mobile internet, the automation of knowledge work, the internet of things, cloud technology, advanced robotics, autonomous and near-autonomous vehicles, next-generation genomics, energy storage, 3-D printing, advanced materials, advanced oil and gas exploration and recovery, and renewable energy. Five other technologies nearly made the list: next-generation nuclear (fission), fusion power, carbon sequestration, advanced water purification and quantum computing. We should determine whether Canada is a strong contender in any of these technologies, and if so which ones, and what Canada needs to do to ensure it has staying power to be a contender through to 2025 and beyond.

What all of these writers share is a belief that without continued gains in productivity through the innovation that comes from the development and exploitation of transformative new technologies, our future growth prospects are weak. This matters because there is a close link between our ability to achieve stronger growth and our ability to deal with inequality and sustain valued health, education and social programs without imposing huge burdens on the next generation. Yet there will be pain because, as King points out, the West cannot grow its way out of its fiscal challenges; there will also be a need to reorder public priorities. These writers also challenge the so-called neoliberal agenda of deregulation, small government and unfettered free markets that have dominated public policy over the past couple of decades and seek a more balanced kind of economy that is able to tap the vast potential of a competitive private sector but with an essential role for government.

In Canada, as Brzustowski stresses, we need to cast our innovation net widely, to link our science and engineering skills much better to our own critical needs to improve productivity and raise living standards through wealth creation. This is not just a matter of public investment in education and research. It means building competitive Canadian companies that can compete in the new global economy, based on innovative, high-value products and services. But building innovative enterprise is hard work and mismanagement can undermine the efforts, as the bankruptcy of Nortel and the troubles of BlackBerry clearly demonstrate, while a weak financial system for innovative entrepreneurs means many of our promising young companies are sold as seed corn to foreign multinationals rather than achieving their potential as Canadian companies.

But where there is need there is opportunity for innovation. Canada will have a federal election in 2015. The country’s future growth potential for a sustainable and equitable society should be the central issue. This is vital for our future well-being, much more so than reforming the Senate or legalizing marijuana.

 

Notes

1 A recent report by Statistics Canada found that in 2012, for example, 78.5 percent of young men aged 25–34 had a full-time job, compared to 87 percent in 1981. Moreover, those who had full-time jobs in 2012 had median wages after inflation that were 4 percent below 1981 levels, despite the fact that they were better educated than their 1981 counterparts and that productivity growth since 1981 should have delivered some benefit.

2 As noted by Brian Murphy of Statistics Canada and Michael Wolfson of the University of Ottawa, between 1982 and 2010 income growth was “largely limited to the top 5% which in turn has been driven largely by increases to the incomes of the top 1% of income recipients in Canada.”

3 A Statistics Canada study by John Baldwin and Ryan Macdonald found that this key growth rate declined from 3.39 percent a year in the 1960s to 2.92 percent in the 1970s, 1.7 percent in the 1980s, 1.47 percent in the 1990s and 1.35 percent in the 2000s.

4 According to the Bank of Canada, the potential growth rate fell from 2.7 percent a year from 1982 to 1989 to 2.5 percent from 1990 to 1999, 2.3 percent from 2000 to 2009 and just 1.8 percent from 2010 to 2013.

5 These growth rates averaged 4 percent a year in the 1960s, 2.2 percent in the 1970s, 1 percent in the 1980s, an uptick to 2 percent in the 1990s and just 0.8 percent a year in the 2000s.