The Innovation-Compensation Connection

The pubic posture taken by most entrepreneurs is that they are driven by the desire to create. That it was and is the dream that spurred them on. Working with inspired colleagues, having fun and building something for the ages was reward enough. The money was incidental.

The riches earned by many have created a somewhat skeptical response to this vision. The dotcom IPOs suggested that anyone denying the impact of wealth accretion as a motivating factor was either naive or disingenuous.

There are also broader macro-economic factors at play, as the following article explains. The reason that technology innovation of the industrial revolution happened where it did - and was followed in the past century by distinct regions like Silicon Valley, Route 128 and the Haidian District of Beijing is not serendipitous. It is a reflection of a mix of needs and incentives refracted through the prism of intellectual ferment and focused investment.

As nations and investors attempt to discern from what and where the next global growth sources will emerge, it is worth remembering that the factors influencing that development may be both more and less obvious than they appear. JL

Tim Harford comments in the Financial Times:

Why did the industrial revolution take off in the UK rather than in China? Five hundred years ago, the world’s richest countries – the western European states – were only twice as wealthy, per person, as the poorest – a modest gap, roughly comparable to that between modern-day Switzerland and Portugal. By the start of the industrial revolution, two centuries ago, the ratio of per-capita incomes had become three to one. It is now 20 or 30 to one; if you look at the very richest and poorest it is far greater than that.

These facts deserve an explanation. Not only do such inequalities define the economy of the modern world, they also present a puzzle. If the basic story here is that rich countries have better technology, it should be fairly easy for poor countries to grow quickly by copying that technology. China is proving the truth of this, but such dramatic catch-up growth has been unusual in the past two centuries.

Perhaps for this reason, economists have tended to point instead to the importance of institutions such as well-functioning courts, or governments able to levy reasonable taxes and spend the money on infrastructure.

But maybe the answer is technology, after all. The economic historian Robert Allen has been studying why the industrial revolution took off in the UK rather than, say, China. Allen waves aside cultural and institutional explanations and focuses instead on economic incentives.

Consider, for example, the fact that while the UK was developing the spinning jenny, British potters were using wasteful bronze-age kiln technology. China, meanwhile, was building highly sophisticated kiln systems to circulate hot air and maximise the energy efficiency of the process. Who had the more innovative culture? For Bob Allen, the question misses the point. Both countries were developing new technologies, but in response to different economic incentives.

At the dawn of the industrial revolution, labour was expensive in the UK, and energy in the form of coal was uniquely cheap. This was less true in continental Europe and the reverse was true in China and India, with cheap labour and expensive energy. British wages were high thanks to the success of the British trading empire. Chinese inventors looked for ways to save energy. British inventors looked for ways to save labour, because the payoff for replacing muscle power with steam power was obvious.

According to Bob Allen’s calculations, had a French entrepreneur been presented with easy-assemble instructions for the spinning jenny in 1780, it would scarcely have been worth building it. In India, it would have been a definite loss-maker. But in the UK, the annual rate of return was almost 40 per cent. So much for the genius of British engineering: it wasn’t that nobody else could develop labour-saving machines, it was that nobody else needed them.

This is a persuasive explanation for the location of the industrial revolution, but it is also a solution to the puzzle with which this column began, because Bob Allen’s view of innovation points towards a self-reinforcing spiral. High wages lead to investment in labour-saving technology; that investment means that each worker will be operating more powerful equipment and producing more; this process in turn raises the productivity of labour and tends to raise wages. The incentive to innovate further only continues.

As Allen observes, China and India were not agricultural economies that for centuries failed to develop a manufacturing sector; they were low-wage manufacturers whose domestic industries were gutted by competition from highly automated British industry. Those countries that did manage to get back on even terms with the UK did so with activist industrial policy and trade tariffs to protect their infant industry. It was not a strategy that the British allowed their Imperial possessions to pursue.