Session II
Perspectives on the U.S. Innovation System


Luc Soete

University of Maastricht, Netherlands and UN Univ-MERIT


Mary Good

University of Arkansas at Little Rock

Dr. Good said that because she was a scientist, her talk would focus on micro-economic aspects of the innovation system in ways that might complement the macro-economic views of Professor Soete, who was an economist.

She began with the following definition of innovation:

“Innovation is a strategy that provides resources to talented people in an atmosphere which promotes creativity and is focused on outcomes ranging from new products, to customer satisfaction, to new scientific insights, to improved processes, to improved social programs. [It is] designed to create wealth and/or improve the human condition.”

Why, she asked, does innovation matter so much in a global economy? In the United States and Western Europe, she said, the standard of living had been built on innovational competition. In particular, the U.S. position in a “free market” has

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Session II ———————————————————— Perspectives on the U.S. Innovation System Moderator: Luc Soete Uniersity of Maastricht, Netherlands and UN Uni-MERIT CHALLENGES AND CURRENT DEVELOPMENTS IN THE U.S. INNOVATION SYSTEM Mary Good Uniersity of Arkansas at Little Rock Dr. Good said that because she was a scientist, her talk would focus on micro-economic aspects of the innovation system in ways that might complement the macro-economic views of Professor Soete, who was an economist. She began with the following definition of innovation: “Innovation is a strategy that provides resources to talented people in an atmosphere which promotes creativity and is focused on outcomes ranging from new products, to customer satisfaction, to new scientific insights, to improved processes, to improved social programs. [It is] designed to create wealth and/or improve the human condition.” Why, she asked, does innovation matter so much in a global economy? In the United States and Western Europe, she said, the standard of living had been built on innovational competition. In particular, the U.S. position in a “free market” has 

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7 SESSION II: PERSPECTIVES ON THE U.S. INNOVATION SYSTEM depended on productivity: the ability to take risks, especially in new enterprises, and an instilled belief in upward mobility. It has provided higher wages for those who “work smarter” and allowed the creation of new wealth for risk takers. Elements of the Innovation System In the current and future global economy, she said, many new competitors are emerging, thanks to low wages, a focus on education in science and engineering, and creative ways to attract capital. Countries now know that innovation requires an interlocking set of priorities, which she listed under the following outline. Talent. Each nation needs a strong educational system and a motivated work- force with diverse skills and interests, as well as a dedication to lifelong learning. Emerging technological powers were creating cadres of technical professionals “capable of inventing the next game-changing technological wave and exploiting the current knowledge base, wherever it exists.” Investment. Each society must provide resources for long-term development of new, unexplored areas and for short-term development of improved products, processes, and services. Infrastructure. Physical environments are needed that are conducive to state-of-the-art exploration and business conditions that encourage risk-taking and collaborative activities. These include IP protections, health care, and energy certainties.6 Innovative societies also need a culture that values and rewards risk taking and tolerates failure, she said. The venture capital community often favors people who have failed, in fact, because they assume that failure is an effective teacher, equipping them to meet the next challenges. Challenges for Innovation in the United States The United States faced several issues in optimizing its innovation capacity, she said, especially that of demographics. The population is adding new young people, many of whom are minorities with little education. Also, the country faces a complex challenge in admitting educated newcomers while restricting illegal immigrants or those who wish the nation harm. Finally, as many of the current generation of scientists and engineers begin to retire, the nation must learn to accommodate their longer life spans and transfer their knowledge to the next generation. 6Adapted from Council on Competitiveness report, Innoate America, Washington, D.C.: Council on Competitiveness, 2005.

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 INNOVATIVE FLANDERS Another difficult issue is education, especially K-12 public education. The level of math and science skills varies widely by geographic and economic status, and the skill of educators. For the public community colleges, which must edu- cate many first-generation Americans, challenges exist, including teaching at a level adequate to allow students to move to 4-year science, math, and engineering curricula. For the public universities, state funding has declined and the schools have difficulty financing lower-income students. She noted an issue that overlaps with education, which is the presence of large numbers of foreign-born students in many fields of science and engineering. In 1994, the U.S.-born graduate population in scientific and engineering depart- ments was far higher than the foreign-born population, but that has dramatically changed. Now about half of S&T graduate students are foreign-born; in engineer- ing, 65-70 percent are foreign-born. U.S. innovation depends on the availability and continued presence of these foreign-born students. But will they stay, she asked, as other countries quickly build up their own research universities and job opportunities and our own immi- gration system discourages them from staying? Another factor weighing on the U.S. innovation system is declining invest- ment in R&D by all sources. While the federal investment has risen in constant dollars since 1976, almost all of this increase has gone to the defense sector. Spending on non-defense research rose in the 1990s, with most of the increase U.S. Innovation System Depends upon Availability and Presence of Such Individuals—But Will They Stay? U.S. 85,000 Foreign 80,000 75,000 0 70,000 9 9 2 65,000 1 9 9 4 60,000 1 9 9 6 1 55,000 9 9 8 1 9 50,000 9 0 1 0 S 0 2 S 2 1 FIGURE 2 Foreign-born students awarded majority of U.S. scientific graduate and PhD degrees. PROC Figure 02

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 SESSION II: PERSPECTIVES ON THE U.S. INNOVATION SYSTEM (Billions of Constant FY 2006 Dollars) 50 Health Outlays for the Conduct of R&D Space 40 Energy 30 Other 20 Nat. Res. = /Env. 10 Gen. Science 0 1953 1959 1965 1971 1977 1983 1989 1995 2001 2007 Fiscal Year FIGURE 3 Trends in non-defense R&D by function, FY1953-2007. PROC Figure 03 NOTE: Some Energy programs shifted to General Science in FY1998. SOURCE: American Association for the Advancement of Science, based on OMB histori- cal tables in Budget of the United States Government FY2007. Constant dollar conversions based on GDP deflators. FY2007 is the President’s request. going to the National Institutes of Health, but has declined slightly since 2000. (See Figure 3.) Unfavorable Trends in Spending on Science A substantial amount of non-defense spending goes to space research, a “tiny” amount to energy, and a small amount to natural resources and environ- ment. The general science category, aside from health spending, received little fiscal attention over time. “In support for the kind of work likely to push innova- tion,” she said, “we’re losing ground.” R&D as a percentage of GDP has been declining since 1976. Trends in R&D spending by business are characterized by a focus on devel- opment, rather than more risky basic research. In general, she said, “Research is driven by business needs, reliance on marketing insights, and a strong applied research orientation. Management makes a huge effort to maximize results from R&D.” Overall business R&D funding was flat in 2003 and 2004, but rebounded in 2005.7 This funding was found primarily in manufacturing, IT, and pharmaceu- ticals, and was dominated by a few large firms: Microsoft, Pfizer, Ford, General Motors, IBM, and Johnson & Johnson.8 7Data from the Industrial Research Institute. 8The Booz Allen Hamilton Global Innovation 1000: “Money Isn’t Everything,” Strategy + Business, Issue 41, Winter 2005.

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0 INNOVATIVE FLANDERS Of the firms most admired for innovation—Apple Computer, Google, and United Health Group9—none was in the top 10 in research spending. Also not found in the top ten in research spending were the firms most admired for manag- ing talent—General Electric, Proctor & Gamble, and Google.10 This suggested, she said, that the most innovative firms were using the research of others rather than investing for the future. One feature of the U.S. R&D landscape, she said, was the trend of state and local governments to recruit R&D organizations in the hope of increasing their economic growth. The State of Florida, for example, had recruited the Torrey Pines Institute for Molecular Studies, the Scripps Research Institute, and the Burnham Institute, promising them a total of about $1 billion in money, land, and other incentives. Other localities providing incentives to boost innovation in their own regions include: • In Ohio, the Columbus 315 Research and Technology Corridor is a 10,000-acre development to be patterned after Research Triangle Park in North Carolina. • In Iowa, $20 million has been allocated to the University of Iowa, Iowa State University, and the University of Northern Iowa—not for students but for economic development. • In Michigan, $100 million has been granted to 61 companies to diversify the Michigan economy. Other important players in the U.S. innovation system are found in the realm of the private foundations and non-profit organizations, which provide a signifi- cant amount of research support. Private foundations include the Howard Hughes Medical Institute and the American Chemical Society’s Petroleum Research Fund, while non-profit R&D organizations include Battelle (whose motto is “The Business of Innovation”) and many other significant entities. The Scarcity of Seed Funding Finally, she addressed the issue of early-stage funding for small R&D firms, which is a major emphasis in Flanders. In the United States, she said, capital is not always available when firms need it most. She showed a chart indicating that VC funding for first-stage firms of rela- tively large size is still available. (See Figure 4.) Seed funding, however, for the smallest firms “is fast disappearing, and that’s got to change.” Startup funding, which once received almost as much VC funding as the first stage, had also 9Fortune, “America’s Most Admired Companies 2006,” 2006. 10Ibid.

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1 SESSION II: PERSPECTIVES ON THE U.S. INNOVATION SYSTEM Billions of Dollars Seed Startup First-stage Year FIGURE 4 The collapse of U.S. seed and first-stage venture capital funding: dwindling high-risk investments. SOURCE: National Science Board, Science and Engineering Indicators 200, Arlington, VA: National Science Foundation, 2004. 04 PROC Fig declined,11 as VC firms sought companies at more advanced stages that were likely to be less risky than startups. Without much federal support, she said, seed funding would have to come primarily from angels and state funds. She summarized the challenges faced by modern nations, and the United States in particular, by dividing the issues of innovation into a series of three over- lapping questions: (1) How do you get talent that does what you need it to do? (2) How do you raise sufficient support to give that talent opportunities? (3) How do you create an infrastructure capable of creating new and exciting things? In response, she recommended actions in the same three categories with which she began her talk. Talent The United States needs strong emphasis on K-12 education at the national, state, and local levels. The universities must be recognized not only as providers of training and education of innovators, but also as engines of economic growth— without diluting the primary mission of education. 11National Science Board, Science and Engineering Indicators 200, Arlington, VA: National Sci- ence Foundation.

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2 INNOVATIVE FLANDERS Investment The nation needs broad initiatives to provide new investments in research, models to stimulate private-sector innovation, and R&D tax credits. There must be more early-stage funding models for small firms, including local, state, and angel funding. Business must renew its investment in R&D, with revised manage- ment structures, to maximize the total innovation chain. Infrastructure We must move from the discussion stage to the action stage to focus on metrics that measure innovation strategies. We need new organizational models to accommodate interdisciplinary R&D and external partnerships, as well as support for and integration of the manufacturing and service sectors. Discussion A questioner asked Dr. Good’s opinion of the competition between states for new industrial plants. She said that competition for R&D facilities probably did no harm, if the facility was producing something new, but she deplored the enor- mous expense of tax money spent by some states to gain a straight manufacturing plant that might or might not repay the investment. GLOBAL COMPETITION, CORPORATE POLICY, AND NATIONAL INTEREST Mark B. Myers Xerox Corporation (retired) Dr. Myers began by emphasizing the point that global innovation occurs within a vast but interactive system, so that no single element is sufficient to dominate it. In some ways, that system had been U.S.-centered for many years, although the num- ber of competing participants and dispersal of resources were growing rapidly. The United States has traditionally deployed its own innovation resources very effectively, he said, supporting a broad portfolio of R&D in basic science and technology. Its funding pattern was part of the general national strategy of investing broadly—of supporting a diverse portfolio of pre-competitive tech- nologies. It maintained an open R&D system in which results are published and freely available and depended on spillovers, mainly from the large proportion of basic science performed by the Department of Defense, to energize the private sector. The private sector created and supported technical innovations through a combination of venture capital, large corporate research laboratories, and the activities of startup firms. Schools of engineering and medicine provided sources of spin-outs and applied generally balanced policies of IP protection.

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 SESSION II: PERSPECTIVES ON THE U.S. INNOVATION SYSTEM Major Changes in the 1990s Through the 1990s, the United States performed well, raising its share of the high-tech global market, increasing its private funding of R&D. Some of the features of U.S. performance then began to change, including more priva- tization of information, an increase in patents filed, and reduced numbers of U.S. scientific pubs. As economy shifted away from manufacturing and toward service activities, the large corporate research labs began to downsize and even disappear. The importance of the research universities rose as they took over the role of the corporate labs, and the “perimeter” of the university, which began to include considerable industrial activity, started to become industrial R&D centers. Monopoly powers disappeared from industry in the 1980s and 1990s, causing great shifts, including the replacement of science-driven R&D by market-driven R&D. The activity of venture capital firms rose rapidly in the 1990s and then fell just as quickly. The globalization of R&D, which no one had foreseen, gave the global innovation system a newly dispersed structure. The 1990s also saw large technical transformations. The first was “Moore’s Law,” which described the regular and rapid increase in microprocessor capacity and the parallel revolution in the speed of product development. This new speed meant that the technology underlying most business models was now constantly under attack and that vertically structured organizations in the PC industry had to become horizontal quickly. IBM barely survived this revolution, while many others—including DEC, Sperry-Univac, and Wang—did not. The shape of enter- prises today is harder to define, with multiple centers and virtual connections. The Transformation of Corporations Other key transformations were brought about by wave division multiplexing, optical networks, and the Internet. Businesses became networked enterprises: flat, virtual, dependent on outward engagement, with competency centers arranged globally. The very definition of companies became blurred. Is Dell a computer company? he asked. Dell spends less than 1 percent of revenues on R&D, while the computer industry as a whole spends 12-15 percent. Is Dell a technology company at all? The answer, he said, is that Dell is a technology company in the same way Wal-Mart is a technology company. Both have focused their innova- tion activities on the supply chain, where the R&D available to them is very sophisticated. The technological revolution, he said, had enabled a different kind of innovation in the way firms are designed at the global level. Traditional kinds of competition, once defined in terms of a global place, can become irrelevant because of the nature of the technology. He cited the example of photography, a field in which Kodak and Fuji Photo had long competed: Neither firm today makes a profit in photography, which was based on a silver halide technology. The firms making a profit in photography today are Canon, Epson, and H-P, who sell digital cameras and whose strength was in information technology rather

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 INNOVATIVE FLANDERS than traditional photography. A combination of geographic dislocation and tech- nological dislocation now defines the competitive space, he said, in which a new entity—the global company—is dominant. As a result, large firms increasingly have to play globally or they will not survive. The global corporation today: • Has a worldwide customer base. • Does R&D that is market driven: the firm needs science, but does not invest in it. • Has a new balance of global and national perspectives. • Seeks the best talent wherever it is available. • Finds the technology it needs through investment, partnerships, and acquisitions. • Forms dynamic partnerships, and makes acquisitions aggressively. • Makes use of networked and open innovation. • Depends on international standards. • Maintains a relentless drive for productivity. • Emphasizes risk management: Can we afford to spend $1 billion on a new drug and not get one? • Needs partners. If you depend on a worldwide supply chain, you need help if that chain is disrupted. Thorny Issues for Innovation Going forward, Dr. Myers saw a series of thorny issues for the global inno- vation system. First, each nation must have policies that address the globaliza- tion and dynamic linkages of modern firms. As universities develop their own “innovation perimeters,” where entrepreneurship is the focus, they must grapple with effects on the primary missions of education and research. Governments, industries, universities, and others must agree on how to fund the “knowledge commons” on which innovation depends. Nations must better deal with work- force capabilities and location as migrations increase across the world. Industries must learn to deal with the different interests of small and large firms, as more growth occurs by acquisition. Few small firms, if attractive, will grow to be large, creating a particular problem for small countries that have difficulty grow- ing large firms. Governments must harmonize their IP policies to sustain the exchange of knowledge. Given such a list of complex issues, Dr. Myers confessed that he was some- what pessimistic about the United States’ ability to respond quickly with innova- tion policies appropriate to this global age. He concluded that unless national leaders can make a persuasive case for policies that are necessary to ensure long-term global competitiveness, they may be forgotten amid more obvious but short-term priorities.

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 SESSION II: PERSPECTIVES ON THE U.S. INNOVATION SYSTEM Discussion Dependence on Old Research Dr. Spencer noted that many innovations driving the economy in recent years, such as the transistor, depended on basic science done 50 years ago. In the face of declining public and industry support for basic science, he asked, where would the inventions for continued innovation come from? Dr. Myers agreed with this characterization, and confessed that he had no answer to the dilemma. He found “disturbing” the long-term decline of federal investments in engineering sciences at universities which, combined with the lack of attractiveness of engi- neering for the American native population and the restrictions of immigration policy, “may cause severe problems. We may need an ‘innovation shock’,” he said, “as we had from Sputnik.” The Importance of Small Advances Professor Soete commented that he could imagine a future of continuous technological expansion based on old technologies, as in the field of medical diagnostics, where the research is “independent, individualized. You’re open- ing up dramatic new areas of discovery, medical areas which are small but are being perceived as extremely useful for the social welfare.” He said that a lot of research at “the bottom of the pyramid” was fascinating because it “challenged the innovation trajectory as we know it, adding features to products cheaply that really help.” He cited the example of wood stoves that are 100 times as efficient as older models, but very cheap. Professor Good agreed with Dr. Spencer’s comment that innovations today are “built on a pool of science 50 years old. If we don’t replenish the pool, there will be no fish.” Innovations in medical imaging, for example, such as the MRI and PET scanners, are based on fundamental but old physics. She said that the United States has probably lost its lead in the high-energy physics that led to such instruments, and U.S. high-energy physicists now go to CERN in Europe. High-energy physics had also led to modern cryogenic engineering, which has also declined in the United States. “Our federal R&D is not keeping up,” she said. “And the private sector is not going to do it.” She added that strong basic research is particularly important for the United States, which decided after World War II to link university research to its training of graduate students in technical fields. Declines in research automatically weaken the training component of that effort. The European Focus on Jobs A questioner asked about the EU strategy set up in Lisbon in 2000 with the goals of a knowledge-based economy and stable jobs for people. He said that jobs

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 INNOVATIVE FLANDERS should be the main goal, but that the new strategies said nothing about this—only about how to spend 3 percent of GDP on R&D by 2010. He questioned the value of scientific papers and invited speakers, and asked what is being done to provide the many new jobs that had been promised for Belgium. Professor Soete acknowl- edged that at Lisbon the ministers of employment were talking about such issues as employment targets and the participation of women, while the ministers of S&T were talking about knowledge, but the two elements were never linked. He said that his response as an economist was that the ultimate aim of a knowledge base is increased welfare—a concept broader than GDP. Dr. Myers added that the time lag between the discovery and application of knowledge compounded the problem for policymakers. At Xerox, he said, the lag between the investment in a research project and the point of peak revenue was 8 years. In pharmaceuticals, the lag is about 13 years. “Most systems are not set up to measure that,” he said, “especially when it needs to satisfy political needs.” Dr. Good noted that good retrospective studies had been done on the value of scientific knowledge, and that economists agreed that more than 50 percent of GDP in the United States since 1950 had been generated by technological inventions. She said that evaluations of investment in R&D must be done on that basis to be meaningful. Dr. Wessner noted “an important political point,” saying that the outcomes of research are not linear, take time to appear, and are often unexpected. He said that the considerable value of IMEC was measurable in many ways, including not only the scientific output but also the employment generated and funds spent by visitors. He also returned to the 3 percent issue, noting that this goal had been discussed in Europe for 6 years and yet countries were still not making serious efforts to reach it. In addition, it seemed unlikely that institutions and regions had the R&D capacity to absorb such a large increase in funding as rapidly and productively as hoped. Finally, relieving unemployment was a complex and general problem that would require many kinds of structural changes, including opening markets. The Complex Route to More Jobs Professor Soete agreed that Europe urgently needed structural economic changes before it could expect better employment and living conditions. He granted that more technical training would play a small role in this. The demand for workers in the health care sector, for example, is anticipated to exceed the total output of most countries’ educational systems. And the number of technology- related employees at the universities in Flanders had increased 70 percent over the past 15 years, so the region’s high-tech policies had already generated additional employment. But this was only a small fraction of what could be achieved by much-needed fiscal measures, such as the reduction of social security payments.

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7 SESSION II: PERSPECTIVES ON THE U.S. INNOVATION SYSTEM These necessary macro-economic changes, he said, had nothing to do with the high-skill jobs being discussed at the conference. He attributed employment imbalances to general mismanagement of labor markets, the failure to open up more markets, and slow progress in using new technical knowledge to generate employment. Europe did not need a policy that puts “everybody into the labor market, no matter what they do,” but “a much more strategic policy of increasing the knowledge intensity of economic activity.” Dr. Myers closed the discussion by mentioning the “Solow paradox,” the dis- covery that when U.S. firms first invested in information technology, they saw no increase in productivity. The problem was that new technology was being applied to existing work processes. His company found that productivity increased only when work procedures, including the production floor, were totally redesigned to fit the new IT. Any discussion of jobs, he said, needed to include a discussion of productivity, both of which are important for secure economic performance.