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2 Ncdional Policies Affecting Advanced Technology Capacity and Competition The innovation process, as we have seen, embraces research, development, manufacturing, marketing, and distribution. A wide variety of government policies affect this process--those explicitly intended to strengthen it, such as federal support of basic research; those framed for a broader impact, such as the nation's fiscal and monetary policies; and those aimed at other objectives that may unintentionally adversely affect the process, such as export controls. In this chapter we consider how national policies affect a nation's advanced technology capacity and international trade position. Many governments have designed comprehensive policies to ensure successful technology and trade development. Their efforts span the whole of the innovation process. The U.S. system supports basic research applicable to broad national goals but does not systematically support the other parts of the process leading to commercial sales. Responsibility for product development, produc- tion, marketing, and distribution are left to the indi- vidual firm. This system of free enterprise has worked remarkably well. However, as other governments coordinate--and provide increasing support to--their advanced technology industries, American firms find themselves competing internationally with government aided firms or groups of firms. U.S. industry feels burdened by an unfair disadvantage. BASIC RESEARCH Governmental support of basic research may serve broad national needs--for national defense, for food produc- tion, for medical care, and for energy availability, but 28

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29 current spending on basic research is only tenuously linked to current competition for markets for advanced technologies. Investment in basic research is a capital investment with a payback period measured in decades rather than years. Because the results of basic research are quickly available globally, governmental support does not spark international conflict. Each country's research benefits others. Indeed, the United States is a major beneficiary not only of its own research but of the research abroad as well. Strength in a nation's research infrastructure, however, is no guarantee of successful technological competition. A country may lead in basic science, but lag in the process of making innovative ideas commer- cially profitable. On the other hand, a country may lag in research, but draw on research conducted abroad as a base for creating commercially successful advanced technologies. Japan has followed this strategy with remarkable success. Japanese leaders recognize, however, that an economically and technologically advanced country must develop a strong domestic research base in order to excell at making world class technological advances. France, too, has chosen to increase support of basic research. The United States has one of the strongest research bases in the world, but this base is not invul- nerable. Federal support for basic research rose rapidly in the United States from 1960 to 1968 discounting inflation, but has increased only marginally against inflation since then (Figure 2). APPLIED RESEARCH AND DEVELOPMENT National practices diverge more sharply with regard to support for applied research and development than with regard to basic research. The three most prominent positions favoring some support follow. First, a traditional U.S. position held by many indus- trial leaders and recent administrations is skeptical of any government effort to select particular sectors of industrial R&D for support. It holds rather that deci- sions on investing in development and the subsequent stages of industrial innovation are best made by private industry. This view, however, does espouse government support through tax credits for industry determined research.

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30 9.o 8.0 CD o . _ ._ 6.0 On J o us 3.0 a: C: 7.0 5.0 4.0 2.0 1.0 l I ! ~ / / i - / , ~ , _ J / ~ _' O 1960 1970 1980 YE AR 9.0 8.0 - ~n o . _ . _ Q - ~n to J J o ~ 4.0 en .,' En He o 7.0 6.0 5.0 3.0 2.0 1.0 n Total Federal I ndustry Universities and Colleges Other Nonprof it I net. 7~/ 1960 1970 1980 YEAR FIGURE 2 Basic research expenditures by source, 1960 to 1981. Estimates are shown for 1979-81. GNP implicit price deflators used to convert current dollars to constant 1972 dollars. SOURCE: National Science Foundation, Science Indicators 1980. Another view, occasionally argued in the United States but practiced primarily in other countries, suggests that the diffuse benefits, or "spillovers," of technological development warrant federal targeted support to particular technologies. It is argued that such support leads to commercially successful products--indeed, that favorable technological spillovers are likely even if the targeted products or processes are unsuccessful. A third position, taken by some foreign governments, is that government support is warranted for those tech- nologies for which there is a national need and in which the private market would tend to underinvest, either because of high risks and costs or because the benefits likely to result from research and development are not

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31 easily captured. Certainly, in the United States and elsewhere, defense and those space technologies where the government is the prime customer receive full governmental research and development support. PRODUCTION France and Japan, among others, believe that government support for new technologies should in part assure produc- tion of the new industrial products. Proponents of this view stress that experience gained in manufacturing is crucial, that there is no clean break between development and production, and that, in any case, intervention by governments in advanced technology is justified by enhanc- ing employment and making broad contributions to the national economy. Support can take a number of forms, including direct subsidies, low-interest loans for produc- tion facilities, and governmental absorption of potential losses. Governmental actions affecting production costs also include regulatory policies--factory environmental standards, worker safety procedures, or production standards. DISTRIBUTION Government programs that support new technological devel- opments politically may require support for the succeeding stages of innovation, including marketing and distribu- tion. It is in the distribution stage that government intervention can be most damaging to free trade. Govern- ments may protect domestic markets through procurement policies or nontariff barriers. They also may attempt to ensure third-country markets through below-market export credits* or political inducements. Such practices frag- ment international markets, denying the economies of scale that drive the continuing evolution of advanced technologies. *Any form of financial assistance, direct or indirect, intended to provide financing in whole or in part for a transaction.

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32 The Emerging Market The latest area for intense competition in advanced technology industries is the Third World's emerging market--the some 113 countries that account for about 40 percent of the world's GNP. Sales to the newly indus- trializing nations--Brazil, Korea, Mexico, Taiwan, etc.-- are a powerful determinant of success in international competition in advanced technologies. The nations or firms that make initial sales to an emerging nation tend to continue as preferred sources. There is concern that competing exporting governments may offer special induce- ments for commercial sales such as weapons, nuclear tech- nology, export credits, or bilateral agreements favorable to the purchasing nation. The perceived use of such inducements has already provoked bitter conflicts. Nontariff Barriers and Procurement Policies Explicit barriers to trade currently are not the major tools for protecting markets. Tariffs for advanced technology trade are quite low among the industrialized countries. Formal quantitative restrictions are ruled out by the General Agreement on Tariffs and Trade (GATT). The Voluntary restraints" and "orderly marketing agree- ments" through which exporting nations agree to curtail sales in another country are familiar in traditional industries, but are absent in the advanced technology area. Instead, protected markets are created through national procurement policies, through suspension of antitrust enforcement, and through nontariff barriers to imports, such as customs delays and regulations. These barriers can be quite effective. For example, national procurement policies limit trade in telecommunication products between the large European countries, even though the advantages of large-scale production and the costs of duplicative research and development may justify special- ization and free trade. 2 Nontariff barriers may be institutional and attitu- dinal factors, such as national loyalties inclining nations to support domestic industries, which effectively prevent import of foreign goods. Imports of foreign goods that compete with domestic products may be ensnared in complex bureaucratic customs procedures, or marketing of products may be blocked by the interlocking control of business. For example, mar-

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33 keting and distribution firms may be owned by or have a special relationship with domestic manufacturing firms and thus refuse to serve foreign suppliers, or local lending institutions may deny financing for foreign product distribution. Investment barriers, like trade barriers, may take the form either of overt legal restrictions or more subtle pressures. A country may limit foreign direct investment in certain domestic businesses. In addition, a government may deny foreign-owned firms "national treatment," i.e., the same privileges as domes- tically based firms, or foreign subsidiaries may be denied access to low-interest loans, excluded from local procure- ment, or denied the right to participate in collaborative R&D. In many cases, firms investing in countries seek local participation, perhaps at a majority level, to avoid this ~second-class" treatment. There are several other ways in which governments' re- strictions on foreign investments may be to the disadvan- tage of firms attempting import: firms may be unable to invest in necessary com- plements to advanced technology exports, such as local parts and service facilities; "offset" requirements or "local content" laws may force firms to produce products in-country (occasionally at low volume and high unit cost) as a condition for access to the local market; . firms may suffer unfavorable conditions of tech- nology transfer--e.g., licensing at disadvantageous terms--because the preferred route of direct investment is closed. NATIONAL PRACTICES--POSITIVE AND NEGATIVE CONSEQUENCES The extent to which our national welfare is interwoven with that of our allies in the fields of science coopera- tion and advanced technology trade is not generally appreciated. The costs and risks of protectionist policies and market fragmentation are probably greater than in almost any other economic field except energy. Paradoxically, the international coordination of trade practices is more backward in advanced technology than in many other fields at a time when both nations and regions within nations are looking more and more to advanced technology as a primary source of economic salvation.

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34 Innovation proceeds most rapidly and efficiently when new products have access to the widest possible markets, thus spreading the costs and risks of innovation over more units and generating the cash flow for follow-on . improvements and further innovation. Thus, the United States should negotiate in international forums t~ Or the openness ot world markets to innovative entrepreneurs wherever they may be based and to eliminate those national actions practiced by other countries that distort the free Such a policy is required, both to preserve the U.S. position as a major source of innovation and to ease growing tensions among the industrialized allies, tensions that threaten not only international economic and political management, but also mutually beneficial cooperation in science and technology. There are a number of practices that effectively close markets in a given country to the advanced technology products of another country. Government intervention to force purchase of products from domestic suppliers is an example. Such practices reduce the total size of the market open to an innovator, reduce the rewards for the innovating firm, and limit the distribution of innovative products globally. Other practices may result in one country rapidly acquiring a larger share of the market in another country than would occur under conditions of free competition. Export credits on highly concessionary terms is an example. Some practices may not be outlawed by international agreement, but may be injurious to trad- ing partners. An example would be the suspension of antitrust policy for specific advanced technology indus- tries in order to accelerate product innovation and foreign sales. Commercial and financial practices that are generally agreed to be harmful to the world trading system as a whole, even if at least temporarily advantageous to the perpetrating country, are not necessarily the ones that cause the most damage. While it may be easiest to elimi- nate by agreement the practices that are acknowledged to be unfair and which add nothing to aggregate world produc- tion, it may be more urgent to take aim at some more debatable tactics that cause clear danger. These tactics are difficult to categorize, but they may be the most important and call for the most immediate hard bargaining. They may be protectionist, trade distorting, or harmful to world welfare. Examples of such practices are: market operation in the United States.

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35 Predatory pricing sales abroad at prices below the domestic selling price or below cost. (Below-cost pricing may be defined as pricing that does not permit recovery of production costs over any plausible projec- tion of the learning curve. This may be very hard to define for advanced technology products because of the steepness of the learning curve and because of the subjectivity of business judgments as to how long a time is reasonable for recovery of Front end" costs.) When systematically applied, predatory pricing can be used to "pick off" one sector after another. Protection against this practice is not readily available from either GATT rules or traditional domestic policies of the U.S. government.3 Targeting" of specific U.S. advanced technology markets by foreign countries through governmentally orchestrated industrial strategies that suspend normal business or regulatory practices with respect to the targeted product line, such as cartelization. Coor- dinated "picking off n of particular U.S. markets through a concentrated effort is especially pernicious. Nontariff type barriers that effectively exclude U.S. products from fair competition with local products in local markets. Government intervention to force purchase of products, especially advanced technology capital goods, from domestic suppliers despite competitive price and/or performance of foreign products. (This would include "Buy American" requirements on U.S. federal or state government contractors.) . Restrictions on foreign direct investment, par- ticularly those that effectively deny distribution outlets for U.S. advanced technology products in the host country. . Exclusion of U.S. foreign subsidiaries from "national treatments equivalent to that afforded national firms. . Use of political leverage or concessions to influence purchasers in third-country markets to buy a foreign product in competition with a U.S. product. This includes tying sales to trade agreements, military weapons support, nuclear development projects, economic/ regional assistance and similar Programs. . , _ , _ Official or unofficial preferential government procurement favoring domestic producers when contrary to GATT rules.

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36 Capital or operating subsidies, including conces- sionary loans that result in extra market penetration of foreign advanced technol~av nr^~.= i non rim c mart or world markets. ~ _ :~ ~ ,1~ ~ ~ ~ ~ &~ _ #A ~ _ _ ~ _ Invocation or tne GATT subsidy rule may provide some protection for the injured party. Unfor- tunately, unless it is vigorously pursued by the firms and country affected within the framework of the GATT rules for subsidies, redress is obtained too late to prevent substantial damage. Export credits on highly concessionary terms, based on government subsidies. In the absence of inter- national agreement on what constitutes a reasonable concessionary interest rate, however, it is difficult to fix a criterion unilaterally that would trigger retalia- tory action. Such retaliation might be equal or better confessional terms. Practices that stimulate innovation by relaxing various domestic rules in the exporting country may nevertheless have some positive spill-over effects. They might be best matched by adopting similar modifications of domestic ground rules for the competing industries in the importing country. If the rule changes were rela- tively mild--for example, exempting research consortia from antitrust regulations, or permitting patent or other information exchanges among competing domestic firms--the net effect might even be positive. R&D subsidies to accelerate the development and commercialization of particular products. Such targeting is considered difficult by many, yet the Japanese record of success seems to be good. Exchange of technical information and agreed product specialization (or "market sharing") among com- petitive firms in a broad technological area. It is frequently pointed out that Japanese law and adminis- trative interpretation permit a degree of both market sharing and technical cooperation in domestic markets that would be illegal under U.S. law and/or regulatory policy. While this may be "unfair practice" from an American point of view, it is within the traditions of the Japanese system. Mutual support among independent firms belonging to industrial "groups" whose members enjoy preferential financial and intellectual or other cooperative relation- ships with each other. Such "group strategy" gives the practitioner a relative competitive advantage in the American market. It represents the kind of rationaliza- tion pursued by large U.S. corporations in the early

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37 twentieth century that U.S. antitrust policy was designed to prevent. It may be acceptable, however, when viewed from some standpoints, e.g., buyers in the emerging market rather than from the standpoint of "fair competitions with the United States. U. . S. . INTERNATIONAL NEGOTIATING STRATEGIES In the preceding discussions, we have described govern- ments' practices affecting their respective advanced technology industrial systems and suggested criteria for assessing those actions according to their consequences for the international trading system. These criteria place value on maintaining open markets, thus rewarding innovators, and making innovative products available globally. We believe that the United States must con- tinue to negotiate in international forums to maintain international systems that foster healthy, mutual com- petition in advanced technology. Such competition will be to the ultimate economic advantage of the world. The United States must give immediate attention to efforts to strengthen its advanced technology capacity and international trade competitiveness. Such efforts will require both a national focus on the importance of advanced technology to U.S. military and economic inter- ests and the need to compete vigorously in international markets. Recommendations for domestic actions will be discussed in Chapters 3 and 4. We recognize that there may be circumstances in which, although our domestic advanced techology capacities are well nurtured and strong, still a few key technological sectors essential to our national welfare may be endan- gered. Successful aggressive policies of our allies could create such vulnerability. If capabilities in a significant advanced technology sector, deemed essential to U.S. economic and military interests, are seriously endangered because of the loss of markets, the United States must take remedial actions. Damage to the nation's total innovative capacity, however, is far more pernicious than adverse impact on a particular product or firm. A first step is to seek to renegotiate multilaterally agreed rules in forums such as the GATT. Such negotia- tions should seek to establish clearer guidelines for government actions in high-technology sectors. A basic requirement of such negotiations would be that countries, including the United States, be prepared to consider altering traditional practices.

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38 When there is a specific threat to U.S. interests from a particular country's government policies, the U.S. government should initiate bilateral consultations within the framework of GATT and other appropriate multilateral institutions. The goal of such negotiations would be to reach agreements on a time scale that would prevent or reverse damage to U.S. capacity for technological innova- tion. If these bilateral consultations are unsuccessful in resolving the issues, the U.S. government should utilize formal multilateral dispute settlement procedures to seek a resolution. If those procedures fail or if the threat of damage is imminent, the United States would be required as a last resort to take unilateral action to protect the national interest. NOTES Japan Committee for Economic Development, Building an Industrial Structure for the 21st Century (Tokyo: JCED, 1982), pp. 14-15. 2 Organisation for Economic Co-operation and Development, Telecommunications Equipment Industry Study (Paris: OECD, 1981), p. 19. 3 The negotiations in the Tokyo Round of GATT on subsidies developed criteria for "material injury" caused by such subsidies. Such criteria would probably define the limits of acceptable practice even when a theoretical argument might conclude that the causative practice resulted in a total mutual benefit that exceeded the injury to one of the parties. Certainly in the case of subsidies to advanced technology industries, the machinery of GATT should be available, although the standards of proof of injury may be harder to apply in the case of advanced technology than for other goods. Richard Rivers and John Greenwald, Subsidies and Counterveiling Measures," Law and Policy in International Business, 2 (1979), pp. 1465-1495.