Innovation Struggles to Survive in Our Economies

Innovation concept with financial elements hand drawn on blackboard

Listening to the radio this morning one of the many state announcements punctuated my enjoyment of Beethoven & Dvorjak, on Classic FM (I live in London now). It was the usual aggressive and threatening diatribe, this time on pension provision. I quote ‘it doesn’t matter how small your business, even if you only employ one person you have to comply. It’s the law’. The whole tone was overtly hostile to business and typical of the modern state apparatchik. I will return to this mind set later, because it is the core of the argument.

Let us look back to the year 1800, arguably the lot of the common man had not changed much since Roman times. Medicinally, in diet, health or longevity. There were some horrid lows in the Middle Ages through pestilence and disease but as a general rule of thumb things had remained largely as miserable. The Great Leap Forward, I use the Chinese phrase advisedly, came after the Napoleonic Wars in Europe. Check the numbers, in 1870 output per capita was up 63% from 1820, by the outbreak of the Great War it was up 76%. Historically this was unprecedented. Until today.

Modern China has seen household income increase sixteen fold between 1987 and 2013.  Moreover, this is for a society of hundreds of millions, not a micro Baltic state or Latin American aberration. Like Europe of the 1900s, it is an awesome industrial revolution accompanied by mass migration from rural areas to urban areas. It is still going on today, McKinsey Ltd estimate the urban Chinese will be earning the equivalent of their counterparts in Brazil and Italy by 2020.

The economic theory generally accepted for the European industrial revolution, led by Great Britain, was that it came about due to the enormous advances in science and engineering. However, this is over simplistic. France was no less scientifically advanced than Britain but was left far behind. Germany caught up later in the century but was a young country. Relatively recently Federated, America began to overtake these economies albeit post Great War. Yet in no way was the US ahead of Europe scientifically. France was at the cutting edge of aero technology and automobile engineering before the Great War, by the Armistice wartime production in France, and particularly the UK, was outdistancing Allies and Axis powers alike. It is not generally known but there were no tanks or guns of American manufacture in Europe in 1918. Unlike WWII it was only American manpower which had come on stream for final victory. The rapid advance of the US therefore must be explained. Another theory must be proffered.

Europe at the end of the industrial revolution metamorphosed into a corporatist economy; not the mercantilist economy of the pre revolution or indeed the state mercantilism of today in Europe and North America. The America of 1840 to 1913 was a country of innovators, as was Great Britain, a country subsequently ruined by war and socialism never to fully recover. American natural resources were re enforced by immigration know how, as well as unskilled labour, combined with one of the most entrepreneurial societies in history. In addition to this extraordinary high octane fuel for any economy, was a monetary system based on hard currency and a banking system, not perfect but without the criminal fractional reserve systems which came to the world later.

Hard money and market driven interest rates encourage investment.

It is worth revisiting here briefly the theory of money, something not generally understood by politicians and central bankers who control it. Dollars, Yen, Euros and Pounds are simply a medium of exchange. Inherently worthless in their own right. They work only when accepted by mutual agreement between contracting parties, who otherwise would be compelled to barter. Traditionally these bills were exchangeable at a bank for specie, gold or silver. In the early 1970s the collapse of the Bretton Woods agreement removed the dollar, the world’s reserve currency off gold, and the outcome, not unsurprisingly, was a massive printing of dollars which inevitably led to currency devaluation.

The dollar today is worth about 9 cents in 1971 purchasing power. We must now address interest rates; this is simply the cost of money. An investor is prepared to defer consumption for a period of time with a view to accumulating more money in the future to purchase goods or services. In exchange for this he expects ‘interest’, it his his reward for so doing. Yet if dollars are to fall in purchasing power to such a great extent in just 40 years, a significant rate of interest must be paid to compensate. Specie backed, or hard money of the industrial revolution, removed currency degradation as gold had to be dug out of the ground, politicians and bankers could not ‘print money’. Those who were not equipped to invent or innovate could invest their wealth by lending to someone who was, maybe via a bank, but often through a bond issue.

Big ideas need capital; capital has its price. Artificially cheap credit leads to malinvestment, disruption of market pricing makes the partnership of investor and innovator all but impossible. Let us examine some examples of innovation as the driving force.

The German company Daimler Benz invented the combustion engine, the French redefined it for use as an Aero power unit with the Gnome radial engine which remained the benchmark until the American Liberty engine in 1918 which perfected the straight V engines recognisable today that gave aero engines the balance needed by modern monoplanes. This trans world innovation was successful as it was not dead handed by government.

Henry Ford did not produce cars which were superior to Renault, Morris or Fiat. His master stroke was the invention of mass production line techniques. This enabled American families to enjoy the luxury of a motor car well before it became the norm for Europeans. These mass production techniques also gave American families refrigerators and vacuum cleaners and a host of other labour saving devices. Make no mistake these techniques were not particular to America. It was often a question of scale, or local logistics. This requires both risk and flexibility.

Today German efficiency is a byword but historically received wisdom is often a myth, few reading this today will be aware that in 1939-40 aircraft production in the UK was five times that of the Third Reich. At no time in the war did they overtake UK production per capita, even with slave labour. In order to reach this pinnacle of production, bureaucracy was cast aside. Private enterprise was led by Lord Beaverbrook to produce this awesome UK production phenomenon which was killed post war by trade unionism and socialism, it took the UK, known as the workshop of the world, down to a manufacturing base of just 11% of GDP in 2013. Yet in a life and death struggle national socialism could not compete with the free market.

Let us examine risk, without which innovation cannot happen. I use here a theory developed by amongst others Richard Thaler on human attitude to risk: I offer you a 50:50 chance of winning £10,000 P=0.5 you win P=0.5 you lose or I offer £3000 not to play, to take away, cash in hand. Nine out of ten people will take the cash, they are risk averse, they are the natural employees of the world, many to be found in the public sector. Now we turn this around: I offer you a roll of the dice 50:50 chance again, only this time you can lose £10000 or break even, or give me £2000 to walk away. Nine out of ten people will roll the dice. Why? Because people hate a guaranteed loss, notice the odds have not changed but perception has. This is known as ‘Loss Aversion’, a powerful motivator in humankind.

What can we deduce from this little experiment? A risk taker is a rare beast, they are very few in number, they are the ‘winner takes all’ guy. This vital cog in the economic wheel is a sensitive plant. If the state makes it difficult to roll the dice, or take away part of the winnings, the risk assessment changes. The player decides it is not worth the candle, he walks away, but he is the wealth creator and employer for the community. He is in fact a priceless asset.

The massive steps forward for ordinary people during the industrial revolution came when government was small, rules and regulations were few, tax was low, government spending as a proportion of GDP, which by modern standards was tiny.

Innovation starts in an individual’s back yard, the germ of an idea. The theory of flight, radio, television, telephones, antibiotics, indeed every thing we now take for granted was the invention of an individual who brought his brainwave to market for the benefit of mankind. This is the reason we in the modern industrial economies live a life style only the aristocracy could countenance 100 years ago. The state created none of this, everything today is provided by the wealth creator, the entrepreneur, the inventor. The route to market is hard, desperately hard even without state interference. When the bureaucrat taxes, regulates and interferes, he can make development impossible. Interestingly the modern legislator and public servant have no commercial experience by definition, public service is designed to attract those who have no entrepreneurial skill. He is the man who never rolls the dice, he is deep in his comfort zone. He is personally risk averse and this affects his judgment in all his decisions.

These handicaps cannot only be laid at the door of the state. Big business loves bureaucracy, it raises the entry level. The pharmaceutical industry in Europe and America exist on the back of Byzantine regulation. Big pharma is dug in deep with a government by regulator and lobby system. It suits the status quo. Lobbyists are expensive beasts to send on a permanent basis to Washington and Brussels. Europe and America have embraced a society which has abandoned any concept of caveat emptor. These monolithic corporations attract the risk averse employees whom in turn become the senior executives, these traits show through in the numbers. American corporations now spend more on patent protection than research and development, a clear form of protectionism. The politicians’ mission statement is to take on the role of consumer champion. The assumption is they know more and are somehow more intelligent than the electorate. Visit any political chamber to observe the absurdity of that. The Austrian theory of economics criticises this, as the presumption of perfect knowledge of the market. I have seen housewives, grandmothers & trade unionists studiously debate hedge fund regulation, while parliamentary committees have only very recently had the concept of hedge funds explained to them.

Regulation raises the entry level, employment lawyers average £400 per hour and to avoid them a company needs a big highly trained HR department but they can’t afford it. In a small business the proprietor’s wife tries to cope, there is no budget for anyone else. Moreover, the regulations sit outside sovereign law and the state starts with the premise that the employer is somehow evil, that the days of the 19th century mill owner are still with us. It is beyond the comprehension of the regulator that the primary task of the modern employer is to attract and retain the good employee, not to gratuitously get rid of them.

Most small businesses do not want to outsource or invest in robotics, a path they are continually being driven down by impossibly one sided legislation. The state now prescribes wages, working hours, holidays, maternity & paternity leave, dispute arbitration, the list is endless. There is even an employment tax. It is almost as though the state is deliberately attempting to stifle business.

A more recent enemy of the innovation economy is a political banking system. Banks today are state sponsored, underwritten by taxpayers and controlled by political appointees at a central bank. Interest rates and international flat currency exchange rates are manipulated by governments, (sometimes known as crony capitalism) the whole system is designed to favour friends of the government of the day. This leads to malinvestment on an unprecedented scale. How could it not. Free credit favours one member of society over the other on a completely arbitrary basis. Why should a borrower be shown favour by the state over a saver? A young person over a pensioner? Or, by subsidy, a land owner over the shop owner.

An inventor could spend years bringing an idea to market, living on bread and water, expending his entire savings, if unsuccessful he fades away, if it takes off for the benefit of us all the state steps in and crucifies him with taxation. Let us assume his business is up and running, leaving aside the employment legislation, he faces a mountain of local health and safety regulations, many of which are designed not to enhance safety but to expand the empire of the local inspectorate. His income is taxed, the capital appreciation of his company is taxed, his product is taxed at the quite extraordinary rate of 20% in Europe, probably greater than his profit margin, finally his place of work or factory is taxed , ironically he gets to pay the salary and pension of his local inspectors, (tormentors ?).

Western economies now are moribund because innovation and the entrepreneurial spirit are actively stifled by government. To return to the opening paragraph the legal threat to small business over pensions is just one of thousands of pettifogging rules and regulations the innovator has to withstand. There are literally millions of words, maternity/paternity leave, discrimination, hours worked, holiday entitlements. Added to this: employment tax. Mix a welfare system which pays people who choose not to work, a disruption of the labour market which would be inconceivable to the entrepreneurs of the industrial revolution.

This is a recipe to kill innovation through the catalyst of small businesses stone dead.

Global debt is now at unprecedented levels, beyond the conception of the human mind, (do you know what a $1 trillion means?). The only thing on which economists agree is debt reduction is necessary to reduce fiscal drag and the sole way or doing it is to grow the economy, not by .3% per quarter, but by 8 or 9% per annum. When state regulation, beyond the wildest dreams of our forebears, and out of control spending are coupled with permanently continuing degradation of currency, competition with Asia is simply not feasible.

China has problems of it own, it is, at present nakedly corporatist. Only 30% of GDP is consumer driven. Does this matter? Yes it does. Historically, innovation comes with healthy home grown markets as an export base. The Chinese buy on line to a far greater extent than Europe or even the US. Yet this new middle class will be the most important consumer base in history in 20 years. At present they thirst for high end luxury goods from Europe, this will probably continue, fashion comes from Europe as do prestige automobiles, but millions will want state of the art tech products at the right price. The Chinese will have to innovate. Copying technology and providing cheap labour withers quickly on the vine when a global market beckons. It may be worth remembering China was a nation of serious innovation from the eleventh to the fourteenth century, particularly in the scientific fields of cartography, clock making and military ordnance. Even now, their watchmaking and jewellery are world class. The catch up rate should terrify the modern politician, but the response is likely to produce a call for more tariffs, ever more protection.

Current growth has been debt fuelled, as China is a closed economy no one knows to what extent. Research and development budgets in China are overtaking the West, as are doctorates in science and engineering.

Modern economists, bureaucrats and politicians have grown up through an educational system heavily controlled in every way by the state. The curriculum is without imagination; teachers are unionised and without inspiration, those few vocational professionals usually crack or abandon the state system leaving 94% of children to the lottery of catchment areas and parental ambition. This system leaves the vast majority of working class children with no hope in a society where unskilled labour is largely unwanted. Yet to break this deadlock a whole revised concept of thinking is overdue.

One could do worse than turn to the great philosopher and economist of yesteryear Frederick Bastiat, sadly not even taught today in specialist economic classes, his concept of the ‘unseen’. This is too frightening for the state sponsored academic of the 21st century. It requires an independence of intellect. Suggest to them and their fellow travellers who support centralised planned economies that the abandonment of employment legislation would lead to more flexibility and they would simply not be able to cope. Surely the evil employer would unfairly sack everyone. In the words of American business men, ‘ If I can’t fire, I can’t hire’. It requires reserves of imagination to follow Bastiat because it doesn’t come in arithmetical form, much loved by the present day economist who assumes humankind responds to circumstances in a formulaic manner. Conjecture, debate and originality have no place in the state classroom.

The question for the West is what can it sell Asia except hand bags and Rolls Royces? But if the West does not prioritise innovation the only option is a sort of Byzantine decline over the next decade.

Governments often ask at election time what they can do for small business. The loud and clear answer is nothing at all, except, ‘Go away and leave the wealth creators to get on with the job’.