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Protectionism vs. the Innovation Nation

Friday, October 16, 2009

The era of measuring national well-being by tallying how many and what kind of advanced products a country makes is long gone.

On September 9, the giant data storage hardware and software company EMC announced it would spend $1.5 billion to further develop its R&D capabilities in India. A new research facility will employ 2,000 engineers and scientists with the potential for an additional 1,500. A day earlier, EMC announced a R&D alliance with the Indian Institute of Information Technology-Bangalore, one of a constellation of Indian research universities equivalent to the Massachusetts Institute of Technology, albeit with harder admissions requirements.

Such announcements are usually met with despair and anger. The decision to domicile those jobs in India nails yet another in the coffin for U.S. industry and R&D, goes the old saw. The naysayers bray that EMC's decision is more evidence that America makes and designs less and less, and has become a soft-bellied country of marketers, PR people, and lawyers—make-nothings, in other words. Even President Barack Obama has joined this chorus, calling for more engineers and a return to a country of people who make things.

Many Indian multinationals, such as Infosys and Wipro, are aggressively hiring in the U.S. to maintain closer ties to U.S. customers in the financial services industry.

But the era of measuring national well-being by tallying what kind and how many advanced products a country makes is long gone and increasingly irrelevant. If America wants to prosper in the 21st century, it will need to learn the new rules of the innovation game—and how the United States can play this game to win. The global outsourcing game is far more nuanced than in the past, and in certain areas, the United States has lost key advantages. But America retains other key advantages and remains well positioned to continue our technology leadership—if we put our resources in the right places and don't waste scarce resources trying to recapture a bygone era.

Here are, in my mind, the new rules of outsourcing, economic production, and innovation.

1) Big R&D follows growth.

That EMC is investing heavily abroad should not surprise. Cisco, IBM, Intel, General Electric, Google, Microsoft, and just about every other innovative technology or research-driven company has significant R&D operations overseas. EMC dove into India because it believes that the subcontinent has vast reserves of untapped engineering and scientific talent. Further, EMC sees greater growth prospects in developing world markets and believed it could be more successful addressing those markets with homegrown talent. EMC is hardly alone in this view. Most of the major technology companies report far greater growth in the developing world than in the developed world. For example, HP gets 69 percent of its revenue from outside the United States, IBM gets 63 percent, Intel and Pfizer 57 percent. In 2008, Caterpillar booked 67 percent of its sales from outside the United States, up from 63 percent in 2007, and 54 percent in 2006.

The best of iQor’s front-line call center workers make over $100,000 per year. No, that's not a typo.

Why is no mystery. The economies of these countries are growing at a far faster rate than economies in the developed world. For EMC, it’s a matter of fiduciary duty to follow the growth and maximize value for shareholders. Of course, some or most of the products developed in EMC's Bangalore facility will have global implications. Data storage is hardly a product that requires cultural differentiation. But EMC and every other company realizes that social ties matter, too. Selling products to Asian and Middle-Eastern companies is fundamentally easier when key teams behind those products live in India.

In the same vein, leveling sanctions against U.S. companies that export jobs is pointless and counterproductive. Mandating that R&D traditionally performed in the United States stay in the United States would tie the hands of U.S. companies at precisely the time they need flexibility to compete against up-and-coming foreign competitors. It is necessary to accept that R&D will migrate to areas of higher growth in order to tap into the new brains in those labor markets, and to gain better knowledge of those markets as well as tap into cultural and economic ties.

In industries such as cleantech, where countries such as China are offering huge incentives and subsidies to industry, we may need to make strategic investments to support private R&D through tax breaks and other incentives. The world isn’t completely flat. The carrot may work better than the stick.

2) Mid-range R&D and outsourcing is far more fluid.

Herein lies a huge opportunity for the United States and its relatively well-trained employee base. Midsized companies do not see the advantage of building R&D facilities in India because many of them still see plenty of room for growth in the United States. Further, if most of their customers are in the United States, then moving research offshore has limited utility because separating engineering from the sales teams that speak most frequently to customers can undermine product development. (For precisely this reason, many Indian multinationals, such as Infosys and Wipro, are aggressively hiring in the United States to maintain closer ties to U.S. customers in the financial services industry. They learned the hard way that building completely offshore operations for advanced financial services functions is very difficult).

Work actually is being outsourced to the U.S. from the United Kingdom, Canada, Australia, Spain—even Saudi Arabia and the United Arab Emirates.

Indeed, serving U.S. customers from India has the advantage of cheaper labor. But that advantage can easily be overcome through better training, technology, and a greater emphasis on people. Consider iQor, a call center and business process outsourcing company that has grown revenues at a 40 percent clip for the past four years. iQor has done this primarily by expanding its U.S. operations. iQor also gives its U.S. employees universal health insurance and salary-plus-bonus structures roughly 50 percent above industry norms. iQor has 12 locations in the United States, plus operations in Canada, India, the Philippines, and the United Kingdom. Over half of iQor's 11,000 employee workforce is based in American cities such as Columbus, Ohio, Greensboro, North Carolina, and Buffalo, New York. And the best of its front-line call center workers make more than $100,000 per year. No, that's not a typo.

How can they do this? iQor aggressively promotes from within and provides the best technology platforms in its class—platforms that have advantages many offshore business process outsourcing (BPO) firms do not have. The technology, in turn, lets iQor employees make up for higher wages with higher productivity and much higher flexibility. That flexibility is key. In the BPO business, half the battle can be creating a proper workflow and system integration with the clients. Add this all up and iQor has taken what is, in essence, a blue-collar business and turned it into a technology and people play.

3) Small-sourcing is actually a competitive business for U.S. workers.

A handful of Internet tools have popped up that allow companies to easily locate and manage contract workers anywhere on Earth. Ironically, these sites have actually proven to be a powerful force for further U.S. employment. Contractors offer a wide variety of skills, ranging from data entry to sophisticated computer programming. Customers vary from small businesses and sole proprietors seeking project help to large businesses that don't have internal skills for a certain type of job. The common thread is that, generally speaking, individuals are the contractors.

This business is thriving. Growth rates are in the high-double digits on an annual basis as more and more companies figure out ways to outsource piecemeal work. And these sites have connected the global workforce with potential part-time employers like never before. For example, one of these companies, oDesk, has contractors from dozens of countries, including China, Singapore, Russia, and Bolivia.

Chinese engineers and MBAs lack role models and mentors who have taken companies public or created truly innovative products earlier in their careers.

One would think that labor costs would dictate that most of the work would flow from the United States abroad to the developing world or lower-cost nations. In fact, that's not happening very much at all. Work actually is being outsourced to the United States from the United Kingdom, Canada, Australia, Spain—even Saudi Arabia and the United Arab Emirates. While the single largest percentage of oDesk work goes to contractors in India, the United States ranks No. 3. And the number of hours worked in the United States is growing at a pace of 267 percent, considerably faster than the 188 percent for India. The salary differentials between India and the United States are far smaller than one might have thought, according to oDesk billing data. Indian workers were paid roughly $11 an hour on average and U.S. workers were paid roughly $17.50 an hour. But Americans receive higher evaluations for their work—an average 4.48 out of 5, compared with 4.12 for India.

Many employers also greatly prefer to work with contractors who are in the same time zone. So American contractors don't have that much of a disadvantage. Companies readily pay a little more for higher-quality work. Granted, the net effect of this global competition will likely be reduced wages for workers in higher-cost centers of the United States, where even menial tech work is billed at $25 per hour and more. But much of the United States is not a high-cost area. And in many parts of this country—particularly rural areas or cities far from the coasts—a $20-per-hour wage can secure a decent lifestyle. Plus, highly skilled workers can make much more. Some with Web design and system administration skills earn $60 to $90 an hour. So on oDesk and its ilk, Americans compete quite nicely, and outsourcing is not nearly the problem that the public perceives.

4) Our competitors are learning the hard way that money and might can’t buy innovation.

Take the semiconductor industry, which we first thought we had lost to Japan in the 1980s and then to China earlier in this decade. China declared this industry strategic and has spent billions trying to achieve technology hegemony. Indeed, a few years ago, it looked like China would achieve the same success as it did with electronics manufacturing.

Much of the rhetoric about the dumbing down of American workers has been based on the false assumption that this country doesn't make anything anymore.

In 2004, China's most advanced chip manufacturer, SMIC, went public on the Hong Kong and New York stock exchanges. The next year, two Chinese chip design companies, Actions and Vimicro, had successful Nasdaq IPOs. The Chinese said there were hundreds more semiconductor design firms waiting in the wings and dozens of new Chinese chip manufacturers were also starting up.

Five years later, most Chinese chip companies remain unprofitable despite China’s training lots of engineers and spending money to subsidize companies and build facilities. It has not been enough to create a successful industry, something I have observed in my own research on R&D in China and confirmed by a new book by Clair Brown and Greg Linden of the University of California at Berkeley, Chips and Change: How Crisis Reshapes the Semiconductor Industry.

Due to China’s poor reputation for protecting intellectual property, multinationals have limited technology transfer to China. Chip giant Intel delayed locating its most cutting edge fabrication facilities in China, even though this increases the cost of logistics to supply China-based electronics factories (that are among the biggest consumers of Intel processors). And witness the dispute between SMIC and TSMC, the Taiwan-based leader in contract chip manufacturing. The Taiwanese chip giant alleged that SMIC hired top TSMC engineers and used them to gain access to trade secrets. SMIC settled in 2005, agreeing to pay TSMC $175 million over six years.

While Chinese semiconductor companies have produced some design wins, the general perception is that China's design shops are good with common reference designs but struggle to produce true silicon breakthroughs. This is likely a product of the variable quality of engineers produced by China's fledgling academic programs which, while ambitious and well-funded, produce quantity at the cost of quality. Likewise, China's pool of MBAs does not have the depth of MBAs from countries with longer histories of business studies and research. And unlike young engineers and MBAs in Silicon Valley, young Chinese engineers and MBAs lack role models and mentors who have taken companies public or created truly innovative products earlier in their careers.

Yes, job counts have declined in industrial areas. But the little secret that nativists don't like to talk about is that job counts in industrial production have also declined in China and other places.

China also suffers from an unhealthy competition for marquee facilities among its local governments. This can lead to overinvestment in favored industries, such as semiconductors. SMIC has been hired by at least two city governments to build and manage chip manufacturing plants for which the municipalities, and not SMIC, will bear the risk. This is occurring at a time when China already has excess chip capacity and idle fabrication lines in a number of semiconductor plants. Such lack of market discipline is critical because semiconductor lines not in use have absorbed billions of dollars in investments that could have been used for far more productive endeavors.

5) Innovation reservoirs in the U.S. run deep and remain untapped.

Much of the rhetoric about the dumbing down of American workers has been based on the false assumption that this country doesn't make anything anymore. A corollary is that America doesn't innovate anymore. Both assumptions are demonstrably false. Industrial production in the United States has continued to climb over the past 20 years (with the brief exception of the past 18 months) even as protectionists have howled about the dangers of giving up our manufacturing base. Yes, job counts have declined in industrial areas. But the little secret that nativists don't like to talk about is that job counts in industrial production have also declined in China and other places. That's because automation is driving efficiency and playing a far greater role in job losses than labor arbitrage plays.

The second false claim is that the United States is no longer a hub of innovation and will suffer from an innovation dearth in the near future. Certainly, the world has gained ground on the United States as other countries have developed their economies and diversified into higher value-added production verticals. But the blanket claim that the gain of foreign competitors is the loss for the U.S. worker and industry is also demonstrably false. Silicon Valley remains a key hub of product design in the consumer electronics and technology space. In aerospace and automotive, despite recent setbacks, the United States remains a key center of innovation.

Over the last four decades, we’ve invested on the order of a trillion dollars on university research.

Plus we have a goldmine of potential innovation locked in the research labs of our universities. Over the last four decades, we’ve invested on the order of a trillion dollars on university research. Hardly 0.1 percent of all funded basic science research results in a commercial venture. And myriad promising discoveries lie dormant in file cabinets of university technology transfer offices, waiting for a white knight. With the right focus, our research commercialization can be turned into a well-oiled factory for innovation.

Where this country has fallen has been in creating processes that make it easier to take these discarded discoveries and turn them into companies. Tech transfer offices are overwhelmed trying to communicate what's in their inventory. The scientists who make the discoveries, for their part, are poorly equipped to form companies built around their research. Venture capitalists and larger companies have little interest in so-called "science projects" unless there is an obvious straight shot from lab to fab or factory.

It is in this early stage of business development that a huge percentage of the later economic value is created. So by doubling or tripling the uptake rate of scientific discoveries, the United States could conceivably drive enormous economic growth and create significant value. This is something that cannot be outsourced and, realistically, will not benefit from outsourcing. The best person to turn a concept into a real product is often the inventor, the person who has the vision and drive to make their baby into something big and wonderful.

A game plan for competitiveness

How can these five observations be coalesced into a game plan for future economic development? First, we need to accept that R&D will now happen globally. We have to build new business models that recognize this reality. Yes, we may have to level the playing field in industries where other countries aren’t playing by the rules, but we need to be smart in how we do this. Second, the midsized companies are less likely to outsource and are more likely to keep innovating in the United States. The key to the success of these firms is technology, so policies that make it easier for mid-tier players to leverage technology could have an outsized impact. Third, small sourcing is nothing to fear over the long haul, either. By encouraging better broadband speeds in this country and providing incentives for continuing education to upgrade skill sets, the United States can help these sole practitioners not only compete but win on a global market. Lastly, mechanisms to break the innovation logjam at the source and unleash a flood of companies built on technology that died in the lab are paramount in tapping into a huge potential source of value, economic development, and continued economic leadership.

Vivek Wadhwa is a visiting scholar at UC-Berkeley, director of research at the Center for Entrepreneurship and Research Commercialization at Duke University, and senior research associate at Harvard Law School. You can find his research at www.globalizationresearch.com and follow him on Twitter at @vwadhwa.

FURTHER READING: Wadhwa also wrote “America’s Other Immigration Crisis” and “The Indian Exception Proving the Rule,” which discusses how the forces driving outsourcing are as strong as ever, with benefits for both India and the West.

Image by Darren Wamboldt/Bergman Group.

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