Triumph of the Innovation Economy – Part 7

What amazing discovery did economists make in the 20th century about the true source of growth? Why was Joseph Schumpeter’s revolutionary “innovation theory” initially dismissed? And what exactly is the key to future progress for our world?

Human Creativity and the History of the world

Part 7

In Parts 1 to 6 of this series of articles, we have journeyed together through time to trace the entire history of innovation across the ages. Why would we want to embark on such an epic and ambitious journey? To prove conclusively to ourselves and to others that innovation is not just a management fad or the latest business buzzword; that it is in fact – and always has been – the fundamental driver of human progress.

From the ancient societies of Mesopotamia through the empires of classical antiquity, the Medieval period and the Renaissance, the Industrial Revolution and right up to our Modern Age, the consistent lesson of history is that technological creativity is the primary fuel for economic growth.

In this final part of the series, we will find out how “innovation theory” – in essence, the Schumpeterian view of economic reality – finally became the central doctrine of modern economics, why this revolutionary theory was at first rejected by economists and politicians, and exactly why innovation is now the greatest economic priority of our times.

Why all the hype?

Look around your room right now, and you would have to conclude that every single item you can see was invented by somebody, somewhere, at some point in history, to improve quality of life – usually with the hope of profiting from or monetizing that invention.

As I have argued throughout this series of articles, innovation is not a new phenomenon. It has been around since we first had the idea to turn rocks into tools, or discovered how to make fire, or invented the wheel, or came up with cuneiform communication on clay writing tablets. It is part of what makes us human.

Indeed, the entire history of the world is a history of creativity, invention, and innovation. In the many millennia of our existence, there has never been a time when humans were not generating new ideas to make life easier and better for themselves in some way.

So why all the hype in recent years? What explains the explosion of newspaper and magazine articles, business books, blog posts, keynote speeches (mine included!), TV shows, workshops, training courses, idea management systems, government programs, and consulting practices all now devoted to innovation?

Why do some people even feel compelled to roll their eyes at yet another mention of the dreaded “I-word”? It’s because in the last few decades the world has finally come to recognize innovation for what it truly is – and always has been – our principal driving force for increased productivity, new wealth creation and economic growth. This may sound axiomatic today, but it wasn’t always so.

The rise of innovation economics

In Adam Smith’s classical model of economics, developed at the beginning of the Industrial Revolution in the 18th century, it was assumed that the only real factors influencing a nation’s economic growth were capital, land and labor.

The neoclassical view, formulated around 1900 and synthesized with Keynesian economics in the 1940s and 1950s, similarly defined capital and labor as the most important factors determining industrial productivity and therefore an economy’s overall performance.

This paradigm, which has dominated mainstream thinking on economics ever since, suggests that the only way to achieve growth in economic output is to continuously increase and optimize these two key inputs. Theoretically, if you triple the amount of capital and labor in the economy, you should get three times the output.

It turns out that isn’t the case. Over the years a number of leading economists, including Robert Solow, who won a Nobel Prize for economics in 1987, discovered that there had to be another significant factor in the whole growth equation.

When they independently analyzed the growth in the output of the U.S. economy over various periods of time, and then measured the growth in traditional inputs (capital and labor) over those same periods, they found in case after case that the increase in inputs could only account for about 15% of the growth in economic output. So what could have delivered the other whopping 85% of that growth?

That’s what had the economists scratching their heads. Their results seemed to contradict the most fundamental model of economics – a theory of growth which had been accepted as gospel for 200 years. After all, a residual of 85% couldn’t be put down to a few marginal variables. It would have to be coming from some other major factor – and a juggernaut of a factor at that.

If the statistics revealed that capital and labor (the traditional inputs of industrialization) were only a minor part of the growth equation, what exactly was this giant and mysterious missing factor – this primary engine of economic growth?

The economists realized there could be only one answer – innovation. It had to be a combination of new scientific knowledge, rapid technological progress through R&D and patent registration, rampant entrepreneurship in society, and the emergence of new networks of firms working in industry clusters and cities.

It was innovation – in the form of new technologies, processes, products, services, and business models – that was chiefly responsible for spurring the higher levels of productivity which were driving economic growth.

It wasn’t simply about accumulating more capital and labor in the economy, and then using it to build increasingly bigger factories to produce more of the same kinds of goods. Rather, it was about using the power of innovation to dramatically improve production process efficiencies, and more importantly to invent completely new-to-the-world products and services, spawning new markets and perhaps even new industries, in turn encouraging new capital investment, creating tens of thousands of new jobs, spreading new wealth, and raising quality of life across societies.

It became clear to these economists that innovation was the tide that was lifting all boats – it was the central catalyst of economic growth.

This conclusion is now undeniably supported by empirical evidence around the world, showing the clear statistical link between innovative activity and economic performance in all kinds of economies at various periods of time.

No wonder the Economist magazine, which is not famous for hyperbole, had this to say about the role of innovation:

“Far from being simply some missing factor in the growth equation, innovation is now recognized as the single most important ingredient in any modern economy—accounting for more than half of economic growth … In short, it is innovation—more than the application of capital or labor—that makes the world go round.”

A return to Schumpeterian theory

This realization is by no means new. It was the great Austrian-American economist Joseph Schumpeter – perhaps best remembered for the concept of “creative destruction” – who arguably first introduced the idea that innovation and technological change were the main drivers of economic growth. In his landmark book Capitalism, Socialism and Democracy, published in 1942, he wrote:

“Innovation is the outstanding fact in the economic history of capitalist society … and also it is largely responsible for most of what we would at first sight attribute to other factors.

The changes in the economic process brought about by innovation, together with all their effects, and the response to them by the economic system, we shall designate by the term Economic Evolution.

There is no reason to expect slackening of the rate of output through exhaustion of technological possibilities.”

This view of things represented a radical departure from classical and neoclassical economics, in which innovation, as Peter Drucker once put it, ‘belonged in the category of “outside catastrophes” like earthquakes, climate or war, which, everybody knew, have profound influence on the economy but are not part of economics.’

Schumpeter’s contrarian stance was that, far from being a force that is peripheral to the economy, innovation is in fact the very core of economics and of all modern economies.

At the time, many rejected Schumpeter’s ideas. Economists and politicians alike were much more attracted to the theories of his contemporary, John Maynard Keynes, and it’s not hard to see why. Keynes’s General Theory, published in 1936, prescribed a set of methods for achieving a balanced, stable and controlled economy where the goal was a state of perfect and perpetual equilibrium. This must have been an incredibly appealing notion when the world was still reeling from the economic devastation of the Great Depression!

Schumpeter, on the other hand, argued that a modern economy would always be in a state of disequilibrium. The forces of “creative destruction” unleashed by innovation would make it forever dynamic, forever in flux, more like a tumultuous, fast-flowing, “white water” river than the Keynesian notion of a closed, self-contained, economic “lake”.

Schumpeter wrote about the “process of industrial mutation that incessantly revolutionizes the economic structure from within, incessantly destroying the old one, incessantly creating a new one.” But in 1942, and the years directly thereafter, while the Second World War was still wreaking unspeakable havoc, there wasn’t much appetite for a message that predicted more economic turmoil and change. People were understandably longing for stability.

So Schumpeter’s talk of unbridled entrepreneurship, of highly competitive and unpredictable markets, of innovations that generate only short-lived profits as they are continuously replaced by newer and better ideas, of industry incumbents and their capital investments being rapidly rendered obsolete by challengers and newcomers, and of runaway economic success ultimately leading to the danger of inflation, fell on a lot of deaf ears.

Today, however, over seven decades later, it is Schumpeter’s view of economic reality, not Keynes’s, which predominantly shapes the thinking of modern politicians, economists and business leaders.

His understanding of the way the economic world actually works, and his vision of the future, now prove to have been highly prophetic. And his theories have guided many of the innovation-focused economic policies which have borne fruit for a whole string of nations.

The central issue in economic prosperity

Thus, the whole notion of an innovation economy had its genesis with Joseph Schumpeter. And despite the many decades it took for this notion to become widely accepted and statistically verified, it is now commonly viewed as the essence of modern economics.

According to Daron Acemoglu, Professor of Economics at MIT, “ninety-five percent of economists agree that innovation is the most important thing for long-run growth.”

At a meeting in Washington in 2008, the leaders of the G-20 issued a joint statement acknowledging that “dynamism, innovation, and entrepreneurship . . . are essential for economic growth.”

Michael Porter, one of the world’s leading experts on competitive strategy and international economic development, calls innovation “the central issue in economic prosperity.”

In the last twenty years, Schumpeter’s concepts have provided the foundation for a new and increasingly popular doctrine of economics, sometimes referred to as “new growth theory,”  “innovation theory”, “neo-Schumpeterian economics,” or simply “innovation economics.”

The emergence of this new movement has had a significant impact on the thinking of economic advisers and policymakers around the world. Fortunately, many have shifted their focus from traditional macroeconomic issues like capital accumulation, money supply, interest rates, budget surpluses, tax cuts, or social spending – things which have only limited impact on economic growth – to the all-important issue of how to formulate national economic policy that fosters private sector growth and productivity through new knowledge, technological progress, entrepreneurship, and innovation.

The key to future progress

This is the new imperative for the world’s leaders – both in large corporations and in national or regional governments. The challenge is how to build an effective innovation system and a cultural environment that will foster and support human creativity and technological progress.

In recent years, this has been recognized and clearly articulated by the most prominent political leaders on the planet. U.S. President Barack Obama said,

“The United States led the world’s economies in the twentieth century because we led the world in innovation. Today, the competition is keener; the challenge is tougher; and that is why innovation is more important than ever… Innovation will be the currency of the twenty-first century.”

Germany’s Chancellor Angela Merkel said: “Innovation must be Germany’s trademark.”

And Xi Jinping, President of China, when asked about the priorities for China’s future, answered, “Innovation, innovation, and innovation.” He continued, “We will follow the strategy of innovation as an impetus for development… as the primary force of productivity.”

These words have been echoed in similar comments from other world leaders in various parts of the globe.

The view of many corporate leaders is no different. Jeff Immelt, Chairman and CEO of General Electric, says,“The only answer for us today is innovation.”

Ginni Rometty, President and CEO of IBM, says, “It’s all about achieving growth through innovation.”

And A.G. Lafley, Chairman and CEO of Procter & Gamble, says,

“Innovation is the central job of every leader — business unit managers, functional leaders, and the CEO.”

Looking around the world we now see a long list of national or regional governments – along with thousands of business organizations – that are working hard to embed innovation as a sustainable and widely distributed capability, and are already reaping the benefits.

As I hope to have shown in this series of articles, economic power has always been inextricably linked with innovation power. This fundamental point can only really be understood by economists, policy makers, and corporate executives by looking back across centuries, indeed millennia.

If the entire history of our world is a history of creativity, invention, and innovation, then it follows that the future prospects for our world, our nations, and our business institutions, are dependent on our ability to leverage exactly these capabilities.

The certainty of creating and exploiting new opportunities in the future should never be taken for granted. What history also teaches us is that no nation or company can stay at the cutting edge of innovation forever.

Joseph Schumpeter recognized that there are always social forces – such as political lobbies, labor unions, corporate leaders or middle managers, trade associations, and various bureaucracies – that block technological progress and try to maintain the status quo by resisting new ideas. We need to continuously work to overcome these forces in order to drive our societies and our corporations forward.

The key to our future progress only becomes truly obvious when we concern ourselves with the progress of the past.

That has been my whole goal with this series of articles. In this endeavor I have stood on the shoulders of many giants from the academic study of economic and technological history, such as David Landes and Donald Cardwell. In particular, I was inspired by the great economic historian Joel Mokyr, with whom I had the pleasure and the honor of speaking some months ago. For decades, Mokyr has argued that innovation has been the critical dimension of economic growth throughout human history, or what he calls “the lever of riches” (see his 1990 book by the same name). His body of work has formed the foundation for much of my research and my own thinking on this subject.

The central challenge for world leaders is this: to unleash and support technological creativity, entrepreneurial activities, and market power by putting the necessary economic, business and cultural preconditions in place for innovation to continually flourish. There is certainly no greater priority in our times.

Find the entire series here.

© Rowan Gibson 2015. All rights reserved.

image credits: Rowan Gibson; en.wikipedia.org; pixabay.com; en.wikipedia.org; en.wikipedia.org; en.wikipedia.org; pixabay.com

Rowan Gibson’s brand new book The Four lenses of Innovation examines the thinking patterns or perspectives that have been catalysts for breakthrough innovation throughout human history, and shows you how to use these perspectives to infuse creativity into your own organization. Order your copy right here.

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Rowan Gibson (rg@rowangibson.com) is recognized as one of the world’s foremost thought leaders on innovation. He is the internationally bestselling author of 3 major books, an award-winning keynote speaker in 60 countries, and a cofounder of Innovation Excellence. His new book is The Four lenses of Innovation. On Twitter he is @RowanGibson.