The outlook for U.S. innovation: bright for how long?

Last year, CE asked the Council on Competitiveness for a 10-year retrospective look at the U.S. economy. This year, we asked the Council to go one level deeper - to assess the nation's innovation IQ, providing a snapshot look at how the U.S. rates relative to other nations, as well as what the future holds.

Less than a decade ago, a number of prominent CEOs warned that the U.S. was about to become a technological colony of Japan. The Japanese government had set its sights on winning the information revolution and mobilized the country's powerful electronics sector to that end. Even after Japan's financial bubble burst, U.S. industry faced a juggernaut that looked poised to dominate semiconductors, high definition television, and fifth generation computing.

What a difference a few years can make. Japan lost all its government-led bets while U.S. industry hit the jackpot by concentrating on microprocessors, software, and communications networking.

This stunning reversal of fortune has left the U.S. the undisputed world leader in translating new ideas into products and services. The U.S.'s edge in innovation is based on information technology but extends far beyond computers and telecommunications into fields as diverse as advanced materials, entertainment, financial services, health, logistics, and retailing.

But the fundamentals of innovation are changing profoundly. The costs and complexity of the process are skyrocketing. New sectors are emerging based on investments in people rather than capital equipment. Companies are gaining the tools to bring new ideas to market on a global basis. Countries are leapfrogging generations of technological development.

How long can the U.S. remain on top when information, capital, and know-how are flowing across borders as never before - and when countries around the world are striving for the high-value part of the innovation chain? The CEOs, university presidents, and labor leaders who make up the Council on Competitiveness have explored this question over the past year through a high-level expert group, regional dialogues around the country, and a first-ever National Innovation Summit at MIT.

The members of the Council agree that innovation has become the indispensable core of U.S. competitiveness. The country has made dramatic progress in cutting costs, improving quality, shortening product cycle time, and putting the nation's financial house in order.

But the U.S. can no longer compete on standard products and services that are fast becoming available everywhere. Now and for the future, the competitive position of the U.S. economy will hinge on its capacity to develop new products, processes, and services that command a premium in global markets and support high living standards.

Strengths and Vulnerabilities

Despite America's current confident mood, CEOs who participated in the recent Innovation Summit at MIT saw no grounds for taking long-term U.S. leadership in innovation for granted. They reached this conclusion in real-time voting after assessing U.S. strengths and vulnerabilities in five key areas that shape the national environment for innovation: the talent pool from which companies draw, the research base that generates new ideas, the vitality of the domestic market for commercializing new ideas, access to global markets, and the supply and allocation of capital.

The Talent Pool

Worries about human resources stood out as the greatest single concern at the Innovation Summit. Nearly half the participants predicted that the U.S. talent pool will be weaker 10 years from now than it is today based on current trends.

Lucent Technologies CEO Richard McGinn captured the concerns of many when he observed, "We have outright leadership in advanced technology and post-secondary education, but we're staring at a growing percentage of the population who lack the skills in math, science, and reading to be full participants in a demanding and innovative marketplace. This is a profound problem, and one that is growing in its dimensions."

Unquestionably, the heart of the talent-pool challenge is K-12 education. International comparisons show American youngsters steadily losing ground in primary school and finishing high school well below the international average in science and math achievement [ILLUSTRATION FOR FIGURE 1 OMITTED]. In addition, the best and brightest American students by no means make up the difference by outperforming their Asian or European counterparts.

The weakness of the K-12 pipeline hurts U.S. competitiveness in two ways. First, a system that leaves large numbers of entry-level workers without basic skills limits their opportunities, imposes a costly remedial burden on the private sector, and fails to ready them for the continuous upgrading of skills needed in today's workplace. It is no accident that CEOs at the innovation summit made the adjustment of immigration quotas to fill the gap in qualified knowledge workers a top short-term priority.

Second, today's K-12 system does not prepare or motivate enough students to pursue further study in science and mathematics. The U.S. leads the world in the percentage of university graduates, but lags in the percentage of American students receiving science and engineering degrees [ILLUSTRATION FOR FIGURE 2 OMITTED]. This shortfall has opened up growing opportunities for non-American students, who now comprise roughly one-third of graduates in math, computer science, and engineering. As career opportunities have increased in their home countries, however, the number of foreign graduates committed to stay in the U.S. has declined [ILLUSTRATION FOR FIGURES 3 AND 4 OMITTED].

In a nutshell, the shortage of U.S. talent is not just cyclical but structural. If this structural demand is not met, the U.S. environment for innovation will look less attractive to both American and foreign companies.

The Research Base

World leadership in innovation demands that the U.S. remain in the forefront of major fields of science and new enabling technologies. Although the U.S. has held such a position for 50 years, Summit participants were sharply divided over the outlook of the U.S. research base. One-quarter saw a weakening trend but nearly as many saw improvement.

Optimists have a definite case to make regarding the nation's future R&D capabilities. The productivity of U.S. research universities, corporate laboratories, and federal facilities in scientific discovery and invention remains unsurpassed. The U.S. has invested more in its research base in absolute terms than Japan, Germany, Britain, and France combined. Overall U.S. R&D spending shows no sign of slowing and has actually turned upward.

Equally, the economic benefits of long-term investment in frontier research are beyond question. Former Secretary of Defense William Perry pointed out at the Innovation Summit that DOD research played a critical role in the development of the silicon chip, communications satellites, and the Internet. The link is even more immediate between the scientific research and explosive growth in the health sector. As Merck CEO Ray Gilmartin noted, the federal investment in basic science has stimulated far-reaching, complementary. research commitments by pharmaceutical companies.

Yet worriers do have real cause for concern. Cost pressures have drawn universities increasingly away from frontier research into product development. Companies have cut back sharply on research unrelated to the bottom line to concentrate on next-generation products. The federal government funds almost 60 percent of basic science and technology, but the federal contribution to overall R&D has steadily declined in relative terms. [ILLUSTRATION FOR FIGURES 5 AND 6 OMITTED] Large cutbacks in DOD research have also shifted Washington's portfolio away from support for physical sciences and engineering toward life sciences. As a result, the national research establishment faces a period of exceptional flux without a unifying vision.

At the same time, other nations are quickly ramping up their investments in R&D [ILLUSTRATION FOR FIGURE 7 OMITTED]. The U.S., Japan, and a handful of European economies are no longer the only centers of high-tech innovation. Taiwan, Korea, Hong Kong, and Singapore have become fast-followers in some key technologies and leaders in a few. The emergence of Ireland, Israel, and India as major niche players in innovation technology scarcely seemed possible a decade ago. Figure 8 illustrates the impact emerging economies have begun to have in registering U.S. patents. Low-cost innovation has become as much a part of the competitive picture as low-cost production.

Domestic Market Vitality

Having the world's richest home market, and one of its most open, gives U.S.-based innovation a powerful edge. A clear majority of CEOs at MIT saw this edge increasing over the next 10 years.

Several factors underpin the positive outlook for U.S. market vitality. One key asset is the depth and sophistication of domestic demand for new products and services. Another is entrepreneurial spirit, which supports risk-taking and tolerates failures: A third distinctive strength is the capacity to diffuse knowledge across the economy, often through collaboration among companies, universities, and government research facilities. These fundamentals set the U.S. apart from any other world market.

The main threats to U.S.-based innovation that CEOs identify stem from the legal and regulatory environment. Figure 9 estimates the cost of regulation in the U.S. per employee, while Figure 10 indicates that the U.S.'s regulatory-cost burden is more than triple the size of the nation's investment in R&D. In addition, CEOs see the U.S. more constrained by the legal environment than many other nations in developing and applying technology [ILLUSTRATION FOR FIGURE 11 OMITTED].

Figure 12 shows that product liability is a particular source of concern as well. On balance, however, the opportunities of the U.S. platform for innovation still outweigh the disincentives.

Access to International Markets

The entry of four billion consumers into the global marketplace since the mid-1980s has made international market access a compelling imperative for all U.S, companies that can provide products and services across borders. A majority of CEOs at the Innovation Summit thought such access would increase over the next decade.

Underlying this optimism is a judgment that globalization is irreversible. CEOs recognize that the U.S. economy is more closely tied to the rest of the world than ever, and they believe that the same logic will hold for others. Although the U.S. already ranks among the best in terms of protecting intellectual property [ILLUSTRATION FOR FIGURE 13 OMITTED], many CEOs see a key role for the federal government in pressing for intellectual property protection offshore and for a trade and investment agenda that supports the interests of the country's most innovative firms.

The obvious concern of CEOs is whether the coalition in favor of U.S. international trade can be sustained in the short term and beyond. A new consensus on trade is needed to restore U.S. leadership in opening international markets.

Capital Availability

The cost of capital is no longer the hot button it used to be for many CEOs. The Innovation Summit did not single out capital issues as a major impediment, as it might have been expected to do a few years ago. Instead, Summit participants were decidedly upbeat about capital availability. A majority viewed the 10-year outlook as positive and ranked the U.S. strong in venture capital availability [ILLUSTRATION FOR FIGURE 14 OMITTED].

This turnaround is no mystery. At nearly eight consecutive years of growth, low inflation, and budget deficit reduction have significantly reduced long-term interest rates. Capital gains have been cut, the U.S. venture capital network is vibrant, and booming financial markets have greatly eased access to low-cost capital for companies of all sizes.

The vulnerabilities of the U.S. capital position are structural, and they don't command much CEO attention these days. A serious lag in saving has required the U.S. to import capital from abroad to meet investment needs. As Paul Volcker has reminded, "It cannot be healthy for the world's largest economy, as well as the center of international financial markets, to be a huge and chronic borrower." Moreover, the projected explosion of entitlement spending after 2005 will restrict federal spending options at a time when public investments in frontier research and enabling technologies may be more needed than ever.

The Bottom Line

Although the U.S. is not about to lose its lead as the world's most dynamic platform for innovation, the game is changing fast. It will take a national focus on people, ideas, capital, and markets to keep winning over the long term.

John Yochelson is president of the Council on Competitiveness, a Washington, D.C.-based non-partisan forum of chief executives from the business, university, and labor communities working to sustain U.S. economic leadership.