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Allison Schrager: No Home for Innovation

Why China will never have the world’s preeminent economy. Being the world's preeminent economy means being on the vanguard of innovation–constantly coming up with new ideas that change the world, or at least having an economy that can recognize and adopt the latest and best technology. For more than a century, America has filled this role. Before that, it was the U.K., which was first to industrialize. Someday, another country will step into this position–but it will never be China.

At least, not China under its current leadership. Over the past month, the Chinese Communist Party (CCP) has demonstrated why China will never be the world's preeminent innovation leader, and thus why it will never be a global economic leader. Recent developments also offer a warning for American politicians and policymakers aiming to emulate some aspects of Chinese industrial policy.

Beijing has halted what would have been one of the world's largest IPOs. It has cracked down on gaming, social media, and tutoring companies by making it extremely difficult for them to list on American exchanges; it is blocking mergers, issuing fines for antitrust violations, questioning these firms' use of data, and burdening them with other punitive regulations. It claims to be doing this for the good of society, echoing many of the same concerns Americans have regarding the influence of Big Tech. The Party claims that it wants to divert resources to more strategic industries, such as semiconductors.

Markets have reacted to these moves, but not as strongly as one might expect. China's actions, after all, are in keeping with how it has handled industrial policy in the past and with Beijing's desire to control the pace and terms of economic growth. The approach has worked well so far: China has averaged more than 7 percent growth in the past ten years, and its GDP is on track to surpass that of the U.S. by 2032. But unless something changes, it's unlikely that China can maintain this high growth rate or become the global economic leader on a per-capita GDP basis.

We've seen this movie before. Other East Asian countries grew rapidly with industrial policy, albeit on a smaller scale. In the 1980s, many worried that the Japanese economy would soon dominate the world. This familiar narrative suggests that industrial policy can bring growth without risk. If only the wise government bureaucrat chooses the best investment projects, no one will lose money, and all the right people will make a profit. Absent continuous innovation, though, this strategy hits a wall, especially in societies with aging populations. So while South Korea, Singapore, and Japan are prosperous, they are not global economic powerhouses.

Economists believe that countries can grow in certain ways–they can add more people, more capital, or both. China, like other East Asian countries, has grown rapidly by doing both. It took advantage of its large population by educating them and moving them into factories and cities, and it adopted foreign technology, making workers even more productive.

After a while, this strategy runs out of steam. You must add new labor, or the economy starts to shrink. Adding more capital won't make much difference, because, for example, one person can only use so many computers. At that point, the only way to grow is by being more productive than everyone else. That takes innovation–finding ways to use your existing inputs better. So far, China has not been tested in this way, and the latest round of economic restrictions suggests that it will never get there.

Innovation doesn't follow government plans. Often the most transformative innovations happen by accident or in areas where one would least expect it. That was the case for penicillin, vulcanized rubber, and the commercial steam engine. China's now-hobbled gaming industry could have been creating the next major innovation–changing the world with its work in facial recognition, 3D spatial analysis, or deepfakes.

Not only can governments not dictate what the next transformative innovation will be; they also cannot determine the best uses of the capital that funds innovation. Beijing is curtailing equity financing, especially from foreign investors. These inputs are crucial to growth for emerging companies. Cutting off equity capital limits these firms' ability to commercialize their innovations. The market also brings discipline because investors demand efficiency, productivity, and commercial viability. They tend to be better at picking winners than government bureaucrats, who have different objectives.

The industries Beijing favors may continue to grow and attract investors, but favored industries can change on a dime. And even these industries now operate at a disadvantage because the Chinese economy, and the world, just lost a major source of innovation. The odds are good that China will continue to grow for the next few years, but growth will slow as its population shrinks and China finds that it lacks the innovation needed to reach the pinnacle of the global economy. American politicians should take note.

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Posted: August 19, 2021 Thursday 02:04 PM