Avinash Persaud. Foreign Affairs. Volume 80, Issue 2. March/April 2001.
A Penny for Your Thoughts?
For a long time, economists saw capital, labor, and natural resources as the essential ingredients of economic enterprise. In recent years, they have also come to recognize the role of technology, as well as information, innovation, and creativity, in expanding economic potential. Now the Internet has increased the scope of innovation by lowering information and distribution costs. As a result, what is emerging today is a combination of innovation with “equitization,” wherein individuals and companies sell equity stakes in good ideas and use the capital they raise-rather than the help of existing profit-to realize these ideas. In the first six months of 2000, for example, biotechnology companies raised $20 billion in the stock markets to finance gene research, even though related revenues are not expected for many decades to come. Despite their lack of profits and recent downgrading, many “new economy” companies with untraditional business models are nevertheless valued in billions of dollars. Established rules on the role of capital in investment and economic growth and development need to be rewritten. The implications are significant-but run contrary to the current consensus.
In a globalizing and liberalizing world, unlimited capital can be tapped across traditional boundaries. According to State Street Bank, cross-border private equity flows have already leapt from $268 billion in 1995 to an estimated $1.1 trillion in 2000. For the first time, such flows now rival those in government bonds. With past profits and current capital no longer a major constraint, a country’s future economic prospects will depend predominantly on knowledge. Yet examining the relative knowledge base of different countries today does not lead to optimism about reducing the income gap. It is doubtful that the knowledge revolution will let developing countries leapfrog to higher levels of development, as many technologists and Internet evangelists assert. In fact, the knowledge gap will likely widen the disparities between rich and poor, imprisoning many developing countries in relative poverty.
But such pessimism is rarely expressed these days. Revolutions begin with bursts of optimistic fervor, and at first glance the knowledge revolution seemed no different. Most financial booms are spiced with stories of excess such as the marbled mansions of the “robber barons,” but the recent technology boom celebrated university dropouts working 20-hour days in abandoned garages, making it big while still wearing the same ungainly spectacles. Developing countries also became actors in this drama, as Internet entrepreneurs from humble backgrounds made instant fortunes in Bangalore, Shanghai, and Seoul. It is also commonly said that the new knowledge technologies bolstered democracy. The Internet and mobile phones helped spread information to places where governments previously held a monopoly on news. Perhaps the best weapons of the protesters in Belgrade, for example, were not stones and placards but the mobile phones that disseminated information and mobilized action.
But reality is less romantic. For the last five years, forward-looking financial markets have suggested that the knowledge economy will actually expand the gap between rich and poor. From 1990 to 1994, when the knowledge revolution was nascent and technology sectors were dwarfed by more traditional sectors, U.S. investors in emerging markets received returns of 17 percent. That high payoff reflected the significant risks involved and the emerging markets’ potential for robust growth from low levels of development. Over the same period, investors would have lost 2 percent in overseas developed markets. In contrast, from 1995 to 2000-when the technology sector first boomed, then plummeted, and yet remained large-emerging market stocks fell 27 percent, whereas those in developed markets rose 43 percent. This comparison would be even more striking if it excluded the handful of middle-income high-flyers, such as Hong Kong, Taiwan, and Singapore.
Why have the markets seen better opportunities in the developed world than in the developing one? Because the equitization of innovation favors rich countries and disadvantages poor ones. This difference stems from the knowledge gap and factors related to it, such as weak institutions, dependence on commodity exports, and the uneven playing field that developing countries face in the global economy.
Continuous, profitable innovation requires three things: knowledge development, the cross-fertilization of ideas among knowledgeable people, and good governance-especially with regard to the legal protection for innovation. On each front exists a widening gap between rich and poor countries that is even more daunting than current income inequalities.
Knowledge comes from people with the time and resources to discuss, think, and experiment. One approximate measure of these activities is the number of scientists and engineers engaged in research and development. According to the most recent World Development Report by the World Bank, the United States, Japan, and Germany have on average 3,805 research scientists and engineers per one million people. That ratio is 31 times the equivalent figure for Malaysia, Thailand, and Brazil-121 per one million. Yet the ratio of per capita GDP for these two groups of countries is just 3 to 1 (if adjusted for purchasing power). The knowledge gap is therefore ten times the size of the income gap. And it is growing due to the brain drain from the developing to the developed world, from which Silicon Valley has already benefited. The United States, the United Kingdom, and Germany are now actively encouraging the immigration of highly skilled workers from developing countries.
Equally vital to the development of innovation is networking between knowledgeable people. When an economist in a small, backwater town in Iowa begins some new research today, she can conduct an Internet search and download previous research from more than a thousand journals on-line. She will also have nearly free access to the archives of major news organizations through a free Internet connection at a very low, off-peak telephone cost. After sorting and digesting this information and developing her own thoughts, she can e-mail her ideas across many countries to the experts she came across in her search. Most will not reply, but a few will, offering advice on further research or invitations to a conference.
Many researchers in developing countries lack this opportunity. The same goes for civil servants who wish to explore policy options. The diminishing costs of computers and Internet access would seem to make knowledge and information more widely available, but poor nations face organizational, training, and cost constraints. Whereas in 1998 an average of 557 telephone lines existed for every i,ooo people in the United States, Japan, and Germany, there were just 3 for every 1,000 in Bangladesh, 4 in Nigeria, and 19 in Pakistan-countries with a combined population of 365 million. In middle-income countries such as Malaysia, Thailand, and Brazil, the average was 134 per 1,000. Some optimists argue that wireless technology has allowed countries to bypass expensive investment in laying lines, but the gap in mobile phones is even wider than in fixed lines. The hot spots of Mumbai (Bombay) may hum with mobile chatter, but there was only one mobile subscriber among every 1,000 people in India in 1999, compared with 310 among every 1,000 Americans. The communications gap is, in effect, a large multiple of the current income gap. More important, certain fields of knowledge cannot be easily transferred across telephone lines. The cross-fertilization of some ideas requires physical proximity. Innovative atomic physicists, biotechnology experts, and geneticists tend to congregate in very few places, putting their more isolated counterparts in poorer countries at a disadvantage. Moreover, many new technologies in automation, information, and molecular genetics are best exploited by companies at the center of large interdisciplinary research networks. Economies of scale are emerging in the knowledge industry, and research networks are already established in the developed world in places such as Palo Alto and Boston.
Patents are one direct measure of the resulting innovation gap. The total number of patents filed by residents in the United States, Germany, and Japan in 1998 was 539,347. That statistic dwarfs the 453 issued in Brazil, Malaysia, and Thailand or the 57 issued in Pakistan, Bangladesh, and Nigeria. China and India, with a combined population of 2.1 billion, filed only 17,862. This yawning patent gap between rich and poor reflects where profitable innovation is taking place and where it is not-and this gap is set to widen further. For example, the completion of the mapping of the human genome has spurred health research into bioinformatics, developmental biology, and protemics—which is leading to a spurt of patent applications almost exclusively in the United States and Europe.
Not only do patents measure the innovation gap; they reinforce it. A patent provides a temporary monopoly on the exploitation of an innovation, adding greatly to its value. Some protection is important to stop an innovation from becoming a public good that would otherwise be unprofitable to develop. But as knowledge becomes more important, rich countries are responding by broadening protection for intellectual-property rights. The U.S. patent office has tried to extend patents on business models, methods, and processes-and then ensure worldwide enforcement. Amazon.com, for instance, has gone to court to protect its patent on the idea of “one-click” shopping.
IBM, often considered to be just a computer company, now earns $1.1 billion every year by licensing patents—a sign of the new commercial role of knowledge. In this sped-up world, it takes less and less time for ideas to become profitable products, so the recent extension and reinforcement of intellectual-property rights by the World Trade Organization (WTO) resembles a power play rather than a rational economic assessment. How far patent protection should go is unclear, but recent developments will no doubt reinforce the advantage of the companies and countries that develop patented ideas. This imbalance shoves yet another wedge between the rich and the poor.
The shift from valuing revenues to valuing the innovations ahead of revenues increases uncertainty. Companies can do only so much to reduce this factor. More important is the business climate, particularly the stability and transparency of property rights. A nation’s fiscal, regulatory, and supervisory environment makes a difference: the greater the uncertainty in developing an idea, the more reluctant investors will be to chase after innovations.
Consequently, countries with weak institutions will be pushed into a self-perpetuating cycle. Knowledge can help governance, and the new knowledge economy places greater emphasis on good governance. Hence, if a country lacks a good knowledge base, it is likely to have poor governance, which in turn will steer capital away. The resulting combination of poor governance and scarce capital will make the development of a knowledge base more difficult. A recent survey by The Economist ranked countries according to good-governance factors such as tax and labor-market policies, infrastructure, skills, and political environment. The top ten were rich nations; New Zealand was the tenth, with per capita GDP around 60 percent of U.S. levels. The bottom ten were all developing countries; Mexico was at the top with per capita GDP around 24 percent of U.S. levels.
The prevalence of corruption is one more form of poor governance that investors dislike. A recent Transparency International survey ranked New Zealand at the top for having the least corrupt public officials, while Nigeria languished at the bottom. The ten least-corrupt countries have developed economies, whereas the ten most-corrupt ones are developing countries. (That said, some developed countries, including Italy, Spain, Greece, Portugal, and Belgium, also fared relatively badly.)
The Commodities Trap
As innovation has become more valuable, other enterprises have suffered, especially if technology adds little to their value. Among the worst hit are commodities, where the Internet’s arrival has reduced already-narrow profit margins. In the past, a commodity exporter could charge a premium for certainty and quality of distribution— important factors when buyers are fragmented and search costs are large. Now the Internet has compressed these costs. Buyers can go to a host of cybermarkets such as e-Steel.com or FreeMarkets.com and post a bid for a graded commodity; in turn, sellers compete for buyers by shrinking their profit margins. As costs fall, buyers win and sellers lose. With a few exceptions such as Australia, New Zealand, Canada, and Norway, most commodity sellers are developing countries; most buyers are developed countries. The ten countries most dependent on agriculture and commodity exports are all developing countries, whereas the ten countries least dependent on agriculture and commodities exports are all developed countries.
Finally, the shrinking of profit margins is most acute for commodity sellers. Unlike sellers of services, for example, commodity exporters cannot use the Internet to repackage unsold products for different markets and sell them at a discount without damaging profit margins in their main market. There are no “special weekend break” prices for a ton of sugar. In contrast, Travelocity.com and other Web sites sell unsold airline tickets and hotel accommodation at costs lower than the prebooked price, helping raise occupancy rates without lowering prices and revenues elsewhere.
Meanwhile, developing countries lag far behind in exporting services. Whereas the big commodity exporters are developing countries, the big services exporters are developed countries. The United States leads this category with 17 percent of the world’s services exports, followed by Japan and France. Only three emerging markets rank in the top 20: China (including Hong Kong), South Korea, and Taiwan.
The consequences of a poor knowledge base and commodity dependence for developing countries are made worse by the global economy’s unfair playing field. As commentators focus on growth rates, they underplay the significance of the economic size of nations in terms of both GDP and the stock of wealth. In recent years, countries such as India and China have grown faster than major industrial countries, but relative wealth (as indicated by stock market growth) has expanded faster in the latter. The knowledge-intensive and militarily strong developed nations have been exploiting their power to promote their economic interests beyond free-market outcomes.
In trade negotiations, the large industrial countries dominate the agenda. The threat of withdrawing aid and trade concessions, freezing assets, and imposing other economic sanctions is enough to compel most developing countries to fall into line. After decades of negotiations under the General Agreement on Tariffs and Trade, tariffs on developing country exports (e.g., textiles and agricultural commodities) remain much higher than those on exports from industrial countries. Today, these tariffs are being removed only gradually while new barriers are emerging in the form of antidumping measures, health and safety “exceptions,” and environmental and labor standards. If they had their way, the antiglobalization protesters who claim to speak for the poor would further impoverish the disadvantaged by implementing unrealistic labor and environmental standards.
Technological, organizational, and marketing hurdles are also making it more difficult for poor countries to penetrate markets. Lagging behind in knowledge and institutional quality, developing countries cannot secure patents or copyrights for the intellectual property they do have. Some developing countries have complained that rich-nation companies copy their traditional practices and medicines to patent them back home and then try to charge locals for abuse of patent. The neem plant, a resin-producing evergreen that has been used for centuries in India for pest control, is a case in point.
Furthermore, when developing countries try to offset their inherent disadvantages by lowering taxes, they are blocked from doing so. For example, the Organization for Economic Cooperation and Development (OECD) is trying to develop an international regime to control offshore financial centers. Although legitimate concerns about money-laundering exist, dubious offshore activities are nothing compared to the much more serious abuses in the major financial centers: investigations into the laundering of $4 billion by the former Nigerian dictator Sani Abacha, for example, have centered on his London accounts. Developing countries thus have genuine concerns that the OECD is really motivated by fear of tax competition. Indeed, the first of the four OECD criteria that classify countries as “uncooperative tax havens” is low or no taxes. In effect, the OECD is attempting to use extraterritorial power to influence offshore tax policies-an area traditionally regarded as a sovereign right of countries that is retained even as economic integration advances. British Prime Minister Tony Blair certainly believes the same when it comes to the European Union’s attempt to harmonize taxes.
Critics of globalization and liberalization claim that these forces marginalize poor countries and aggravate poverty. In fact, globalization is not a zero-sum game, and all can benefit. But its current manifestation harms the poorer developing countries because they miss out on the knowledge and innovation needed to exploit the expanded opportunities resulting from globalization. Their decline is not only relative but absolute-because the advanced world remains more adept at capturing opportunities, even some of those that developing countries had previously exploited.
Boom and Bust
The knowledge revolution has already started to make life difficult for developing countries as cutting-edge technology sectors compete with emerging markets for access to risk capital. Indeed, over the past five years, returns have been far higher for the technology sector of world markets than for emerging-market equities; more than go percent of the global technology sector is in developed countries. For investors devoted to high-risk, high-return ventures, technology and emerging markets have become substitutes for each other. As technology markets have outperformed emerging markets, cross-border portfolio flows have switched from emerging markets to technology. From August 1999 to August 2000, when shares in the global technology sector rose almost threefold, the flow of foreign money out of emerging markets (excluding Asia) roughly equaled the entire market capitalization of those same markets. The flow of foreign direct investment into developing countries may appear strong today, but it is highly concentrated; much is devoted to one-time privatization in established areas such as telecommunications and utilities rather than new-business expansion.
To some extent, the switch out of emerging markets into technology markets has been amplified by the tendency of investors to chase returns. Once technology stocks stabilize at more sustainable levels and returns in emerging markets revive from recent turmoil, some of these trend-chasers may come back to the emerging world. However, even if both markets offered the same returns and the same historical volatility, portfolio flows will likely still favor technology markets in developed countries, given the large, nonquantifiable risks in developing countries. These risks include concerns over political stability and the certainty and enforceability of property rights. Not only do emerging markets have to compete with technology returns, but their markets must outperform to attract international capital. Even as technology shares have fallen in recent months, investors continue to flee emerging markets. Those that still attract investors are a handful of liquid and technology-heavy markets such as those of South Korea, Taiwan, and Hong Kong-which have absorbed the lion’s share of equity portfolio flows to emerging markets. Moreover, despite the current gyrations of the markets, the technological revolution is not over. In the case of biotechnology, it has just begun. The shift out of emerging markets into the technology sector of developed markets is not just a feature of the technology boom. It underscores the permanent disadvantage that emerging markets face as the equitization of innovation makes developed markets more and more attractive.
A Slippery Slope
Five initiatives could stop the knowledge gap from further widening the income gap. First, developing countries need to pursue a twin strategy of opening their borders to more foreign direct investment and improving basic education. Knowledge spreads more easily as foreign companies introduce foreign technologies. Just as rich countries are relaxing immigration restrictions for those individuals with the right technology skills, poor countries can relax foreign-investment restrictions for their own knowledge-intensive industries. But knowledge cannot take hold without proper literacy. The priorities of cash-strapped governments should be to provide basic education to all, spread knowledge opportunities through foreign direct investment, and offer tax breaks to encourage the private sector to support training and advanced education.
Second, developing countries need to break up their communication monopolies. Knowledge grows as it runs along telephone lines, e-mail, and wireless connections. The more expensive and restricted these means of communication are, the more limited is the development of knowledge. Given current trade agreements, developing countries can even call on the WTO for help in revising those contracts that have ceded monopoly rights to private companies.
Third, developing countries can help their local companies gain access to international lenders and investors by encouraging them to adopt international standards of accounting, supervision, and prudential controls. Fourth, developing countries need to prioritize what is needed for good governance: a well-trained civil service appointed on merit, clear property rights, an independent judiciary, and tough and enforceable laws against corruption. All these are more easily said than afforded; even well-intentioned governments in developed countries sometimes succumb to temptations of power. The best guarantors of good governance are an effective democracy, educated voters, and a free press. International organizations and donor governments should make these three pillars conditions of any economic support beyond emergency aid.
Fifth, rich countries need to practice what they preach on trade. Their economic security makes them well placed to open their markets to products from all low-income countries-not just the poorest. This openness not only will promote economic development but will support their own economic and security interests. Yet rich nations often behave like old-fashioned mercantilists. In doing so, they make the current global trading system vulnerable to a backlash from developing countries and to public opinion in developed countries. Through their disproportionate influence, they have insisted on free trade only in services in which they are dominant, opposed low-tax centers that may threaten their revenue-raising powers, and called for labor and environmental standards to protect their industries at the expense of those in developing countries. Moreover, they have been dragging their feet for decades on reducing tariffs on agricultural and semi-manufactured goods from poorer nations. If rich nations continue this behavior by insisting on extended patent protection-which also benefits them disproportionately-the developing countries will likely lose all sense of having a stake in the global economy. The harmful repercussions will hinder the West’s ability to secure peace and prosperity.
None of these five initiatives are relevant only to the knowledge revolution. They are initiatives that governments should pursue anyway. But the knowledge gap has made it vital that countries pursue and prioritize these issues. Those developing nations that grasp this imperative have a chance to climb up. Those that do not will find that the slope has become steeper-and all too quickly iced over.