And what about the risk of innovation success?

The outcome of any innovative endeavour is by no means certain. Rather, innovation entails risk for the innovator as well as for the society he’s working in. The first might be considered the risk of innovation failure, which I have already addressed in a previous post. The second risk is the risk of innovation success, and that’s what I’ll focus today’s post on.

I drew considerable inspiration from Karl Smith’s article on Economic Growth in the Age of Diminishing Labor, published on the Online Forum of the Cato Institute. From a macro-economic perspective Smith addresses the effects of decreasing birth rates on societies’ ability to support the innovation necessary to sustain economic growth. In essence, he sees a risk that:

Lower population growth rates have the potential to undermine
the virtuous cycle of risk-taking and innovation.

Smith builds his argument around a virtuous circle in which population growth promotes innovation which in turn drives further population growth. At first glance, you might dismiss this idea as an unbelievable macro-economic perpetual motion machine. Yet, at second glance, this thought model reveals its descriptive power for a defining period of the global economic history, and it can help us see some of the current trends in their developing context.

This virtuous cycle is most easily described as starting with a growing population. In order to sustain this larger population, the overall capital stock must increase. More capital stock allows for more investment in innovation, which in turn promotes economic growth. And the increase in Gross Domestic Product can support further population growth. So far, so simple. In theory, this cycle could go on forever; but in reality there are obviously numerous constraints, limits, and influencing factors. To my mind, the strength of this model is really in the questions it raises: What are were the conditions necessary to get this cycle going? How did society handle the risk of innovation success?  And what is our situation today?

How could this cycle get started?

Smith points to the Industrial Revolution as the essential event to start off the virtuous cycle. So let’s take a closer look at the conditions in England (where that revolution gained shape) around that time, say 1760.

Population growth had occurred throughout human history, even though at fairly modest rates and frequently interrupted by periods of war, famine, or epidemics. This modest population growth had been driven by productivity improvements, but it had remained constrained by what we know today as the Malthusian Trap: in the long run, every gain in productivity was eventually eaten up by fertility, so that income per capita kept hovering barely above subsistence level. This was certainly the case in England in the early 18th century, but it was in no way unique to that place or that time.

Increasing capital stock is necessary to sustain a larger population. This capital stock is formed as the return on the investments made. Hence a growing population is best supported by an increase in investments, which, in today’s terminology, requires a positive investment climate: people with capital need to have the trust in the stability of the political and economic outlook, so that they invest their capital into the future rather than consuming it today. This trust and confidence is based on existing institutions, their ability to ensure access to markets as well as the rule of law. Now, let’s remember that the Glorious Revolution and the Bill of Rights actually preceeded the Industrial Revolution by almost a century, and we can see the positive effects of inclusive institutions, both political and economic. These institutional changes set the conditions to empower larger parts of the population to actively engage in the economy, as investors, as innovators, as business people. These changes were unique to England in the 17th century; even though they took a few generations to expose their full transformational effect, they defined the place and time for the virtuous cycle to commence.

Innovation needs capital investment for its successful implementation. Therefore, the institutional changes described above prepared fertile ground to grow new ideas and harvest innovation. The seeds of course didn’t simply fall from the sky. Rather, the Scientific Revolution that occurred across Europe in the 17th century (e.g., the Royal Society in London was founded in 1660) had slowly paved the way for systematic investigations into the laws of nature and possible ways to employ them for a human purpose. On that basis, and strongly supported by the positive investment climate, the Industrial Revolution took off in England around 1760.

Finally, economic growth. The sustained innovation activity that was emblematic for the Industrial Revolution brought about technological advances that were initially focused on the textile and steel industry, but ultimately affected the entire economy. The resulting increase in productivity soon reached an unprecedented level, and it remained high for many decades. That economic growth added to the wealth of the investors as much as it supported further population growth. Hence, by 1800 at the latest, the virtuous cycle was complete and running full steam ahead.

How did society handle the innovation risk?

Once the virtuous cycle was in full swing, society had the natural desire to keep the benefits of economic growth. To that end, the innovation engine needed to be kept going, continuously fed with capital. Hence society’s innovation-related risk was essentially a drying out of capital investment.

Karl Smith offers two interconnected observations to describe society’s risk mitigation strategy at the macro-economic scale: First, he sees different behaviours in different age groups: middle aged citizens are typically savers, who put aside the surplus income they have; whereas the young citizens are typically borrowers, who tend to expend more money than they earn. Second, he sees a cross-general connection:

In a modern society, purchasing power is almost always
transferred to the younger generation.

Whether his transfer occurs directly (“it stays in the family”) or indirectly (facilitated through the banking system), it provides the younger generation with capital to invest. As a consequence, the risk of innovation success is handed down to the next generation. And as long as future generations muster sufficient capital to invest in innovation, the virtuous cycle can continue.

What is our situation today?

From today’s perspective, we can clearly see that there is no guarantee nor even necessity for economic growth to encourage population growth. The Industrial Revolution has itself launched an innovation avalanche that has shaken society at its foundation. While innovation has brought about economic prosperity, technological progress, and healthier and longer life for many, it became quite obvious that innovation is not always just positive. Over several generations, society responded with institutional changes that help control the immediately negative effects innovation can have: just think about social security systems as we know them today.

Those institutional changes have far-reaching effects on the virtuous cycle. For example, social security systems ensure the livelihood of the elderly after retirement; as one of many outcomes, the number of childbirths per woman dropped dramatically, in several nations even below the sheer replacement level. At the same time, while economic growth could still be used to sustain a larger population, it is increasingly used to accrue individual wealth: inequality has reached levels that were previously unknown. Further, the younger generation’s borrowing of capital can of course be employed for investment, but we also see a growing trend to “borrow to consume”. In the business world, we observe the effects of the shareholder value philosophy, which supports the self-interest of the corporation, but not the longer-term needs of society. Even though this cannot be an exhaustive list, you get an impression that the concept of a virtuous cycle is challenged for many different reasons. And let’s not forget that a growth strategy that is based on increasing population will hit the ceiling of global environmental sustainability on a finite planet.

In summary, the virtuous cycle is a useful model to describe and analyse historic developments, as well as the evolutions still ongoing in some of the developing economies. But essentially, it is a tool of the past. Increasingly, the globalised world is leaving the cycle behind. So we’ll need to find alternative ways for directing capital investment towards innovation, ways that will not depend on population growth.

Looking to the future, Smith turns to Japan. Earlier than any other modern economy, Japan was faced with demographic change, decreasing birth rate, ageing population, and shrinking work force. In response to this challenge, government and industry both invested heavily in robotics. Though initially focused on mechanical labor in industrial production, applications of robotics increasingly explore less expected fields, such as elderly care. If you replace the term “robotics” with “autonomous systems“, you’ll see where this idea is leading us: generating economic growth without human intervention or supervision. Technology has already come a long way on that path, while, as Smith points out, legal and regulatory clarification is still required to facilitate wider acceptance of autonomous systems.

From a macro-economic perspective, autonomous systems can serve as a tool to sustain prosperity even in ageing and shrinking populations. Another inspiring idea to drive further posts; more to follow …