Innovation’s Long March

After years in the dark, state-run economies such as China’s are now cutting-edge. Is free-market capitalism obsolete?

By Joshua Kurlantzick


Over the past five years, as much of the developed world has staggered through crisis, a new type of capitalism has emerged as a challenger to laissez-faire economics. Across much of the developing world, state capitalism — in which the state either owns companies or plays a major role in supporting or directing them — is replacing the free market. By 2015 state-owned wealth funds will control some $12 trillion in assets, far outpacing private investors. From 2004 through 2009, 120 state-owned companies made their debut on the Forbes list of the world’s largest corporations, while 250 private companies fell off it. State companies now control about 90 percent of the world’s oil and large percentages of other resources — a far cry from the past, when BP and ExxonMobil could dictate terms to the world.

Even as state capitalism has risen, some writers, business leaders, and politicians contend that such systems fail to encourage innovation, the key to long-term growth and economic wealth. Ian Bremmer, the president of Eurasia Group and author of The End of the Free Market: Who Wins the War Between Corporations and States, argues that state capitalists “fear creative destruction — for the same reason they fear all other forms of destruction that they cannot control.” In China 2030, a recent analysis of China’s economy, the World Bank concurred, noting that the country needs “a better innovation policy, [which] will begin with a redefinition of government’s role in the national innovation system ... [and] a competitive market system.”

It is a mistake, however, to underestimate the innovative potential of state capitalism. Rising powers such as Brazil and India have used the levers of state power to promote innovation in critical, targeted sectors of their economies, producing world-class companies in the process. Despite its overspending on some state sectors, the Chinese government has nevertheless intervened effectively to promote skilled research and development in advanced industries. In so doing, the state capitalists have shattered the idea that they can’t foster innovation to match developed economies. State capitalists’ combination of government resources and innovation could put U.S. and European multinationals at a serious disadvantage competing around the globe.

State intervention in economic affairs runs against the established wisdom that the market is best for promoting ideas. At the same time, throughout history, the governments of many developed nations have actively fostered groundbreaking companies, from Bell Labs in the U.S. to Airbus in Europe.

Brazil is perhaps the best current example of how a state-capitalist system can build innovative industries. Successive Brazilian governments have intervened — with incentives, loans, and subsidies — to promote industries that otherwise would have needed long-term private investment to make them competitive with U.S. and European rivals. At the same time, Brazil preserved strong, independent management of state-backed firms, ensuring they did not become political boondoggles.

Three decades ago, for example, the Brazilian government gave aircraft manufacturer Embraer lucrative contracts and various subsidies, recognizing that it could potentially find a niche in producing smaller, regional aircraft. Private investors were dubious of Embraer’s chances. Had it relied solely on private investment, the company probably would have failed; instead, it flourished, becoming the world’s biggest maker of regional jets. Similarly, by investing in deep-sea drilling technology, Petrobras, a state oil company with an independent management board, has made itself competitive with multinational giants such as Chevron, Shell, and BP.

By picking industries it could dominate and supporting them even when private capital was scarce, Brazil has created internationally competitive companies in a range of industries, from aerospace to clean energy. Today the government often backs companies as a minority shareholder or through indirect vehicles, allowing for corporate independence while still helping companies make important investments in research and skills. Many of Brazil’s state-backed companies have survived the global slump far better than multinationals because they can rely on government assistance to see them through.

Combining government support with a mandate for profitability and independent management has yielded successful businesses in other state-capitalist economies. Singapore has used government incentives to push companies to move into industries such as solar and other clean energies, which, although not necessarily profitable now, will be the emerging technologies of this century. A comprehensive 2009 paper by Harvard Business School looked at India’s more than 40 state-owned science and engineering research laboratories, which have used a similar type of public-private collaboration. It found that the Indian state labs had “more U.S. patents than all domestic [Indian] private firms combined.” In China, greater political interference in state-supported companies has been worse for profitability and innovation than in places like Brazil. And yet in recent years, China’s score has steadily risen on the Global Competitiveness Index, a World Economic Forum ranking of nations, even as the score of the U.S. has dropped.

The rise of innovative state capitalists presents a more than formidable challenge to U.S. and European businesses; it could push multinationals out of some markets entirely. In oil and gas, for example, state companies already control most of the world’s reserves, and as state companies like Petrobras become as innovative as multinationals, they will not require foreign companies for exploration, deepwater technology, or refining. In their own large domestic markets the innovative state capitalists will be able to match multinationals’ technology, giving them dominance over mobile communications, high-end retailing, and other businesses.

Some developed countries may respond by either curbing state-capitalist companies’ access to their markets or by intervening heavily in their own economies. Neither of these solutions is really viable. As the state capitalists’ biggest companies expand their global operations, their technology, connections, and capital will be almost impossible to keep out. And aging, heavily indebted nations face huge challenges reforming their entitlement programs: They’re in no position to pour the amount of resources into companies that Brazil, India, or China can.

Instead of trying to prevent — or worse, dismiss altogether — the rise of state-capitalist systems, U.S. and European companies and governments would do better to learn from them. Singapore offers one model of how the state can intervene in the economy without stifling entrepreneurship. The government there identifies industries that are critical to innovation and future technology, helps provide initial angel investments in small companies, tries to woo talented men and women from other countries who work in these industries, and uses state resources to ensure that universities focus on basic science research that will yield dividends in the future.

All these strategies require only modest state investment, and nothing on the scope of China’s or Brazil’s large-scale lending to state companies. The U.S. itself has effectively employed such policies in the past — before restrictive immigration policies kept skilled foreigners out, state and federal governments robbed funds from universities for other programs, and even the idea of the government helping foster new industries such as clean energy became politically toxic. (See Solyndra.)

Developed nations still possess a huge advantage over their emerging-market competitors: The U.S. and countries in Europe have mature, large venture capital firms, while places like India don’t. In emerging markets, when innovative companies become large enough to leave the state’s embrace, they may have nowhere to turn. Venture capital giants, on the other hand, can help small groundbreakers grow. This advantage can be enormous for countries like the U.S. And in a world where the emergingmarket giants are learning to innovate, any advantage will be critical.

Joshua Kurlantzick is Fellow for Southeast Asia at the Council on Foreign Relations.


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