The Historical Innovation Champion

Europe was once unified under the Roman Empire (if we view the Roman Empire as a predecessor to Europe, although geographically the Roman Empire did not cover exactly the same region as modern Europe). The Roman Empire was geographically and demographically the largest country in the world during this period, even significantly larger than the Han dynasty in China. It is estimated that the Roman Empire had a population of 80 million, 30% larger than the population of contemporary China. Rome was the largest city in the world, with a population of a million, double the size of Chang'an, the largest city in China. Just like China, language was a unifying element; the official languages were Greek and Latin, and the exchange of goods, people, and ideas was vibrant among the Roman provinces across the Mediterranean Sea. The Roman Empire was also the global leader in innovation and science. Its engineering, military, navigation, and transportation technologies were at the forefront of its time. Unfortunately, due to both internal and external factors, many of which are still being argued about by historians, the Roman Empire collapsed around 400 AD and was broken up into many smaller states. At the same time, China's Han dynasty also collapsed. However, a few hundred years later, China was united again during the Tang and Song dynasties. China was the world's leading innovator for the next 1,000 years, until the 1500s, when the Chinese emperor made the fateful decision to close China to international trade.

Meanwhile, several European countries, particularly those in Western Europe, started to experiment with navigation technologies to explore the Atlantic Ocean; they had a lucky break when they discovered the New World. These Western European countries were of small and medium size, including Portugal, the Netherlands, Spain, and the United Kingdom. Owing to their limited size, these nations had a strong incentive to explore the ocean to find new trading routes to link to the lucrative markets of West Asia and China. This explains why it was these four smaller nations that took the lead in exploring the Atlantic rather than France or the Austro-Hungarian Empire, which were much larger. The discovery of the New World allowed these countries to access natural resources, and the new trading routes also allowed these countries to access new markets in Asia, making them wealthier. Their per capita income was much higher than that of the other non-trading nations in Europe. During the late 1700s, after a series of conflicts, the United Kingdom, the largest country of the four, with a superior navy, secured supremacy of the high seas and became the dominant player in world trade and the most successful colonizer.

During this period, the United Kingdom was the most advanced nation in the world. Even though its population was smaller than that of France, the United Kingdom had access to a much larger market, including India and China. As a result, it enjoyed one of the highest living standards in the world (second only to the Netherlands, which was much smaller), and had more entrepreneurs and engineers than other European countries. This was one of the key factors that led to the Industrial Revolution in the late 1700s in the United Kingdom. During the late 1700s and early 1800s, the United Kingdom was the undisputed dominant power and a leader in innovation in the world.

The Industrial Revolution started in the United Kingdom, but quickly spread to the rest of Europe and the United States. For a brief period, France was the largest country in Europe, with the largest population and the largest GDP, but multiple wars caused significant population loss and destabilized its political system; further, repeated revolutions led to internal disruption and a low fertility rate. On the other hand, Germany, following its unification, soon had a population larger than those of France and the United Kingdom. The scale advantage started to favor Germany on the global stage, and it became a leader in the Second Industrial Revolution that started in the late 1800s. German scientists founded modern chemistry and German companies became world leaders in the modern chemical industry. By the early 1900s, Germany's per capita income was one of the highest in the world.

In the early twentieth century, Germany may have been the largest country in Europe, but it was still much smaller in population than the United States. As a matter of fact, Germany was not quite the largest in Europe either, if we count Russia as a European country. Soviet Russia had a much larger, faster-growing population than Germany, and it was catching up quickly in terms of both industrialization and innovation. By the time of the Second World War, Nazi Germany greatly underestimated the strength of the Soviet Union; in fact, the Soviet Union was a much stronger power than France, with three times its population. The direct result of this was the German defeat at the hands of the Soviets; of course, with the help of the United States (an even bigger country), the fate was sealed for Nazi Germany right from the start.

A common pattern in European history is that a small country can have a lucky break in the innovation of new technologies or organizational forms, and enjoy the fruits of their success for a short period of time. However, in the long term, the technology and organization innovation will spread and reach larger countries. Once larger countries catch up, their scale advantage will be overwhelming, and they will usually win the innovation race by becoming the center of innovation.

Is it Too Early to Write Off Germany?

Germany became a superpower in Europe following its unification in the 1800s. It had the largest population in Europe, and for a brief period in the late 1800s, it had the largest population of the Western world before it was surpassed by the United States. During this period, Germany led the world in terms of technology, innovation, and scientific research. Recently, with its reunification with East Germany, Germany has once again become the largest and strongest economy in Europe, and a leader in many industries (especially high-end manufacturing). There are many high-tech German multinationals, such as Mercedes and Siemens. Germany, much like Japan, will likely continue to be a strong player in high-end manufacturing. Unfortunately, the problem is that manufacturing will be less important in the future. The industries of the future are information technology, entertainment, and high-end services; these industries will represent an ever-increasing share of the economy. In these vibrant and innovative industries, it is the size of the home market that matters, and the United States and China will enjoy an advantage.

Let us look at the Internet industry. There are almost no European home-grown Internet companies. In the service sector, Accor is the only large hotel chain brand and, not surprisingly, it was created in France, which was the largest market in Europe before the reunification of Germany. There are very few large software companies too; the only exception is SAP, which is a manufacturing software company. Nokia was a very successful mobile phone manufacturer, but when phones effectively turned into computers in the mobile Internet age, Nokia was no match for Silicon Valley companies such as Apple. In the entertainment industry, Continental European countries lag far behind the United States. The only exception is the United Kingdom. Thanks to English, the United Kingdom essentially has the whole English-speaking market as its home market; it is for this reason that it is able to create global media sensations such as Harry Potter.

Why has Europe failed to innovate in the service, information technology, and entertainment industries? Again, market size is the critical factor here. A website or mobile app built for a single European country simply cannot compete with the United States or China in terms of research and development expenditure. In the manufacturing industry, where product quality specifications are objective and easily measured, an innovative firm can enjoy the scale of the world market by exporting its products around the world. However, in services, and the software and Internet industries, a firm's service offerings need to be co-created with its customers, so having a large and sophisticated home market to experiment with is a big advantage. The exceptional success of the German software giant SAP was primarily because its software was aimed at manufacturing companies. Many of its manufacturing customers are based in Germany and other parts of Europe, so SAP was able to take advantage of a sophisticated home market.

The scale advantage is especially important in the Internet industry, where speed is everything. The ability to capture early adopters of a new technology is critical to gaining a head start in the race. Hypothetically, let's assume that 1 million users is the critical mass for a social networking website. Facebook only needs to wait for the penetration rate to reach 0.25% in the United States, but in the United Kingdom, with less than one-quarter of the U.S. population, any potential native social networking website will need to wait for the penetration rate to reach 1.3%. Thus, Facebook, the U.S. social networking website, has an early head start, giving it enough time to launch and perfect its product in the United States first and enter the U.K. market later, dispatching any indigenous competitors. In contrast, such ruthless action may not be possible in China, because it has a larger indigenous market than that of the United States. Native Chinese companies can imitate U.S. companies almost immediately as a result, and can research and trial their own groundbreaking technologies and developments.

The abysmal performance of indigenous European companies in the software and Internet industry is reflected in venture capital statistics (see Table 9.1).

The other problem for Europe is the lack of entrepreneurship. The most disruptive technologies, such as the Internet and e-commerce, usually come from new firms. Some people say that the dearth of European entrepreneurship is a result of culture. Maybe so, as the United States has a more entrepreneurial culture on account of its immigrants, who are self-selected for their enterprising potential, but I don't believe that this is the main reason for the lack of entrepreneurial drive in Europe. The main reason is again the scale of the market; in a smaller country, the prize of winning is smaller. If somebody wants to start a French travel website, the incentive is five times smaller than establishing a U.S. travel website, not to mention that U.S. travel websites have a much better chance of tapping users in other countries and capturing a portion of the world market, for the reasons explained earlier. The disadvantageous risk-to-reward ratio is one of the most significant reasons for the lack of an entrepreneurial culture. The situation for China is the complete opposite; culturally, it is less individualistic than Europe, but in China's huge market, even a very small niche product can generate a large profit. As a result, entrepreneurship is very attractive to anyone willing to take a risk in China.

The third problem is that the labor market is not as competitive. Visibly, Europeans are more laid back than Americans—they work fewer hours per week and take longer vacations. But I would argue that this is also due to the size of the market. Despite unrestricted labor mobility across EU countries, labor is not completely mobile due to language and cultural differences. A French professor in a typical French university is effectively only competing with other French-speaking professors, not with a much larger English academic community in the world. The same is true for other highly skilled workers. Therefore, highly skilled workers in Europe are less driven than their comparable American counterparts, because they have less competition. This is the same reason why residents in large cities work harder; in other words, diligence increases with city size.

Is the United Kingdom Different?

In this regard, the United Kingdom is an exception among other European countries, mainly because of the continuing dominance of English globally. The United Kingdom has a smaller market, but its labor market is effectively connected with other English-speaking countries (visa is not a barrier, as most countries welcome highly skilled immigrants). Some people argue that German and French people can speak English well, but in order to be an effective business leader, author, or script writer, English as a native language is a distinct advantage for highly skilled positions in English-speaking countries.

The English language factor has both pros and cons for the United Kingdom. On the one hand, British talent can move to countries such as the United States more easily, further bolstering this already strong competitor. On the other hand, in certain easily exportable industries such as the entertainment industry, U.K. firms can take advantage of the large English-speaking market. Moreover, being English speaking is also advantageous in attracting immigrants. Lastly, it is easier for U.S. multinational firms (and even Chinese multinational firms) to relocate their research and development facilities to the United Kingdom because of English being the indigenous language.

Overall, having English as the first language is a significant advantage for the United Kingdom and for other English-speaking countries such as Canada and Australia. These countries effectively enjoy the scale advantage of a much larger English-speaking product and labor market. Theoretically, they can be as successful as any U.S. region or city, but the key is probably to be closely integrated with the United States and other English-speaking countries.

Is Russia a Part of Europe?

At the opposite end of the spectrum to the United Kingdom is Russia. Although it is geographically within Europe, it is not a part of the EU, which means it is isolated from the EU market. Moreover, culturally and politically, it is quite different from Western Europe, but similar to Eastern Europe. After the Second World War, the Soviet Union had a population that was even larger than that of the United States. Even with a centrally planned economy that forbade entrepreneurship, innovation was strong in certain areas under direct state control, and the Soviet Union launched the first satellite into space. However, like all other centrally planned economies, without the incentives for private entrepreneurship, innovation withered and the economy eventually collapsed. After the breakup of the Soviet Union, this huge country lost almost half of its population. Currently, Russia has a population of only 150 million, less than half that of the United States and only slightly higher than Japan. To make matters worse, it has a low fertility rate, currently standing at 1.6, making the country's prospects appear quite bleak. The abundance of natural resources is not helpful, and actually could pose a problem (the “resource curse”), as commodity prices fluctuate and possibly even decline in the future. As argued earlier in this book, the possession of natural resources is not a positive factor for economic development or innovation. A resource-rich country is typified by an unstable government, ineffective institutions, and inadequate property protection laws, all of which are detrimental to the nurturing of innovation. It seems that Russia has exactly these problems.

The Prospect of Innovation in Europe

The prospects for Europe becoming an innovation powerhouse are poor. The integration of Europe as a single market will not be complete in the short term, due to inherent cultural, political, and language barriers. Furthermore, efforts to raise the fertility rate have had mixed results. Immigration might be an option, but Continental Europe is a much less attractive destination for highly skilled workers compared with the United States (primarily because of language). Hence, overall, Europe will likely be a secondary player to the United States or China when it comes to innovation.

Fertility and Aging

On average, Europe has a fertility rate of 1.6 (i.e. 25% below the replacement level), but there are a few bright spots (see Figure 9.1). The high-fertility countries include the United Kingdom, France, and the Northern European countries. The United Kingdom has a fertility rate of 1.9 and France has a fertility rate of 2.0. The low-fertility countries are Germany and Southern and Eastern European countries.

The strongest economy, Germany, has a fertility rate of 1.4, one of the lowest in the world. Germany has a zero or negative population growth, even with a large annual inflow of immigrants. It is not surprising that many Germans do not want to have children, as this is a common problem of all wealthy industrialized nations. To make the fertility situation worse, German women are among the most educated and therefore more likely to focus on career over children, and historically the government has not provided generous child-support benefits compared with other wealthy European nations. Germany, with a strong economy, certainly can afford to increase benefits for families, and recently the government has increased spending on family-friendly policies; time will tell whether or not this yields results.

Other low-fertility-rate countries are Southern and Eastern European countries. Italy has a fertility rate of 1.5, and both Spain and Poland have a fertility rate of 1.4. Consequently, the populations in these countries are aging rapidly. In contrast to Germany, these countries have underdeveloped economies, and are not attractive immigration destinations. In fact, they are losing many talented young people to the United States and other EU countries. Furthermore, unlike Germany, these countries are financially weak and do not have the resources to offer subsidies to large families, so there is little hope for these countries becoming centers of innovation.

At the opposite end of the spectrum are the high-fertility countries, such as the United Kingdom, France, and the Scandinavian countries. The United Kingdom has a fertility rate of 1.9, France 2.0, and Sweden 2.0. It begs the question: What is the difference between high-fertility countries and low-fertility countries?

What is Causing the Difference in Fertility Rates?

The difference seems to be that the governments of the high-fertility countries offer generous financial support and other pro-fertility benefits, such as free daycare centers. On average, spending directly on supporting families accounts for 3–4% of GDP in high-fertility countries, compared with an average of 1–2% in low-fertility countries. In general, there is a positive relationship between family support spending and a higher fertility rate. Of course, this is hardly good news for most low-fertility countries, because most Southern and Eastern European countries have a weak economy with tight government budgets.

The other difference is the attitude toward marriage and out-of-wedlock births. With the rise in female education and employment, the marriage rate has declined universally. The decline of the marriage ratio is not a problem for fertility if the out-of-wedlock fertility rises. However, out-of-wedlock birth rates in the low-fertility countries are typically much lower than those in the high-fertility Scandinavian countries, for example. The reason for the low out-of-wedlock birth rate could be cultural—these countries still value the traditional family and therefore they frown upon single-parent families. It could also be a result of economic policy; as explained earlier, low-fertility countries spend less on family support, making it harder for a single woman to raise a child independently. If the reason is the latter, then Germany still has a chance to raise its fertility rate by spending more to support larger families, as well as single-parent families.

Immigration

The United States has benefited a great deal from immigration, especially highly skilled immigration. Can European countries rely on immigration as a way out of their demographic doldrums? Let us look at the numbers. Figure 9.2 shows the number of immigrants in major EU countries and North America.

From this data, we see that the major Western European countries are accepting just as many immigrants as the United States, and some even more as a share of the total population.

But What About the Skill Level of Immigrants?

Comparing immigration numbers with the United States is a bit unfair for individual European countries. The EU can be considered as one country, and inter-EU migration can be thought of as moving from one state to another in the United States. Table 9.2 breaks down the immigration numbers into EU immigrants and non-EU immigrants.

From Table 9.2, non-EU immigrants are much higher in number—almost twice the number of inter-EU migrants. Actually, the number of inter-EU migrants is much smaller than inter-state movement in the United States, which means that labor mobility between EU countries is lower than labor mobility between states in the United States. This is another excellent reason why this book still treats the EU as a collection of countries rather than a single economic entity. Approximately two-thirds of the immigrants to EU countries are from non-EU countries, and they tend to be unskilled.

Are large European countries taking in highly skilled innovators just like the United States? For Germany, France, and Spain, the share of immigrants with a college-level education is lower than the native population, as shown in Figure 9.3. Moreover, the share of college graduates is just a part of the total picture; the United States attracts a far larger proportion of top talent (e.g. those with PhD degrees) than do European countries.

In a sense, European countries seem to be attracting the wrong type of immigrants. Obviously, immigration policies can be designed to attract the right type of immigrants. Canada's points system, which prioritizes immigrants based on education, skills, and age, is being adopted by more countries around the world. However, in general, the attractiveness of Western European countries for the most innovative workers is much lower than that of the United States, because these countries do not have the best universities or innovative companies (not to mention the English factor).

Muslim Immigration

One hundred years ago, the United States was also admitting immigrants with a lower level of skill and education than the native population. However, the children of these poor Irish, Chinese, and Indian immigrants are well integrated into society, and actively participate socially and politically; many of them became entrepreneurs and innovators.

Some people worry that Muslims have difficulty in assimilating, and their high fertility rate will turn Europe into a Muslim continent. This worry might be premature.

Currently, Muslims only make up about 6% of the European population (Figure 9.4). The fertility rate of the Muslim population is about 50% higher on average than that of the native population, which means that it will take one generation (2050) for the Muslim population to make up 10% of the population, and three generations (2100) to make up 20% of the population (Table 9.3). Even at 20%, Muslims would remain a minority. Despite this, and because of the highly visible nature of the Muslim presence in some countries and cities, where the Muslim population already exceeds 10%, this growth of the Muslim population is a source of friction and worry for the native populace.

These projections are all made under the assumption that all Muslim immigrants' fertility will remain much higher than that of native women, even in the second or third generation. As discussed in Chapter 1, the main reason for the higher fertility of Muslim women is their low level of education and work force participation rate. The big question is, will these Muslim women in Europe, in their second and third generations, be more like natives in having more education and careers instead of more babies?

Eighty years ago, Catholics, to a large extent devout, were perceived to be just as radical as the Muslims of today. This was particularly true in the United States. Look at how this perception has changed in two or three generations. All around the world, people are becoming more secular, and women are pursuing more education and careers. In many parts of the world, Muslim fertility rates are also falling, with urbanization and rising income. Iran already has a fertility rate below the replacement level. The fertility rates of European Muslims will likely be similar to those of the native population in the future. So, by 2100, two generations from now, the Muslim share of the European population will more likely be 15% rather than 20%. The growth in the Muslim population is therefore unlikely to rescue the low-fertility European countries from their demographic trap.

In Europe, the fertility rate of Muslim women is not much higher than the replacement level. The problem is that the native population only has a fertility rate of 1.6. The challenge is how to encourage the native population, which typically has higher education and income, to have more babies. Singapore, with a significant Muslim population, once had a policy to give fertility cash bonuses only to women with a college degree. This particular policy is politically a non-starter in democratic countries (it lasted only a year, even in Singapore), but other ways of providing fertility benefits to working women—such as long maternity leave and tax exemptions—should be considered, to help higher-income families have more babies.

Brexit and the Future of the European Union

Britain's exit from the EU is a huge blow to the bloc. Envious of the enormous size advantage of the U.S. market, the EU was founded out of the ambition to form a large single market with a population larger than that of the United States. Ideally, the EU should be a “United States of Europe,” but the reality is that the EU is more like a free-trade bloc made up of many different independent entities. First, due to difference in language and culture, labor is not nearly as mobile as in the United States. More importantly, the development levels of different European countries are much more varied than the development levels of different states in the United States. The wealthy Western and Northern European counties have a per capita income five times that of the poorest countries, such as Romania. In contrast, the richest U.S. state (New Jersey) has a per capita income only twice that of the poorest U.S. state (Alabama). I think the EU has been overly ambitious trying to include too many countries in a short period of time; rather, it should have worked more slowly to just include the wealthy countries first. With such a large difference among its members, it's hard to have a one-size-fits-all policy. When the voters of a country think the EU policies are consistently suboptimal for them, they have an incentive to leave.

One of the major reasons behind Brexit was that U.K. voters did not like the EU's overly generous immigration and social policies. Most economists say that the cost of leaving the EU is high, because the United Kingdom's exports to the EU might be hurt by a tariff. However, the United Kingdom is unique in that its goods exports to the EU are small compared with its service trade, and the United Kingdom imports a lot more goods from the EU than it exports to the EU. More importantly, the United Kingdom is a financial powerhouse, with large service exports to the EU and the world. The EU has vowed to punish the United Kingdom for the exit, because Brexit sets such a bad example for other countries, which may well choose to follow in the U.K.'s footsteps; but keep in mind that taxing U.K. exports will not only hurt the United Kingdom, but also hurt the EU, because it further reduces the size advantage of a single market. Moreover, I am not sure how the EU could hurt Britain's prominent status as a financial center in Europe. Right now, there is no other European city that is even close to having the status of London, which has attracted a huge network of world-class firms and highly skilled workers in the financial industry.

The United Kingdom's highly skilled labor market and financial market is actually more integrated with the United States than with other EU countries. Furthermore, the United Kingdom was also the favorite European country for the Chinese (and other countries) to do business with and invest in, because it is a relatively open and free economy, and because it is more accessible as a result of the English language. Recently, Ctrip.com made a £1.4 billion investment into a United Kingdom-based Internet company serving the European market. I am still quite optimistic about the post-Brexit United Kingdom, especially if it can form a tighter relationship with the United States and China, and continue to be a financial gateway to Europe.

Policy Recommendations

The country that has the best chance of raising its fertility rate is Germany, which is the only large and wealthy country with a low fertility rate (the United Kingdom and France have a high fertility rate). Germany has a lot to learn from the Scandinavian countries, which spend about 2–4% to support large families. Germany certainly has the financial resources to do the same.

On the subject of immigration, while countries should remain open to all kinds of immigrants, they should design policies to attract more highly skilled workers. Continental European countries should try to be more English-friendly, and should stop at nothing short of creating a dual official language system just like Singapore. This will likely make the countries more attractive to highly skilled immigrants whose first or second language is English.

For Germany, the focus should be on high-end manufacturing, where market size does not matter as much as it does with the service industry. Also, a generally good strategy for smaller countries is to be more tolerant and pro-active about promoting promising yet controversial technologies such as genetic engineering and driverless cars; in contrast, larger countries are typically slow to adapt their laws and regulations to controversial new technologies. For example, while the United States is still working on its laws on driverless cars, Singapore just announced that it will implement driverless cars within the next five years.

The United Kingdom, with the advantage of having English as its first language, has carved out niches not just in manufacturing, but in high-end services. It can act as a gateway between Europe, the United States, and the rest of the world. It is already the financial center for Europe, and also a first stop for U.S. and Chinese multinationals to get into Europe. So, the trick is to integrate both with Europe and with the United States; and if this strategy works, the United Kingdom will continue to be one of the strongest economies in Europe.

Other Developed Countries

To be a gateway economy, a country might not need to be very innovative in technology, but it is important to be innovative in terms of regulations and institutions. Hong Kong was a gateway to China for the second half of the last century, and although it was not a great innovator in terms of technology, its gateway status made it very prosperous. Singapore is also a good example; it is rapidly becoming a gateway between South East Asian countries and the rest of the world. In fact it is more successful than Hong Kong, because South East Asia, which is relatively more backward than China, relies on Singapore more than China relies on Hong Kong. As a part of the gateway strategy, both Singapore and Hong Kong correctly pursued very open and free market-oriented policies, with low taxes and low welfare; moreover, both emphasized English as the official language. These policies are good ingredients for the gateway strategy, and also essential to attract the right type of immigrants.

Outside Europe, East Asia, and North America, there are only a few wealthy countries. Some are gateway city states, which are very rich and small, such as Singapore. Others are resource-rich English-speaking countries, like Australia and Canada. Some people attribute their success to their abundant resources, but there are many poor resource-rich countries in South America and the Middle East. The resource-rich English-speaking countries are different because they have highly developed human capital and good institutions, and are very well connected to other wealthy countries because of the common English heritage and language. However, the disadvantage of these countries is still large: they are too small to have a critical mass of talent.

Israel is a special case. It has very high-quality human capital and is very innovative but because of its small size, it cannot build very large companies. Most of its technology innovations are sold to U.S. or Chinese companies after the initial stage of development. With the emergence of China and India as competitors, it will feel the pressure of losing talent to the United States, India, and China.

Conclusion

Europe, because of its fragmented market, low fertility rate, and language barriers, will be much weaker economically and much less innovative than the United States or China in the future. However, if European countries are more open to highly skilled immigration from the rest of the world, more English-friendly, and increase financial support to raise the fertility rate, the prospect of innovation remains promising, especially in high-end manufacturing industries.