Better conditions for innovation, the driver of higher employment, growth, and wealth in Europe

Summary of a presentation held by Roland Berger for representatives of the press on June 24, 2003 in Munich

With the Lisbon Strategy, Europe set itself the goal of becoming the most competitive economic zone by 2010. That we will reach this goal is in more than a little doubt, in view of the massive structural weaknesses faced by Germany and other European countries.

However, it is possible – if we create better conditions. After all, innovation is the most important driver of employment, growth, and wealth in an open global economy.

A. INNOVATION IS THE DRIVER OF EMPLOYMENT, GROWTH, AND WEALTH IN AN OPEN GLOBAL ECONOMY – SEVEN FACTS

Fact number 1: Three types of innovation drive economic development – in different ways

Firstly, product or service innovation, or inventing and selling new products and services. This creates new markets, additional growth, and more well paid employment.

Secondly, structural innovation. This drives the transformation of our value-creation structures, division of labor, and thus the structure of our labor market. As happened, for example, during the transformation from an agricultural to an industrial economy, and now to a knowledge-based service economy.

Thirdly, process innovation, which ultimately leads to higher productivity and allows unit prices to be reduced and/or pay to be increased. Process innovation thus raises the wealth of the population.

A balance between employment, growth, and wealth can exist only when all three types of innovation take effect simultaneously and in harmony.

Fact number 2: Service innovation secures wealth in high-wage countries

Our wealth in Germany, a high-wage country, is largely the result of our innovative edge. Like other large industrialized nations, we are in a position to produce and sell products and services that other countries need but cannot produce themselves. They are therefore forced to pay our– relatively high– prices, i.e. wages.

We can continue to live on our "island of wealth" only as long as we maintain this innovative edge. After all, if you don't innovate, you imitate and end up producing commodities, which translates into selling fewer and fewer products and services at ever lower prices.

Fact number 3: Service innovation creates economic growth

The greater the share of highly innovative products and branches of industry an economy has, the higher the growth of its economy and its GDP. High-tech sectors enjoy above-average growth levels: the innovation-intensive high-tech sector grew by 9.4 percent p.a. over the past eight years in Germany. Conversely, industries poor in R&D activities grew by a mere 1.7 percent p.a., or just one fifth as much, in the same period.

Comparing Germany with the US clearly shows what a focus on high-tech can do for a national economy: the US economy boasts double Germany's share of high-tech companies (16.6 percent vs. 9.0 percent) and much stronger GDP growth (3.4 percent p.a. between 1991 and 2001 vs. 1.4 percent p.a.). The same goes for growth of GDP per capita, i.e. wealth, where Germany lags well behind the US.

Fact number 4: The speed of structural innovation is, after labor productivity, the main driver of employment, growth, and wealth

The speed of structural innovation is the speed at which we modify our economic structures and transform our traditional industrial economy into a knowledge-based service economy. The speed of this structural change largely determines the speed at which employment, the economy, and wealth in our country grow.

Germany has lost considerable ground to the US in this respect. In Germany, the secondary, i.e. industrial, sector accounts for just under 31 percent of jobs, and for just over 20 percent in the US. Here in Germany, the private service sector employs just over 50 percent of the workforce, while it is home to almost two thirds of the labor force in the United States. If we could build up more high-tech and more services on the basis of our industrial sector, employment and wealth would grow in Germany, too.

Fact number 5: Global competition for jobs is pushing down the price of labor and undermining wealth in countries lacking in structural innovation

Global competition is encroaching ever more into national job markets. Workers in Germany are in indirect competition with their counterparts in China. This makes price the top competitive factor – unless we can stay one step ahead with service innovation and fast structural innovation.

In Germany, the demand for labor has been declining for more than 40 years. Hence, the price of labor should also be declining. In Germany, however, labor costs are increasing. If costs cannot fall, the response will be a volume reduction – meaning higher unemployment, and with it, slower growth and decreasing wealth.

If we compare Germany and the US, it becomes clear how important structural innovation is for job creation. In Germany, the demand for labor has declined from 60billion to less than 57billion hours worked p.a. in the past 10 years alone. This is due to our slow pace of structural innovation. The increase in the total demand for labor in the private service sector (+25.8 percent since 1991) cannot compensate for the decline in industry (-22.1 percent), agriculture (-36.2 percent), the public sector, retail, and transportation.

Things are different in the US. The absolute demand for labor has not fallen, but rather grown by almost 23 percent – just less than a quarter – over the same period. In the US, private services (+38.9 percent since 1991) and retail and transportation (+62.0 percent) have expanded tremendously and more than compensated for the decline in industry and agriculture. In other words, the driving force behind America's "employment miracle" is the fast pace of innovation in its economic structures, or the country's rapid transformation from a traditional industrial economy to a new knowledge-based service economy.

Fact number 6: Most innovation in Germany happens in medium-tech areas and among industrial heavyweights

In the medium-tech sector, which includes industries such as automotive and printing technology, engineered products and systems engineering, Germany is still the global leader in innovation. However, in the industries of the future, i.e. particularly high-growth sectors such as genetic engineering, nanotechnology, biotech, and IT/communications, the number of patents filed in Germany is significantly lower than in the US.

Moreover, the pattern of innovation differs across the Atlantic. R&D is largely done by industrial heavyweights in Germany, while it is startups that stimulate the American economy with their high-tech innovations.

Fact number 7: Germany does not invest enough in service and structural innovation and our strengths in process innovation cannot compensate

Germany's R&D spending is too low in absolute terms, and as if that weren't bad enough, it is declining. While the amount we spent grew by 7.3 percent p.a. in the 1980s, by the 1990s the average growth rate was half that amount, at 3.4 percent p.a.

Economic growth declined similarly dramatically, from an average 2.5 percent p.a. in the 1980s to 1.5 percent p.a. in the 1990s. Employment growth was 0.7 percent in the 1980s, dropping to less than a third, or 0.2 percent, in the 1990s. The growth of GDP per capita experienced the same fate, declining from 3.1 percent p.a. in the 1980s to a mere 1.1 percent p.a. in the 1990s.

B. SEVEN SUCCESS FACTORS OF INNOVATIVE COMPANIES

1. Establish a culture of innovation and allow the unexpected to happen

Many innovations happened by accident: the X-ray, Scotch tape, penicillin, Viagra, Velcro. Many inventions only come about in the first place because people are willing to go the extra mile and to take risks, and because the conditions they work in promote curiosity, the wish to experiment, and a tolerance of mistakes. All companies would do well to create these conditions for their employees.

Of course, innovation needs to be recognized as a corporate goal and the creative principle needs to be lived out through entrepreneurial management. Giving employees freedom and leaving room in budgets, having flat hierarchies, and allowing for open communication instead of installing bureaucratic control mechanisms are all essential for a stimulating culture of innovation to thrive.

2. Question existing structures

Success comes only from following Schumpeter's principle of creative destruction of the status quo. In other words, it is vital to constantly question the established recipes for success. At the organizational level, this entails rewarding flexibility and the will to change and allowing for job rotation between all functions and levels of hierarchy.

It is important to remember that a company's capacity to adapt must always be greater than the speed at which its environment changes.

3. Make your employees into entrepreneurs

Every employee must think and act like an entrepreneur. Such a mindset can be created by a decentralized organization with clear staff responsibilities, competition between employees and business units, and performance-based pay and career development.

In innovative companies, there is no contradiction between teamwork and competition between employees. Rather, they both promote entrepreneurial thinking. These days, innovation is more likely to be the result of mutual intellectual and interdisciplinary stimulation in a team than a stroke of genius from one person.

4. Introduce professional knowledge management

In innovative companies, all employees are part of the knowledge pool. Everyone has access to the know-how generated within and outside of the company. This demands investment in technology, culture, organization, and skill development.

A culture of knowledge can be established by rewarding knowledge sharing without inhibiting the competitive spirit between employees. Those who try to keep their know-how to themselves must be penalized. Professional knowledge management raises productivity and enhances the speed and output of corporate innovation processes.

5. Define clear strategies for innovation

A clear innovation strategy must be based on detailed knowledge of who your customers are and what your resources are– now and in the future. This means that companies must realistically assess the future potential of the technologies and products they have today. Companies must innovate today in order to meet the demands of the future.

A company's success depends largely on its innovation strategy. First movers invest more, but their reward is high profits and market share. Fast followers can enjoy success if they optimize their production and marketing resources. Most profitable of all is the trendsetter strategy, when a company succeeds in creating a global standard, such as Microsoft did.

Aside from the R&D perspective, companies also have to make sure they bring their product and service innovations to market with the right strategy. For first movers and fast followers alike, a detailed analysis of the opportunities and threats of any innovation strategy is an absolute must.

6. Systematically exploit external knowledge sources

Access to know-how through networking with external experts is another success factor for innovative companies. They cooperate on a local and a global basis with universities, research institutes, companies, and other inventors and innovators. Their perpetual aim must be to become innovation leaders by integrating internal and external knowledge and value chains.

Innovation cycles, generators, and users are widely spread across the globe in this day and age. Thus, it is vital to obtain early access to new technologies, their generators, and their users.

7. Become an innovation leader with the 3S strategy

Innovative companies pursue the 3S strategy: speed, share, and scale. In practice, this means that they are the first to bring innovative products and services to market. This allows them to acquire the largest share of the market and puts them in a position to realize economies of scale that translate into low unit costs and high margins.

By consistently employing the 3S strategy, innovative companies can manage their competitive edge and invest in yet more innovation to secure and develop their position in the long term.

C. GERMANY NEEDS A POLITICAL PARADIGM SHIFT FOR INNOVATION TO FLOURISH

We are still using our financial and human capital primarily to maintain the status quo. Germany's government spending is around 48 percent of GDP, compared with America's 30 percent. Welfare spending in Germany takes up about one third of GDP, while in the US the figure is just one fifth. Subsidies, which we use in Germany to maintain the status quo, account for almost 2 percent of the country's GDP, compared with 0.4 percent in the US.

Germany cuts a poor figure in terms of investing in the future. We invest 5.6 percent of our GDP in education, while the US invests 6.5 percent. Our investment in research and development is also lower: 2.5 percent of GDP compared with 2.8 percent in the United States. And our investment in equipment totals less than 9 percent of GDP, while in America the figure is 11.5 percent.

So what must we do? The answer is clear for all to see. We need to have the courage to change our priorities. Our resource allocation, human and capital alike, must reflect the demands of the future.

We need to cut government spending from just under 50 percent to less than 40 percent of GDP. Welfare spending must not be allowed to exceed one quarter of GDP – Germany could take the European average of 26 percent as a yardstick here. And if we cut subsidies from 2 percent to 1 percent, we would save over 20 billion euros.

At the same time, we need to bring our education spending up to at least 7 percent of GDP, increase what we spend on R&D to over 3 percent, and raise the amount we invest in equipment to more than 10 percent.

If we do this, employment, the economy, and wealth in Germany will have the chance to grow through more, and more successful, innovation.