by Shuwei Fang

Dan Breznitz is an Associate Professor at Georgia Institute of Technology’s Sam Nunn School of International Affairs and The College of Management, and is an Associate Professor by courtesy at the School of Public Policy. Prof. Breznitz’s most recent book (co-authored with Michael Murphree) is The Run of the Red Queen: Government, Innovation, Globalization, and Economic Growth in China.

Berfrois

How does the Chinese growth experience differ from that of other emerging economies, for instance, another transition economy such as Russia and why?

Breznitz

Well, let us be a bit more precise here, we must not compare apples to oranges. To simplify things there are two kinds, if you will, of economies you can compare the Chinese story to. First, there are the former communist economies. Second, there are the poor and less developed economies that have “emerged.” The fact that Russia and China were both communist centrally-planned economies, actually hide the fact that Russia was a highly advanced, highly-educated and very technologically savvy economy in 1978. At the same time, China was poor, backward and not at all technologically advanced. Hence, it make more sense to compare China to other less-developed authoritarian economies, such as Korea and Taiwan, that grew rapidly thanks to a set of state-led policies and initiatives.

When you look at it that way, you are immediately struck by just how different China’s story has been so far. There are two interlinked, major differences between China’s economic rise and, let us say, Japan and Korea. The first, which you can be excused to think the opposite if you read the newspapers, is that China’s is an extremely open economy and, in reality the only case of a big diversified economy where FDI (foreign direct investment) and joint (foreign-led) ventures have been playing an extremely (though some might say the most) important, role in its growth. Multinational companies were virtually locked-out of Japan and Korea, and are still, for all purposes, not “allowed” into Japan. The opposite is the case in China.

Secondly, China’s rise is intimately tied to the changes in the way production is now internationally managed. If at the time that the Japanese and Koreans started to create their modern industry, the name of the game was big vertically integrated firms that were doing most, many times all, of the work from early R&D and conceptualization to the final product assembly and sale, today we talk about fragmentation. That is, the growing de-linking of discrete production stages, where activities such as R&D, design, fabrications, and assembly for final productions, sub-systems, and even components (such as IC chips, or pumps) is done by different companies that specializes in these specific set of activities and stages of production. This allowed specific locales to enter the global production system of industries, both high- and low-tech, in multiple entry points, without the need to amass the skills and the capital needed to excel in every stage of production, from R&D all the way to Quality Assurance.

Indeed, in my earlier work (Innovation and the State, Yale University Press), I showed how these processes allow Israel, Taiwan and Ireland to excel by the late 1990s in high technology through supplying very different outputs to the mostly US controlled, global ICT industry. China opening up and growth, was fortuitously timed at the perfect moment where these changes occurred. Consequently, China quickly become the manufacturing hub of the world, and could do that while being poor in both skills and capital, since it was foreigners who supplied the capital, the demand, the specification and the market knowledge. Thus, if Japan and Korea become manufacturing powerhouses of national champions who have strangling hold on the domestic market and sell complete products abroad. China quickly became the place where everything is produced by everyone for everywhere. In so doing, Chinese enterprises have been developing unique strengths, and now excel in a whole set of innovation activities around the production stages in which China is dominating the world.

Berfrois

The title of your most recent book, The Run of the Red Queen is a play on Lewis Carroll’s character, the Red Queen from Through the Looking Glass, who says, “it takes all the running you can do, to keep in the same place.” How does this apply in the context of Chinese economic growth?

Breznitz

Actually it is a double play, if you remember the Red Queen of Chess (not to be confused, thanks to Disney, with Queen of Hearts), explains to Alice that her world is a very fast world, and hence, one needs to run as fast as one can in order to stay in the same spot. Now if we go back to the major changes in the ways things and services are now produced globally in discrete stages, and follow this logic to the end (which sadly no economic growth or innovation theory has yet to do, leading to some very strange policies in both the developed and developing world), it follows that different locales, even these specializing in the same industry needs very different innovation capabilities to reach sustained success. Thus, if in the past, one could argue that all economies must master novel-product innovation in order to achieve long-term growth, we argue that under a world of fragmented production there are multiple strategies, each fits better different locales, and each with very different outcomes in terms of the number and kind of jobs created and the kind of skills and business models that companies need to excel in.

The Run of the Red Queen documents the coevolution of public policy and industrial strategy in China, which accidentally created two innovation systems, one national and one regional. These parallel systems have so far precluded novel-product innovation, but has allowed China to thrive in second generation, production and process innovation. We call this course of development China’s “Run of the Red Queen”. China shines by keeping its industrial production and service industries in perfect tandem with the technological frontier. Like the Red Queen, it runs as fast as possible in order to remain at the cusp of the global technology frontier, while not actually advancing the frontier itself. Nonetheless, if Alice was disappointed to find herself in the same place, China has since found out that this strategy has been leading it to become the world’s longest and most rapid economic growth miracle.

As the technology frontier moves ever further ahead, China has found that running fast enough to keep in step is extremely beneficial. Within an international economic system of globally fragmented production, China can excel in a wide array of innovative activities that might not advance the technological frontier but can certainly transform how the global economy works. Thus, as the technological cutting edge is advanced in other geographical locations in the world, China continuously grows in importance as a critical location for innovations building upon these discoveries. Furthermore, and crucial to the story of China, this changed model of globalized production creates new dependencies among and between countries and industries. Therefore, China’s rise to prominence in the IT industry has been due, in large part, to the new opportunities in specific stages of production opened by the fragmentation of the IT industry. However, China’s excelling in these stages not only transformed China into a critical part of the global production networks of the IT industry, but also created a new mutual dependency. On the one hand, the Chinese IT industry needs foreign – novel-product innovating – companies to keep producing in China. On the other, foreign companies are completely dependent on Chinese companies to be able to produce their novel-products, a capability they no longer (or never did) possess. For example, China might need Apple to develop concept and definition for the iPod, iPhone and iPad, but Apple would not be able to produce and sell these products without China. In our world of flexible IT “mass” production, the Red Queen country needs the novel-product-innovators to keep churning new ideas, and the novel-product-innovation countries need the Red Queen country to keep innovating on almost every other aspect of production and delivery.

Last but certainly not least on this point, we must emphasize that this model of development, China’s “Run of the Red Queen”, was developed by accident, partly as a result of local experimentation, and looks quite different from the declared goals of the central government.

Berfrois

The system of mutual dependency that you speak of, whereby China provides the production and foreign companies provides the ideas, how sustainable is this, if one assumes reliance on a cheap and abundant labour force to produce the goods?

Breznitz

Well, firstly I take beef with your assumption. As we document in the book, this is an incorrect view of what really happens in China. While part of the allure of China is the abundant labour (more and more viewed by many as a future market in itself as well as labour). Cheapness is not the core of China’s advantage anymore. Chinese companies (and I would be careful here not to say China, since this is not what the Central government truly wishes for, nor is it all or even most Chinese companies either) have developed significant innovative capacities around production. I think you will be hard pressed to find an American company that even knows how to produce many of its own products. Hence, the assumption that they can just hand this off to a generic Chinese company that would produce it according to their design and their guidance is, to be blunt, wrong. What you have is a system with growing “true” interdependencies.

Let me give you an example, Apple’s power supply system, the white cable with a box you stick to the socket. There is unbelievable amount of innovation and R&D that goes into making this system smaller, more efficient, and more reliable (remember that laptops going up in flames is not the best publicity). For that to happen, you need to have continuous R&D efforts with many engineers devoted to the task. I will give you one guess as to where in the world it happens: China. Thus, a key component, not very fashionable, nor one that we even think about in terms of innovation, but crucial to Apple (which many people thinks embodies everything which is good about Silicon Valley innovation) is utterly dependent on China, and China’s innovation capabilities, and not China’s infinite supply of unskilled cheap labour.

Consequently, your question is misframed, for the production and technological point of view, yes the system is sustainable. But, from the political point of view, especially with China’s seemingly growing strength, and the US stagnation (and growing unemployment) this is a very different question. True interdependency means that we cannot even have your own products without the other side. Hence, economically it seems natural that all should work together toward mutual enrichment. Politically, however, it means that both sides are critically vulnerable to the other side misbehaving (either on purpose or by mistake), which should lead both sides to very quickly escalate minor mishaps, for the fear of a strategic move. Solving these kinds of coordination problems necessitate better (or at least very aware of the issues), global governance mechanisms, vehicles and institutions. I would leave it to you to decide whether we have them at the moment, and whether our political leaders will even try to build them.

Berfrois

In the book you say that politics is the key to understanding China’s “Run of the Red Queen”. What do you mean by “Structural Uncertainty” and why has it shaped the trajectory of Chinese industry and innovation?

Breznitz

We define structured uncertainty as an agreement to disagree about the goals and methods of policy, leading to intrinsic unpredictability, and hence, ambiguity in implementation and enforcement of economic policies and rules. Structured uncertainty cements multiplicity of action without legitimizing any specific course or form of behaviour as the proper one. This ambiguity leads to some tolerance for multiple interpretations and implementations of the same policy.

For Chinese companies seeking new opportunities, at the same time that plurality of policy actions is tolerated, punishment for deemed transgressors can be severe, abrupt and seemingly arbitrary. The limits of tolerance are undefined, adding to the ambiguity. Structured uncertainty can thus be thought of as an institutional feature that guarantees a plurality of behaviours will be followed in any specific domain, with none of the actors knowing in advance what should be the appropriate ways to conduct themselves. Structured uncertainty exists to a certain degree in almost all policy domains in most countries. Indeed, it is the main reason why street-level bureaucracy is so important in every society. However, it takes on a different qualitative and quantitative manifestation in the Chinese system due to the specificities of its halting but continuous transformation from a revolutionary society to a more organized, bureaucratic rule-bound one.



Alice and the Red Queen, from Alice Through the Looking Glass, Lewis Carroll, 1865. Illustration by Sir John Tenniel

Structured uncertainty has particularly pronounced effects on R&D undertakings. As succinctly argued by Kenneth Arrow, even under conditions of perfect market competition there is a tendency for private economic agents to under-invest in R&D. Structured uncertainty, through its impact on the ability to appropriate and increased uncertainty, augments R&D’s inherent characteristics of indivisibility, inappropriability, and uncertainty, reducing private incentives to underwrite R&D. Under structured uncertainty the great puzzle for economic theory is why some Chinese companies even perform significant R&D.

Under these conditions Chinese organizations use multiple approaches, both official and unofficial, to mitigate uncertainty. These have led to the emergence of a strongly innovative organizational ecosystem, but one different from the West in its focus, and decidedly different from the one envisioned and coveted by China’s central government. This innovation ecosystem fosters a wide array of innovation activities but not novel product innovation.

To ensure an incentive for productive activities, innovators must be able to appropriate returns without resorting to extra-legal means. Organizations must ensure they are secure from predatory officials if they are to seek productive activities. To do so in China, organizations adopt multiple ownership forms and cultivate back channel relationships with officialdom to ensure protection from the fickle winds of state and to guarantee their chosen market remains viable. Organizations can choose to establish themselves as wholly-owned foreign enterprises, collectives, private enterprises, state-owned ones as well as more amorphous ownership forms such as minying. By redefining ownership, merging different types of ownership, and extending ownership rights to government at various levels, uncertainty regarding the behavior of officials can be partly mitigated. We can see across China’s high technology industries that this is the case: an industrial structure of mixed ownership types that offer greater assurance as to the ability to appropriate returns, but with relatively ambiguous channels of management authority by Western standards.

In terms of innovation capabilities, adapting to structured uncertainty means Chinese firms are relatively well able to avoid predations by the state but are less able to move forcefully in any area which demands commitment to high risk with long timeframes, exactly what is needed for novel product R&D. This limitation does not mean Chinese enterprises have no incentives to innovate. It is critically important to remember the flip-side of structured uncertainty. If there is one agreed upon benchmark with which to judge whether a policy or action by business is “proper” it is revenue growth and job creation. These are seen as categorical goods by both political and economic actors; hence they are pursued over and above all else. The goal of public policy, and research conducted by or within business, is to maximize revenue and job creation as fast as possible while generating and sustaining the least amount of risk. It follows, therefore, that enterprises will emphasize short-time horizons and incremental activities in proven technologies and market niches.

Second, in order to feel confident they will be able to appropriate returns, organizations in China seek workable means of securing them in an environment that lacks fully enforced formal property rights. The actual strategy an organization adopts derives from the industry sector in which the organization operates as well as the resources, human and otherwise, available to it. Most frequently, Chinese enterprises release incrementally improved models of their products and services with a very short lag time between new versions. This strategy limits the value of copying by would-be competitors and ensures the company manages to keep a profitable edge. China’s strengths in flexible manufacturing enable rapid turnarounds and short-runs of products, thus making this a workable innovation strategy. A second approach, exercised by large scale enterprises with major internal resources is to specialize in innovation of production methods or large-scale equipment design and fabrication. For these industries, the value of imitation is lower since prospective imitators would require massive capital assets of their own as well as – and more importantly – tacit knowledge in order to successfully pirate the organization’s technology. Such high end capital-intensive innovation strategy lends some protection copying by competitors even in the absence of property rights. Third, the most advanced local organizations or, more commonly, branches of foreign multinational companies opt to use the highest end local human resources to conduct highly theoretical or abstract research. Such primary research does not lend itself readily to imitation and requires the embedded tacit knowledge and technology transfer practices of the innovating firm in order to capitalize on any findings and deploy them in a final product.

Finally, when dealing with the financial system, firms in China adopt approaches designed to ensure access to capital. China’s financial organizations, even those which title themselves venture capital, are generally highly risk averse with the partial exception of state financing. Risk aversion privileges large-scale enterprises, proven business models using already developed technologies, or foreign enterprises. The relative scarcity and weaknesses of both traditional investment capital and venture capital mean that the role of government is greatly enhanced. However, the central state often opts to support only those ventures which accord with its development plans and its specific understanding of innovation. This means firms developing technologies outside the state’s vision are largely excluded but those in chosen industries can enjoy privileged access to capital. However, the lack of patient venture financing limits the range of R&D activities in which firms may engage, thus further encouraging their specialization in non-novel-product innovation niches.

That is not to say that Chinese firms do not derive lasting advantages from their innovations. Under fragmentation of production, Chinese enterprises aggressively pursue enduring advantages within specific phases of production. Global production networks not only make this strategy viable, but also supply China with the needed inputs in terms of novel ideas developed elsewhere, and the necessary market demand for innovations across the production cycle to make it sustainable. For innovative Chinese organizations, specialization under the new global conditions is significant because such it provides types of embedded knowledge that similarly to novel product innovations are valuable in granting lasting competitive advantage. Accordingly, the resulting benefits to the organization in terms of securing a competitive advantage in the market place are the same. Stage specialization and development of the related skills enables a firm to continue to innovate and grow at a given level without a strong need to excel in novel-product innovation.

Berfrois

What lessons can be learned from the Chinese experience for emerging economies, and indeed, the developed world. Can the “Run of the Red Queen” cross borders?

Breznitz

In the book we argue that China is not a sui generis, and that other nations can learn both what to do as well as what not to do from China’s example, particularly with regards to development and innovation policies. Like all countries, China has unique features and history but this does not mean theories of comparative political economy stop working when they cross its borders, or that intuitional analysis of China does not grant us insights relevant beyond the pale of the Middle Kingdom.

We dispelled two critical myths about innovation and the rise of China in the current age of global fragmented production. The lessons learned from dispelling these myths speak much to other emerging economies. The first lesson that China teaches other emerging economies is about the impact of the fragmentation of production on the array of new options available to them, as well as which options no longer exist for the same reason. Unlike what we are led to believe, the current processes of intensified, globally fragmented production give emerging economies a larger number of entry points to the global economy, and hence more development alternatives than they had since World War II. The escalation of economic globalization and fragmentation does limit the choices of government, since many traditional fiscal and industrial policies either no longer work, are no longer tolerated, or both. At the same time, fragmentation gives emerging economies more choices of action than ever before, as the increasing complexity and openness of the world economy allows states to devise development strategies hitherto unavailable in an era of vertically-integrated firms and national economies.

China has used this situation to its advantage: entering the IT industry’s global production networks at the simplest point – assembly – China has since developed a massive array of capabilities around production, logistics, incremental improvements and second generation innovation. Looking at the deep crisis that faced China in 1978, it is an open question whether China’s piecemeal approach to reform – groping for stones to cross the river – would have been successful, or even sufficient, without the global decomposition of production. Without the advent of the spatial fragmentation of production, China would have had to develop missing capabilities and invest on a much larger scale then either its economic and financial resources or political situation would have permitted. Thus, emerging economies will do well to carefully analyze the various entry points which are open to them, and devise their policies to specifically fit the stages of production (and accordingly innovation) at which they wish to excel. Policy deliberation and experimentation by local officials is critical, since economic development is, above all, a contextual science. Furthermore, this process of deliberation and decision-making is especially important as these choices will have long term consequences on the development of their high technology industries.

This lesson about the availability of multiple entry points leads us to the second lesson China teaches the world in general, and emerging economies in particular – the need to go back into a more refined, subtle and comprehensive understanding of innovation. Such a Schumpeterian understanding does not equate innovation solely with novel products and technology, and does not suffer from an on almost religious reverence for new inventions. While invention is critical and, of course, necessary, if the main aim of national policy is sustained economic growth, China’s recent history makes it absolutely clear that in a world of fragmented production, the fetishism of novelty celebrated by policy makers and the popular press, is not the only or the best option for emerging economies. The rapid and continuous rise of China, and the new interdependencies brought by the international decomposition of productive activities, questions the core assumption that states must at some point master novel-product-innovation if they are to sustain growth.

Emerging economies that care about economic growth, and are less worried about winning national self-esteem competitions, would do well to consider all options and models of rapid-based-innovation industrial development. China’s example shows that from a national point of view it might be better to possess regions that excel in the Red Queen Run, rather than regions that excel in imitating Silicon Valley. The current state of the State of California makes one wonder if “possessing” the original Silicon Valley is such a boon for states and their tax payers as its proponents make it out to be.

However, when applying these lessons we also need to remember other important domains of comparison with China that have great influence on the particular policies other emerging economies should take. First and foremost is, of course, size. Not many emerging economies have the same size advantages as China. Apart from perhaps India, Brazil and Indonesia, other emerging economies should be keenly aware that size limitations, especially in labor force and market size, would prevent them from replicating the Chinese feat of simultaneously advancing in so many industries, niches and stages of production within these industries. It is here that extra specialization, and hence careful analysis by policy makers on the particular niches and stages of production in which a given economy would do better to specialize, are of utmost importance.

It is on the ability to devise and implement policies that another Chinese lesson for emerging economies shines through. As we made clear throughout the book, the Chinese central state and bureaucracy have had far less influence and power than in South Korea, Japan or Germany in their eras of rapid development. The trajectory and current state of China’s high technology industry is far from the vision of the central government. Nevertheless, overall, and in all levels, the Chinese state and bureaucracy are one of the most professional and powerful in the world, specifically in comparison to most emerging economies. At the end of the day, especially in an economy so widely influenced by the state and party as China, it is mostly thanks to the daily toil of officials – from provincial ones looking after their locale to mandarins in Beijing envisioning a new China – that China has managed the world’s longest and fastest economic growth miracle. An emerging economy without some semblance of a professional and publically motivated bureaucracy would not fare well on the road to economic growth. It might very well be that a critical lesson from China, to be carefully studied not only by other emerging economies but also by international organizations such as the World Bank and the IMF, is that state capabilities must be built first. Only then can free market logic be enforced in developing states. If nothing else, the current financial crisis exposed that the free market cannot operate efficiently without a well working regulatory system – a system which is supervised by professional and capable civil servants.

The last implication of China’s economic rise for other emerging economies stems from the fact that by now the world production system is dominated by China. Consequently, other emerging economies should take into account China, its array of capabilities, and large and fast expanding market when devising their own path to rapid-innovation-based industrial development. If the global fragmentation of production opens up many more entry points for emerging economies, then the rise of China might seem as if it closes many of them. While it is true that the existence of a fast developing, extremely large emerging economy which is far from exhausting is reserve of poor rural workers, poses a significant challenge to small and poorer emerging economies, it also opens up many opportunities. First and foremost, it is clear that many multinational companies no longer feel comfortable in limiting their choice of suppliers to one country or even one region. Apart from the power structure within global production networks, where the multinational companies move to prevent the Red Queen from amassing too much power, the current crisis, recent political turmoil, and several natural ones, such as earthquakes and tsunamis, have sharpened minds as to the need to have a portfolio approach to managing globally fragmented production.

The story of Vietnam clearly shows that a small emerging economy can quite easily plug into the global production networks and successfully compete against China in its chosen market niches and stages of production. Thus, an emerging economy that carefully picks its preferred niches and stages of production can achieve success in terms of rapid-innovation-based economic growth. A second opportunity which the rise of China opens to emerging economies is China itself. The Chinese market is rapidly growing and Chinese consumers and companies alike are quickly developing an insatiable appetite for imports. Consequently, for the first time in many decades, emerging economies are not limited only to the already saturated – and now significantly weakened – markets of the advanced economies, but also have the export option of an exponentially growing underserved market which might very well become the world’s largest market in our life time.

Berfrois

Throwing in an element of political economy here, and the difficult question of Chinese democracy. Can you speculate as to what would happen to the “Run of the Red Queen” should China move to anything beyond a one-party system?

Breznitz

Let me start answering this question with a beautiful citation from Eric Hobsbawm:

It is often assumed that an economy of private enterprise has an automatic bias toward innovation, but this is not so. It has a bias only toward profit (Hobsbawm, 1969).

Now it is a bit different from the hidden premise of your question – which suggests more freedom in both the political and business sphere – not a change of ownership (which by the way in the Chinese case, where the state central/ provincial/local have between a finger to full control in each and every business, might have at least a big of an impact and might or might not be correlated to a change in political control).

However, the citation should serve as a chilling reality check to the views of the great positive/negative impact of democracy on business behaviour. A second slightly interesting fact is that exactly on that point we had two, not only one, recent experimentations right next to China: Taiwan and South Korea. What is clear is that both Taiwan and Korea became much more just, equitable, and vibrant societies, since they gained greater political freedoms. What is not at all clear is whether there are any major revolutionary changes in their market structure and/or innovation models.

Furthermore, democracy can, hypothetically, actually strengthen the “Run of the Red Queen” model in China. If one of the greatest danger to this model is the growing fear both foreign businesses and government have of the trustworthiness of China, then assuming a more Democratic China is more willing to play by the rules, collaborate, and maybe even sing “Kum bay ya, my Lord” while holding hands with world leaders around the fire during their annual “we love ourselves fest” (also known as the World Economic Forum in Davos), which is an extremely tall order bordering on fantasy, there is actually every expectation that the “Run of the Red Queen” model would channel even more profit, business, and jobs to China for even less effort on the Chinese part.

But subtlety might be a better way to predict hypothetical futures. The answer here is actually surprising. Looking at South Korean and Taiwan as our benchmark, from the point of view of the “boring business” in industry, not much has change on either count. However, there is one set of industries: these that have a lot to do with what we now in a politically correct way call “content.” So anything to do with media, entertainment, and the creation of content, from TV, industrialized culture, to video games, and other varieties of entertainment will probably enjoy unbelievable infusion in novel-product innovation. Indeed these are the areas in South Korea and Taiwan where we see more such innovational activities than anywhere else in these two economies. In China this would probably be the case, partly since this is the sphere where any activity, innovative or not, is extremely tightly controlled, and partly because the way to make money is specifically the creation of new content.

Building on this insight, I would also hazard a guess that industries that are closely related to content would also move to novel innovation and away from the “Run of the Red Queen Model” (the recent success of the Taiwanese company HTC comes to mind here, although it suggest a very slow move from the Red Queen Run). Apart from content (so culture and media related industries), I would expect major changes only in these industries where either the state has absolute control, or the fact that China is a state-led communist power with ambiguous laws currently creates a serious business hazard, such as some of the new ICT-based services – cloud data storage of private foreign business and individuals for example.

The “Run of the Red Queen” model is creating millions of jobs, earns China billions in foreign exchanges, has low risk, and by now Chinese companies (and the institutional environment) have developed capabilities that make China the world’s most competitive and innovative location for the development and employment of such business models. Since, in the end of the day, the aim of business and entrepreneurs is to make money, a change in political freedom would probably not suddenly change the business logic apart from in very few specific industries; at least not in the short or even medium term.