Yves here. A look at how China used and improved on the old US and Japanese developmental state models. Authors Bill Lazonick and Yin Li stress the importance of China adopting sound corporate governance models, versus the US falling prey to financialization.
By William Lazonick, Professor of Economics, University of Massachusetts Lowell and Yin Li, Assistant Professor, School of International Relations and Public Affairs, Fudan University. Originally published at the Institute for New Economic Thinking website
In our INET working paper, “China’s Development Path,” we employ the “social conditions of innovative enterprise” framework to analyze the key determinants of China’s development path from the economic reforms of 1978 to the present. First, we focus on how government investments in human capabilities and physical infrastructure provided foundational support for the emergence of Chinese enterprises capable of technological learning. Second, we delve into the main modes by which Chinese firms engaged in technological learning from abroad—joint ventures with foreign multinationals, global value chains, and experienced high-tech returnees—that have contributed to industrial development in China. Third, we provide evidence on achievements in indigenous innovation—by which we mean improvements in national productive capabilities that build on learning from abroad and enable the innovating firms to engage in global competition—in the computer, automobile, communication-technology, and semiconductor-fabrication industries. Finally, we sketch out the implications of our approach for the role of innovation in China’s development path as it continues to unfold.
Like any national economy that has achieved sustained economic growth, the Chinese state has invested in human capabilities and physical infrastructure that provide goods and services to the business sector. The Chinese developmental state has not, however, been a passive investor in these productive resources. It has implemented proactive policies to support the expansion of advanced manufacturing capacity by attracting, negotiating, and coordinating foreign investment, and by fostering the inflows of talent and knowledge to China. Such investments have formed the foundation of the nation’s technological learning. Furthermore, to foster innovative business enterprises, the Chinese government often has provided sustained funding, described as “patient capital”, which otherwise would not have been available through nonstate financial channels.
The case of China also demonstrates that the success of the developmental state in fostering a dynamic of growth eventually depends on the emergence of innovative enterprises. From the perspective of the theory of innovative enterprise, the importance of indigenous innovation derives from the concept of the locus of strategic control. Companies that seek to become global competitors in technology industries must go beyond technology learning from abroad to develop superior productive capabilities at home. Key to indigenous innovation are, first, the devolution of strategic control to autonomous business enterprises that can engage in domestic and global competition by investing in learning processes, and second, the exercise of strategic control within these business enterprises by senior executives who have both the abilities and incentives to allocate corporate resources to investment in innovation.
As indicated in our essay, a distinctive feature of China’s development path has been the wide range of governance structures, from minying to employee ownership to joint ventures to state-owned enterprises to venture-backed startups, under which innovative firms have emerged since the 1980s. The key issue is not the form of enterprise ownership but rather the abilities and incentives of those who exercise strategic control, given an ownership structure. Not all Chinese firms possess these strategic capabilities, but, from our study of China’s development path, it is our contention that the most successful Chinese companies have been those in which, given the supportive national ecosystem, senior executives have had the autonomy, ability, and incentive to invest in innovation.
Strategic control over corporate resource allocation gives top executives the power to invest in the productive capabilities of the workforce and, through organizational integration, transform those productive capabilities into the organizational-learning processes that are the essence of innovation, enabling the generation of higher-quality, lower-cost products. Building these organizational capabilities inevitably entails the high fixed cost of attracting, training, motivating, and retaining the labor force engaged in organizational learning. For innovation to be successful, this fixed-cost investment in productive capabilities must result in a higher-quality product than would otherwise have been available for the firm’s market segment. Then, by virtue of possessing a higher-quality product, the innovating firm can transform the high fixed cost of developing that higher-quality product into low unit cost by accessing a large extent of that market segment, thus achieving economies of scale. Over the last four decades, those Chinese companies which have been able to generate higher-quality products have had the advantage of access to both a rapidly growing domestic market, resulting from national economic growth, and a massive export market enabled by China’s participation in the global economy.
In addition to strategic control and organizational integration, innovative enterprise requires financial commitment. To accumulate technological capability, Chinese companies have reinvested profits in productive capabilities, often complemented by loans from the state-run banking system. This financial commitment has combined with strategic control and organizational integration as social conditions of innovative enterprise for Chinese firms. Underpinning the success of enterprise growth in China has been the dynamic interaction of innovative business strategy and developmental government policy.
As principles of economic transformation, the social conditions of innovative enterprise that have enabled China’s development path are not unique to China. Following the publication of Chalmers Johnson, MITI and the Japanese Miracle in 1982, it became common to credit the “developmental state” for Japan’s rise to global leadership in a range of mass-production industries. Yet, from the late nineteenth century, it was the United States that possessed the most formidable developmental state in history. From the perspective of the accumulation of knowledge that provided a foundation for Japan’s indigenous innovation, the United States, first and foremost among the advanced economies, functioned as Japan’s developmental state. Central to Japan’s success was the growth of innovative enterprises, supported by national institutions—specifically, stable shareholding, permanent employment, and main-bank lending—that provided Japanese corporations with the social conditions that enabled indigenous innovation and, in many cases, the subsequent transition to global technology leadership.
By transferring this knowledge from abroad and then improving upon it, by the last decades of the century Japanese corporations were outcompeting their US rivals in industries such as automobiles, consumer electronics, machine tools, and steel, in which US companies had been world leaders. The organizational foundation of US leadership in mass-production industries had been the combination of secure employment under the norm of career with one company for both blue-collar operatives, typically organized in unions with first-hired, last-fired seniority provisions, and white-collar engineers, whose attachment to the company was cemented by promotion up the corporate hierarchy and the availability of company-funded nonportable defined-benefit pensions, based on years of service with the company. These employment relations characterized what Lazonick has called the “Old Economy business model” (OEBM).
Under Japan’s system of permanent (aka “lifetime”) employment, which evolved in the post-World War II decades, blue-collar operatives and white-collar engineers also had, as in the United States, employment security over the course of their careers. In the United States, however, there was an organizational segmentation of the routine work of “semi-skilled” operatives from the organizational learning among engineers who were deemed to be part of the management structure. In sharp contrast, the key source of Japanese competitive advantage in the mass-production industries was organizational integration of the skills and efforts of shop-floor operatives with those of professional engineers to enable the collective and cumulative learning required to generate higher-quality, lower-cost products. In effect, the Japanese surpassed the United States in mass-production manufacturing by perfecting the OEBM.
In the 1970s and 1980s, as an outcome of indigenous innovation commenced in Japan in the 1950s, Japanese electronics corporations also used their integrated skill bases to become global leaders in memory chips, a segment of the semiconductor industry in which value is added by reducing defects and increasing yields. This development forced major US semiconductor companies to retreat from this segment of the market, with Intel facing the possibility of bankruptcy in the process. Led by Intel with its microprocessor for the IBM PC and its clones, US companies became world leaders in logic chips, in which value is added through design and functionality. Indeed, the IBM PC, with its open-systems “Wintel” architecture, formed the basis for the rise to dominance of a “New Economy business model” (NEBM), characterized by offshoring and outsourcing of manufacturing, mainly to Asia; insecure employment, marked by interfirm labor mobility; stock-based pay and defined-contribution pensions; and the emergence of a global technology labor force, with India and China playing leading roles in the supply of highly educated people, particularly to the tech industry of the United States.
With ten times the population of Japan and the world’s second-largest economy, China has become a formidable global competitor, engaging in indigenous innovation through its global participation in the US-led NEBM. Despite their accumulated technological capabilities in information and communication technology, Japanese firms failed to prevail as major global competitors in the mobility revolution because they remained ensconced in the OEBM. In contrast, China’s emergence as a global competitor in ICT, with companies such as Lenovo, Huawei, and Alibaba, has been based on taking a development path that has become integral to NEBM on a global scale, with a pervasive presence in global value chains.
While through the process of indigenous innovation, Chinese companies have become major global competitors, many US technology companies have fallen victim to corporate financialization. The starkest contrast is between the success of Huawei Technologies in communication infrastructure, in which the company is the world leader (followed by Sweden’s Ericsson and Finland’s Nokia), and the failure of US-based Cisco Systems to become a significant competitor in this segment. In a forthcoming paper, “The Pursuit of Shareholder Value: Cisco’s Transformation from Innovation to Financialization,” Marie Carpenter and William Lazonick document how, at the turn of this century, Cisco was positioned technologically to build on its global leadership in enterprise networking equipment to become a major competitor in the more sophisticated service-provider infrastructure segment. To do so, Cisco would have had to make large-scale investments in manufacturing and marketing as well as R&D. Instead, from 2002-2021, Cisco distributed USD144 billion (98 percent of net income) to shareholders in the form of stock buybacks as well as USD48 billion (another 33 percent of net income) as dividends. More generally, corporate financialization has robbed the United States of the possibility of attaining a leadership position in 5G and IoT.
In smartphone competition with Huawei, Apple has benefited immensely from US trade policy that, from the fourth quarter of 2020, eviscerated the Chinese company’s high-end smartphone output by coercing TSMC to stop shipping advanced nanometer chips to HiSilicon, Huawei’s chip-design subsidiary. Yet TSMC’s rise to global dominance of advanced chip fabrication was enabled by the fact that Apple itself chose to outsource semiconductor fabrication while, between October 2012 and June 2022, wasting USD529 billion on stock buybacks (92 percent of net income) to give manipulative boosts to its stock price. Apple could have deployed just a fraction of this cash to fund on a sustained basis its own state-of-the-art fab—as indeed an industrial journalist suggested to Apple CEO Steve Jobs in 2010. To put the extent of this corporate financialization in perspective, the combined USD27 billion that TSMC and Samsung Electronics committed to spending over several years from 2021 to launch state-of-the-art fabs in the United States was less than one-third of the USD86 billion that Apple spent on buybacks in 2021 alone.
Meanwhile, as has explicitly been recognized by Pat Gelsinger, Intel’s CEO, who took office in February 2021, corporate financialization has been a prime cause of that company’s loss of world leadership in chip fabrication to TSMC and Samsung. China’s SMIC may be struggling to catch up with the Taiwanese and Korean companies in advanced nanometer platforms, but Intel’s financialization has helped create an opening for SMIC’s development path. The same argument can be made about how Boeing’s corporate financialization, manifested by USD43 billion in buybacks from January 2013 to the first week of March 2019, just before the second of the two Boeing 737 MAX crashes, crippled a US-based technology leader, enhancing the possibility that China’s Comac, with its C919, might break into the Boeing-Airbus duopoly in the global manufacture of large aircraft.
More generally, a book could be written about how US-based companies have supported China’s development path to the mutual benefit of both nations, but how the US-based companies have squandered these gains in the name of “maximizing shareholder value”. Indeed, such a book could focus solely on the story of China’s rise to global leadership in green technology, with corporate financialization causing the United States to fall further and further behind. For the past decade or so, as the success of China’s development path has become clear in global competition, US interests have complained about China’s currency manipulation, intellectual property theft, unfair government subsidies, violation of WTO rules, and attacks on US national security. While, depending on the facts of the matter, there may be cause for US concern on any or all of these issues of US-China relations, a policy agenda that limits itself to litigating these questions will fail to comprehend the technological learning that since the 1980s has been driving China’s development path. At the same time, this US penchant for blaming China will ignore, or at best underestimate, the damage to the development path of the United States that corporate financialization has wrought.
 The pioneering academic work on indigenous innovation in China was done by Qiwen Lu, on a project led by William Lazonick at the UMass Center for Industrial Competitiveness from 1993 to 1998 and the Euro-Asia Centre, INSEAD, from 1998 until Professor Lu’s untimely death in August 1999, just after his submission of the final book manuscript China’s Leap into the Information Age: Innovation and Organization in the Computer Industry to Oxford University Press (published in 2000). During the late 1990s, Qiwen Lu was in contact with Feng Lu, who was completing his Columbia University PhD dissertation on the reform of Chinese state-owned enterprises. Feng Lu subsequently became a faculty member at Tsinghua University, where, with his student Kaidong Feng, he ran a project on the limits imposed on indigenous innovation of the Chinese policy of “trading market for technology” in the automobile industry. In the spring of 2004, Feng Lu, by that time professor of political economy at Peking University, met with officials at the Chinese Ministry of Science and Technology (MOST) to discuss his report carried out with Kaidong Feng, The Policy Choice to Develop Our State’s Automobile industry with Indigenous Intellectual Property Rights. This report was influential in making “indigenous innovation” central to MOST’s Medium and Long Term Plan. For the last decade, William Lazonick and Yin Li have been collaborating with Kaidong Feng on a project on indigenous innovation and economic development in China.