How the U.S. Can Rebuild Its Capacity to Innovate

Many U.S. firms have long had a simple mantra: “Invent here, manufacture there.” But, increasingly, those same companies are now choosing to invent as well as manufacture abroad. From automotive to semiconductors to pharma to clean energy, America’s innovation centers have shifted east, offering growing evidence that the U.S. has lost what Harvard Business School’s Willy Shih calls the “industrial commons”: indispensable production skills and capabilities. It’s not just that virtually all consumer electronics are designed and made overseas. It’s that the U.S. has lost the underlying capacity to make products like flat-panel displays, cell phones, and laptops; nearly half of the foreign R&D centers established in China now belong to U.S.-based companies.

This isn’t just a lesson for the United States. It’s a lesson for countries around the world: Once manufacturing bids farewell, engineering and production know-how depart as well, and innovation activities eventually follow. We can trace how this happened in the U.S. by looking back to the original offshoring frenzy which started with consumer electronics in the 1960s. The invention of modern transistors, the adoption of standardized shipping containers, and the advent of low-cost assembly lines in East Asia lowered costs and created larger markets for televisions and radios, setting the stage for an Asian manufacturing powerhouse. By the time that substantial U.S. federal research investments enabled the invention of the magnetic storage drive, lithium-ion batteries, and liquid crystal display technologies that paved the way for the next generation of consumer electronics in the 1980s and 1990s, the U.S. had already ceded electronics manufacturing to Asia.

U.S. firms took offshoring a step further and began contracting design and product development activities overseas around the turn of the millennium when China joined the World Trade Organization and Asian producers started investing in major capacity improvements. That pattern has continued. In a recent survey of 369 manufacturers, researchers found that across a range of fields U.S. companies were deciding to move R&D to China to be closer to manufacturers, suppliers, and talent as well as to reap lower development costs and higher-growth markets.

We know from looking at strong economies around that world that a nation needs both R&D and manufacturing activities to maintain a healthy 21st Century industrial ecosystem. While America has continued leading the world in terms of investment in basic science research, it has lost the ability to do the kinds of process improvements that are essential for innovation. When it comes to manufacturing, the country has lost the capacity for “learning by doing.”

But it should be possible for the United States to reverse these developments. We have identified four principles with straightforward steps that policymakers, business leaders, and universities can take to restore innovation ecosystems.

1. Don’t fear picking winners. The United States invests an unrivaled $140 billion annually in federal R&D, and yet the U.S. annual trade deficit in advanced technology products alone stands around $100 billion. America’s problem? It isn’t seriously investing in turning good ideas from laboratories into manufacturable products. In too many cases, other countries are securing new industries by taking advantage of promising results from America’s federal research investments: maturing innovations that were seeded in U.S. basic research laboratories, manufacturing products, and exporting those products back to the United States.

The United States needs investment in “translational research.” This means investing in not only basic science, but also the design, engineering and manufacturing work that can turn a promising idea into a valuable product. Take the example of lithium-ion batteries. While U.S. federal research in the 1990s largely established the feasibility of the technology, U.S. battery companies including Duracell and Energizer opted out of volume manufacturing these new products—not because of domestic labor costs, but because of fears of high upfront investments, long development cycles, and a lack of access to consumers of rechargeable batteries. Countries in East Asia saw an opportunity for job creation and decided to help homegrown firms overcome these hurdles. They provided facilities, loans, and other assistance to establish domestic manufacturing in the field. It worked. Today, US firms have less than 2% of market share in the multi-billion automotive lithium-ion battery industry.

Japan spends about 7% of its government R&D budget on practical “translational research”—converting basic research into meaningful new manufactured goods and processes. Germany spends about 12%. South Korea spends roughly 30%. The U.S., in contrast, spends just 0.5 percent. Even with Japan’s smaller national budget, its total government spending on translational research amounts to about three-times what the U.S. spends. Germany’s translational investments amount to about six-times total U.S. investments. South Korea’s are approximately eight-times what the U.S. spends. Historically, Americans have been averse to translational investments for fear of “picking winners and losers.” But other free-market economies have been able to pick winners and make these investments in fair, unbiased ways that demonstrably boost competitiveness.

Rather than allowing promising R&D results to languish in labs or even be commercialized by foreign competitors, the U.S. should launch a “National Innovation Foundation” to invest in engineering and manufacturing R&D to mature emerging technologies and anchor their production onshore. Right now, there’s no single “focal point” for manufacturing-related R&D in the U.S. federal government. MForesight, a federally-funded independent consortium of academia and industry focused on the future of U.S. manufacturing, estimates that with about 5% of the $140 billion federal research budget, the U.S. could create such an institution and significantly increase the return-on-investment from taxpayer-funded research. This would simply bring the United States into line with the rest of the industrialized world. An estimated 50 countries now have government-backed innovation foundations or similar agencies devoted to turning discoveries and inventions into commercially-viable and socially-beneficial results.

2. Invest in hardware startups and scale-ups. According to a recent study, even when MIT-based hardware startups had access to the skills and financing needed for R&D and proof-of-concept work, they required additional capital, production capabilities, and lead customers that the U.S. simply couldn’t provide. The result: most still had to go to China or elsewhere to scale production up to commercial levels.

The problem lies with both the U.S. government and venture capital (VC). The U.S. government has a long history of strengthening innovation through a combination of R&D and strategic procurement (think both aviation and internet). Government purchase orders, for example, can help companies to raise needed capital (both investments and loans), initiate pilot production or scale production in the U.S., and catalyze private investment. In recent decades, however, the U.S. has generally decreased these types of investments, leaving startups and scale-ups to piece together their own funding. Over recent decades, VCs have overwhelmingly focused on software and biotech investments over “hardware” investments, closing additional doors to manufacturing innovations. It’s no wonder that so many promising manufacturing enterprises have to look abroad to simply get off the ground—let alone soar.

U.S. policymakers can correct this imbalance by building on existing resources to help innovative hardware startups and scale-ups succeed—particularly through domestic government procurement. Other countries—including OECD members like Australia, Sweden, France, and Germany, as well as China—use government procurement skillfully to foster innovation. For example, France used a combination of national public policy and procurement to build a world-class nuclear power industry. China has employed government procurement, strategic technology transfer, and domestic technology development to build its respected high-speed rail industry. Local and regional governments also use procurement to drive innovation. Consider how Barcelona, for example, systematically seeks innovative solutions from entrepreneurs: winning proposals receive guaranteed contracts, plus additional support like office space for their operations.

3. Mind the Mittelstand. Ask a German businessperson or policymaker about the secrets to the strength of their manufacturing sector, and they’re likely to mention the Mittelstand, their small and medium enterprises. For good reason: these firms are diverse, resilient, and geographically distributed engines of innovation. They’re defined by high levels of “buy-in” from owners, investors, managers, and employees. They’re an important basis of “bottom-up innovation.”

In this era, large multinational firms are essentially “systems integrators”—they depend on suppliers, mostly Small and Medium Manufacturers (SMMs), to provide most of the needed components in any product. While few SMMs entertain offshoring strategies, they do, increasingly, compete globally.

The loss of America’s industrial commons has led to the consolidation, weakening, or loss of many small suppliers. This can be corrected. In the United States, SMMs still amount to about 250,000 firms, or 98% of all manufacturing firms. By strengthening and supporting these firms, the U.S. could rebuild the backbone of its manufacturing sector. For example, America’s public sector could help by offering loan guarantees and technical assistance to SMMs to speed up the pace of adoption of new smart manufacturing technologies that are becoming essential for process improvements. Further, government could work to ensure that SMMs are taking advantage of existing opportunities and expanded programs to build awareness about procurement opportunities, emerging domestic and export market opportunities, and new technologies. SMMs can play crucial roles in innovation by engaging in partnerships with universities and other laboratories to help mature technologies. Finally, there’s a straightforward way to help SMMs boost their own expertise: The U.S. could launch a program of industry fellowships to pay recent engineering and business retirees to help SMMs as well as to “coach” next generation of manufacturing start-ups, business incubators, and technology accelerators.

4. Power to the people. The U.S.’s manufacturing innovation decline has traced a similar decline in practical engineering talent. While American high schools typically require students to dissect a frog, few require students to disassemble a power tool. Exposure to real-world engineering is a crucial and cost-effective way to build interest in manufacturing careers—through either four-year engineering degrees or vocational training. Germany’s dual vocational training systems, which pairs apprenticeship with practical classroom learning, has long been a global gold standard. More recently, China has made major investments in talent to address the exponential growth of its manufacturing sector.

Around the world, educated people are the one single indispensable ingredient for innovation. This starts with elementary education and early opportunities to cultivate the necessary creative mindset—think Maker Faires and FIRST Robotics. At higher levels, the public sector can address the need for talent by boosting the availability of graduate fellowships for qualified students. Industry can also work with local technical schools to customize classroom training and experiential learning programs—particularly in areas of identified talent needs.

The common denominator to all these strategies is patience. From the examples above we can see that real innovation takes time. We understand that this is difficult. With the overwhelming pressures of quarterly profit reporting and short-term election cycles, it’s hard for business leaders and policy makers to focus on long-term strategies for strengthening innovation ecosystems. But history does show us: with a foresighted, sustained, cross-sectoral strategy it is possible to both invent and manufacture at home. Strong economies depend on it.