E15 Innovation and Trade - Background Paper

Strengthening the multilateral trading system

Trad e and Innovation Challenges and Policy Options

Draft background paper, not for citation

Ultimately, all human progress is based on technological development, which in turn is proximately driven by innovation. Trade provides the framework and is a prime means for dissemination of innovation.

Innovation and trade together are thus central to finding and implementing practical responses to the daunting challenges facing policymakers today – growth, development, and sustainability, never mind other matters such as health and food security.

Frontier innovation typically takes place at leading-edge centres concentrated to date largely

in advanced countries. Accordingly, the trading system, together with foreign direct investment, plays a critical role in disseminating technological advance which is largely embodied in traded goods and services. At the same time, international trade rules, which perform a critical role in maintaining the openness of the system to this flow of embodied (and to a lesser extent disembodied) technology, increasingly intrude into domestic policy spheres that affect the intensity and the orientation of the research that feeds innovation in individual economies. Accordingly, there is a profound twoway interaction between trade and innovation to which trade rules must be sensitive and in the best case scenario supportive.

Figure 1. The trade and innovation nexus

Source: APEC Conference on Innovation and Trade: April 4-5, 2012 see: http://www.meti.go.jp/english/press/ 2012/0323_04.html

A key question thus is whether or not existing WTO set of rules and disciplines are adequate to support the global drive to promote innovation. According to one author, sustainable global innovation is either not their mission or not thought to be important. For the WTO, this argument goes, expanded trade flow is all that matters.1 However, the question remains an open one and will be the focus of the work of this Expert group, which will seek to identify a range of recommendations and actions to ensure that the global trading system of the future is supportive of national and global efforts to promote innovation.

There is no single overarching WTO agreement that deals with innovation. Figure 2 below, therefore identifies a number of policies and measures that are commonly pursued by governments to promote innovation and the corresponding relevant WTO agreement/rules. It illustrates that innovation-related policies and measures span a wide range of WTO disciplines and rules relating to subsidies, intellectual property, investment, trade in services and government procurement.

1 Stephen Ezzel, A Bretton Woods for Innovation, World Policy Journal, Fall 2011 http://www.worldpolicy.org/journal/fall2011/ bretton-woods

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Figure 2. Innovation related policies/measures and WTO agreements/rules Innovation related policy/measure

Relevant WTO agreement/rules

Domestic R&D support and incentives (subsidies, SCM Agreement tax breaks ) Agriculture Agreement Protection and enforcement of intellectual property TRIPS Agreement rights Commercialization of publicly funded research

TRIPS Agreement

Know how and technology transfer

GATS, TRIMS, TRIPS

Government procurement

GATT, TRIMS

Agreement on Government Procurement Technical Standards

GATT, TBT Agreement

Competition policy

TRIPS Agreement, TRIMS

Policy and regulatory frameworks and general Aid for Trade infrastructure As can be seen from Figure 2, innovation-related policies and measures span a wide range of the WTO disciplines and rules relating to subsidies, intellectual property, investment and government procurement.

As a large and rapidly growing body of firm-level trade theoretical and empirical papers show it appears to be increasingly, clear that trade is a driver of innovation and technology adoption.

The OECD synthesis summarizes as follows: “First, imports and foreign direct investment (FDI) as well as trade in technology serve as channels of technology diffusion. Second, imports, FDI and technology licensing contribute to intensifying competition, which can affect incentives for innovation. Third, exports can affect innovation as it serves as a learning opportunity and gives incentives for innovative activities.”2 While leading-edge science and innovation is essential, innovation well inside the frontier is also essential. Trade in this case is a great enabler.

A simple example suffices. A Stanford-educated Ethiopian, Eleni Gabre-Madhin, observed how difficult it was for rural Ethiopian growers to find buyers, for buyers to find sellers, and for contracts to be settled and enforced. In a land lacking market infrastructure, surpluses of grain were not matched to needs in drought-stricken parts of the countries and millions died while Ethiopia turned to the international community for aid. Her innovation? The Ethiopian Commodity Exchange, the first such in Africa, which is cell-phone driven, has expanded its reach to 2.4 million participants

in four years, and now fields 1.2 million calls per month for price information which in turn spreads through local markets.3 And in the absence of a full rural electric grid – solar powered phones are used. Education, exports, cellphone imports, foreign direct investment in infrastructure and local innovation (or was it simply only imitation?) combined to allow Ethiopian agriculture to make a quantum leap forward in meeting the needs of one of the world’s hungriest countries.

In mainstream economics, however acknowledgement of the role of innovation has come relatively late, almost grudgingly, and still remains relatively undigested. This undoubtedly reflects the fact that it is hard to measure. Economists are more comfortable with assessing the growth impact of labour, capital and “productivity” than with coming to grips with innovation, which rests uncomfortably in our discipline as a black box,4 or perhaps better as a dark zone around which economists circle, inferring what is going on inside through the evidence of R&D spending going in, patents, copyrights or other intellectual property or scientific papers and citations coming out, the emergence of new products at the extensive margin of trade as evidence that it indeed happened, or a change in behaviour of firms associated with innovators as evidence that it spilled over. Literature has developed about how to manage it, the nature of industrial districts in which it emerges, and the framework conditions that governments might put it place to nurture it. And rent-seekers have developed various ways to exploit it without actually contributing to

2 Nobuo Kiriyama. 2012. “Trade and Innovation: Synthesis Report”, OECD Trade Policy Papers, No. 135, Abstract.

3 “How Africa’s first commodity exchange revolutionised Ethiopia’s economy,” The Guardian 13 December 2012.

4 The classic black box is of course the Solow residual.

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it. Innovation remains, therefore, very much a mystery.

intellectual property (which is generally treated as “liberalization”) serve to reinforce this link.

There are some stylized facts that are worth noting, however.

It is possible that these simple conclusions are not tenable given the complexity of the innovation and trade nexus. The key question for this Expert Group and others is whether there are tractable ways to address these issues? Several observations may be made in this regard.

• First, the various indicators associated with innovation are poorly correlated. Intellectual property rights, as one imperfect indicator among many, have no particular claim to identity with innovation.

• Second, just as firms are highly heterogeneous, so are returns to patents and other forms of intellectual property. For example, data from university technology offices shows that most income is derived from one lucky hit. The vast bulk of intellectual property rights issued by national authorities and protected under TRIPs appear, upon analysis, to be largely worthless.

• Third, the amalgam of research and development is unfortunate. Most research is done in the public sphere; most development is done in the corporate sphere. An emphasis on corporate “R&D” vs. public “R&D” thus results in an imbalance in the allocation of effort, ignoring the research that ultimately feeds the development.

• Fourth, the gains from imitation (as the Ethiopian example cited above shows) can be huge.

• Fifth, abuse possible.

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In the modern theoretical framework for trade (e.g., Melitz, 2003), which has incorporated firmlevel innovation as a central feature in explaining empirical regularities in the size distribution and export orientation of firms, innovation remains as noted above a black box, treated as an exogenous technology “draw”, a gamble that firms must regularly take and which determines their prospects for survival, but over which firms have no control (at least in economic theoretical terms).

At the same time, the policy conclusions that have emerged from the review of trade and innovation boil down to two remarkably simple propositions: there is positive link between innovation and trade, and trade liberalisation and protection of

The theoretical foundations of the GATT/ WTO The GATT and WTO Agreements were built on the intellectual foundations of what might be termed “traditional” trade theory, together with “new” trade theory, and an admixture of the theory of multinational enterprises – Krugman and Helpman (1996) provide the textbook-ready treatment of trade and investment theory at the time that the most recent WTO Agreements were conducted and signed. Innovation was only indirectly and weakly represented in this theory – and this is reflected in the weak and indirect way in which innovation was addressed in the Agreements. Since 2003, trade theory has been totally renovated; today, we think about trade in terms of “new new trade theory”, which emphasizes the role of firms in trade and which incorporates dynamic innovation-driven theories of the firm from the industrial organization literature. If the WTO is to disprove Keynes’ dictum concerning practical people being slaves of defunct economists, its foundational articles must be reviewed in light of the new theory. Accordingly, one central point of departure for our current Expert Group would be to conduct an in-depth review of the implications for the WTO instruments listed above in Figure 2 of the “new new” trade theory from the perspective of how they affect innovation.5

The Respective Roles of the Market and Public Spheres in Innovation The prevailing trade rules were framed with the perspective that the purely private good (in the sense of a good that has no externalities) was in some sense the “norm” and externalities were an “aberration” or “market failure” to be addressed on a case-by-case basis. In this world (as noted by Sykes, 2005), there is a presumption against public sector involvement in any sphere of human activity, given the deadweight cost of taxes to fund such intervention. At the same

5 See, for example, Dan Ciuriak, Beverly Lapham, and Robert Wolfe, with Terry Collins-Williams and John M. Curtis. 2011. “New-new trade policy,” QED Working Paper, Queen’s Economics Department (2011); at http://ssrn.com/abstract=1814226.

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time, the innovation literature makes clear that private “R&D” is mostly “D” with very little “R”.

Accordingly, the premises that have underpinned the WTO Agreements have inevitably safeguard the “D” but impeded the “R” – to the extent it actually is carried out in this “R”-unfriendly environment. But since the “D” happens at the “end of the pipe” and depends on the “R” which provides the feedstock at the “front of the pipe”, the system is internally incoherent. It is essential within our Expert Group to functionally distinguish between “R” and “D” such that the former, which tends to be performed almost exclusively on the basis of public funding, is in no way discouraged by trade rules. This might involve a re-opening of the idea of a “green box” for a category of public activities that would otherwise be impugned as “subsidies”.

Intellectual Property Disciplines: Constraining the Patent Mill As a perhaps unintended consequence of the recognition of the role of innovation in driving economic growth, there has been almost an obsession with the metrics of innovation – including patents applied for and issued, . Overworked patent offices are faced with a deluge of applications which they must assess for prior art, whether there is a non-obvious innovative step, and other criteria. There are numerous “horror stories” that attest to the fact that all too often patent offices in particular are failing – badly – in terms of issuing patents for “innovations” for which there is well-established prior art, or which involve no innovative step. The value of patents is highly skewed (the weight of evidence suggests a log normal distribution and possibly an even more highly skewed Pareto-Levy distribution), but the threat of legal action by “patent trolls” has resulted in massive amounts of money being spent on “cross-licensing” of the non-performing tail, which is little more than insurance against bad legal judgements being handed down by courts to transfer wealth to the trolls. TRIPS provisions within the WTO, for example commit countries to grant patents in all fields of technology without safeguards to ensure ‘patent quality’ and guard against the proliferation of ‘trivial ‘patents. Here, the WTO can serve its classical role as a means of disciplining domestic policy against abuses, but not as commonly portrayed by increasing enforcement of IP rights, but rather by erecting disciplines on the granting of such rights.

Our Expert Group could launch a debate on these critical issues by attempting to provide guidance on how to better fulfill the principal objectives of TRIPS (“the protection and enforcement of intellectual property rights should contribute to the promotion of technological innovation and to the transfer and dissemination of technology, to the mutual advantage of producers and users of technological knowledge and in a manner conducive to social and economic welfare, and to a balance of rights and obligations.”

Quantitative Assessments of Intellectual Property Rights Protection in Trade Agreements The characterization of an increase in intellectual property rights protection as “liberalization” is at best awkward. Within national systems, the grant of intellectual property rights is understood as a necessary evil to induce the publication of what would otherwise be trade secrets and more generally to promote dissemination and as well as to induce more effort with respect to further innovation than would otherwise take place. But it is not liberalization. In trade this characterization has implications for experimental design.

At the TRIPS Council session of November 2012, Brazil and the United States took the joint initiative of adding an agenda item on the Council’s deliberations on “intellectual property and innovation,” The stated objective was to achieve a better understanding of the relationship between intellectual property rules and the much broader concept of innovation. At the same session, Brazil noted that high standards of intellectual property do not translate automatically into greater innovation, calling for an assessment of TRIPS implementation twenty years after its adoption to determine its impacts on countries, including on innovation. In its statement, the US outlined elements of an innovation strategy encompassing IP and non-IP aspects.

The Digital Environment and Innovation The Internet revolution and the digital environment have spurred a significant amount of innovative activity that has had spillover effects on many sectors of the economy. For a growing group of countries – both developed and developing - digital goods and services have become an important engine of economic growth.

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A number of industry groups such as the US National Foreign Trade Council (NFTC) argue that WTO rules are outdated and need to be updated to deal with this significant development. They underline, in particular, the need for clarifying and improving international rules and frameworks for trade in digital goods, services, and information. For instance, suggestions have been made by such groups to examine the development of a plurilateral innovation framework for rules governing goods and services market access, e-commerce, transparency, government procurement and cyber-security.

Some industries have also mobilized to advocate in favour of new national legislation domestically (e.g., SOPA and PIIPA in the US) and internationally (through a plurilateral Agreement such as ACTA) to achieve stronger enforcement rules against counterfeiting and piracy in the digital environment. Thus, the key question to be posed for our Expert Group and perhaps others is what role for the international system and particularly for WTO in this field?

Industrial Policy and Innovation To advance industrial policy objectives and build innovative capacities, there is a growing resort by some countries to measures such as mandatory technology transfer requirements, national preference schemes in government procurement and local content requirements, particularly in areas such as renewable energies. To what extent are such measures consistent with WTO rules and

what is the space provided by the WTO system to pursue such objectives?

The Benefits of Free Public Goods for Innovation: The World Bank’s Open Data Initiative Anecdotally, it may be observed that one of the biggest differences in the lives of the rich and the poor is the massive amounts of public goods to which the rich have access and the virtual absence of such for the poor (e.g., public economic infrastructure). It is true that, at the margin, if something can be commercialized – that is access can be restricted and a price put on it – that there is more measured output. The question is: is the measured output greater than the un-measured output that is foregone?

LDCs and Innovation As noted earlier, technological and innovative capacities in many LDCs remain weak and limited, although there are encouraging counter examples such as Ethiopian case referred to above. For LDCs, usually characterised by low flows of international trade and investment as a proportion of GDP, the trade system does not appear to spur the kind of technological diffusion witnessed in middle income and emerging economies. It is widely acknowledged that Article 66.2 of TRIPS, which is the multilateral trading system’s core response to the specific needs of LDCs, has yielded little for its intended beneficiaries. More research here and elsewhere needs to be done.

e15initiative.org

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