Corporate Governance, Finance and the Technological Advantage of Nations (Routledge Studies in Global Competition)

Corporate Governance, Finance and the Technological Advantage of Nations

There is much debate regarding which countries’ economies have the best economic systems to encourage economic growth and technological change. This book is a major contribution to this discussion, connecting the fields of corporate governance and finance with the field of innovation and technology and analysing the ways in which countries’ systems of corporate governance affect firms’ ability to meet the technological challenges of different sectors. Tylecote and Visintin combine incisive analysis with empirical studies of systems of corporate governance in the US, Europe, East Asia and China, demonstrating how these systems vary and how the demands on those who control and finance industry are changing. The authors argue that while certain types of system have worked for particular sectors, the technological revolution through which we are passing demands innovation in corporate governance and finance. Indeed, this book goes some way to challenge accepted views of best practice in corporate governance and finance, showing how structures and rules intended to advance ‘shareholder value’ may undermine it by inhibiting technological change. This book will be required reading for students and researchers engaged with corporate governance and national business systems, as well as those interested in systems of innovation. Andrew Tylecote is Professor of the Economics and Management of Technological Change at the University of Sheffield. Francesca Visintin is Associate Professor in the Department of Economics at the University of Udine.

Routledge studies in global competition Edited by John Cantwell University of Reading, UK and

David Mowery University of California, Berkeley, USA

1 Japanese Firms in Europe Edited by Frédérique Sachwald 2 Technological Innovation, Multinational Corporations and New International Competitiveness The case of intermediate countries Edited by José Molero 3 Global Competition and the Labour Market Nigel Driffield 4 The Source of Capital Goods Innovation The role of user firms in Japan and Korea Kong-Rae Lee 5 Climates of Global Competition Maria Bengtsson 6 Multinational Enterprises and Technological Spillovers Tommaso Perez 7 Governance of International Strategic Alliances Technology and transaction costs Joanne E. Oxley

8 Strategy in Emerging Markets Telecommunications establishments in Europe Anders Pehrsson 9 Going Multinational The Korean experience of direct investment Edited by Frédérique Sachwald 10 Multinational Firms and Impacts on Employment, Trade and Technology New perspectives for a new century Edited by Robert E. Lipsey and Jean-Louis Mucchielli 11 Multinational Firms The global–local dilemma Edited by John H. Dunning and Jean-Louis Mucchielli 12 MIT and the Rise of Entrepreneurial Science Henry Etzkowitz 13 Technological Resources and the Logic of Corporate Diversification Brian Silverman

14 The Economics of Innovation, New Technologies and Structural Change Cristiano Antonelli 15 European Union Direct Investment in China Characteristics, challenges and perspectives Daniel Van Den Bulcke, Haiyan Zhang and Maria do Céu Esteves 16 Biotechnology in Comparative Perspective Edited by Gerhard Fuchs 17 Technological Change and Economic Performance Albert L. Link and Donald S. Siegel 18 Multinational Corporations and European Regional Systems of Innovation John Cantwell and Simona Iammarino 19 Knowledge and Innovation in Regional Industry An entrepreneurial coalition Roel Rutten 20 Local Industrial Clusters Existence, emergence and evolution Thomas Brenner 21 The Emerging Industrial Structure of the Wider Europe Edited by Francis McGowen, Slavo Radosevic and Nick Von Tunzelmann

22 Entrepreneurship A new perspective Thomas Grebel 23 Evaluating Public Research Institutions The U.S. Advanced Technology Program’s Intramural Research Initiative Albert N. Link and John T. Scott 24 Location and Competition Edited by Steven Brakman and Harry Garretsen 25 Entrepreneurship and Dynamics in the Knowledge Economy Edited by Charlie Karlsson, Börje Johansson and Roger R. Stough 26 Evolution and Design of Institutions Edited by Christian Schubert and Georg von Wangenheim 27 The Changing Economic Geography of Globalization Reinventing space Edited by Giovanna Vertova 28 Economics of the Firm Analysis, evolution and history Edited by Michael Dietrich 29 Innovation, Technology and Hypercompetition Hans Gottinger 30 Mergers and Acquisitions in Asia A global perspective Roger Y.W. Tang and Ali M. Metwalli

31 Competitiveness of New Industries Institutional framework and learning in information technology in Japan, the U.S. and Germany Edited by Cornelia Storz and Andreas Moerke

34 Risk Appraisal and Venture Capital in High Technology New Ventures Gavin C. Reid and Julia A. Smith

32 Entry and Post-Entry Performance of Newborn Firms Marco Vivarelli

36 Corporate Governance, Finance and the Technological Advantage of Nations Andrew Tylecote and Francesca Visintin

33 Changes in Regional Firm Founding Activities A theoretical explanation and empirical evidence Dirk Fornahl

35 Competing for Knowledge Creating, connecting and growing Robert Huggins and Hiro Izushi

Corporate Governance, Finance and the Technological Advantage of Nations Andrew Tylecote and Francesca Visintin

First published 2008 by Routledge 2 Park Square, Milton Park, Abingdon, Oxon OX14 4RN Simultaneously published in the USA and Canada by Routledge 270 Madison Ave, New York, NY 10016 This edition published in the Taylor & Francis e-Library, 2007. “To purchase your own copy of this or any of Taylor & Francis or Routledge’s collection of thousands of eBooks please go to www.eBookstore.tandf.co.uk.” Routledge is an imprint of the Taylor & Francis Group, an informa business © 2008 Andrew Tylecote and Francesca Visintin All rights reserved. No part of this book may be reprinted or reproduced or utilised in any form or by any electronic, mechanical, or other means, now known or hereafter invented, including photocopying and recording, or in any information storage or retrieval system, without permission in writing from the publishers. British Library Cataloguing in Publication Data A catalogue record for this book is available from the British Library Library of Congress Cataloging in Publication Data A catalog record for this book has been requested ISBN 0-203-93388-5 Master e-book ISBN ISBN10: 0-415-11221-4 (hbk) ISBN10: 0-203-93388-5 (ebk) ISBN13: 978-0-415-11221-5 (hbk) ISBN13: 978-0-203-93388-6 (ebk)

For all my sons ABT For Matteo FV

Contents

List of figures List of tables Preface and acknowledgements 1

Introduction: the role of corporate governance and finance in innovation

xiii xiv xvii

1

1.1 How do nations get technological advantage? 1 1.2 How can one classify and assess national systems of finance and corporate governance? 5 1.3 Financing and controlling technological change: the challenges 8 1.4 The demands of technological change on the finance and corporate governance system (FCGS) 11 1.5 Who controls firms, what are their objectives, and why should it matter? 15 1.6 Autonomy, stewardship and stakeholders 21 1.7 Technological regimes and technological revolutions 25 1.8 What this book sets out to do 26

2

How sectors vary in their requirements from the system of corporate governance and finance 2.1 2.2 2.3 2.4 2.5 2.6 2.7 2.8

Introduction 31 Opportunity and need for reconfiguration 33 Visibility and appropriability 34 Changes over time 35 How scale matters 36 The high-technology sectors 37 The medium-high-technology sectors 50 Conclusion 60

31

x

3

Contents

How national systems of corporate governance and finance vary

63

3.1 Introduction 63 3.2 The shareholder–manager relationship 64 3.3 The manager–manager relationship 67 3.4 The role of employees 68 3.5 Our four categories 71 3.6 Poles of control; or, where does stakeholder capitalism come from? 72 3.7 Directness of control and degree of managerial autonomy 73 3.8 Mainland China, Taiwan and Italy 74 3.9 Family capitalism and what remained of it near the end of the twentieth century 75 3.10 Financial systems and the match with corporate governance 81 3.11 Financial systems: the evidence 85 3.12 Conclusion 87 Appendix 90

4

Corporate governance, finance and innovation in the US, the UK, and Switzerland

92

4.1 Introduction 92 4.2 The United States: more direct control than meets the eye 92 4.3 The UK: families fade, and the City rules 96 4.4 Switzerland: an oligarchy of families? 102 4.5 Corporate governance and technological advantage: what would one expect? 105 4.6 The high-technology sectors 107 4.7 The medium-high-technology sectors 121 4.8 Conclusion 126

5

Corporate governance, finance and innovation in Japan, Germany, and Sweden 5.1 Introduction 127 5.2 Germany: how stakeholder structures developed 127 5.3 Japan: how stakeholder understandings developed 129 5.4 Sweden: stakeholder capitalism gained and largely thrown away 131

127

Contents

xi

5.5 Stakeholding capitalisms compared 133 5.6 Corporate governance and technological advantage: what would one expect? 134 5.7 The high-technology sectors 137 5.8 The medium-high technology sectors 145 5.9 Conclusion 151

6

Corporate governance, finance, and innovation in France and Korea

152

6.1 State-led capitalism – changing fast 152 6.2 France 152 6.3 Korea 157 6.4 Corporate governance and technological advantage – what would one expect? 161 6.5 The high-technology sectors 165 6.6 The medium-high-technology sectors 177 6.7 Conclusion 182

7

Corporate governance, finance, and innovation in Italy and Taiwan

184

7.1 Introduction 184 7.2 Italy 184 7.3 Taiwan 190 7.4 Corporate governance and technological advantage, what would one expect? 195 7.5 The high-technology sectors 196 7.6 The medium-high-technology sectors 202 7.7 Conclusion 207

8

Corporate governance, finance, and technological development in mainland China 8.1 The new China: state and family capitalism, separate and together 208 8.2 The financial handicaps of the private sector 209 8.3 How the governance flaws of state-owned firms affect managerial behaviour 211 8.4 How finance and corporate governance undermined Chinese technological development 215 8.5 The evidence 217

208

xii

Contents 8.6 The outsiders: why their corporate governance works and why there are not more of them 218 8.7 The outcomes: strengths and weaknesses of Chinese businesses 220

9

Looking forward: current trends, future prospects, and modest proposals

223

9.1 Introduction: shareholder capitalism triumphant? 223 9.2 The performance of the competing systems 226 9.3 Corporate governance and stakeholder inclusion in a time of technological revolution 228 9.4 Current trends in governance 234 9.5 A prescription for ‘hybrid’ corporate governance 238

Statistical appendix

244

Notes Bibliography Index

262 272 299

Figures

1.1 1.2 2.1 3.1 4.1 4.2 6.1 7.1 A1 A2 A3

Manufacturing trade balance (2001) Revealed technological advantage (1990–1999) Average size of firms (1999), by number of employees Employee protection and length of employment Relevance of biotech for discovery activity in pharmaceuticals Market share of the best selling new medicines, by country in which the main providing firm is based Production in sector X/total production. Year 2000 R&D spending as a percentage of GDP: Italy, Taiwan, EU Weight of each sector in each country’s value added (2000) Distribution of employees by sector among firms by nationality, 2001 Proportion of total R&D spending devoted to each sector

2 3 38 69 112 112 178 188 260 260 261

Tables

1.1 1.2

Types of corporate governance and financial system Dimensions of technological regimes and financial and corporate governance systems 2.1 High-technology and medium-high-technology industries 2.2 Determinants and indicators of challenges of technological change for finance and corporate governance 2.3 Characteristics of technological change in high-technology manufacturing sectors 2.4 Top ten world software producers, turnover in FFm. 1997 2.5 Characteristics of technological change in medium-hightechnology manufacturing sectors 2.6 Broad-brush synthesis of findings 3.1 Insider- and outsider-dominated financial systems: the stereotypes 3.2 Soskice’s measures of business coordination, 1970s–1980s 3.3 Enterprise-level codetermination: employee representation on company boards, c.2000 3.4 Systems categorised by labour market/labour relations character 3.5 Corporate governance types by ‘polarity’ of control 3.6 Trust, by country 3.7 Comparative stock market capitalisation (as a percentage of GDP, late 1996) 3.8 Ultimate control of publicly-traded firms, 1996–1999 3.9 Ownership concentration and identities in large listed firms, 1990s 3.10 Ownership of listed stocks by sector 3.11 Countries by flow of Venture Capital Investment, 1999 3.12a Structure of net financing of non-financial enterprises, 1980–1990 3.12b Debt to equity ratios, 1980–1991 3.12c Structure of net financing of non-financial enterprises, 1970–1989 3.13 Business enterprise expenditure on R&D (BERD) as a percentage of value added in industry

6 15 32 34 39 48 53–54 61 65 67 70 71 73 76 77 78 79–80 81 83 86 86 86 90

Tables xv 3.14 3.15 4.1 4.2 4.3 4.4 4.5 4.6 4.7 4.8 4.9 4.10 5.1 5.2 5.3 5.4 5.5 5.6 5.7 5.8 5.9 5.10 6.1 6.2 6.3 6.4 6.5 6.6 6.7 6.8 6.9 6.10 7.1 7.2

Distribution of employment in manufacturing by size class (1999) Selected data from European Innovation Scoreboard 2001 Characteristics of shareholder capitalisms, early 1990s Aerospace: US, UK, and Switzerland Pharmaceuticals: US, UK, and Switzerland Office, accounting and computing machinery: US, UK, and Switzerland Radio, television and communication equipment: US, UK, and Switzerland Top ten world software producers, turnover in FFm. 1997 Software and IT services: US, UK, and Switzerland Chemicals: US, UK, and Switzerland Machinery and equipment not elsewhere classified: US, UK, and Switzerland Automotive: US, UK, and Switzerland Ranking of ‘lack of appropriate sources of finance’ as a factor hampering innovation, 1990–1992 Characteristics of stakeholding capitalisms, late 1980s Aerospace: Japan, Germany, and Sweden Pharmaceuticals: Japan, Germany, and Sweden Office, accounting and computing machinery: Japan, Germany, and Sweden Radio, television and communication equipment: Japan, Germany, and Sweden Software and IT services: Japan, Germany, and Sweden Chemicals: Japan, Germany, and Sweden Machinery and equipment not elsewhere classified: Japan, Germany, and Sweden Automotive: Japan, Germany, and Sweden Characteristics of state-led capitalisms, mid-1980s Aerospace: France and Korea Pharmaceuticals: France and Korea Foreign share of electronic output and exports (US$ million) in South Korea Office, accounting and computing machinery: France and Korea Radio, television and communication equipment: France and Korea Software and IT services: France and Korea Chemicals: France and Korea Machinery and equipment not elsewhere classified: France and Korea Automotive: France and Korea Characteristics of family/state capitalisms Aerospace: Italy and Taiwan

91 91 105 109 111 117 118 120 120 121 123 125 129 134 137 138 142 142 144 145 147 150 161 166 169 170 171 171 176 178 179 181 195 197

xvi 7.3 7.4 7.5 7.6 7.7 7.8 7.9 7.10 8.1 A1 A2 A3 A4 A5 A6 A7 A8 A9 A10 A11

Tables Pharmaceuticals: Italy and Taiwan 198 Taiwan’s world market share in electronic products (2003) 200 Office, accounting and computing machinery: Italy and Taiwan 200 Radio, television and communications equipment: Italy and Taiwan 201 Software and IT services: Italy and Taiwan 202 Chemicals: Italy and Taiwan 203 Machinery and equipment not elsewhere classified: Italy and Taiwan 204 Automotive: Italy and Taiwan 206 Advantages and disadvantages of types of ownership in mainland China 214 Synthesis of data for Aerospace 246 Synthesis of data for Pharmaceuticals 247 Synthesis of data for Office, accounting and computing machinery 248–249 Synthesis of data for Radio, television and communication equipment 250–251 Synthesis of data for Software and IT services 252 Synthesis of data for Chemicals 253 Synthesis of data for Machinery and equipment not elsewhere classified 254 Synthesis of data for Electrical machinery and apparatus 255 Synthesis of data for Automotive 256 Pattern of specialization in the production of machine tools 257 Revealed technological advantage, various periods 258–259

Preface and acknowledgements

It is a very odd thing, in a capitalist system, that it should be necessary to argue that profit, capital, and the power of those who own it, are important. Our economies are driven by firms, which are set up with capital, and absorb more. Making a profit is probably their central purpose and certainly their central requirement. Accordingly, their chief financial officers play a crucial governance role in everything they do – including innovation and technological change. Often that role is negative. When we have gone into big firms and talked to the middle managers who really know how technological change takes place there, most had a story to tell of how the CFO had inhibited or distorted it by his requirements for return on capital or cash flow. Yet turn to almost any textbook on the economics of technological change, or technology management, and you will be in another world. The CFOs, and the shareholders they represent, have disappeared. Profit and cash flow as aim and constraint are scarcely mentioned. Corporate governance is not mentioned at all. In smaller firms it is most obviously external finance which constrains or directs their technological change. This is not ignored in the technology literature. But most of the scholars who have written on it have looked at the financing with venture capital of the new high-tech elite – a subset of a much more general issue. What holds for firms holds for nations. We show in this book how the technological advantage of nations – their overall performance and their pattern of specialisation – has been, and is being, profoundly affected by their finance and corporate governance systems, broadly defined. There is a community of scholars, to which we belong, which works on national systems of innovation. All of us accept that a country’s science base, labour markets, and government policy play important roles in its system of innovation. These roles are by now far better understood than those of finance and corporate governance, which remain neglected areas in the NSI literature. We are also members of the finance and corporate governance academic communities, who need no persuasion of the importance of money and power. Many there have written well on the effect of finance and corporate governance on firms’ and even countries’ performance. Some have even addressed themselves to their effects on technological change. But they look at technology

xviii Preface and acknowledgements from a distance, and rarely if at all do they get to grips with it. Financing and controlling technological change is really very different from ordinary investments. The special nature of technological change is not only a problem for academics. It is one that dogs those who try to make money out of it in the real world. That is in one way easier, in another a great deal more difficult, now than it was (say) 30 years ago, because since then a technological revolution has hit us, which is still raging. Information and communication technology has presented us with a new paradigm of technological advance. On the one hand, this means a wealth of new technological (and commercial) opportunities, compared to what there were 30 years ago. On the other hand, there is not really an established way of making money out of them. In fact, as everyone knows, a great deal of money was lost by those who hurried to exploit them in the boom years of the late 1990s. A central problem is that in order to make money out of those opportunities, we know that most of our investment has to be in intangible, intellectual capital. Henry Ford and those who followed him had it much easier, raising money mostly for equipment, assets that accountants could enter in a balance sheet and a suspicious investor or financier could see. It is not easy to finance and govern what needs to be invested in technological change now. The result is underinvestment. In the face of a cornucopia of opportunity, the rate of investment in developed countries is low by historical standards. This represents not only a missed opportunity, but a real macroeconomic danger. Demand in the developed world is being maintained largely by the consumers and government of the United States, and to a lesser extent the United Kingdom, spending more than they earn. Colour has been put back into the pallid cheeks of the German and Japanese economies by demand for equipment from China, which is spending to catch up. If and when either of these locomotives falters – let alone both – deep recession must follow, unless in the meantime we have hitched up the best locomotive of all. So a discussion of this subject needs to be both backward-looking and forward-looking. What worked in this or that sector even in the recent past will not necessarily work even in the near future. The book concludes by sketching the sort of changes needed to construct financial and corporate governance systems that can cope with the new challenges. We wish to acknowledge the help and advice of those who commented on draft chapters or on elements of the book presented at seminars and conferences too numerous to list, and that our colleagues on the EU COPI project. Notably we thank Sergio Albertini, Andrea Baruzzo, Robert Boyer, Cai Jing, Steve Casper, Cristiana Compagno, Gao Xudong, Marc Goergen, Louis Goldish, Anna Grandori, Gu Shulin, Liu Jiajia, Lu Feng, Bengt-Åke Lundvall, Stuart Macdonald, Ferdinando Maraschini, Jacques Mazier, Bart Nooteboom, Paolo Omero, Pascal Petit, Daniel Pittino, Paulina Ramirez, Felix Schmid, Urs Schöttli, Su Yuezhen, Tu Jun, Nick von Tunzelmann, Franz Waldenberger, Sean Wang, Richard Whitley, and Wu Guisheng. The usual disclaimer applies with more than usual force: we apologise for the limited extent to which we were able to

Preface and acknowledgements

xix

act on excellent advice. We hope friends and colleagues will not feel they cast pearls before swine. At this point it is customary to express appreciation and offer apologies to exploited spouses and neglected children. We shall not do so. On the contrary, we declare that the writing of this book has not involved or caused any suffering by defenceless family members. Unfortunately, somebody always has to pay a price for high ethical standards. In this case that has fallen to a succession of Routledge editors, over the years (we shall not disclose how many). To Alison Kirk, Alan Jarvis, Robert Langham, Terry Clague and Thomas Sutton, we now say, sorry, thanks for the tactful nagging, and we trust it was worth the wait. Parts of Chapter 1 draw on Andrew Tylecote, ‘The role of finance and corporate governance in national systems of innovation’, Organization Studies, September 2007. Parts of Chapter 3 draw on Andrew Tylecote and Francesca Visintin, ‘A new taxonomy of national systems of corporate governance’, in: Lars Mjøset and Tommy H. Clausen (eds) Capitalisms Compared, Comparative Social Research, vol. 24 (Amsterdam: Elsevier JAI, 2007), pp. 71–122. Parts of Chapter 9 draw on Andrew Tylecote, ‘Organisational structure and the diffusion of new forms of corporate governance in Europe’, in: E. Lorenz and B.Å. Lundvall (eds) How Europe’s Economies Learn – Co-ordinating Competing Models (Oxford: Oxford University Press, 2006), ch. 8 pp. 178–202. Acknowledgement is given to, respectively, Sage, Elsevier and OUP, for their permissions to reproduce the above material. We also acknowledge the financial support of the European Union through the Targeted Socio-Economic Research programme.

1

Introduction The role of corporate governance and finance in innovation

1.1 How do nations get technological advantage? The aim of this book is to show how far a set of institutions and relationships, which we call corporate governance, together with a closely related set, which we call finance, can go to explain the technological advantage of nations. Corporate governance we will define simply as who controls firms, and how – although that begs many questions, which will be answered later in this chapter and in Chapter 3. Finance is probably clear enough for the moment. The technological advantage of nations, we will dwell on now. The phrase recalls Michael Porter’s book on The Competitive Advantage of Nations, as it was intended to. Porter asked, as we ask, why does one country do better in industry A and another in industry B? And why do some do better overall? But we refer to technological advantage. Technological innovation is one of the driving forces of modern capitalism, and arguably the main one. We do not mean by this that those who develop or first introduce a new technology are necessarily those who dominate the economy. The race may go not to the technologically strongest, but to those with the sharpest commercial nose, or the best organised to exploit the new technology. Google did not invent or introduce the search engine but they thought of a refinement that would help it to serve the searcher better. Dell have done little to make computers better, but they were the first to introduce the techniques of e-business effectively for selling them and (starting from the sale) organising the supply chain. Both firms needed to master one or more novel areas of information and communication technology (ICT) in order to introduce their ‘commercial’ or ‘organisational’ innovations. For us, that is technological enough. So our measures of technological advantage will not be only the production of new technology, as measured (very imperfectly) by rates of patenting. We shall also look at countries’ levels of production, and their trade balances, in sectors which can be defined as technologically demanding. The pattern of specialisation as shown by trade balances (as percentage of sector output: Figure 1.1) is broadly the same as that shown by relative patenting rates (otherwise known as Revealed Technological Advantage – Figure 1.2); that is, if a country has a trade surplus in sector X, then (out of all the patents taken out from that

2

Introduction Italy

France

Sweden

Japan

Germany

Switzerland

UK

US 6

4

2

Motor vehicles Radio, television, and communication equipment

0

2

Electrical machinery Office, accounting, and computing machinery

4

6

8

10

Machinery and equipment

Chemicals

Pharmaceuticals

Aerospace

Figure 1.1 Manufacturing trade balance (2001) percentage of output (source: OECD (2003a)).

country) the proportion of them relating to sector X is likely to be relatively high compared to other countries. (For definitions of these measures see Statistical Appendix.) Thus, on both measures Japan and the United States are very strong in various areas of ICT hardware; Germany and Japan lead in motor vehicles; Germany, Japan and Italy lead in non-electrical machinery; Germany leads in chemicals. In a few rather ‘globalised’ industries this is not the case. In pharmaceuticals the US is strong on relative patenting but not on trade performance. This does not mean that patenting is a poor indicator of technological prowess in pharmaceuticals or that technological strength does not lead to commercial success there: it shows mainly that US firms often find it convenient to supply the huge US market with medicines they manufacture elsewhere.

Introduction

Italy

3

Motor vehicles Electrical machinery

France

Machinery and equipment Chemicals

Sweden Radio, television, and communication equipment Japan Office, accounting, and computing machinery Germany Pharmaceuticals Aerospace Switzerland

UK

US

0

1

2

3

Figure 1.2 Revealed technological advantage (1990–1999) (source: authors’ calculations on www.nber.org/patents (see Statistical Appendix)).

But are countries, or nations, the right level to consider technological advantage at? Do countries innovate? No, the main unit that can be said to innovate in a capitalist economy, is the firm. Still, firms are not isolated units: they compete and cooperate with others, and they have connections with other institutions of various kinds. Their interactions are particularly important in innovation, since innovation revolves around learning, and learning, as argued by Bengt-Åke Lundvall (1992: 1), ‘is predominantly an interactive and therefore socially embedded process which cannot be understood without taking into consideration its institutional and cultural context’. We have then to consider systems of innovation. The first problem is where to set the boundaries of those systems. The early writings on systems of innovation were on national systems of innovation. The first book on the subject was Christopher Freeman’s (1987) on Japan, although Freeman gracefully conceded first use of the term to Lundvall.1 There were two

4

Introduction

key early edited works on national systems: Lundvall’s (1992) National Systems of Innovation: Towards a Theory of Innovation and Interactive Learning and Richard Nelson’s (1993) National Systems of Innovation: A Comparative Study. Even in a globalising world economy, there are factors that vary more among countries than within them – conditioning factors like consumer tastes; supportive factors like educational systems and research institutions. The interactions that are key to innovation – cooperation between firms and research institutions, collaborations among firms, rivalry and imitation among them – take place more frequently and intensely where geographical and cultural distances are short. And the national state even now can play an important role in the direction and rhythm of technological innovation (Niosi et al. 1993; Patel and Pavitt 1994; Freeman 1995; Edquist 1997). Other authors place a major emphasis on regional systems of innovation, where regions might cross national borders or be part of a wider national system. For example Braczyk et al. (1998) trace the history and the structural characteristics of 14 regional systems of innovation. Useful as this work is, most would accept it as something of a supplement to that on national systems. Both these approaches are geographical in the definition of space. The alternative is to divide the world economy by type of activity. That can be done in two different planes, vertical (following chains of production which connect producers to users), and horizontal (looking at a particular sector such as pharmaceuticals or steel). There are accordingly two competing approaches. The Technological Systems of Innovation approach (Carlsson and Stankiewicz 1991) emphasises cooperative relationships, many of which are in the vertical plane of interaction. Sectoral Innovation Systems, on the other hand ‘focuses on competitive relationships among firms by explicitly considering the role of selection environment’ (Breschi and Malerba 1997: 131). In other words, competition among the firms in a sector helps to determine which innovation emerges victorious. The other firms with which the firm relates – cooperatively as well as competitively – may well of course be foreign, and in a globalising world a sectoral innovation system will certainly extend across borders, as an ever-increasing number of firms do. We shall draw on the insights of both these approaches from time to time, particularly in Chapter 2. Yet there is still something rather national about firms, most of them at least, and some of the most national aspects of firms, we shall argue, are connected to their finance and corporate governance. Finance and corporate governance (as the reader will be expecting us to insist) are important, and they are closely connected. Firms are organisations set up with the primary purpose (normally), and requirement (universally), of making profit. Firms must raise, use and reproduce capital in order to come into being, survive and grow: so the question of finance is central to a firm’s being, not a mere necessary inconvenience as it might be for a university or a government. Accordingly, those whose capital is most at risk in it – the shareholders – have the first (although perhaps not the only) claim to power over it. One cannot expect to understand firms’ behaviour in any area without understanding their finance and corporate governance.

Introduction

5

In other words: in capitalism, capital and capitalists count. One might therefore expect the literature on technological innovation to give a central place to finance and corporate governance. It did so once. The founding father of the economics of technological innovation, Joseph Schumpeter, recognised the importance of finance and corporate governance. Innovation was usually expensive: ‘major innovations and also many minor ones entail construction of New Plant (and equipment) – or the rebuilding of old plant – requiring non-negligible time and outlay’ (Schumpeter 1939: 68). In his early work he saw these ‘new combinations’ as generally introduced by firms founded for the purpose – by entrepreneurs who were ‘new men’ not established in business (Schumpeter 1911/1996). Such innovators required external finance. Later, influenced by developments in US business, Schumpeter (1942) saw the main driver of innovation as the ‘perfectly bureaucratized giant industrial unit’, reinvesting profits into a routinised innovation process. Thus, for Schumpeter Mark I, financial institutions decided who should be given the resources to innovate: ‘[the banker] authorises people, in the name of society as it were, to form [“new combinations”]’ (Schumpeter 1911/1996: 74); for Schumpeter Mark II, the key decisions on resource allocation were part of the corporate governance of large firms. After Schumpeter, the literature on innovation seems mysteriously to have fallen almost silent on matters of finance and governance. By way of example, we conducted a brief survey of 400 articles on innovation, between May 1998 and October 2003, and found only seven which gave any prominence (i.e. a mention in the abstract) to questions of finance or corporate governance.2 There are distinguished exceptions to this neglect. Lundvall’s 1992 book on NSI contained a chapter (by Jesper Christensen) on the role of finance. There is the work of Lazonick and O’Sullivan which we shall discuss later. And Keith Pavitt in the decade before his untimely death in 2003 looked more than once at the role of finance and corporate governance in national systems of innovation (Pavitt 1999). He argued, as we shall, that alongside national systems of innovation, and interacting with them, there are national systems of finance and corporate governance, and that the manner and outcome of innovation has been decidedly different between the US and UK on one hand and Japan and Germany on the other, because of radical differences in their systems of finance and corporate governance (Tidd et al. 2001: 93).

1.2 How can one classify and assess national systems of finance and corporate governance? In parallel to, but quite separate from, the work done on national systems of innovation, there is now a large body of work on national systems of finance and/or corporate governance. It defines categories, assigns countries to them, and in a general way evaluates them. At one time the most popular distinction was between stock exchange-based and bank-based (or market-oriented and bank-oriented) financial systems (Zysman 1983; Levine 1997, 2002; Allen and Gale 2000). The attraction was

6

Introduction

that this classification appeared to combine categories of corporate financing, equity ownership, and corporate control: thus, bank-oriented systems were for long believed to exhibit high levels of bank finance and of equity holdings by banks, leading to close and long-term relations between banks and firms and active governance by the banks. Few countries however display all these features. In one ‘bank-oriented’ economy, Germany for example, bank financing has been rather low (Edwards and Fischer 1994). Another major economy, Italy, fits poorly into either category (Tylecote and Visintin 2002). Categorisation by ownership and control has been found more robust and useful. Franks and Mayer (1997) coined the terms ‘insider system’ and ‘outsider system’ to denote, respectively, •

•

economies with highly concentrated equity ownership, where larger blocks were generally held with control in mind (‘control-oriented systems’ in Berglöf 1997) economies with low equity concentration, where even the larger shareholders were generally uninterested in control (Berglöf’s ‘arms-length systems’).

See Table 1.1. The ‘outsider’ category corresponds well with the ‘stock exchange-based’ category above. The ‘insider’ systems comfortably include all the (allegedly) bank-oriented systems, but within them banks, where active, are merely one category of insider – family owners, government, and cross-holding firms are others. LaPorta et al. (1999) and Barca and Becht (2001) placed virtually all the non-English-speaking economies in the insider category, and the English-speaking economies in the outsider category. (We shall see later that the United States’ place is more arguable than most.) It is by now well established that each type of corporate governance system has its advantages. When a number of economies with insider systems (such as Table 1.1 Types of corporate governance and financial system Type of financial system

Share of control-oriented finance Financial markets Share of all firms listed on exchanges Ownership of debt and equity Investor orientation Dominant conflict of interest Role of hostile take-overs

Insider-dominated (Control-oriented)

Outsider-dominated (Arms-length)

High Small, less liquid Small Concentrated Control-oriented Controlling vs. minority shareholders Very limited

Low Large, highly liquid Large Dispersed Portfolio-oriented All shareholders vs. management Potentially important

Source: Adapted from Berglöf (1997) ‘Reforming corporate governance: redirecting the European agenda’, Economic Policy, April, pp. 93–123, Table 1.

Introduction

7

Germany and Japan) seemed highly successful, in the 1980s, economists naturally noticed their strong points. Stiglitz (1988), Shleifer and Vishny (1986), and Huddart (1983) pointed out that concentration of ownership, such as insider systems show, provides strong incentives for active corporate governance. In the 1990, as the flaws of insider systems became more apparent in practice, and the US economy made a come-back, the theorists became more conscious of the arguments against them. Shleifer and Vishny (1997) and LaPorta et al. (1999) argued that the exercise of power by dominant shareholders can be at the expense of minority investors and, in consequence, can limit the availability of external capital. Franks and Mayer (1997) were conscious of the advantages of both types of system. They argued that large ‘blockholders’ can commit to longterm cooperative relationships with other stakeholders (such as employees, suppliers and customers); which may be an advantage where such relationships are needed, but a disadvantage where changes like the adoption of new technologies are resisted by such stakeholders. Mayer (2002) added another point in favour of the outsider system: financial institutions that diversify their portfolios of assets, with only small stakes in any one firm, can take a relaxed approach to high-risk investment. ‘Insiders’ may have too many eggs in one basket to do so. If each type of system has its advantages, each will presumably tend to specialise in sectors in which its advantages are valuable and its disadvantages do little damage; and avoid sectors where the converse applies. A range of work has been done to explore this general proposition. Most of it gives more attention to the characterisation of the financial/corporate governance system than to that of the sectors examined. Thus, the one sectoral characteristic with which Rajan and Zingales (1998) and Cetorelli and Gambera (2001) are concerned is dependence on external finance. Carlin and Mayer (2003) go deeper: they look at industry measures of external equity financing, bank financing, and skill levels. The insider–outsider distinction fits well into still wider frameworks, developed mainly by political scientists and sociologists, distinguishing ‘national business systems’ (Whitley 1999, 2002, 2003) or ‘varieties of capitalism’ (Hall and Soskice 2001). We discuss this literature in some detail in Chapter 3; we shall only refer here to Hall and Soskice’s work. In brief, capitalism is seen as coming in two main varieties: • •

economies in which the market is allowed to structure economic relationships, economies which are to a large extent coordinated through non-market relationships.

The first are called Liberal Market Economies (LMEs), the second, Coordinated Market Economies (CMEs), of which the main category is Business-Coordinated. Neatly, the LMEs (led by the US and the UK) have ‘outsider’ corporate governance (CG) systems, and the CMEs (of which the leading business-coordinated ones are Germany and Japan) have ‘insider’ CG systems. Neatly again, the explanation and predictions of ‘varieties of capitalism’ are generally quite consistent with those of the financial and

8

Introduction

corporate governance economists. The LMEs, driven by the market, excel in industries that involve ‘radical’ technological change; the CMEs, in which market forces are restrained, excel where ‘incremental’ change predominates. (Rajan and Zingales et al. would agree, because the former seem likely to require more R&D, thus more risk capital, thus more equity financing, which the outsider systems are seen as better at providing.) Hall and Soskice (H&S) compare the US and Germany, using data on patenting, and duly find that the US is generally more specialised in sectors they classify as ‘radically-innovative’, Germany in ‘incrementally-innovative’ ones. The sceptic Mark Taylor (2004) reviewed their work. First, he cleared them of the natural suspicion that sectors had been classified to suit the argument. He used the extent to which patents in a sector had, on average, been cited in subsequent patent applications as the criterion of ‘radicalness’, and broadly agreed with H&S’s classification. Second, he repeated their tests, first for the US and Germany, and then for LMEs compared with (business-coordinated) CMEs. It was for the expanded data set that the predictions failed – or rather, they depended totally on the inclusion of the US as an LME. Whatever the other LMEs have in common with the US – besides speaking English – it does not seem to be anything that makes for radical innovation. Likewise, on the CME side, Japan stood out, inconveniently, as a radical innovator, next after the US. There is, in short, something about international specialisation – or, if you like, the technological advantage of nations – which remains to be explained, and it seems reasonable to look for a large part of the explanation in finance and corporate governance, broadly defined. None of the studies discussed started from a systematic analysis of the specific problems of financing and governing innovation and technological change. We shall now offer one.

1.3 Financing and controlling technological change: the challenges The problems of financing and controlling technological change are related to the difficulties of analysing it. These are severe. Technology is a factor of production which, from the point of view of conventional neoclassical economics, misbehaves utterly. With the other main factors, land, labour and capital (physical or financial), the more is used the less is left. The reverse applies with technology, since it is essentially knowledge, the fruit of learning, and one learns by doing and by using. Frameworks of thought which have been developed to cope with the allocation of scarce resources, do not, therefore, apply to technology (Arrow 1962b; Stiglitz 1988). The other factors, moreover, are in every sense of the word visible: the quantities at a firm’s disposal can be measured and valued fairly reliably and accurately. Technology cannot be. Even codified knowledge, such as one finds in a formula or a blueprint, is hard to value, and much knowledge may not be codifiable; or firms may choose not to codify it: they may keep it tacit. The technological capability of a firm in practice is based on a complex and changing amalgam of codified and tacit

Introduction

9

knowledge, of intellectual and human capital (Teece et al. 1998). Moreover the monetary value of this capability – the profit that can be derived from it – depends crucially on its scarcity, which given the nature of technology is essentially artificial. Other firms must be prevented from getting it, by means which will usually involve a degree of secrecy. This reduces visibility even more. The difficulties of valuing technological capability at a point in time – the valuation of technology as a stock – are great. Greater still may be the difficulties of valuing the resources invested in increased technological capability, during a period of time – technology investment as a flow. Clearly, research and development is part of it. So, in some degree, is new equipment. New equipment is visible in the firm’s accounts, and so in principle is research and development; but it is well known that much R&D, particularly in small firms, is informal, and not measured as such (Vossen 1999). Even more important, and even less visible, is the learning, or contribution to learning, of employees in sales and marketing, production, purchasing, whose main tasks are to do with current output but who have opportunities linked to their daily jobs to see how products or processes might be improved. They are, or should be, key actors in innovation. Their contributions to it may be cheap, but they are rarely free. The sales representative who (alongside selling the current range of products) finds time to talk to customers about what changes and new products they would like to see, and then finds more time to pass on what (s)he has learned to (say) someone in R&D, is by using that time spending the firm’s resources. It is highly unlikely that this expenditure will be separately monitored, let alone measured and recorded as an investment. These are problems of costing investments in improving technological capability. There are further problems of valuing the future output to be expected from that investment, many of them to do with technological uncertainty – ‘will it work?’ – and market uncertainty – ‘will it sell’? One of the worst of them relates to the effective ownership and control of that capability. Part of the ‘amalgam’ which we referred to above is human capital, which may, as it chooses, walk out of the door – lost to the firm and perhaps gained by a rival. Another part of the amalgam is that part of intellectual capital which is in some sense distinct from human capital: that is, it is not diminished by the departure of employees – within limits at least. But even then the firm depends on employees’ cooperation in keeping rivals from knowing too much about its intellectual capital, and about what is being done to increase it. The firm depends also in some degree on suppliers and customers with close and constructive relationships with the firm. The technological capability thus does not belong securely to the firm and its shareholders. The return the shareholders get from their investment in it may depend heavily on the firm’s relationship with these other stakeholders. So the tasks of finance and corporate governance in resourcing and controlling technological capability and innovation are extremely demanding. Financiers and shareholders will always need to understand the rate and the manner in which a firm is investing, and might invest, in improving its capability, and the likely

10

Introduction

outcomes in terms of value added and profit. It would be naïve to suppose that if they have such understanding, it will always lead them to encourage and support such investments. They may sometimes conclude that, however attractive to management – carrying forward one of their pet projects, satisfying their curiosity, realising their empire-building ambitions – a proposed investment in innovation and technological change would be unlikely to cover its cost of capital and should not be carried out. Under some circumstances such restraint might be for the best all round: the firm would make more profit and later be able to finance more successful and profitable innovation. But some firms might simply not have good opportunities for investing profitably in innovation, and in those firms, informed shareholder control might mean more profit, but less innovation than managers would have carried out if left to themselves – if autonomous. Another kind of disagreement between managers and well-informed shareholders might arise over the direction of technological change. Managers who have grown up with a certain technological paradigm – a way of thinking and a path or trajectory of improvement – are likely to be attached to it. They want to improve, but to do so in a familiar way. A move to a new paradigm will devalue their accumulated expertise – or be competence-destroying, in the words of Tushman and Anderson (1986) – and leave them dependent on the skills of a new generation who will then deserve to supplant them in power. Managers in such a situation need to be intellectually courageous and honest to admit even to themselves, let alone others, that the switch is for the best. Most will fail this test, at least until competitors have proved them wrong. Well-informed but detached shareholders and financiers – if there are any such available – then have the task of forcing radical change on the unwilling manager. Thus, as the Japanese camera industry was confronted by digitalisation in the late 1990s, the senior people in Canon’s photographic equipment division were reluctant: ‘The majority of technologists in the company thought that the quality of picture by digital camera must be much lower than with conventional cameras’ (Yada 2004: 27). In the end, the decision to introduce digital cameras – just in time for the company to win top position in the digital camera market – was driven through by the chief executive, an accountant by training. He himself was under pressure from American investors – themselves advised by industry analysts who typically take a sector-wide view of technological trends (Tylecote and Ramirez 2006). One area where the role of the well-informed shareholder will be supportive rather than intrusive, will be in management’s building of relationships with stakeholders. Close and constructive relationships with suppliers and customers, and employees, such as may be needed to protect and nurture innovation, take time to develop. They may require behaviour by management which is not profit-maximising over a short period of time or even with respect to a particular project. For example, a new product might be developed because it helped to maintain employment, although it was not expected to cover its cost of capital. The understanding among employees that the firm was doing its best to save their jobs might make them tolerant of process change that, in and of itself,

Introduction

11

tended to reduce employment. The outcome overall – of the new product plus the process change – would be more profit and more employment than doing neither. Shareholder pressure for profit, applied without understanding of such a trade-off, might spoil the deal. One can hardly expect that the various challenges that we have sketched here are faced in equal measure in every sector at all times. Nor, therefore, are the skills and relationships we have described of equal value, always and everywhere. There is therefore no point in trying to identify a national system of finance and corporate governance that is the best for technological change of all kinds. We need rather to explain why system A has come out on top in sector X, while system B has got the upper hand in sector Y; and perhaps why system C (generally deficient in all those skills and relationships) has performed badly across the board. For this we need an analytical framework that shows how sectors, and sub-sectors, may vary and change, in ways that affect the demands they make on the finance and corporate governance system. The next section sets out these dimensions of variation.

1.4 The demands of technological change on the finance and corporate governance system (FCGS) In 1982, Richard Nelson and Sidney Winter, in An Evolutionary Theory of Economic Change, introduced the idea of technological regimes, referring to the learning and knowledge environment faced at a given time by firms in a particular sector or sub-sector. We believe we have identified four dimensions of technological regimes that define the pattern and balance of the demands made upon the FCGS – the characteristics it needs to have in order to control and finance that sector properly. This determines the suitability of a particular FCGS to that sector – at that time. We shall state them and explain them one by one, showing what they demand from the FCGS (see Table 1.2 on p. 15). 1

We mentioned above that a move to a new technological paradigm would be competence-destroying. How far are the changes which a firm needs to introduce, competence-enhancing or competence-destroying? Competenceenhancing change is paradigmatic, path-dependent and cumulative (Malerba and Orsenigo 1997; Malerba 2004). Competence-destroying change involves radical shifts in direction, and to succeed in that, reconfiguration is needed: the firm has to reconfigure its organisation and change its methods, technologies and/or workforce. (As Teece 1998: 201 argues, ‘in rapidly changing environments, there is . . . value in the ability to reconfigure the firm’s asset structure and to accomplish the necessary internal and external transformation’.) There will inevitably be internal resistance, and an effective way to overcome that may be through pressure for higher value-added from owners or financiers who are well-informed – well-informed about the industry as a whole. (See the Canon example, above.) Sometimes, however, particularly where the most radical change is required, the leading firms do

12

2

3

Introduction not budge. Time and again, when top managers in large old firms blocked the development of a radically new product (Xerox with personal computers, Disney with computer animation), small new firms have taken up the running – Apple with the PC, Pixar with animation (Economist 2006c). If the most effective way to overcome such resistance is indeed to set up a new firm, then it will be very helpful to have strong and very well-informed venture capital, to establish and nurture such new firms. (This is not a new story. Venture capital is a term coined in the mid-twentieth century, but venture capital institutions, thinly disguised as banks, were operating in England in the 1770s, financing new high-technology mining firms using advanced steam engines, Brunt 2006.) Another of Malerba and Orsenigo’s dimensions is technological opportunity: the likelihood of innovating successfully – profitably – for any given amount of money invested in the attempt. Where there is high technological opportunity, there will be high spending on R&D and other innovative activities, and fast growth. What does high technological opportunity require from the FCGS? Clearly, a lot of money. Those who provide it should have a decent knowledge of the industry as a whole – industry-wide expertise again – although if no paradigm change is involved, and the money is going to established firms, much less expertise is required than for radical reconfiguration. They must also accept that even spending within an established paradigm is risky – some rival may get there first – so they are providing risk capital, which will normally be equity. It follows that equity or other risk capital must be available in generous quantities (most likely, on the face of it, in a ‘stock exchange-based’ financial system); and the firm must be prepared to take it on the terms on which it is available. Neither availability nor acceptability can be taken for granted, as we shall see in Chapter 3. If the firm is established, and profitable, it may be able to finance a high level of innovative expenditure out of its own cash flow – as managers would probably be glad to do; and so in that case management autonomy may be sufficient. The third of our ‘regime dimensions’ is visibility. This is very much our own, introduced in Tylecote and Conesa (1999) but prefigured in Tylecote and Demirag (1992). In fieldwork with British firms in the early 1990s, managers in large firms listed on the stock exchange persistently complained that their innovative activities were financially constrained; which seemed odd, given their easy access to risk capital on the stock exchange. In one sector alone, pharmaceuticals, the story was different. Gradually we came to understand what the main problem was: low visibility. The managers needed to satisfy the shareholders, who had only very limited information about the firm – mostly its financial accounts. Heavy spending on innovation would lead to lower profits for some years. Shareholders would only accept that if they had a clear understanding of the inputs and likely outputs of innovation. For the pharmaceuticals firms, they did: spending on innovation there, was mostly conducted in rather centralised laboratories, on R&D which could be easily measured, and its immediate

Introduction

4

13

outputs were ‘new chemical entities’ (medicines) which (being well protected by patent) could be safely discussed in public, at least in the last year or two before their introduction. In a word, their innovative activities had high visibility. No other sectors met all these conditions, and some met none. One example of low-visibility investment is the effort of the sales representative, mentioned in the last section. One British R&D director, of a cable-manufacturing firm, explained to us that one of the reasons why his firm was losing ground to its main Continental European competitor was that its competitor’s sales representatives talked regularly to customers about ideas for new products. His firm’s reps didn’t, because they, like everyone else, were being driven for immediate profit. If they took time to talk about future products it would reduce their division’s profit – the finance director whose financial controls were driving the business would not recognise this as an investment. When the visibility of innovation is low, owners and financiers need to engage closely with the firm, to develop firm-specific understanding – so as to be able to see below the surface to what is really being done for future innovative success. That seems to have been happening in the Continental cable firm. Failing that, a good second best is high management autonomy: managers being able to spend more or less as they choose on innovation, because they have access to a strong internal cash flow, and for some reason they can thumb their noses at the shareholders. (See Section 1.5 below.) In fact many managers who could not ignore shareholders’ wishes and interests indefinitely, can do so for a year or two, with a promise that patience will be rewarded. So an alternative to high visibility may be a fast pay-off. An example of extremely slow pay-off is given by the jet engine sector. Rolls-Royce’s development of the RB-211 engine, which began in the late 1960s, caused it massive losses during the 1970s, but was ultimately responsible for steady improvement in its market share for new engines during the 1990s (Lazonick and Prencipe 2005). The benefit to profitability came about a decade later still – because profits in this market come mostly from supplying spare parts and services. Pratt and Whitney, one of its two US competitors, effectively gave up the innovative battle during the 1980s and 1990s – the pay-off was too slow. (Why Rolls-Royce, a British firm, held on is explained in Chapter 4.) The last of our dimensions is stakeholder spill-overs: the extent to which employees and allied firms (notably customers and suppliers) benefit from and are able to contribute to the firm’s technological changes. (See for example the ‘quid pro quo’ mentioned in Section 1.3, where employees go along with process change in exchange for new product development.) In some sectors this is certainly of great importance. Here is Malerba summing up the situation in ‘specialized suppliers’ (mostly equipment producers), one of the four types of sector that Pavitt (1984) identified in his famous taxonomy: ‘innovation is focused on performance improvement, reliability

14

Introduction and customization, with the sources of innovation being both internal (tacit knowledge and experience of skilled technicians) and external (userproducer interaction)’ (Malerba 2004 p. 384; italics added). Clearly for such firms, close and constructive relationships with stakeholders – here, skilled employees and ‘lead’ industrial customers – are vital. We sum up such relationships, with employees and other firms, as ‘stakeholder inclusion’.

Stakeholder inclusion is relevant not only to the making of innovations, but also to the protecting of them, or appropriation: the challenge of ensuring that the firm, or more specifically its owners, pockets as much as possible of the returns from innovation. The standard work on this area is that of Teece (1986, 1998) who puts the emphasis very much on the danger of imitation by rivals, and sets out four main means of defending those returns: inherent difficulty in replicating the innovation (for example where much tacit knowledge is involved); intellectual property protection (patents, copyrights, etc.); investment in complementary assets and technologies such as manufacturing and marketing facilities; and dynamic capabilities that in effect make the firm a moving target by producing a stream of further innovations. We can insert stakeholder inclusion into Teece’s argument. Take the difficulty of replication, which depends largely on the degree of codification: this is to some extent for the firm to choose. The more the relevant employees can be trusted – not to talk, and not to walk – the better sense it makes to keep knowledge tacit. Even when it is necessarily codified – as for example with a chemical formula – if employees can be trusted to keep a secret, patenting can be delayed, thus increasing the life of the patent after launch. Dynamic capabilities, again, go very well with trustworthy employees and reliance on secrecy: if rivals only find out about products after launch, it may be too late, where the innovator already has another improvement in the pipeline. There may be limited scope for investment in complementary assets and technologies where the firm has industrial suppliers and customers who, so to say, box it in, in a vertically-disintegrated chain of production. In this situation a relationship of mutual loyalty with them may be to some extent an alternative to such an investment; and again, it may help in maintaining secrecy. The extent to which firms can take advantage of stakeholder inclusion – or need to – varies greatly by sector. For ‘specialised suppliers’, as Malerba (2004: 384) says, ‘appropriability comes mainly from the localized and interactive nature of knowledge’. The role of stakeholder inclusion in appropriation is much less in pharmaceuticals, where a product innovation, for example, is extremely easy to replicate but can be exceptionally well defended by patents. In defensibility by patents, pharmaceuticals lead, followed by chemicals, then electricals; mechanical sectors trail (Granstrand 2004). There are links and correlations among our four dimensions. Low visibility and high stakeholder spillovers tend to go together, because they both arise when lower-level employees, customers and suppliers are closely involved in

Introduction

15

Table 1.2 Dimensions of technological regimes and financial and corporate governance systems Dimension

Technological regime

Finance and corporate governance

1

Extent of competence destruction and consequent need for reconfiguration of firm structure.

2

Technological opportunity

3

Low visibility/slow pay-off of innovation Stakeholder spill-overs in innovation

Availability of expert finance for new firms in areas affected by radical innovation Pressure from expert owners for higher value-added in such areas Availability and acceptability of expert risk capital; management autonomy Shareholder/ financier engagement; management autonomy Stakeholder inclusion

4

innovation. One clear link between them is secrecy to protect an innovation: secrecy reduces visibility, and it requires the inclusion of whoever shares the secret. There is, on the other hand, a tension between stakeholder inclusion and competence destruction. Existing shop-floor employees, customers and suppliers may give vital help to an innovating firm in producing a competence-destroying change, but once it has happened in a sector, it is likely to reduce the value to all the firms in this sector of those who have the old competencies – what they know and can provide loses value, and commitments to them can indeed become a serious liability, not asset. Technological opportunity stands slightly apart from the other three: the sectors that show competence destruction, through radical innovation, naturally tend to show high opportunity, but they are a subset of the high opportunity sectors: as we shall argue in Chapter 2, there are sectors that show high opportunity without much competence destruction over considerable periods, (see Table 1.2).

1.5 Who controls firms, what are their objectives, and why should it matter? Having set out what demands innovation may make on the system of corporate governance and finance, we will consider now how far the insider/outsider distinction can help us predict whether a system can meet one or other demand. 1.5.1 Control in outsider systems The modern literature on corporate governance starts from Berle and Means’ (1932) claim that the top managers of most large US companies were no longer in any obvious sense under direct shareholder control, largely because shareholdings were fragmented. (B&M’s own data showed that this claim was

16

Introduction

highly exaggerated (Gadhoum et al. 2005).) Within another generation it was shown, much more convincingly, that this was true for Britain (Florence 1961). This stylised fact has since been the basis of a large literature written by mainstream economists familiar with America or Britain. (Even scholars living in very different corporate governance systems have frequently theorised about the stereotypical Anglo-American company or system.) Being mainstream economists, they naturally assumed that the parties involved were selfishly rational members of Homo economicus. They also assumed that the firm in every possible sense belonged to its owners, more particularly its ‘residual’ owners, the shareholders, and that the greatest social good could be expected to arise via the maximisation of shareholder wealth. The main current within this literature took shareholders to be principals, and managers to be agents, in a classic principal/agent relationship (Jensen and Meckling 1976; Fama and Jensen 1983; Shleifer and Vishny 1997). A principal, who is too busy or otherwise disinclined to run his or her own business, employs an agent to do it. The terms of employment are set by the principal – subject of course to there being a suitable person prepared to accept them. So the principal is in ultimate control; but the agent has the advantage of being on the spot. And the agent, like everyone else, is (to repeat) selfishly rational: looking after Number One. Given information asymmetry between principals and agents – that is, the agents are much better informed both about their own actions and about their outcomes – it is never likely to be optimal for the agents to act in a way that is optimal for the principals.3 How top managers’ behaviour will diverge from the ‘shareholders’ optimum’ depends on the way they are paid. Let us assume first that they are simply paid a fixed salary according to their position. Assume also (for the moment) that they will stay in the firm until they retire – or until they are fired, or the firm goes bust. They will only be fired for blatant underperformance because anything less than that can be explained away to the shareholders. Then chief executives, who have no higher to rise, will be •

•

lazy and/or luxury-loving, at the firm’s expense. Why not concentrate on having a good time, if you will be paid the same regardless of effort and economy? excessively risk-averse, normally, because if they take a risk and the worst happens, the result is dismissal, whereas if the outcome is good there is no gain compared to the cautious option. The exception arises where for some reason there is a very bad situation and they can expect even the cautious option to lead to dismissal. Then one may as well play for high stakes – ‘double or quits’: if the risk comes off the job is saved, if it does not, the outcome will be worse for the shareholders but not for the manager.

Next, let us be a little more realistic, and assume both that managers may be promoted, either inside or outside the firm, and that they will be paid not only a

Introduction

17

salary, but also a profit-based bonus. Now they have an incentive to ‘perform’, or rather to be seen to do so. Their firm, or their section of it, should be as profitable as possible – or appear to be. That will give them the largest possible bonus and, other things being equal, the best chance of promotion inside or outside. So in this situation there is some incentive for effort and economy, and even for taking risks. The main distortion now is towards too-short time horizons. There are many courses of action that can give high profits for a year or two at the expense of the further future. If the executive has moved on (or retired) by the time the ‘further future’ arrives, that is somebody else’s problem. An even better way of ‘aligning incentives’, in principle, is the stock option. Give Firm X’s chief executive at time t the right to buy (say) a million of X’s shares, five years on, at the price at which they stand at time t: say $10. If X’s share price in the market has risen by time t + 5 to $30, then for each share there is an instant capital gain of $20, and the chief executive can be $20 million richer overnight. He or she then has a strong incentive to do what it takes to push up the share price. The share price will depend on profits between t and t + 5 (the ‘exercise date’), and also on what are seen as the firm’s prospects. (Note that there is no ‘downside risk’ attached to stock options: if things go badly and the share price goes down, the shares do not have to be bought: the manager has only an option, not an obligation, to buy.) This should wipe out any remaining tendency to be risk-averse. What it does to short-termism depends on how far ahead is the exercise date for the options, and also how perceptive the ‘market’ is about the firm’s prospects. If the exercise date is close and the ‘market’ seems to the managers not to be perceptive, then there is a very strong incentive for short-termism, and sheer deceit. Further, giving enough stock options to motivate managers strongly is expensive. The notorious case of Enron shows how stock options can, in the worst case, transfer large amounts of money to managers in exchange not for high profits but for the appearance of high profits. The choice for principals in the face of severe information asymmetry thus seems to be between the plague and the cholera. The solution is then, if possible, to reduce the information asymmetry, by active monitoring. This is what auditors and non-executive directors are mainly for. The Enron scandal (and others about the same time) suggested that neither could be relied upon. But why not? In principle both should be very useful to shareholders. The main problem is that a key initial assumption in the principal–agent theory of corporate governance is flawed: ‘Shareholders are principals’. Principals choose their agents. In most large listed firms in the United States and Britain – the firms with dispersed ownership to which the corporate governance theorising relates – this is not the situation. Shareholders do not choose managers or decide how to pay and monitor them – managers choose managers, and decide how they themselves are to be paid and monitored. To be painfully precise, directors choose top managers, but top managers choose (and are) directors. They also choose their auditors. Even top managers who have not the slightest intention of misbehaving

18

Introduction

have a natural tendency to choose ‘monitors’ who will agree with what they are doing and want to do. This odd situation will make information asymmetry greater than it would be if shareholders really were principals. It will also increase the degree of managerial autonomy – managerial freedom to act openly against shareholders’ wishes – beyond what it would then be. How much autonomy there will be, is debatable, and has been much debated. In principle, shareholders, however dispersed, can come together and elect a new board of directors who will fire the top management. Alternatively they can sell to a hostile takeover bidder who will do the same. The latter requires no initiative by the shareholders, who may simply accept an offer made to them, although one can well imagine disgruntled shareholders seeking out and encouraging a potential bidder. This is what is referred to by ‘the market for corporate control’, which is assumed to be active in ‘outsider’ systems. But is it? In the United States, ‘shark repellents’ (takeover protection devices) have long been deployed by incumbent managements. They were briefly ruled illegal in the early 1980s, then restored to full efficacy by a number of court judgments and state laws (Weston et al. 2004). Management protection against takeovers (and against direct shareholder intervention) is far weaker in Britain, as we shall see in Chapter 4. So managerial autonomy (in the stereotypical large firm with dispersed shareholdings) is much greater in the US than Britain. Assume that there is at least some managerial autonomy, then. What will managers do with it? No one would really accept the economist’s crude assumption that all managers are interested in is money and leisure. There is general agreement that they are interested in power as well. (In the next section we see that some noneconomists ascribe higher motives to them too.) So ‘empire-building’ is included among managerial objectives. There are two ways of building empires: by organic, internal growth, and by acquisition. It is well understood that growth by acquisition will often be pursued beyond the point of profit maximisation – which is why when a takeover bid is announced the usual stock market reaction is to lower the price of the bidding company. Organic growth may also be pursued beyond this point. Marris (1964) constructed a persuasive theory of ‘managerial capitalism’ based on the idea of growth maximisation subject to a profit constraint: that is, profit would be sacrificed to growth but only down to a certain level. The ‘floor’ of minimum profit might be set at what the shareholders would tolerate or it might be determined by what was required to finance the growth strategy. Strong shareholder dissatisfaction will at the very least lead to a low share price which will make it impossibly expensive to raise new capital in the stock market or to pay for an acquisition with the firm’s own shares. As far as the top management of one firm is concerned, organic growth and growth by acquisition are alternative means to the same end – a larger ‘empire’. Organic growth will benefit lower management and other employees, which an acquisition probably will not; but acquisition is quicker. However, if hostile bids are blocked, firms must be found whose managers are willing to surrender their own power. Owner-managers who want to get rich are obvious candidates – if the price is right.

Introduction

19

Even managers who are well protected from shareholder interference or hostile takeover may then have every incentive to present themselves as loyal servants of shareholder interest – as maximisers of shareholder value, to use the current buzzword. As such they will find equity capital, for acquisitions or other investments, cheaper to come by. For such managers the stock option has been manna from heaven. As we showed above, if used by intelligent controlling shareholders it should align managers’ incentives more closely to shareholder interests. If used by controlling managers, it gives them a further incentive to do what it takes to raise the share price, and reassures shareholders that this is what they will try to do; although they should not be much reassured, since the record shows that options will be manipulated to enrich managers regardless of the firm’s performance. (In the next section we look at the effects of the vogue for ‘maximising shareholder value’, since the 1980s.) How will the extent of managerial autonomy in a firm affect the amount spent on investment generally and innovation in particular? It depends on the opportunities it has for profitable growth, and on how severe is the information asymmetry problem. If a firm has good opportunities for profitable growth and information asymmetry is mild, there is nothing to gain by autonomy, since shareholders will be in favour of a fast-growth strategy and with them in tight control there will be less waste and less conservatism. However, if the opportunities for profitable growth are poor, autonomous managers are likely to invest more heavily and innovate more rapidly than managers with shareholders in control. Likewise, if information asymmetry is severe (because shareholders lack industrial expertise, or being disengaged cannot appreciate low-visibility investments) then whatever the opportunities, shareholder power will be a drag on innovation and growth. We shall see in Chapter 4 that this last point applies with force to Britain. We can conclude that it would be dangerous to expect uniformity from ‘outsider’ systems in their technological performance. Management autonomy can vary and we have already seen – comparing the US and UK – that it does. The industrial expertise and engagement of shareholders and financiers may also, in principle, vary (and with this the availability of venture capital). In Chapters 3 and 4 we shall see that it does. We have not so far discussed stakeholder inclusion: in Section 1.6 we shall see that it can and does vary too. Finally, this may be a good point to enter a warning about stereotypes. Just as Berle and Means (1932) understated the extent of direct shareholder control in the US in the 1930s – a time at which, for example, Henry Ford controlled Ford and the Du Pont family controlled both DuPont and General Motors – so recent writers understate it too. Gadhoum et al. (2005) have shown that a larger proportion of the largest firms in the United States are controlled by families and founding entrepreneurs than in Germany, the UK or Japan – and who should be surprised, when we know that the Waltons control Walmart, the Fords Ford, Bill Gates and his fellow founders Microsoft? The ‘shark repellents’ (deterrents to hostile takeover) that in some large US firms protect management autonomy, in others make it possible to maintain secure family control with a modest minority shareholding. (In Britain, more

20

Introduction

friendly to takeover, this is rarely possible.) So the largest ‘outsider’ economy is in large measure an insider economy. We discuss the stereotypes and realities of the US and UK further in Chapters 3 and 4. 1.5.2 Control in insider systems Insider systems might seem designed to minimise the two variables we have just been discussing: management autonomy and information asymmetry. The meaning of ‘insider shareholder’, of which the two classic types are founders and their families, and banks, is that the shares are bought and held with a view to some degree of direct control. It certainly makes sense for an insider to ‘engage’ with the firm and to invest the time required to develop ‘firm-specific understanding’. The insider, or one or more representatives, can sit on the firm’s board of directors and as such be privy to its secrets. So insiders should be able to cope well with low visibility. Whether they have the sort of industrial expertise required when the need for reconfiguration or the level of opportunity is high, is another matter. For the nurturing and exploitation of industry-wide expertise one needs industry-wide interests: stakes in a number of firms in the same industry. A big bank might well have the resources needed for that, but if it builds such stakes questions will be asked about monopoly power, as they were in Germany in the 1970s. In fact the insider may not exercise control effectively: family or bank oversight may be slack, and allow management a great deal of autonomy. The main limits to such autonomy will be in the raising of capital. An issue of new share capital, or a share swap as part of an acquisition, may ‘dilute’ the insider’s holding(s) and jeopardise their control. Heavy borrowing will increase their risks. So when either possibility is on the table one would, so to say, expect the sleeping ‘insider’ to wake up. Whether newly awoken or awake all along, the need to raise capital is a serious challenge for the insider and the insiderdominated firm. The most engaged insider is likely to be one that has a large proportion of its assets tied up in the firm – typically, the founding family. In that case it may have difficulty in providing extra share capital, while (as pointed out above) having misgivings about external capital; and the difficulty will be greatest for the riskier ventures. A bank shareholder, which will have less difficulty in finding finance, is on the other hand less likely to be fully engaged. A third important category of insider shareholder is another firm. Here we have to distinguish between two types of ‘cross-holding’: one way and two-way. Where Firm X has a large shareholding in Firm Y (but not vice versa) this is essentially the projection of whoever has power over (or in) X. Where the crossholdings are reciprocal – X and Y have shareholdings in each other – they may provide a buttress for management autonomy in both. This will be strong autonomy, which does not end when external capital is required, if the partner increases its shareholding in proportion to the shares being bought by outsiders. Government, at whatever level (central, regional etc.) also counts as an insider, in the sense that if it holds shares, it will be for control, or at least influence.

Introduction

21

Of course many firms are, or have been, wholly state-owned. It will be an odd sort of insider, however – at the opposite end of the insider spectrum from a founding family, since no individual will be involved whose own wealth is at stake. The incentive for any individual official, or group of officials, to develop understanding of the firm, or industrial expertise, is likely to be low – unless the firm is seen as important to government policy. If it does not seem important, its management will probably be allowed to go its own way, although perhaps starved of capital and inhibited from firing employees. We conclude that in insider systems as in outsider systems, there is nothing like uniformity where it counts. Only in industry-wide expertise, and thus in coping with high need for reconfiguration, is the picture fairly uniform (and bleak). In engagement, in the availability and acceptability of risk capital, and in management autonomy, anything is possible. The same is true, as we shall see in Chapter 3, for stakeholder inclusion.

1.6 Autonomy, stewardship and stakeholders There is a theory of, or approach to, corporate governance that is very much in favour of managerial autonomy, because it is rather optimistic about what managers will do with it. So far we have been working with some rather harsh assumptions about managerial aims and motives. To selfish love of wealth, luxury and leisure we added lust for power. The ‘stewardship’ approach rejects such assumptions. Drawing on the model of man put forward by Argyris (1973), and generally on psychology and sociology, proponents see managers as naturally inclined to cooperative, pro-organisational behaviour rather than to self-serving individualism. They gain satisfaction from the success of the firm they run and, as a consequence, their actions are most effective when the corporate governance structures give them authority and discretion: ‘. . . stewardship theorists focus on structures that facilitate and empower rather than those that monitor and control’ (Davis et al. 1997: 26). But how will top managers define ‘success’? Their motives are assumed to be ‘aligned with the objectives of their principals’ (Davis et al. 1997: 26) – who are taken by Davis and subsequent writers, always and everywhere, to be the shareholders. This last assumption is highly questionable. Is it psychologically and sociologically natural for managers to devote themselves to shareholders’ interests, when shareholders are not people with whom they deal and work? It is interesting that the model is the medieval steward, who looked after his lord’s lands while the great man was away at court or at war. The ideal steward of course looked after those lands as though they were his own. But who knows what the real steward might have done if he had thought he could get away with it – if he had been ‘facilitated and empowered’: dipped his own hand once or twice in the treasure chest? Or perhaps cut the rents, and increased wages? Lubatkin et al. (2005) argue for what amounts to a conditional or contingent stewardship approach: managerial opportunism as assumed by principal/agent

22

Introduction

theories appears plausible to them in the US, because of US culture and institutions, but not to anywhere near the same extent in Sweden or France. But who are the Swedish and French managers acting as (more or less) loyal stewards for? In both Sweden and France, it is explained, there are dominant shareholders that are much better able than the stereotypical US or UK shareholder to get their interests respected. Nonetheless, the managers’ sense of obligation is not simply to the shareholder, but to a wider set of stakeholders. (In Chapter 3 we shall see who these variously are, in Sweden and France and elsewhere.) Although this difference is put down by Lubatkin et al. to culture and institutions, it can be partly explained by law. In law, it is almost only in the Englishspeaking world that the enterprise belongs in the full sense of the word to the shareholders: elsewhere, managers have a legal obligation to act in the interests of a number of stakeholders (Kay and Silberston 1995). That, we submit, goes with the sociological and psychological grain. Serving a multitude of unseen and unknown shareholders, doesn’t. There is in fact an excellent economic justification for this wider approach to ‘belonging’. Margaret Blair (1995, 1996) points out that employees invest in ‘firm-specific human capital’ – capital that will be largely lost if they are dismissed or the firm closes. Thus ‘The value of the rents that employees have at risk in the typical large corporation is, in the aggregate, roughly the same order of magnitude as the stake that shareholders have’ (Blair 1996: 11). It follows that ‘management and directors should focus on maximising the total wealthcreating potential of the firm, not just on maximising the value of the stake held by shareholders’ (Blair 1996: 13). Blair’s conclusion is that corporate governance rules should be adjusted to give employees a share of control that corresponds to their investment in the firm. Blasi et al. (2003a) argue strongly in the same general direction. They point out that US industry, with the encouragement of legislators, has gone a long way towards making employees shareholders. However the problem of employee shareholdings, as the Enron debacle shows, is that they double the employees’ downside risk: if it fails they lose not only their jobs but part of their savings. Blasi et al. show that the neatest way of matching the inevitable downside risk that employees share with the firm, with a share of the upside (if it becomes highly profitable they should benefit accordingly) is to give all or most of them stock options – rights to buy shares in the future at a price fixed in the past, so that if its share price rises, they make an instant capital gain once the exercise date arrives. As we pointed out above, with stock options there is no downside risk because one is not obliged to exercise them. Justified as Blasi’s criticisms are, employee shareholding is another striking ‘insider’ element in the United States corporate governance system. Employee shareholdings can in some circumstances be voted, although almost always in favour of incumbent management (Weston et al. 2004). Whether they can or not, they make for a more cooperative relationship between management and employees; they notably help to dissuade employees from using what power they may have against the interests of shareholders. For example they may not

Introduction

23

resist the closure of a loss-making division, so that more funds may be put into a growth area. Blair and Blasi’s arguments for employee ‘inclusion’ are not specifically based on its benefits for innovation. William Lazonick’s and Mary O’Sullivan’s are, and what is more they are put in the context of an analysis of how finance and corporate governance systems affect innovation.4 Its starting point is a proposition with which we strongly agree: that the learning process required for innovation is uncertain, cumulative, and collective. It is uncertain because ‘what needs to be learned about transforming technologies and accessing markets can only become known through the process itself’. It is cumulative because ‘learning cannot be done all at once; what is learned today provides a foundation for what can be learned tomorrow’. Since for both these reasons the investment in learning takes time, it requires ‘sustained, committed finance’: financial commitment. Learning is also collective: it ‘requires the collaboration of different people with different capabilities [and thus] the integration of the work of these people into an organization’: organisational integration (all quotations from Lazonick 2004: 30). ‘The essence of the innovative firm is the organizational integration of a skill base that can engage in collective and cumulative learning’ (Lazonick 2004: 34). (Organisational integration is clearly closely related to our ‘stakeholder inclusion’.) In some degree, Lazonick and O’Sullivan seem thus to be doing what we are not trying to do: set out a one best way of financing and governing innovation. In fact within their second requirement there is room for variation: ‘The types of organizational integration that result in innovation vary across industries and institutional environments as well as over time . . .’ (italics added; Lazonick 2004: 50). ‘In industries such as electronics and automobiles, Japanese companies such as Sony and Toyota . . . remain leading innovators in those types of products in which . . . their integrated skill bases gave them international competitive advantage’ (Lazonick 2004: 45). American firms, at least recently, have tended to focus on ‘those types of activities in which innovation can be generated by investing in ‘narrow and concentrated’ skill bases of highly educated personnel’ (Lazonick and O’Sullivan 2000). It is organisational integration which thus bears the main load of explaining the sectoral specialisation of nations (Lazonick 2002a). It is the first requirement, financial commitment, which seems to offer a uniform prescription – put very plainly in Lazonick and O’Sullivan (2000) as ‘retain and reinvest’. There is some justification for this. Lazonick and O’Sullivan have shown how US industry enjoyed and gained from financial commitment during its global dominance in the early and mid twentieth century, and how that financial commitment helped provide conditions in which organisational integration could be developed and maintained. They have shown how Japan and Germany benefited from their own styles of financial commitment and organisational integration – the latter extending further than the US style, to encompass a large part of the non-managerial workforce (Lazonick 2002b; O’Sullivan 2002). The great contrast is with the decline of

24

Introduction

financial commitment in the late twentieth century United States, under attack from the ideology of ‘maximising shareholder value’, which they argue is responsible for a far-reaching erosion of organisational integration. In our terms, what serves to raise profits in the short term – sharp cuts in the labour force, buying from the cheapest supplier, for example – is adverse to stakeholder inclusion. Lazonick and O’Sullivan and their collaborators have shown how this undermined the US position in industries such as machine tools and jet engines (Forrant 2002; Almeida 2002). However, machine tools are a specialised-supplier sector which requires engagement and inclusion (Section 4); jet engines, as we pointed out above, have a very slow pay-off which requires engagement or real management autonomy. ‘Retain and reinvest’ suits them very well. But what of those areas where, because of their need for reconfiguration combined with high opportunity, we would expect to need new firms, supported by venture capital? Today’s best-known venture capitalist, John Doerr, calculates that between 1981 and 1990 the value of the new personal computer industry grew from virtually nothing to $100 billion, the largest legal accumulation of wealth in history. More than 70 per cent of these firms were venture-backed; nearly a third were backed by Mr. Doerr’s own firm. . . . the total of venture-capital investments [in all industries, in the US, defined as investments in start-ups and young companies] reached a record $10 billion last year [1996] . . . in 1995 70 per cent of American venture investments went to technology companies; two-thirds of those were in information technology, mostly computer hardware, software, and networking equipment [and 24 per cent went into biotechnology]. . . . (The Economist, 1997a: 9–20) This was the highest of the high ground of the new technologies, which was being occupied by the shock troops of the US economy, in the face of relatively feeble European and Asian opposition: Nearly half of Europe’s $9 billion in venture financing in 1995 went to management buyouts, an altogether stodgier business . .. . They funnelled just 2 per cent of their investment into biotechnology firms; communications, computers and other electronics received 16 per cent. Asian venture capital is often recorded as being nearly as big as America’s but it mostly takes the form of corporate investment by giant conglomerates and family-run businesses. ... (The Economist, 1997a: 20) Whatever damage was being done to other areas of the US economy by the abandonment of ‘retain and reinvest’, something valuable was being done here by capital that was presumably available because it was not being retained and reinvested. In the next section we consider whether there has been more of a need for such mobile capital recently than in the heyday of financial commitment in the US.

Introduction

25

1.7 Technological regimes and technological revolutions No doubt there is always some sector or sub-sector where competencies are being destroyed, and many where they are being enhanced. But it would be unwise to suppose that the rate of competence destruction, across developed economies in general, is always much the same. There is strong evidence by now that it fluctuates in long cycles or waves. There are times when there is an established set of technological paradigms, and enhancement dominates. There are other times when a new set becomes more-or-less accepted, and starts to destroy competencies across a wide range of industries – these are times of technological revolution. A technological revolution is in progress now, consisting of the wide diffusion and application of the new information and communication technologies. It is the fifth such revolution since the 1780s (Perez 1983; Tylecote 1991; Freeman and Louçã 2001). This allows us, learning from history, to make some generalisations about their economic and organisational effects. Perez (2002) focuses on the relationship of finance with management – or as she puts it, on the relationship of financial capital with production capital. This relationship develops and changes according to the degree of maturity of the ruling technological paradigm. In the period when the established paradigm has become mature (most recently, the 1960s and 1970s) there is a resulting reduction in profit opportunities and growing strain between financial and production capital. ‘Financial capital is footloose by nature’ (Perez 2002: 73). Incumbent production capital is tied down to the current paradigm by its investment in physical capital, the knowledge and experience of its management and personnel, its networks of suppliers, distributors and customers. ‘As the low risk investment opportunities in the established paradigm begin to diminish, either in innovation or in market expansion, there is a growing mass of idle capital looking for profitable uses and willing to venture in new directions . . .’ (Perez 2002: 33). When the new paradigm appears and some innovators want to try to commercialise it, It is here that the separation between financial and production capital has its most fruitful consequences . . . Financial capital will back the new entrepreneurs and it will be more likely to do so, in spite of the high risk, the more exhausted the possibilities are for investing in the accustomed direction. (Perez 2002: 33) However, in order to exploit the new paradigm fully, there has to be a new understanding between financial and production capital: they have to come much more closely together again. This in due course takes place – although not until there has been a period of frenzy (in this revolution, the late 1990s boom and internet bubble) followed by disillusion. Perez’s framework is attractive as a schematic, stylised account of a long cycle in the relationship of finance and industry, at least with regard to the outsider systems she seems to be describing. It reminds us that there is something to

26

Introduction

be said for ‘footloose capital’, and the more so at times like the present. However, like Lazonick, she does not differentiate systematically among sectors. The financial capital that backs the new entrepreneurs is, in the present period, venture capital, and one can see the importance of its role in the new sectors which are the spearhead of the revolution, such as software and microelectronics. But of equal interest to the sectors that are created by the new paradigm are those, much more numerous, which are transformed by it. Some transformations (as with machine tools) have happened already; others are in progress; others are still to come. We discuss some of these changes in Chapter 2, and in Chapter 9 we look ahead to how finance and corporate governance may respond to them.

1.8 What this book sets out to do As we said earlier: in capitalism, capital and capitalists count. Finance and corporate governance is surely important. And the nature of finance and corporate governance (FCG) is all the more important in innovation and technological change because financing and governing it is so difficult. The quality of a country’s finance and corporate governance system must greatly affect its success in innovation and technological change, and the type of its FCG system must affect which sectors it tends to specialise in. The aim of this book is to show how this works. We do not wish to claim too much. Even with the broad definition we give to ‘finance and corporate governance’, we have to concede that other factors are important too. Looking across the world economy there are some factors, such as labour market institutions, which are to some extent complementary to FCG because they affect mostly where the dominant firms in an industry choose to invest, while FCG affects mostly where those dominant firms are from. But those factors, and others, are also to some degree competitive with FCG. Where new young firms are trying to establish themselves, both the local FCG and the local labour market arrangements will affect their chances of success. It is quite obvious, likewise, that firms in high-technology industries (at least) need good access to the latest scientific and technological advances. A country without a strong science base in the appropriate disciplines is unlikely to be really successful in any high-technology sector. Another obvious limitation comes from path-dependence. Knowledge and the other factors which bring success in business are always to some (varying) extent cumulative: in any industry it helps a great deal in being successful today, if one was successful in that industry (or at the very least a related one) last year and last decade. History matters: and in sectors such as aerospace where, as we shall see, progress is highly cumulative, it matters a great deal. Aerospace is also of course a largely military industry. So the most important factor in determining technological advantage – any advantage – in aerospace now is what side a country was on in the Second World War. The losers lost their seats at the table, and they have had, and are still having, great difficulty in getting them back.

Introduction

27

Another more subtle case of path-dependence is electronics. Electronics took off, one may say, in the 1960s and 1970s, and changed very fast during this early period. This meant that there was relatively little cumulated knowledge during that period, and a newcomer could rather easily get a seat at the table if certain criteria were met. However, those countries that failed to get established in the sector then or shortly after, would find it much more difficult to do so later. Path dependence applies to most of the factors affecting technological advantage, and competitive advantage generally. It certainly applies to Michael Porter’s famous diamond, of four key determinants of national competitive advantage: factor conditions, demand conditions, related and supporting industries, and firm strategy, structure and rivalry. It must be rather disheartening (for example) for a policy-maker trying to use the diamond to guide policy, to be told (quite rightly) by Porter that it is very helpful in sector X to have strong ‘lead customers’5 for X within the country, and to have well-developed research and higher educational institutions serving the sector. If a country is not already strong in sector X it is unlikely to have these advantages and it will find it hard (although not impossible) to get them. But if some important factors in competitive advantage show a degree of path-dependence, it is all the more interesting to ask, what other factors may help, over a period of time, to move them to a higher path? It is a fascinating exercise to read Porter’s Competitive Advantage of Nations from this point of view, and in particular to consider how far finance and corporate governance can play such a role, of an unseen prime mover. Not that finance and corporate governance is always unseen by Porter. In the book and elsewhere he shows a good understanding of its direct role. His Chapter 3 has a great deal about finance and corporate governance systems. His central emphasis, however, is on interactions among firms. He stresses the value of interaction with homebased suppliers and customers, but as he points out, it does not occur automatically. We have already argued that finance and corporate governance may have a lot to do with it. In fact, where there is cross-holding of shares among suppliers and customers, the relationship with them is part of corporate governance – as we shall see most particularly in the case of Japan. Likewise, Porter strongly emphasises the importance of domestic rivalry. He therefore deplores the merger of competitors into one ‘national champion’. Now, sure, this may take place because of mistaken state policies, and it may be prevented by the good sense of regulators. But above all the key is the wishes of managers and shareholders in the firms that may merge – which takes us back to finance and corporate governance. Likewise, rivalry can be generated or regenerated by the setting up of new businesses, which draws on another part of the finance and corporate governance system. Another approach to inter-firm interaction which is deservedly fashionable is via ‘clusters’ or ‘industrial districts’. In Dynamics of National Advantage (Chapter 4 of this book) Porter has an important section on Interchange within Clusters, and he looks at its causes as well as its benefits. He gives two lists:

28

Introduction

1 Facilitators of information flow • • • • •

Personal relationships due to schooling, military service. Ties through the scientific community or professional association. Community ties due to geographic proximity. Trade associations encompassing clusters. Norms of behavior such as a belief in continuity and long-term relationships.

2 Sources of goal congruence or compatibility within clusters • • • • •

Family or quasi-family ties between firms. Common ownership within an industrial group. Ownership of partial equity stakes. Interlocking directors. National patriotism.

The first list includes some factors shaping finance and corporate governance and others affected by it. Most of the second list is directly finance and corporate governance. There are, clearly, some considerable lags in the system. Finance and corporate governance affect some other determinants of technological advantage, and these in their turn take time to work. So how far back in time does one go? Tylecote and Vertova (2007) showed how FCG, among other factors, could explain the changing technological advantage of the US, Germany and Britain in some key industries from the beginning of the twentieth century. In this book we shall not go so far. We aim to explain only current performance, and recent changes over up to about 30 years – depending on the availability of data, and whether there is an interesting story to tell. Clearly we need to trace the explaining factor, finance and corporate governance, back further than the explained one, technological performance, because of the lags in the mechanism. Happily, in most of the countries we shall be looking at there was a period of considerable stability in the FCG system as in others, between the 1950s and the 1980s. So it is not a great simplification to assign most of our countries to a particular distinct FCG category at least until the 1980s, and treat that as our main driving force in determining technological advantage. The nearer one comes to the present, the more mobile the FCG scene becomes, particularly in the ‘insider’ systems. Some of them changed far enough soon enough for the effects of those changes to be traceable in technological performance. Even where FCG systems were not changing rapidly, some sectors were doing so in ways that meant a country whose FCG was suited to success in sector X in (say) 1985 was no longer in that position by 2000. How did we choose our economies? Most of them chose themselves. The United States, Japan, Germany, Britain, France and Italy seem just too important to ignore. We rather arbitrarily added Sweden and Switzerland because, although small, they are interestingly different and there is enough data. Moreover, in spite of their small size, they have powerful multinationals. By the same

Introduction

29

token, Canada and Australia were excluded partly because of the strength of foreign multinationals there. The Netherlands is excluded partly because two of the three firms that dominate its economy – Royal Dutch/Shell and Unilever, the third being Philips – are Anglo-Dutch. In Asia, South Korea and Taiwan are the two largest of the four strikingly successful ‘East Asian tigers’. Then there is (mainland) China. Unlike all the others it is a developing not a developed country (many would not class South Korea as developed either, but at present rates of progress they soon will do) and it does not fit comfortably into any of our categories. On the other hand, one could (and we would) argue that its technological performance over the next decade and more, matters as much as that of all the rest put together. Happily, one of us knows China quite well. Our apologies to readers in, or from, the other obvious candidates, excluded more because of our ignorance than their unimportance. We hope that when you see how we analyse our 11 you will be in a position to do a do-it-yourself job on the country of your choice. If and when there is a second edition of this book we doubt whether we shall leave out India again. How did we choose our sectors? The OECD list of high-technology and medium-high technology manufacturing sectors seemed a good place to start, covering most of the key battlegrounds of technological competition among developed countries (see Figure 1.2). We look at all these sectors except for the smallest in each group, ‘medical, precision and optical equipment’, and ‘railway and other transport equipment’; although as we explain in Chapter 2, another ‘medium-high technology’ sector, electrical machinery, turns out to be impossible to discuss usefully for our purposes. Another battleground that is too important to ignore is software and IT services. We cover that too. We would like to have looked in depth at a wider range of services. We are always being told that it is hopelessly out of date to focus mostly on manufacturing when services make up most of any developed economy and a rapidly expanding part of international trade and investment. If we had also been told where to get the necessary data we would have been glad to oblige. As it was we added a rather half-hearted look at telecommunications services, and a glance at business services in general. We think they yield one or two interesting insights, but our treatment is superficial. In fact, the depth and thoroughness of our treatment varies a great deal among sectors. In some cases we were restricted by the availability of data. In others, such as aerospace, we see little point in discussion at great length when manifestly the main factors determining technological advantage now, are not finance and corporate governance now, recently or ever. Of course that lays us open to the charge of selecting what (metaphorically and literally) suits our book. We deny that, but certainly if one aims to go anywhere in the direction of systematic testing of any proposition such as ours, this is not the way to go about it. One would rather have to make unimpeachable lists of sectors and countries, find dependent variables to be explained for which reasonable data were available, do likewise with the independent variables, and conduct multivariate regressions of one sort or another. We have done some of this sort of exercise in the past (e.g. Tylecote and Conesa 1999) and mean to do more in the future, but

30

Introduction

it is dry stuff. It makes dull reading and still proves nothing. We prefer to be interesting, and aim to be, by taking the reader on a sort of aerial tour of the landscape, showing what features of it finance and corporate governance factors can explain, and how. Sometimes it will seem to make sense to look at them alone, sometimes to do so in conjunction with other factors which are obviously important. The sequence is as follows. In Chapter 2 we look, sector by sector, at the characteristics that determine the demands technological change makes on the finance and corporate governance system – what they are and how they have been changing. In Chapter 3, we look at finance and corporate governance systems, in the very broadest sense, show how they can be categorised, and assign our countries to categories. In most cases, as we said above, there was a degree of stability for some decades after the Second World War, and so it is convenient to do the ‘assigning’ as of the 1980s – but not for (mainland) China, for which it must be much more recent. We then look at our economies in turn, first in trios: the US, UK and Switzerland; Japan, Germany and Sweden; then in pairs: France and Korea; Italy and Taiwan; finally mainland China. The aim is to group together economies with strong similarities in finance and corporate governance. In each case we give a more detailed discussion of the development of FCG than there was scope for in Chapter 3, and show how it accounts for at least some aspects of the general pattern of specialisation and change. In each chapter, except that on China, we focus for some time on one or two major sectors in which the countries discussed are or have been strong. In the final chapter, we bring together the discussions in the country chapters of recent developments in FCG, and consider the general trends and tendencies of change, and how they are affecting, and are likely to affect, technological change and advantage. We then turn prescriptive. We argue that the current near-consensus on corporate governance is in some respects too narrow and in other respects plain wrong. The stereotype of ‘good’ corporate governance does not describe what has worked best in any industry, still less does it measure up to the needs of firms and economies in the midst of the current technological revolution. There will have to be real institutional creativity if the most is to be made of the extraordinary opportunities for technological progress that now exist.

2

How sectors vary in their requirements from the system of corporate governance and finance

2.1 Introduction We argued in Chapter 1 that innovation poses four challenges for corporate governance and financial systems, each of which they can meet, given the appropriate capabilities or characteristics: •

•

•

•

The opportunity for innovation: to take advantage of high opportunity requires heavy spending on innovation, which in turn demands high availability (and acceptability) of risk capital. The need for reconfiguration: how far does a product or process of innovation involve, or need, radically new ways of organising its development or production, radically new technologies, and/or radically new markets or selling methods? To what extent (therefore) does the organisation of the firm need to be reconfigured in order to succeed in innovation? Radical reconfiguration can most readily be pushed through where there is strong pressure for higher value-added. If the need for reconfiguration goes to the point of requiring new start-up firms – firms configured from nothing – then strong venture capital is required to establish and nurture them. The visibility of innovation: how easy is it for controllers or financiers not closely involved in managing the development of a new product or process, to judge what resources are being devoted to it, and how efficiently? Alternatively, how long will it be until there is a visible pay-off in market share and profit? The lower the visibility (and/or slower the pay-off), the more the monitors need firm-specific understanding, which can be developed through engagement with the firm. Stakeholder spill-overs in innovation: can the firm ensure straightforwardly (for example by patents) that the bulk of the returns on it are appropriated by the shareholders; or does innovation in the industry naturally tend to involve large spill-overs to, or from, other stakeholders? The latter case, which could also be called low appropriability, can be met by some form of stakeholder inclusion: formal or informal arrangements which ensure some proportionality between the inputs from and benefits to each party while (at best) giving stakeholders influence over the firm.

32

How sectors vary

We shall be considering in this chapter how these requirements vary by sector. We shall be concerned, as throughout the book, only with sectors that can be regarded as technologically demanding; a slightly arbitrary judgement in which we shall follow the OECD when it set out a list of manufacturing industries in order of R&D intensity, that is, the proportion of sales revenue spent on research and development. The OECD arranged them into groups of similar R&D intensity and called them, accordingly, ‘high technology’, ‘medium-high technology’, ‘medium-low technology’ and ‘low technology’. That seems to make reasonable sense: a high-technology sector is surely highly-innovative, and although R&D is not the only kind of spending on innovation, it is the most prominent. The five manufacturing sectors categorised by the OECD as ‘high Table 2.1 High-technology and medium-high-technology industries ISIC Rev.3 number

High-technology industries Office, accounting and computing machinery (‘IT hardware’ for DTI) Aircraft and spacecraft Pharmaceuticals (and biotech) Radio, TV and communications equipment Software and IT services

R&D/ production, 1999* (2003)**, %

R&D/ value added, 1997***, %

Production/ value added 1997

30

7.2 (8.6)

39.7

3.78

353

10.3 (4.9)

36.5

2.87

2423 32

10.5 (15.0) 7.4

25.4 19.9

2.25 2.43

72

(10.7)

Medium-high-technology industries Motor vehicles, trailers 34 and semi-trailers (automobiles) Electrical machinery 31 and apparatus, not elsewhere classified Chemicals excluding 24–2423 pharmaceuticals Machinery and 29 equipment, n.e.c.

–

–

3.5 (4.3)

13.4

3.82

3.6

10.3

2.71

2.9 (3.7)

7.9

3.04

2.2 (2.5)

5.0

2.63

Sources: * OECD (2003a): STI Scoreboard, Annexe 1.1. ** DTI, The 2005 R&D Scoreboard (relates to the average R&D intensity in 2004 of the largest world companies in the sector). *** OECD (2001b) STI Scoreboard, Annexe 1.1. The production/value added figure is the result of own calculations.

How sectors vary

33

technology’, on this basis, are plausible enough: aerospace; pharmaceuticals; office, accounting and computing machinery; radio, television & communications equipment; and medical, precision and optical instruments. The next five sectors in the OECD ranking order (by R&D intensity) are defined as ‘medium-high technology’: electrical machinery and apparatus, not elsewhere classified (n.e.c.); motor vehicles; chemicals excluding pharmaceuticals; railroad equipment and transport equipment n.e.c.; and machinery and equipment n.e.c. (see Table 2.1). These two categories cover the main manufacturing sectors in which the advanced countries compete – and in which the stronger developing countries are trying to establish themselves. The ‘lowertechnology’ sectors below them are less important, and performance in them depends less on innovation and technological change, so we feel justified in ignoring them. Even in our chosen categories we shall leave out one sector in each category as too small and heterogeneous for our purposes: medical etc. in high-tech, railways etc. in medium-high-tech. We shall also leave out electrical machinery from detailed consideration in our ‘country chapters’, for reasons we shall explain below. Sadly, we were obliged to leave out all service sectors except software and IT services: important some of them may now be, but the data is simply not good enough. There are reasonable data for software and IT services: this is fortunate, for if ever there was a sector that was at the cutting edge of technological (and organisational) change, it has been that one, at least for the last 20 years. It seems to meet the OECD requirement of high R&D intensity, comparable to the ‘top five’ of manufacturing, although perhaps a little below them. (Software development is not really a service in the true sense: its production is analogous to the production of a capital good, with the difference that once it is made it can be multiplied n times without having to be produced again.) The task is now to give a rating, approximate as it may have to be, to each of the sectors we have chosen to look at, in terms of our four challenges, our four faces of innovation, opportunity, reconfiguration, visibility and stakeholder spillovers (see Table 2.2).

2.2 Opportunity and need for reconfiguration Technological opportunity is to do with how much can profitably be spent on innovation. R&D intensity shows how much is being spent on one important element of innovation, so it is a reasonable indicator of the level of opportunity. But there are different kinds of technological change. There may be high R&D spending propelling an industry along an established trajectory of change; or a complete paradigm shift in which all the rules of the game are rewritten and only new firms, or firms prepared to make radical organisational and technical changes, will prosper. It is in the latter case that one sees not only high opportunity, but also high need for reconfiguration. As we have already pointed out, the most pervasive ‘shifter of paradigms’ of the last 30 years has been the complex of changes in information and communication technology, which has

34

How sectors vary

Table 2.2 Determinants and indicators of challenges of technological change for finance and corporate governance Opportunity Need for reconfiguration Visibility and spillovers/ appropriability

• • • • • • • • • •

R&D intensity frequency and scope of paradigm shifts turnover of companies proportion of research/basic research in innovation spend proportion of fixed capital in innovation spend codifiability of knowledge vs. cumulativeness on the shop floor importance of patents protecting products and processes vs. importance of secrecy importance of relationships with employees, customers and suppliers scale at which innovation takes place speed of pay-off

left no industry unaffected but has naturally had most effect on those which make ICT’s tools. Another has perhaps cut as deep but has not spread so wide – biotechnology. We shall argue that, in general, the high-technology sectors have been more affected by ICT and/or biotechnology than the rest, but that the degree of paradigm shift has varied a good deal among them too. A good indicator of its extent is the turnover of firms: how many among the dominant firms in an industry are completely new – at one extreme – or (at the other extreme) were already dominant in that sector (say) 50 years ago?

2.3 Visibility and appropriability There is a picture that can be painted of high visibility and of high appropriability/low stakeholder spill-overs. Imagine a firm where innovation revolves around research, as opposed to development – and assume that this research, as is often the case, is carried on in central labs. The results of the research, whether new products or processes, are codified – expressed in words, symbols, blueprints – and in that form protected by patents and perhaps copyrights, which in this industry we shall assume are both very effective protective devices for intellectual property. Some of the new knowledge is then embodied in new equipment. The patents and the equipment belong, unarguably, to the firm and thus to its shareholders, who in due course will profit from them. Meanwhile, the process of innovation, as described, is as visible as it can be. The top management are well able to monitor it, and (because their intellectual property rights are secure) to tell the shareholders as much about it as they want to hear. Now imagine a second, very different, firm. There are no central labs here. What R&D is done is all D, and the development is split into a thousand piecemeal mini-projects scattered around the firm – much of it not even registered as R&D, but simply the informal part-time activity of those whose main responsibilities are for one or other of its daily operations – production, say, or

How sectors vary

35

sales. Each of those projects draws on the suggestions and ideas of customers and suppliers, and low-level employees in whatever department or division. What emerges from each of the projects, feeds back into the operations of the customers and suppliers, and into those of the firm’s own employees, and the changes are mostly not codified or embodied. The shareholders may well benefit greatly from all this innovative activity, but if they do, it will be partly because the employees, customers, suppliers involved did not give the fruits of it away to rivals, and because they were prepared to make the effort in the first place. From the point of view of outside shareholders who wish to monitor what is being done for their future enrichment, and to keep the gains from it for themselves, firm no. 2 is a hopeless case: the visibility of innovation is abysmal, and its appropriation is a mess. Reality of course is spread out along the line between these two poles. We can judge visibility and appropriability roughly from some factors that can be measured, and others that must be roughly gauged or guessed. ‘Proportion of research and fixed capital in innovation spend’ come in the first category, ‘codifiability of knowledge versus cumulativeness on the shop floor’ and ‘importance of relationships with employees, customers and suppliers’ come in the second. It turns out that there are fairly good data on the effectiveness of patents protecting products and processes; in particular, two US surveys relating to 1983 (Levin et al. 1987, hereinafter ‘1983’) and 1994 (Cohen et al. 2000; hereinafter ‘1994’) respectively. The later of these two seminal studies gives sectoral data on the effectiveness of a range of appropriability mechanisms, including secrecy. It seems to be the high-technology sectors which are, on the whole, the more visible and the more appropriable via patents and other legal measures – but there is a lot of variation in both the high-tech and medium-high-tech categories, as we shall see.

2.4 Changes over time There is some evidence that reliance on patents for appropriation has been increasing, at least for large firms (Cohen et al. 2000). There was a clear-cut upward change in trend from about 1984 in applications for patents in the United States. This can partly be explained by a flurry of legal changes in the US in favour of patenting, in 1980–1982.1 But it is interesting that the ‘structural break’ change in trend did not affect chemicals and pharmaceuticals, but did clearly affect the ‘electrical, computers and communication’ category, and also ‘mechanical and other’ (Cohen et al. 2000). ICT and the accompanying digitalisation of measurement has led to a great increase in codification. To take an example from production technology, a computer-numerically-controlled machine tool can conduct a range of different operations, each of which must be digitally specified: it cannot operate without codified knowledge. This affects chemicals and pharmaceuticals least, because chemical formulae are a quite different and longestablished form of codification. The codification of knowledge makes it easier to formulate a patent application, and it makes patent protection, if effective, more

36

How sectors vary

attractive since imitation of codified knowledge is easier. But patent protection may not be effective. Apart from the difficulty of enforcing a patent right against infringement (a nightmare for a small firm facing a larger one), a patent may simply provide a conveniently visible target for a competitor to ‘invent around’. Patents have become increasingly visible, in this dangerous sense, with the development of programmes for scanning large numbers of patents in an automated manner. What is certain is that patents have become more important as a tool of business strategy. As we shall see in the final chapter, they have come to play a role in finance and corporate governance, since analysis of a patent portfolio can be used as part of an exercise of valuation of a firm. They have also become an important issue for United States foreign policy. A great success for the United States was the TRIPS agreement of 1994, a powerful move to extend the protection of intellectual property internationally. Whether they have become more effective as a means of safeguarding the profits from innovation is more debatable. Between the 1983 and 1994 surveys the most conspicuous change in this area was a rise in the importance of secrecy (at the expense of sales and service for product innovations, and of lead time and sales and service for processes). Secrecy is an alternative to patenting, at least at a point in time (one may use secrecy first and patent later). What continues to be true for patents, as we shall see, is that they work a great deal better for some sectors than others.

2.5 How scale matters The visibility of innovation is affected by scale of production – and scale of innovation project. Other things being equal, a large-scale firm counts as more visible because it is, so to speak, more worth looking hard at. Every unit of time and effort an investor spends engaging with it, getting understanding of it, will yield a better return. If an activity is an inevitably small-scale one – let us say the development, manufacture and sales of a highly specialised machine – it can still be carried on by a large firm, but if it is, it will be a small part of that firm’s activities, and as such its visibility will be relatively low – even to top management. If it is – more appropriately – carried on by a small firm, in the extreme case one which does nothing else, then anyone who has a good understanding of that firm will understand that activity. The problem is then the low visibility of the whole firm, from the lofty height of a large institutional investor. Of course (the reader may object) a small firm does not even think of getting funding from a large institutional investor – it will seek it from its local bank. Unfortunately the same principle usually applies: for a small loan, it is not worth the bank taking the trouble to look carefully at the firm’s plans, technologies and prospects. It will not bother to engage – unless it has a policy of doing so, perhaps because it is a public-sector bank with a mission that goes beyond profit. (The only other way the small firm may find a lender with a good understanding of what it is trying to do, is in an ‘industrial district’ where half the town is making much the same thing. A bank manager who has made a dozen loans to

How sectors vary

37

similar firms for similar purposes already that month, may be able to size up the proposition, and the proposer, in ten minutes.) So small-scale activities need investors with, if you like, a high propensity to engage; and the obvious candidates are family owners. As we shall see in the next chapter, national systems vary greatly in the availability of engaged family owners, as they vary in the availability of banks willing to engage. Scale also affects stakeholder spill-overs and appropriability. If we hold the size of firm constant, the scale of an investment will, or should, determine what level of management has discretion over it. A decision to double the capacity of its largest plant is one for the very top; the decision whether to replace or repair a small machine should be taken a long way down. The same applies to investments in innovation, of every kind. An ‘included’ employee can probably be trusted to use his or her discretion in the interests of the firm. It is relatively easy to ‘include’ the top management – they will naturally identify with the firm, ‘their’ firm, and they will get shares or stock options if anyone does. (There remain of course the reservations we set out in Chapter 1 about their aims, and who the ‘firm’ is anyway.) Much rarer is the firm in which the average production operative, lab technician or sales rep feels ‘included’. So the stakeholder inclusion problem in innovation depends partly on what level or levels of the firm really need to drive it. Difference in firm size also will have an effect on appropriability. As mentioned in the last section, a small firm will find it hard to defend any patent it may have against infringement by a large one,2 and it is increasingly easy for large firms to find patents with a view to infringing or inventing around them; which may explain why, between the 1983 and 1994 surveys, concern over information disclosure became more important as a reason not to patent (Cohen et al. 2000). The 1994 survey found that the smaller the firm (and/or the business unit), the less the patent effectiveness. The stakeholder inclusion (above all employee inclusion) needed to protect its secrecy is then all the more valuable. Scale matters, then. As Figure 2.1 shows, it also varies considerably among our sectors.

2.6 The high-technology sectors 2.6.1 Aerospace We have to make a sharp distinction in aerospace between level of opportunity and need for reconfiguration. The very high R&D intensity (whether by turnover or by value-added) shows that opportunity is high. But this is the high-technology sector that displays easily the most continuity. So little has changed in 30 or 40 years: aircraft still consist of fuselages, wings and tails of much the same shape, and they are powered in much the same way. Of course the industry has not been unaffected by the ICT revolution – but so far as aerospace is concerned, it has been a long, slow revolution. This was one of the first industries to be deeply affected by electronics – during the 1940s.

38

How sectors vary

300 250 200 150 100 50

Motor vehicles, trailers, and semitrailers

Electrical machinery

Machinery and equipment

Chemicals

Radio, TV, and communication equipment

Office, accounting, and computing machinery

Aircraft and spacecraft

0

Figure 2.1 Average size of firms (1999), by number of employees (source: author’s calculations on OECD (2006)). Note Chemicals include pharmaceuticals

Computer-numerically controlled machine tools are (literally) the cutting edge of the ICT revolution in terms of production processes; well, aerospace was the first industry to introduce CNC tools, in the 1960s. The essential continuity of change is reflected in the very slow turnover of firms. Most large civilian aircraft flying today were made by the same company, Boeing, that made most aircraft, 30 or 40 years ago – and many of them indeed are of models that were developed 30 years ago. The Airbus consortium (now part of a firm, EADS), which is Boeing’s main rival, was founded in 1970, and the various European manufacturers that came together in it, at that time and afterwards, were then making most European aircraft. The world’s three main aero-engine makers today, GE, Pratt & Whitney and Rolls-Royce, were its three main aero-engine makers 30 years ago. The temporary catching up of Boeing by Airbus, and the overtaking of Pratt & Whitney by RollsRoyce, are interesting developments, which we shall discuss in Chapters 4 and 5 – but they are not earth-shattering. So the need for reconfiguration is decidedly low. There are some features of the industry that do not make for high visibility or appropriability. Pity the poor top executives who wish to explain to outside shareholders the beauties of the new model they are preparing for launch. Patents are relatively ineffective in protecting product innovations in aerospace – secrecy is exceptionally important (see Table 2.3). Outside shareholders cannot be trusted to keep secrets. Employees at all levels may be – if they are loyal enough. This is then an industry that needs employee inclusion – helpful too when one considers

251.78

Average size of firms (employees) (1999) (7)**

C: Low S: 2.2 25.4 2 since 1970s; Not high until 1990s NA

99.08

C: Medium S: 3.0* 39.7 Full effect of ICT shifts; Quite high

44/43

87.64

Semiconductors and related equipment: 4.5/3.2 Communications equipment: 3.6/3.1 PATENTS Semic.: 27/23 Electronic components: 21/15 Comm. 26/15 TV/Radio:39/19 SECRECY Semic.: 60/58 El.comp: 34/47 Comm.: 47/35 TVRadio: 50/48 C: Mixed S: NA 19.9 Varying effect of ICT shifts; Moderate

NA/66.1

Radio, television and communication equipment

Notes * IT Hardware. ** The data refer only to the countries included in the book.

Sources: (1) Istat (1995); (2) Doudeyns and Hayman (1993); (3) Levin et al. (1987); (4) Cohen et al. (2001); (5) C: selling only to few industrial customers: very high; selling only to mass market: very low. S: Sales over value-added, for top 600 European companies, DTI Value-Added Scoreboard 2004/5; (6) OECD (2003a); (7) Own calculations on Hwwa worldwide matrix (www.hwwa.de).

C: High S: 2.4 36.5 None; Very low

53/68

55/49

41/30

3.4/3.3

6.5/4.9

50/36

0.8/64.8

Office, accounting and computing machinery

NA/66.7

Pharma.

33/21

Importance of relationships with customers (C) and suppliers (S) (5) R&D intensity (R&D spend/value-added) (6) Frequency of paradigm shifts; Turnover of companies

Effectiveness of appropriation mechanisms for products/processes (1994) (4): Patents on products/processes (mean of full sample: 35/23) Secrecy on products/processes (mean of full sample: 51/51) (4)

Percentage of basic research in innovation spend (1) 36.6/NA and/or % of research in innovation spend (2) Relative importance of patents protecting products/ 3.8/3.1 processes (1983) (Mean of full sample 3.5/4.3) (3)

Aircraft and spacecraft

Table 2.3 Characteristics of technological change in high-technology manufacturing sectors

40

How sectors vary

the cumulation of employee skills which follows from the continuity of products and processes. Some other features favour visibility and appropriability. This is a ‘scaleintensive’ industry: it is dominated by very large firms that spend very large amounts of money on individual projects for new aircraft or new engines. There are, accordingly, a small number of big decisions that have to be taken by very senior people. Those big decisions could be explained to, or discussed with, outsiders with an adequate technical and scientific background – as long as they could be trusted to keep secrets. Such people exist, or may exist, in government ministries. For them, and for top executives, the visibility of innovation will be relatively high. Likewise, there is no need to blur the boundaries of self-interest between aircraft manufacturers and their customers. Of course the major airlines are important customers to be cultivated individually with great care – but there is no long-term commitment. What makes airlines reluctant to switch from Airbus to Boeing or from Boeing to Airbus is the cost of doing so, not any kind of long-term trusting relationship – or cross-shareholding. Suppliers, on the other hand, are of great importance in such an ‘assembled’ industry – although the relationship with the engine manufacturers is made less dependent by the fact that most large civil aircraft are designed to be able to fly with more than one manufacturer’s engines. 2.6.2 Pharmaceuticals The production of medicines is of course a very old industry. Until very recently it was, from a scientific point of view, an alliance between medicine and botany, since most medicines were of herbal origin. During the nineteenth century, as Henderson et al. (1999) explain, all that changed, with the discovery of the medical effects of dyestuffs and other organic chemicals. Henceforth, chemists were able to synthesise an ever-increasing number of New Chemical Entities (NCEs) which might (with luck) turn out to have therapeutic effects, and (with much more luck) not have too severe side effects. Their understanding of the NCEs’ structure and direct chemical activity steadily increased. Understanding of how they worked in the body lagged behind. As long as that was so, the industry could be, and was, treated as a branch of the chemical industry; and many pharmaceutical companies, particularly in Europe, were divisions of large chemical firms. The dominant research technique in pharmaceuticals, in the 1950s and 1960s, was the so-called random screening approach. With this method, many synthetic chemicals (produced by chemical synthesis or fermentation) or natural products are indiscriminately tested for biological activity. As at the time there was not a precise understanding of what caused a specific medical problem, the compounds were tested in vivo, on animals that presented the ‘target pathology’. This kind of technology in experimentation depended heavily on tacit knowledge and, in particular, on ‘chemists’ intuition’ (Nightingale 2000). Random screening was a very costly and time-consuming technique but it worked very effectively during the 1950s and 1960s to develop many important drugs such as diuretics and vasodilators (Henderson et al. 1999).

How sectors vary

41

Since then, the industry has undergone two paradigm shifts. The first, which occurred during the 1970s, was the transition from random screening to the ‘guided discovery’ approach. A ‘pathway of disease’ was identified by collaboration between clinical (medical) and biomedical scientists: chemists then had to find, or synthesise, a chemical entity that had the properties required to break that pathway. Their tacit knowledge remained important, but they were thenceforth playing second fiddle to that clinical–biomedical collaboration. Strong connections with scientific centres of clinical and biomedical excellence became of great importance for pharmaceutical firms. The second paradigm shift, which took place during the late 1980s and 1990s, had several elements that drew variously on informatics and biotechnology. ‘Combinatorial chemistry’, based on fundamental advances in miniaturisation, robotics and receptor development, allows scientists to create large populations of molecules, or libraries. Genetic engineering allowed the development of cloned reactors as assays for automated testing: this ‘high-throughput screening’ allows those libraries to be efficiently tested for therapeutic effect (Gordon et al. 1994). The high degree of automation involved in Combinatorial Chemistry drastically reduced the centrality of chemists’ tacit knowledge or intuition (Nightingale 1998). The impact that biotechnology or genetic engineering has long been expected to have on the industry, goes much further, but has only been partly realised. On the production side, genetic engineering has been employed in the production of natural proteins like insulin whose therapeutic effects were already known and exploited, and were too complex to be produced with the traditional chemical methods. A stream of new biotechnology-derived drugs has been developed since the early 1980s but, as complex proteins, they have repeatedly come up against the difficulty of administering them, since they are destroyed by stomach acid. Diabetics may be resigned to injecting insulin, but any patient who has the alternative of swallowing a pill will take it. There are other strong stabilising factors in the industry. Any new drug has to be subjected to a long, rigorous and expensive series of pre-clinical tests (on animals) and clinical tests (on humans), whose results must then be presented to regulatory authorities like the Food and Drug Administration in the USA. For all the scientific and technical advances that have been made, only a small percentage of the drugs that begin this marathon will survive to the end. The competencies that are required to navigate the testing and regulatory procedures have changed only gradually over the decades, and the large pharma firms have them. They also have the large sales and marketing departments required to make sure that new drugs get the commercial success they deserve. New ‘dedicated biotechnology firms’ (DBFs), which sought not only to discover but to develop, even to sell new drugs, have found that these were all expensive barriers to surmount; and those investors who provided the funds to allow them to do it learned the hard way what Big Pharma already knew – that the odds against success for any one drug were high. (Introducing a new drug on the market takes on average 12 years, and costs over $800 million, according to the US Office of Technology Assessment in 2000. Only one of 5000 screened compounds is

42

How sectors vary

approved as a new medicine and only three of ten marketed drugs produce revenues that match or exceed R&D costs (Nightingale 2000).) On the other hand Big Pharma’s own mechanisms for drug discovery (and evaluation of drugs discovered) are in crisis. The big pharma firms are struggling to stop their drug pipelines running dry.3 The DBFs now exist in an uneasy symbiosis with Big Pharma: they do much of the discovery of promising new drugs, particularly those requiring innovative approaches (whether or not they involve genetic engineering) and, having patented the drug and done some of the early (and cheaper) testing, then find a big firm willing to pay them for a license on it. How can we rate pharmaceuticals, then, on our four dimensions? Opportunity is clearly high, to judge by R&D intensity – although measuring that over valueadded, as opposed to turnover, it is not as high as aerospace or computing. The need for reconfiguration likewise is high but not top. Since the 1970s, change has been rapid, and with some deep organisational consequences; but (except for the ‘upstream’, discovery end) the gains have gone not to new firms, but to old firms that made the necessary changes earlier and more skilfully than the rest. Those that were part of chemicals groups, had to be de-merged; and if they were dominated by chemists, the chemists had to be dethroned. Those that were inward-looking, had to forge close links with the science base; those that were scattered across a large number of therapeutic areas had to specialise in a few in which they concentrated their biomedical and marketing competencies. In the areas selected they had to be as favourable to those NCEs discovered by startups as to those discovered in-house. And firms that spread their development resources thinly over a large number of NCEs regardless of their prospects of approval or the volume of sales they could hope for, had to learn that big profits went mainly to those firms that focused early and brutally on a few likely ‘blockbuster’ drugs, selected by cross-functional teams. Where pharma leads, in most respects, is in visibility and appropriability. All authorities agree that product patents are an unusually effective method of appropriation in this industry.4 Secrecy, interestingly, is also rated somewhat above average for product protection. The need for this is nonetheless limited to the discovery phase. Not all knowledge here is codified, or codifiable: ‘While high-throughput processes are used at the start of research tasks, the final stages of biological analysis and chemical synthesis are still very craft-based’ (Nightingale 2000: 350). Knowledge accumulated on the shop floor is important in this sector as in others, but the shop floor is, in this case, the high-tech lab. Once the clinical testing starts, it would be hard to keep much secret about a new drug, and it would matter relatively little if a rival found out, since it would first have to ‘invent around’ the patent, then start down the same long road, a long way behind – without knowing whether the first firm has a winner anyway. The people who really need to keep secrets are the few people, mostly scientists and technicians, involved at the discovery end. So employee inclusion is valuable, but not outside a rather small core. Near the end of the long development process, when success is at least likely, the shareholders can be told about the progress of specific drugs. They can be given quite good general information as

How sectors vary

43

well. As shown in Table 2.3, the proportion of R&D in innovation spend is very high, and it is rather common for a firm in this sector to display its R&D expenditure (and that on capital and marketing) and to communicate to the market detailed information about the employment of new technologies or research alliances with other companies and universities (Ramirez and Tylecote 2004). There are certainly few obstacles to visibility within the firm. The top management have a good view of the innovation process, because of its formalised, regulated, codified nature, and because a new drug has a rather fixed character, defined by its chemical composition. A mechanical or electrical product will be modified in all kinds of significant and insignificant ways during its development process, to make it easier to produce and to sell – this is mainly what the development process is for, and that is why authority over that process needs to be decentralised to relatively low levels of the firm, who can be responsive to those who will have to produce and sell the product. With a new drug, on the other hand, one will learn something about dosage and perhaps about the type of patients who will benefit from the drug, and not much more; not enough to justify decentralisation of authority. The only important factor demanding shareholder engagement (or management autonomy) is slow pay-off. From the beginning of research in an area, to the launch of a product resulting from it, could well be 15 years, given the long series of pre-clinical, then clinical tests required. Not until after launch can shareholders have any confidence that a drug will succeed. Indeed they cannot even be sure then, given the possibility of disasters such as Merck’s withdrawal in 2004 of its successful pain-killer Vioxx, launched in 1999; a withdrawal that cut $27 billion from Merck’s market value (The Economist 2005c).5 We have seen that inclusion of a small core of employees is valuable. No other stakeholders count for much. Sales are to a mass market, not to a few cherished customers. The sales/value-added ratio is unusually low, and the tendency to outsource discovery to the biotech firms, and parts of testing to contract research organisations, does not require the big pharma firm to develop hightrust long-term relationships with either of them.6 2.6.3 Office, accounting and computer equipment For all intents and purposes, the computer industry is a creation of the second half of the twentieth century. It is, of course, one of the spearheads of the ICT revolution, and it has itself been revolutionised several times in its short history – in each case led very much by the United States. Each revolution, or paradigm shift, in hardware was naturally accompanied by a shift in software, and although our primary concern in this section is with hardware, we shall make some references also to software. The first paradigm shift in the industry that we need mention arose from the development of integrated circuits, which led to the launch, in 1965, of the PDP8, the first general purpose minicomputer – far cheaper than any mainframe. This opened up a totally new and rapidly-growing market segment, and new start-ups of minicomputer producers entered the market. Some

44

How sectors vary

of them were spin-offs from universities, others from incumbent firms. There was also entry by instrument firms such as Hewlett-Packard. Another, related shift took place in the same period: computer vendors began to ‘unbundle’ the hardware from the software (hardware and software started to be considered as different products and invoiced separately), which offered new entry opportunities for software developers – and indeed made entry easier on the hardware side too (Bresnahan and Malerba 1999). The next shift again followed a leap forward in the key component: the development of the microprocessor led to the introduction of Personal Computers or microcomputers in 1981. PCs were less powerful than mainframes and minicomputers but much cheaper and easier to use. The introduction of PCs revolutionised the market for computers. It led to the transformation of computers into consumer durables (opening up huge opportunities for new companies); and to a parallel spread of software houses that specialised in the development of various applications. As with minicomputers, the entrance of new firms occurred mainly in the US, whereas in Europe and Japan new entries were not numerous, the only exception being the UK (Torrisi 1996). The introduction and spreading of PCs had an enormous impact on the software market and on the competitive strategy of software developers. In fact, operating systems and software applications were now sold on the mass market and not customised to the needs of the users as with mainframes and even minicomputers. Long-term relationships with customers, which were previously crucial for innovation, became irrelevant and formal intellectual property rights (mainly copyright and patents) acquired more importance. The most recent shift was that which culminated in the Internet: the appearance during the 1990s of new devices (and the related software) that support networks of computers, within the same firm (LAN, Local Area Network) or on a much wider scale (WAN, Wide Area Network). Operating systems and applications can now be stored on a central server (inside or outside the organisation) and utilised by PCs through the net. This has developed new market segments. For example, application service providers have increased, who deliver and manage applications from remote computer centres to numerous users via the Internet or private networks. This is clearly an industry that for at least the last 40 years, has displayed very high opportunity (confirmed by the R&D intensity figures), and very high need for reconfiguration, as radical changes in technology have led to equally far-reaching changes in the market.7 Ten years or so after the introduction of the PC, it was possible to think that computers themselves – as opposed to the connections between them that we have just mentioned – were settling down. The appearance of still smaller categories – lap-tops, notebooks, palm-tops – alongside PCs was not a comparable transformation to the development of the PC; and PCs were becoming a ‘commodity’ item. There then followed a much less visible but still important shift – in the nature of production. Many of the US producers of hardware sold most or all of their manufacturing facilities to companies that did nothing but manufacturing, and henceforth restricted themselves to development and design,

How sectors vary

45

and sales and marketing (Sturgeon 2002). By doing so they not only sharpened their focus, they made the whole chain of production more efficient. While they could not forecast accurately what their market share would be in the next round of product development, and had therefore been condemned, when manufacturing, to regular periods of excess capacity and capacity shortage, the specialist manufacturers could expect a smoother ride. If customer A won market share from customer B, what did they care? They would make more for one and less for the other. Opportunity may have been declining, then, in much of the sector; less so, the need for reconfiguration. The big change has been in visibility and appropriability. In the 1983 survey, the effectiveness of product patents on computers was well below average (3.4 against 4.3) and that of process patents a little below. By the time of the 1994 survey, that of product patents was clearly above average (41 against 35) as was that of process patents (30 against 23).8 The 1983 survey gives no sectoral figures for secrecy, but we can assume that as patents became more effective, its effectiveness declined – to the point where the 1994 computer figure was clearly below average for both products and processes. All this we might have guessed from Sturgeon’s findings on the separation of manufacturing from the rest: as he pointed out, this only took place because of a high degree of codification of knowledge about products and processes. Without that it would not have been feasible – how could designers and manufacturers have communicated at long range? Nor, without the patenting of the codified knowledge, would it have been safe. (Neatly enough, the change was made possible by advances in computing itself – the development of CAD-CAM, computer-aided design linked to computer-aided manufacturing.) The trend to rising visibility and appropriability must have been reinforced by the evolution of relationships with customers and suppliers. Since the rise of the PC there have been far too many individual customers – whether business or consumer – for there to be anything but a distant relationship with them. On the supplier side, this is clearly an industry with a high degree of vertical disintegration; yet with the codification of computer design, and the commodification of components, together with the globalisation of their production, there is little scope for long-term trusting relationships with suppliers. Only among the employees in the technological core of the firm – the design and development function – is there any obvious need for inclusion. 2.6.4 Radio, television and communication equipment This sector is misleadingly titled, for it includes semiconductors and related equipment, and electronic components – very important categories, which accounted for the majority of the US firms in the sector in the 1994 survey, even though the main producers of electronic components were and are in East Asia.9 The sector is, for the most part, a spearhead of the ICT revolution, much like computers, and as such high in opportunity (confirmed by its R&D intensity) but it seems to have been rather less subject to paradigm shift. For example, as we

46

How sectors vary

have seen, the successive developments of integrated circuits and microprocessors convulsed the sectors that used them – computer hardware and software. The integrated circuit brought a paradigm shift in the sector that produced it, too; but microprocessors were not much more than an important milestone along an established trajectory, which followed Moore’s Law (that the density of data on integrated circuits doubles approximately every 18 months). Likewise the essential design of the TV or monitor remained the same for more than 50 years, until the advent of digital transmission. Each of its components has of course been progressively improved and made more sophisticated, especially with the introduction of the micro-chip; but none of the innovations involved, not even the introduction of colour, or of remote control, was a competence-destroying radical innovation. The invention of videocassette recorders modified the use of the television but it did not bring about important transformations in the television itself. The same applies to TV transmission, and to radio. The replacement of the cathode ray tube by liquid crystal displays is a competence-destroying innovation so far as it goes – and many of the firms that make LCDs did not make CRTs; but it was a strikingly slow and predictable innovation. When LCD finally started to displace the cathode ray tube, it had been known for decades – with a number of firms patiently chipping away the obstacles to cheap manufacture of large high-quality screens.10 The Walkman, VCRs and CDs were striking innovations so far as the consumer was concerned, but developing and making them drew on little beyond a familiar set of electronic and mechanical competencies, and they could be sold to much the same people in much the same way. The picture of a sector in which change is generally evolutionary is confirmed by the slow turnover of dominant firms. A flurry of US start-ups in the 1950s produced Intel, which proceeded to establish dominance of the high end of the silicon chip market – and keep it into the next century. Major Japanese firms, followed by Korean chaebol groups, established and kept dominance of other electronic components and equipment, and the machinery to make them, in a similar way (Berggren and Nomura 1997: ch.7). The need for reconfiguration has thus been, by high-tech standards, low in most of the sector. This has some implications for visibility and appropriability; for in such circumstances, competencies cumulate. Shop floor manufacturing skills count, certainly for components (assembly, rather as with computers, is less high-tech and can be outsourced or (more likely) located where the labour is cheap11). So do good relationships with suppliers (of materials, components and machinery). Customers for components are large firms, and again, the opportunity will exist to build and make the most of a high-trust long-term relationship; in many cases, the relationship is between divisions of one large firm. It is notable that while computing moved from somewhat below average to somewhat above it for patent protection of products, this sector moved the other way, and was, as of 1994, firmly established as low on patent protection (except, marginally, for TV/Radio). For semiconductors, secrecy was correspondingly high, but not for the other parts. Electronic components – much like the typical commodity

How sectors vary

47

sectors, metals and glass – depended instead heavily on complementary manufacturing, sales and service to protect their new products (and processes). Telecommunications equipment is rather different. Until recently it was dominated by the telephone exchange segment, equipment notable for being sold overwhelmingly to very large, mostly state-owned telecommunications service providers, and for being itself large in scale. One segment of the sector stands out as an exception: mobile telecommunications. A number of radical innovations have made the sector more diverse: optical fibre cables, satellite earth stations, and above all the development of mobile telecommunications. It is the creation of a recent paradigm shift and is still changing very fast, and one striking piece of evidence for that is the transformation of Nokia from anonymity as a small Finnish conglomerate in the late 1980s to the (precarious) leadership of the industry some 15 years later. To be precise, Nokia’s leadership was in mobile hand-set manufacturing: and it was in that sub-segment most of all that the rules of the game were rewritten, with extremely rapid development of new products, to be sold to a mass, mainly young consumer market – in an industry accustomed to selling slowly-changing products to middle-aged industrial buyers. The advent of digital technology across the ICT sectors, heralds a real and general paradigm shift.12 In TV and radio transmission, the improvement in quality that it allows, and the multiplication of channels, are typical incremental changes, but the paradigm-changing fact is that the digital technology is the same as employed by computers, CDs, the internet and mobile phones. Suddenly separate products, technologies, and markets, are on a convergence course. The effect on the converging industries is, however, so far only in its early stages. The Apple iPod is an example of effective response.13 2.6.5 Software and IT services The service sectors are horribly neglected by statisticians, who are attached to the familiar manufacturing categories that they have tended for decades, and are slow to recognise the need for new ones. All business services suffer, moreover, from an obstinate demarcation problem: they can all be provided ‘in-house’ by employees of firms whose main business is something else (manufacturing, for example), and this is how they commonly are provided (although less so than in the past). With the best will in the world, the statistician could not recognise such activity as part of any service sector. Software is afflicted by both problems in full measure. A large proportion of software engineers, worldwide, are employed by manufacturing (mostly electronics) firms. Worse, for most statistical purposes software firms – that develop, create, software – are lumped in with IT service firms – which help other organisations to buy and use software and ICT in general. These are of course very different activities: to repeat a point made above, software development is akin to the manufacturing of a capital good, except that once created this capital good will never wear out (although it will become obsolete) and can be manufactured in unlimited quantities for next to nothing. IT services are much more typical services.

48

How sectors vary

Not surprisingly, it is software that is the more R&D-intensive, and the more obviously high-technology. Partly for that reason, it has had more academic attention – although not enough to get it included in either the 1983 or the 1994 survey on appropriation mechanisms. We have been saved from the inadequacies of the official data by Casper and Whitley’s (2004) pioneering work. They divided the industry into standard (or application-based) software, middleware, and enterprise software. Standard software includes graphic application software (e.g. CAD/CAM), multimedia and computer entertainment software, and a variety of application software used to run computer networks, such as email and groupware. Middleware includes secure payments systems used in e-commerce, and search engines used for navigation on the Web. Enterprise software is extensively customised for individual clients. It includes enterprise resource planning and customer relationship management products as well as sector-specific enterprise tools such as logistics and supply chain management tools. (These three sub-sectors are not exhaustive: there is, as pointed out by Berggren and Nomura 1997, also the customised software that forms part of complex industrial and technical equipment, and that is embedded in consumer products, such as camcorders; but both are largely produced in-house by the hardware producers, and so largely invisible in much of the available data. They are included however in Table 2.4.) Before we retell Casper and Whitley’s account of the current scene, we had better give some historical background. At the core of software development, of course, is programming. Programming has undergone several major transformations. While the first two generations of languages, the machine language and the assembly language, were in use, programming was something like a craft activity, an art more than a science, and based on skills that could be accumulated only over several years of learning. Accordingly, the programmers themselves played a key role in product and process innovation. With the advent of the third generation languages (FORTRAN, COBOL, PASCAL) and even more with the fourth (APL, Nomad 2) programming became much simpler and more routine. An equally important, and separate, change was the spread at the beginning of the Table 2.4 Top ten world software producers, turnover in FFm.1997 IBM (US) Microsoft (US) Fujitsu (J) Computer Associates (US) Oracle (US) NEC (J) SAP (G) Hitachi (J) Novell (US) Digital (US) Source: Nohara and Verdier (2001).

69.3 51.5 24.4 15.8 12.5 11.9 9.2 6.9 6.3 6.3

How sectors vary

49

1990s of component-based development (Pree 1997), in which components from existing systems are used for the development of new ones, without changes in the codes. This system is defined as ‘black-box re-use’ as there is no need to know the code of the components re-used. Component-based development is better able to handle complexity and to reduce development time and costs: it will however almost certainly create a program that has more code and needs more power than one written from scratch.14 As hardware became more powerful this disadvantage became less important; larger and larger blocks could be put together with more redundancy in each. The competencies needed to (so to say) tie the blocks together are rather standard and quickly learnt. As programming has become routinised, other professional figures have gained more importance in the software development process – those that operate at higher levels of abstraction and take care of the software concept (identify the high-level requirements of the system and the basic functions that the system must perform) and of the architectural design (define the high-level software architecture that outlines the functions, relationships, and interfaces for major components).15 Team-working has become a central feature of software development processes, as the increased complexity of projects now requires a variety of knowledge and skills. All the members of the team, to be able to cooperate and communicate effectively, need to have multi-disciplinary competencies (De Marco and Lister 1999). In general, as a fast-expanding and fast-changing industry, software development must have high opportunity and high need for reconfiguration – the latter particularly with the advent of component-based development. The entry rate in the sector is very high, thanks to the strong support of venture capitalists both in the US and in Europe, where financing of software start-ups accounts, respectively, for 20 per cent and 30 per cent of total technology venture capital (OECD 2002). In 1999, 40 per cent of the top 500 vendors were established after 1990 (OECD 2002). That figure would have been considerably higher, but for the fact that large incumbent firms have frequently acquired new successful start-ups to enter new market segments or gain access to new technologies. On the other hand we cannot treat it as a high-visibility, high-appropriability industry, so long as employees (whether the programmers of old, or the multidisciplinary teams of today) have important tacit knowledge. One highly controversial development has certainly done much to increase appropriability over the last 20 years: the extension of legal protection for intellectual property. As we have already seen, this has been a general phenomenon, but in software it has moved further because it has started from a very low base. The US Computer Software Act of 1980 marked a major extension of copyright protection in the industry, and subsequent legislation and court decisions made a wider range of innovations in software patentable in the US – a wider range than in Europe. We can now, with Casper and Whitley’s help, make some crucial distinctions within the industry. They find that standard software, which is created for large homogeneous markets, has high ‘competence destruction’ through radical innovation, but limited ‘appropriability risks’ – it is relatively easy to protect

50

How sectors vary

through some combination of patent/copyright protection, secrecy over its ‘source code’, and lock-in effects once successful. (Take Microsoft for example!) This clearly is a sub-sector requiring radical reconfiguration and little ‘nurturing of cumulative shop-floor knowledge and long-term customer-supplier relationships’. At the other extreme is enterprise software, which Casper and Whitley classify as having limited competence destruction but high appropriability risk, due to relatively weak intellectual property regimes. ‘While patents for particular technologies exist, work-arounds are relatively common once initial innovators establish proof of principle’ (Casper and Whitley 2004: 94). The extensive customisation of products for individual clients in this sub-sector means that long-term trusting relationships with customers will be beneficial; together with similar relationships with the workforce, these can (among other benefits) help to protect the firm’s IP. Middleware is in the middle: it is described by Casper and Whitley as ‘radically innovative’, with low technological cumulativeness, and with limited appropriability risk. But unlike standard software it has an inter-firm co-ordination problem because it must integrate interdependent kinds of knowledge provided by different firms. Trusting relationships are therefore very valuable, particularly with large firms that dominate a technology cluster. Casper and Whitley do not deal with IT services, but they would appear to have at least as much need as enterprise software for long-term trusting relationships with customers and the workforce: their IP regime is presumably even weaker, the intellectual property residing almost entirely in their employees’ heads. Nor is competence destruction likely to be stronger, since while of course the (fast-changing) IT available must be understood, a crucial part of the competence resides in understanding customer needs and the organisational difficulties of getting IT to suit them.

2.7 The medium-high-technology sectors 2.7.1 Chemicals The chemicals industry was the world’s first science-based industry, in the nineteenth century, and a pioneer both of the R&D department and of systematic industry–university links, in the latter part of the century (Murmann 2003). As such, it has had a long time to mature, and it has done so. Organic chemicals became dominant in the late nineteenth century, and have remained so. Petroleum took over from coal as the main hydrocarbon raw material for organic chemicals in the early twentieth century, and so it has remained. At much the same stage, highly mechanised continuous flow technologies were introduced, and with them came the rise of the chemical engineer as distinct from the chemist: the chemist learning how to synthesise a new chemical in the laboratory, while the chemical engineer, with the chemist’s help, would then tackle the quite different problems of volume production. All that was settled before 1950. Scale economies and cost reductions soon became so central to competitive advantage that by the 1960s

How sectors vary

51

specialised engineering firms (SEFs) had taken a central role in the industry. With a few exceptions, these engineering firms never invented radical new processes, but strongly contributed to shortening the learning curve. With all that settled, the industry seems to have enjoyed a golden age of some 20 years after which it ran into diminishing returns: as shown by Achilladelis et al. (1990), the rate of innovation (judged by patenting of chemical compounds) was much higher between 1950 and 1970, than from then to the late 1980s. By then, as we have seen, chemicals had in effect lost its most innovative part, pharmaceuticals – although confusingly much of the available data on the industry includes pharmaceuticals. In the past 20 years, new product and process development (in particular, testing and control processes) have been deeply affected by the development of new technologies (mainly ICTs), and by the increasing stringency of regulations on pollution both from the production, and from the use and disposal, of chemicals. Nonetheless, these are not major shifts.16 The impression of stability is confirmed by the very low rate of turnover. Of the 25 largest chemical firms in the world in 1994, 17 were engaged in chemicals production before 1914 (the others are mainly oil companies that entered the market during the 1940s) (Harris 1996). Since then, several mergers and acquisitions have occurred and the splitting and swapping of assets have generated ‘new’ firms and the reconfiguration of old ones; but much of that was the long-overdue shedding of pharmaceutical operations. There has been virtually no new entry: scale economies are a deterrent to start-ups, and there are probably no areas of chemicals where (due to some kind of convergence of technology) a non-chemical outsider could compete on equal terms with the incumbents. So we can put the industry in general down as only modest on opportunity (although that will vary by sub-sector, as we shall see) and even low on need for reconfiguration. The judgement on visibility and appropriation must depend very much on the sub-sector, but there are certain factors inherent in the technology of chemicals. A chemical compound can be precisely defined in scientific terms, which makes patenting relatively straightforward (although it does not preclude ‘inventing around’ with a very similar compound). So product knowledge is codifiable and likely to be codified. Likewise, although some aspects of scaling up may not be precisely predictable in advance, process innovation is not a matter for trial and error on the shop floor, or piecemeal improvement by skilled production workers: it must be firmly under the control of experts in R&D and engineering departments, and will also be largely codifiable. It may not, for secrecy’s sake, be codified, since here as elsewhere patents are less effective for processes than for products. There is then a certain minimum degree of visibility and appropriability. There are of course major variations in the pace and direction of innovation within the industry. With pharmaceuticals excluded, the main categories are base chemicals, specialty and fine chemicals, and consumer chemicals, accounting (within the EU) for respectively 50 per cent, 37 per cent and 13 per cent of total sales (European Chemicals Industry 200517).

52

How sectors vary

Base chemicals include petrochemicals and derivatives (plastics and synthetic rubber) and basic inorganics. These products are produced in large volumes and are sold to the chemical industry itself or to other industries. Process innovation predominates, since new product development is slow and markets highly pricecompetitive. According to the 1994 survey, process patents in ‘basic chemicals’ are slightly more effective than average (30), but that is not saying much – secrecy is almost twice as effective (58) (see Table 2.5). In price-competitive ‘commodity’ markets, relationships with customers are not likely to be close. If there is any outside ‘stakeholder’ involved in process innovation, it is likely to be one of the specialist engineering firms mentioned above. New process technologies are often developed in conjunction with the chemical companies on the basis of exclusive relationships (Moretti 1999). The main reason for not expecting a major problem of low visibility or appropriability in innovation, is that there is not likely to be much innovation going on. This is not the case in the second sub-sector. Specialty (dyes and pigments, oleochemicals, crop protection, paints and inks) and fine chemicals (pharmaintermediates, agro-intermediates, chemical intermediates) have a very high added value per unit weight, and are the main area of spending on new product development, and on innovation generally. Their opportunity must be higher than the rest. It is extremely likely that a product will be sold to a small number of very demanding industrial customers, and there is clearly a good deal of scope to gain from close and trusting inter-firm relationships. In the past ten to 15 years, such relationships have become the accepted norm: producers have become progressively closer to their customers. They have generally shifted from the production of a single product to the production of systems of products, often engineered to satisfy the specific needs of a customer. The chemical companies and the users co-define the features of the product and work jointly to identify the specific chemical component that the user needs, the most appropriate ways to produce and sell it and the ways in which products have to be used, reused and recycled. This usually occurs through long-term inter-firm agreements, namely long-term contracts or joint-ventures (Moretti 1999). These relationships provide probably the best protection for innovation – patents are not what they once were. While the 1983 survey found product patents for organic chemicals nearly as effective as for drugs – 6.1 against a sample mean of 4.3 – the 1994 survey put Chemicals n.e.c. and Miscellaneous Chemicals barely above average; presumably combinatorial chemistry is helping in the ‘inventing around’. On the other hand Miscellaneous Chemicals had top score for Secrecy for product innovations – relatively easily protected within an exclusive relationship with the customer. Finally, consumer chemicals – soaps and detergents, perfumes and cosmetics – have a modest rate of new product development, much exaggerated of course by their marketing departments. They are produced for a mass market, so relationships with customers are not an option, and it seems unlikely that relationships with suppliers will be of great importance either. This sub-sector seems to have high visibility and limited spill-overs to outside stakeholders. We have very little

Percentage of basic research in innovation spend (1)/per cent of research in innovation spend (2) Relative importance of patents protecting products/processes (1983) (Mean of full sample 3.5/4.3) (3) Effectiveness of appropriation mechanisms for products/ processes (1994) (4) Patents (mean 35/23) Secrecy (mean 51/51) NA PATENTS 2910 General purpose machinery n.e.c.: 39/24 2920 Special purpose machinery n.e.c.: 49/29 2922 Machine Tools: 36/18 SECRECY: 2910 General purpose machinery, n.e.c.: 49/38 2920 Special purpose machinery n.e.c.: 45/42

Inorganic 4.6/5.2 Organic 4.1/6.1 PATENTS 2400 Chemicals n.e.c.; 38/20 2411 Basic chemicals: 39/30 2413 Plastic resins: 33/21 2429 Misc. Chemicals: 40/27 SECRECY 2400 Chemicals n.e.c: 53/54 2411 Basic chemicals: 48/58 2413 Plastic resins: 56/67

35.4/ 47.6

Machinery and equipment n.e.c.

NA/47.3*

Chemicals excluding pharmaceuticals

PATENTS 3100 Electrical equipment: 35/19 3110 Motor/ Generator: 25/22 SECRECY 3100 Electrical equipment: 39/32 3110 Motor/ Generator: 51/43

Motor/generators/ controls 2.7/3.5

29.3/NA

Electrical machinery and apparatus n.e.c.

Table 2.5 Characteristics of technological change in medium-high-technology manufacturing sectors

(continued)

PATENTS 3410 Car/Truck: 39/22 3430 Autoparts: 44/24 SECRECY 3410 Car/Truck: 42/34 3430 Autoparts: 51/56

4.5

29.2/ 37.8

Motor vehicles, trailers and semi-trailers

C: Medium S: 2.89** 5.0 Low/Medium low 38.49

93.67

2922 Machine Tools: 62/48

2429 Misc. Chemicals: 71/76 C: High S: 2.84 7.9 Low/Low

Machinery and equipment n.e.c.

Chemicals excluding pharmaceuticals

60.59

C: Medium S: NA 10.3 Low/NA

Electrical machinery and apparatus n.e.c.

178.72

C: High S: 3.5*** 13.4 Low/Low

Motor vehicles, trailers and semi-trailers

Notes * Basic industrial chemicals; ** Engineering and machinery; *** Automobiles; **** Data relate only to the countries included in the book.

Sources: (1) Istat (1995); (2) Doudeyns and Hayman (1993); (3) Levin et al. (1987); (4) Cohen et al. (2001); (5) C: selling only to few industrial customers: very high; selling only to mass market: very low. S: Sales over value-added, for top 600 European companies, DTI Value-Added Scoreboard 2004/5 (6) OECD (2003a); (7) Own calculations on Hwwa Worldwide matrix (www.hwwa.de).

R&D intensity (6) Frequency of paradigm shifts/ Turnover of companies Average size of firms (employees) (1999) (7)****

Importance of relationships with customers (C) and suppliers (S) (5)

Table 2.5 continued

How sectors vary

55

information about appropriation mechanisms, since the 1994 survey is silent on this sub-sector; the 1983 survey looks only at cosmetics and finds the effectiveness of patents below average both for products and patents. This suggests that there may be heavy dependence on employees to keep secrets, at least as regards processes. The best defence against imitative competition on products probably lies in the capable hands of the marketing department. 2.7.2 The machinery industries: machinery and equipment n.e.c. and electrical machinery and apparatus n.e.c. The machinery sectors include two large groups of machinery: ‘machinery and equipment not elsewhere classified’ (both general purpose machinery and special purpose machinery18 plus domestic appliances) and ‘electrical machinery and equipment, not elsewhere classified’. Machinery n.e.c. The majority of machines (or to be more general, capital goods) have two things in common: first, they are made in much smaller quantities than the intermediate or consumer goods (or services) which are made with them; second, their manufacturers need to be in close contact with their users. These two features are linked: the machine is made in small quantities because it is made for the specialised needs of a certain segment of a certain industry – so those needs have to be carefully considered and addressed. This is the ‘specialised supplier’ situation described by Pavitt and mentioned in Section 1.4. Clearly there are certain types of machine that are made in large quantities and for a much wider spectrum of business use, and then the relationship with user firms has little or no importance. Other machines are indeed made for a mass consumer market. Most office equipment comes into one or other of these two categories, as do those very important capital goods called motor vehicles. Helpfully, machinery n.e.c. is mostly of the specialised supplier type, with the clear-cut exception of domestic appliances (which in our countries varies between 58 per cent of the sector in the US and 7 per cent in Germany (see Statistical Appendix, Table A7). This is why machinery firms are typically rather small (see Figure 2.1). For a capital goods producer, its product innovations count as process innovations for its customers. This makes its rate of progress highly dependent on having the right sort of ‘lead customers’: technically progressive firms able and willing to spend today on the sort of machines that the rest will be willing to buy tomorrow if someone else serves as guinea-pig. To a perhaps lesser extent, the ‘lead customer’ gains from having a capital goods producer close to it (geographically and otherwise). (In a very new industry with highly specific needs, the user firm is very likely to make its own machinery.) The specialisation has implications also for investors: they cannot expect to get a good understanding of what the firm is doing from familiarity with a wider industry, what is crucial

56 How sectors vary is engagement with the firm itself. Of course, if the firm is small, that means it needs an engaged family (or entrepreneur). One area in which one will not expect specialisation is in the equipment that the firm itself uses: for such small volumes, dedicated equipment would normally be too expensive to develop or make. Until the late 1970s, the only alternative was general-purpose equipment used by highly-skilled workers with much tacit knowledge. From the 1980s the advent of CNC tools and FMS (flexible manufacturing systems) has partially eased that requirement, but does not change the consequent need for skilled employees with specialised knowledge of the firm’s products and processes. It is unlikely, except perhaps in an industrial district, that there will be any alternative employers requiring similar skills available to these employees: their skills are then effectively firm-specific and this implies or demands a mutual commitment of employees and firm. If the firm does not do enough product improvement or new product development to maintain employment, the employees must fear unemployment. The sector, in general, clearly has a need for stakeholder inclusion, but we should note some variations within it. In the 1994 survey (Table 2.5) special purpose machinery is the only one of the group with higher scores (on product protection) for patents (49) than for secrecy (45) (also its score for lead time (60) is high). This suggests a relatively high degree of appropriability, supported by its respectable score on patent protection of processes. At the other extreme, machine tools stands out as having high scores on secrecy (62) and lead time (61) for the protection of products, while this category comes bottom for patent protection of processes. That should make them particularly dependent on customer and employee inclusion. General purpose machinery is broadly located between the first two. Typically, innovations in these sectors are incremental and the level of opportunity and need for reconfiguration are rather low. This is confirmed by the very low R&D intensity (see Table 2.5). With very few exceptions, most of the machine builders do not maintain formal R&D activities (see Sciberras and Payne 1985 for machine tools). For machinery and equipment n.e.c., the only major paradigm shift occurred in the 1970s, with the diffusion of numerical controls first and then of computer controls, which brought about a radical transformation in the system of production of the sector. This new technology was first developed within the machine tools sub-sector in the US in the early 1950s by the John C. Parsons Corporation, the US Air Force and the Servomechanisms Laboratory at MIT to produce highly complex metallic parts for the US Air Force. When first invented, numerical controls consisted of punched tapes, cards or operator push buttons that allowed programming and directing the operations of the machine (Wieandt 1994). With numerical controls, machine tools made possible much more flexibility than the previous specialised machines. However, their diffusion remained quite limited, as they were very expensive and unreliable. Further, shifting from one type of production to the other required the substitution of hardware components (Carlsson 1989). The significant diffusion of numerical controls occurred only with the

How sectors vary

57

use of microprocessors as control devices. A Japanese firm, FANUC, the current leader in controls production, was the first to apply the new computer technology to machines, starting a new era in the history of the sector. Electrical machinery, n.e.c. This sector includes machinery for the production, distribution and storage of electrical power (about half of the value of output); insulated cables and wires (about 15 per cent); electric lamps and lighting equipment (less than 10 per cent) and a large ‘not elsewhere classified’ remainder of about a quarter (Table A8). In the 1994 survey of appropriability mechanisms, ‘electrical equipment’ has an almost uniquely miserable position, with below-average scores on five out of six of the survey’s measures, the only exception being patents, on which it is just on the mean. (What is more, it scores six out of six below the mean on process protection.) It is not clear whether this category includes lighting. It certainly includes switchgear. The difficulties of appropriation in this sub-sector were vividly brought out by the revelation in 2006 that an international cartel had been operating in it since 1988, involving ten major European and Japanese firms (Echikson 2007). Cartels typically operate where firms are trying to avoid price competition in the market for a standardised commodity – which many of the products in the sector appear to be, sold to a large number of industrial customers. Another response to such difficulties is protection of domestic producers, either by formal means like tariffs or (now that tariffs are low and other obstacles to trade forbidden) by ‘preferential public purchasing’. It seems that protection of one sort or another has indeed been strong, from the exceptionally low variance of the patenting, trade and production figures for this sector, indicating little specialisation among countries (see Statistical Appendix, Table A8). Electric motors/generators are shown separately in the 1994 survey (see Table 2.5). Their appropriability conditions are fairly similar to those of machinery in general. The understanding of technological competition in this sub-sector is complicated by the gas turbine. The major technological breakthrough of the last century in electric power generation was the introduction in the 1970s of the Combined Cycle Gas Turbine, which has almost 50 per cent higher thermal efficiency than other fossil fuel power stations, with much lower capital cost and shorter construction times – and is much smaller and less polluting, so it can be sited close to cities (Watson 2001). Before this paradigm shift, and for more than half a century, steam turbines were completely dominant in electricity generation, whatever the source of heat to make the steam. However, the technology of gas turbines had been developed in the 1940s with the jet engine, which is essentially a gas turbine, and in the US (not elsewhere) was assigned by the Department of Defence to steam turbine manufacturers (GE and Westinghouse) to make. It became apparent that the gas turbine used by itself offered electricity generation with low capital cost per unit but lower thermal efficiency than the steam turbine. Gas turbines were accordingly used first as back-up generators in the late 1960s, in the US and UK. It was not hard to see

58

How sectors vary

that the very hot exhaust from the turbine (which was responsible for the low efficiency) could be used to generate steam, in a combined cycle. The first to act on this, not surprisingly, were the US manufacturers who were already making both types of turbine. They introduced CCGT in the early 1970s; it gradually came in after that, reaching its dominant position over a period of some 20 years. It thus gave an advantage to those manufacturers who were able, like GE and Rolls-Royce, to use their understanding of gas turbines as jet engines, to develop gas turbines for electricity generation. What we have described, then, is a highly heterogeneous sector, in which one major part is much influenced by developments in the completely separate sector of aerospace. Much of the rest appears to be dogged by appropriability problems: this means that neither patenting and other intellectual property protection, nor stakeholder inclusion, are obvious solutions, and in such circumstances our approach has little to say. Electric lamps and lighting are for the most part a mass consumer commodity, quite distinct from the rest. We would therefore find it difficult to discuss national advantage in this sector usefully without splitting it into sub-sectors – for which there is not much disaggregated data available. Happily there is, as we have just pointed out, very little national advantage to discuss. So we shall say little more about this sector. 2.7.3 Automotive We argued a few pages back that the essential stability of the shape and power source of an aircraft did much to give the industry that made it, continuity. That is even truer for cars, trucks and buses. One could take to the road today in an automobile made in the 1920s, and some people do. One would find little essential difference in shape or power source – or materials – from most made today; and if it were a 1920s Ford, even the means of manufacture (body pressing, for example) would be quite similar. As in aerospace, the industry has moved (though not completely) to CNC machine tools and the other elements of flexible manufacturing systems. The main difference is that it started the move later (in Japan in the 1970s) and that the switch was from the dedicated high-volume equipment introduced by Henry Ford, whereas aerospace moved from generalpurpose tools. In fact the change of best-practice methods could be said to have come in two stages. The first was in the 1950s and 1960s, when the German producers showed that their more participative, higher-skill adaptation of ‘Fordism’ was more productive than the American original (particularly in the segments in which Germany came increasingly to specialise: more expensive cars, and trucks);19 the second in the 1970s when the Japanese producers showed that theirs (including CNC etc.) was better still (particularly for cheaper cars).20 It is clear that the nature of automobile technology is decidedly cumulative, with long trajectories of incremental change: it is not given to radical innovation, even in processes, let alone in products. The need for reconfiguration thus must be very low. Opportunity however (to judge by R&D intensity) is moderate. That is where the easy judgments stop. Ten or 15 years ago this could have been

How sectors vary

59

judged a classic ‘stakeholder capitalist’ industry. Since its product is assembled from a multitude of components, the motor vehicle industry benefits greatly from close relationships between assembling firms and their component suppliers (Womack et al. 1990); as ‘Toyotism’ has demonstrated. Since the successive stages of manufacture and assembly remain incompletely mechanised, and are large-scale, each plant needs rather large numbers of shop-floor workers – a challenge to employee inclusion. How unsurprising, then, that the countries that came to dominate the industry are the two great exponents of stakeholder capitalism, Germany and Japan. Equally unsurprising should be the less well-known fact that the motor vehicle industry has (for a large-scale industry) an unusual presence of family-controlled firms: Ford, Toyota, Peugeot, Fiat, BMW;21 for an engaged controlling family can support continuity of policy, and commitment to trusting relationships with other firms and with employees. Now, the advantages of stakeholder inclusion in the industry are less apparent. It is now a globalised industry, in which all the main producers have production operations in all three of the main regions: North America, Europe, and East Asia, although low US fuel prices ensure that the models made and sold there are mostly different from the other regions. In each of those regions there has been a steady move of employment away from the highest-cost locations; first to the American South, to poorer regions in Western Europe, and to South Korea; more recently to Mexico, the new EU entrants, and China. The structures and understandings (and even, in Germany, laws) that underpin stakeholder inclusion at home, are very difficult to apply abroad. It is easier to base longdistance relationships – within and between firms – on codified knowledge; that is, if the knowledge can be codified. Increasingly it can, because of CAD-CAM. Can it, if codified, be protected? For motor vehicle parts, effectiveness of protection by product patents was rated just above the sample mean by the 1983 survey (4.5 to 4.3); process patents likewise (3.7 to 3.5), although as usual the absolute effectiveness was less. Eleven years later, with reliance on patents apparently rising generally, the 1994 survey found motor vehicle parts clearly above average in effectiveness of product patents (44 to 35) although secrecy was still more effective (51; just on the mean).22 Cars and trucks themselves (not covered in the 1983 survey) were rather less well protected (39). Both parts and vehicles showed high scores for lead time (64, 65, against a mean of 53) in protecting products; parts also in protecting processes (50, against 38). In other words, if the early stages of innovation can be protected by secrecy, patents and lead time together can be quite effective later on. There may be an innovative core within motor vehicle firms and their suppliers which stays close to home – R&D departments, designers, etc. – and could operate on a stakeholder basis; but it is not clear that it needs to include manufacturing. There is another important feature of the industry that jars with the picture of a perfect marriage with stakeholder capitalism: its customers. The ideal stakeholder firm buys from and sells to firms, a few firms, who can then be part of its stakeholder group. That is true for the parts makers, but not for the assemblers: most of their customers are not firms, and those that are (fleet buyers of cars,

60

How sectors vary

trucking firms) are numerous. A perhaps significant detail is that most of the individual customers are now female.23 The car industry seems for long to have been protected from rule by marketing by the fact that its product was difficult to make well, and the consumer was forced to prefer the models that were well made. Now, reliability and durability are generally acceptable, and the consumer can indulge his, or more likely her, inclinations as to style. Murat Gunak,VW’s chief designer, says that emotions are playing an ever larger role for carmakers as technology has reached such high standards across the industry. ‘The customer is no longer as strongly focused on technological innovations but on the brand and its identity and how the product fills the demands’. Such remarks reflect one of the key changes in the automobile industry: the growing importance of brand image against technology . . . . Ralf Kalmbach, a consultant . . . says . . . ‘In the view of the customer, the brand must be created, positioned and established. Automotive makers must redefine themselves from the technology end to the customer base’ . . . . Mr Gunat says that the growing importance of brand image in cars has given designers a much larger role. (Uta Harnischfeger 2003: 5) We now have a situation, then, where product differentiation is more a matter of intelligent designer choice from a portfolio of possible features, than a complex struggle to overcome technical obstacles to product innovation and to raise quality of production. Likewise cost reduction depends less on overcoming the difficulties of process change, than on the freedom to make a shrewd lowcost choice of plant location. Given the large scale of the industry, these are not low-visibility decisions, nor do they favour firms with stakeholder inclusion.

2.8 Conclusion The reality of sectoral requirements turned out to be quite complex. It was reasonable to treat technological opportunity, and thus requirement for expert risk capital, as relatively high in the ‘high-technology’ sectors – aerospace, pharmaceuticals, the ICT hardware areas, and software. They varied greatly, however, in competence destruction and thus need for reconfiguration – low in aerospace, quite low then rising in pharmaceuticals, generally high in computing, variable in communications, generally high in software. The ‘medium-high technology’ sectors – chemicals, motor vehicles, machinery and electrical machinery n.e.c. – were generally lower in technological opportunity, and with no more than episodes of serious competence destruction – none as yet in chemicals, two in motor vehicles (the advent of lean production, and then digitalisation), the arrival of computer numerical control in machinery. (See Table 2.6 for an overview of findings.) On visibility/speed of pay-off and stakeholder spill-overs, the sectors divided up on different lines. Appropriability through patents used to be very much the

How sectors vary

61

Table 2.6 Broad-brush synthesis of findings Opportunity

Need for reconfiguration

Visibility

Stakeholders’ spill-overs

Aircraft and spacecraft

High

Low

Pharmaceuticals

High

Office, accounting, and computing machinery

High

Moderate (rising – biotech) High

Low (High for ‘insiders’); slow pay-off High; rather slow pay-off High

Generally high (except customers) Low (except for research employees) Moderate

Radio, TV and communications equipment: Semiconductors High Moderate

Low

Electronic components

Moderate

Low

Low

TV/Radio

Low

Low

Moderate

Telecommunications: Consumer equipment

High

High

Moderate

Producer equipment

High

Moderate

Moderate

High (suppliers) High

Software and IT services: Standard Middleware Enterprise IT services

High High Moderate Moderate

High Moderate Moderate Moderate

Low Low Low Low

Low Moderate High High

Medium-high technology industries Chemicals: Base Low Specialty and fine Med. –high Consumer Low

Low Low Low

High Moderate High

Low High Low

Machinery and equipment, n.e.c. Special purpose Low

Low

Moderate

General purpose Machine tools

Low Low

Low Low

Low Low

High (customers) High High

Low

Low

Low

High

Low Low/ moderate

Low Low

Moderate Low but rising

Moderate High but falling

High-technology industries

Electrical machinery, n.e.c. Electric motors/ generators Electrical equipment Motor vehicles etc. (automobiles and trucks)

High (employees) High (customers) High (suppliers)

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How sectors vary

preserve of pharmaceuticals and chemicals; the onset of digitalisation and the extension of intellectual property rights seem to have brought much of the ICT industries – hardware and software – up nearly to the same level, and affected others, such as motor vehicles. This tended to reduce the need for employee inclusion, and to increase visibility. Another dividing line was between sectors (or rather sub-sectors) where producers dealt with important individual industrial customers with whom cooperative relationships could be developed, and those where they sold either to a mass consumer market or to a large number of firms. Most machinery came into the first category; so did specialty chemicals, and enterprise software. These sub-sectors demanded stakeholder (customer/supplier) inclusion. The speed of pay-off clearly varied, too, although it was difficult to get reliable and comparable data. In pharma the time to market was long; in aerospace the products were long-lived and it would take a long time until they paid off their (heavy) development costs. The speed of development and product turnover was clearly much higher in the ICT industries, but in many cases this disguised the need for a sustained effort to build up technological capability and brand acceptance through a series of products and models. Finally, size mattered, and varied. Where success depended on large centrally-coordinated projects, visibility and appropriability were likely, other things equal, to be high, and there would be relatively little need for engagement or inclusion. This applied generally to aerospace and motor vehicles; more arguably to pharma. Where the scale of development and production was small, as in the case of most ‘machinery n.e.c.’, innovation needed to be driven either by the top management of small firms or the lower management of big firms. Either way, there would be a challenge of low visibility – for the financiers of small firms, for the shareholders and top managers of large firms. For the big firms there would also be a challenge of employee inclusion. We now have a reasonably firm basis on which to predict and explain the technological advantage and performance of nations – once we have categorised their systems of corporate governance and finance in the appropriate way. That is the task for the next chapter.

3

How national systems of corporate governance and finance vary

3.1 Introduction This chapter’s central purpose is to examine how our 11 economies vary in terms of corporate governance and finance. To repeat: we understand corporate governance in a very broad sense, as who controls and influences firms, and how. This means that various aspects of firms’ relationships with the state and their employees will be treated as relevant. We are thus dealing very much with what some authors have called ‘varieties of capitalism’. In a sense we shall be seeking to characterise national systems of corporate governance and finance, but we must stress that our concern is always with the situation of the individual firm. We shall find it convenient at certain points to give one label to a country’s whole economy, but this will always be an approximation that conceals variations among that country’s firms. At other points we shall distinguish types of firm and indicate the rough proportions of each type in a particular economy. Another consequence of our focus on the individual firm, as we have already pointed out in Chapter 1, is that the nationality of ownership and control1 is more interesting to us than the national location of activity. Thus, for example, we would treat the corporate governance of IBM’s British subsidiary as essentially American, because it is an extension of American structures of power, albeit operating mainly on the British labour and product markets. This helps, as we said, to account for our choice of countries: thus Switzerland as a place to produce may not be important enough to be worth discussing, but Swiss firms, including a number of very powerful multinationals, certainly are. We concentrate in this chapter on giving something of a comparative snapshot, or a set of snapshots, at a period of time (the 1980s and early 1990s) which was, generally speaking, the end of several decades of relative institutional stability. There are three practical reasons for this. First, much of the available literature relates to this period, more or less. Second, there are some clear and striking differences among countries at this time which are convenient for the taxonomist. The picture can be properly painted in primary colours. Since then there has been a good deal of convergence. Third, as we have argued, there are quite long lags in the effects of finance and corporate governance. The FCG

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How national systems vary

picture up to 1990 or so can explain, as far as FCG can, the main features of technological advantage now and recently. There is, however, one major exception: China. Mainland China was in flux in the 1980s and early 1990s, en route to capitalism, and it is much more convenient to take the snapshot roughly as of 2000, when although change was still fast, a recognisable Chinese capitalism had taken shape. There are four minor exceptions, too: France, Sweden, Taiwan and South Korea changed very considerably between the early 1980s and late 1990s – enough, and soon enough, to have affected technological advantage already. We shall take account of this in the country chapters; here we shall focus mainly on their characteristics before the major changes. This will not be enough. Capitalist economies are dynamic, and where they are is no more important than where they are headed, which in turn can only be understood by examining where they have come from. Giving only a little historical background in this chapter, we shall give more in subsequent chapters. There, we shall also show how financial and corporate governance systems have been changing over the last decade and how that helps to understand current changes – and predict future changes – in technological advantage. But we need the big picture first.

3.2 The shareholder–manager relationship There are those who prefer to narrow the definition of corporate governance. ‘Corporate governance . . . is defined as the organisation of the relationship between the owners and the managers in the control of a corporation’ (Lannoo 1999:272); and the ‘owners’ are taken to be the shareholders. If this narrowed approach is accepted (we shall do so for the moment), it suggests three questions: 1 2 3

Who are the shareholders? What are their broad objectives as corporate owners? What is the nature of their relationship with the managers?

All three of these questions appear to be answered at once by the broad distinction discussed in Chapter 1, between ‘outsider-dominated’ and ‘insiderdominated’ financial and corporate governance systems. In outsider systems, the predominant shareholders (in weight and influence) are assumed to be financial institutions that have traditionally sought to manage a diversified portfolio of financial assets with the sole aim of maximising their return on them. (The main categories are investment funds, pension funds and insurance companies.) In order to do so they put liquidity above power, and their relationship with management is ‘arms-length’. Accordingly they do not put their representatives as non-executive directors on company boards. Individuals (‘households’) may also have a large number of shares (as in the USA), but their holdings in each firm are (it is supposed) generally small. The ‘insiders’, by contrast, have in common that they seek control, more or less direct control, over management.

How national systems vary

65

They accordingly generally do have their ‘own’ non-executive directors on the board. They may be families, banks, insurance companies, government, or other firms (see Table 3.1, modified from Table 1.1). The outsider/insider distinction provides an elegant simplification into two categories when one might have had many more. Where it is least satisfactory is in the answer to the last of our questions, on the nature of the relationship with management. The problem is more obvious in the outsider system. What does the arms-length relationship lead to? Management control, or autonomy? As we saw in Chapter 1, that does not automatically follow: there is in principle the possibility of indirect shareholder control, which operates essentially through the stock market: if the ‘market’ generally approves of Firm X’s performance, its stock price goes up, making new share capital cheaper to raise for investment or acquisition of other firms; if it disapproves, X’s share price goes down, with the opposite effect – and making it cheaper for another firm to buy. The spread of stock options as part of management’s remuneration certainly seems to strengthen indirect shareholder control, by giving management a very strong personal interest in raising the share price. We should not overestimate the effect of these mechanisms. Stock options can be managed by management rather as a way of helping themselves to a chunk of shareholders’ wealth. If the stock market goes up generally, as in the late 1990s, they can cash in even if their firm underperforms. If the stock market falls, as after 2000, they can reasonably complain that that is not their fault – and hand themselves out more options at generous prices. Likewise, as we pointed out in Chapter 1, the threat of the hostile takeover bid, which is the key ‘stick’ in indirect control, can be blocked by various kinds of ‘shark repellents’ – so long Table 3.1 Insider- and outsider-dominated financial systems: the stereotypes Type of system Insider-dominated

Outsider-dominated

Main shareholders

Families, banks, other firms, government

Ownership of debt and equity Investor priorities How do shareholders express dissatisfaction? Who do non-executive directors represent? How does control change?

Concentrated

Pension funds, mutual funds, insurance companies, households Dispersed

Control By ‘voice’

Liquidity By ‘exit’

Each represents specific major shareholder By agreement of main shareholders All non-English speaking countries, until at least 1990s

All shareholders equally

Countries usually assigned to category

Through takeover – agreed or hostile USA, UK, other Englishspeaking

66

How national systems vary

as these are permitted by the law of the country (or state) in which the firm is incorporated. The ‘carrots’ remain: but for either carrot or stick to work, shareholders (present and prospective) need information and the expertise with which to understand it. We cannot take the quality of either their information or their expertise for granted. One reason for scepticism about the indirect control mechanism in the ‘outsider’ system arises from the institutions on which it depends. The main financial institutions – pension funds, mutual funds, insurance companies – are run by people who are investing other people’s money. There is a double divorce of ownership from control – not just shareholder from manager, but investor from fund manager from industrial manager. In fact those who run pension funds frequently hand over the management of their assets to ‘asset management houses’: that makes a treble divorce – beneficiary/fund trustee/asset manager/industrial manager. All kinds of conflict of interest are then possible – if for example the ‘house’ that manages pension fund or mutual fund assets including shares in Firm X, is part of a financial institution that has another relationship with Firm X. They might then not sell X’s shares when they should sell. Even more likely, they might stick rigidly to the arms-length ‘outsider’ posture when it would make much better sense for once to join with other shareholders and intervene directly – if only to prevent abuse of the stock option system, or to stop management deploying ‘shark repellents’, and thus help indirect control to work. The insiders’ relationships with management are also far from clear. Where the dominant insiders are a family it is at least clear where their interest lies: in exercising control with a view to long-term profit, so as to protect and increase the family’s wealth (and perhaps influence and prestige). (Arrogance or foolishness may of course lead to quite different results, and some families may not take the trouble to exercise their power.) But all the other insiders are institutions – what about their corporate governance? Who guards these guardians? With what objectives will the managers of these institutions control the managers of firms? They may act purposefully in the interests of their own ultimate beneficiaries – the banks’ own shareholders or depositors; the cross-holding firms’ own shareholders; the government’s voters and citizens, and so on. But they may not. It is equally likely that these ‘guardians’ will in some degree collude with the top management of the firm they appear to control. Where Firm X and Firm Y (or Firm X and Bank Y) have shares in each other, the motive for mutual back-scratching is obvious; perhaps also when shareholding by Y in X is balanced by buying by X from Y. The most likely danger of all is simply personal friendship. Insider systems are generally rather stable: shareholdings are held for a long time. Y’s director on X’s board has probably known X’s CEO for years. They are probably both directors on Z’s board. Perhaps they play golf together. Y’s man (we can assume it is a man) is at the very least unlikely to try very hard to get the information and expertise he would need in order to exercise real control over X. Management control is thus a possibility also in insider systems.

How national systems vary

67

3.3 The manager–manager relationship We now revert to our broad definition of corporate governance as who controls firms, and how. Perhaps part of the who, or at least part of the how, is: other managers. Some at least of the insider systems appear to have a high degree of cohesion among firms. This may arise because of networks of cross-shareholding (as in Japan); because banks or governments control or influence a number of firms that can then be persuaded to cooperate with one another; or simply because in a small country or region everyone who matters knows everyone else. We believe the degree of cohesion is an important variable. So does David Soskice (1999). He makes a key distinction between Liberal Market Economies (LMEs) where such cohesion is low, and ‘business-coordinated market economies’ (CMEs), in which there is ‘considerable non-market coordination directly and indirectly between companies, with the state playing a framework-setting role’ (Soskice 1999: 103). He excludes from this category a country (like France) in which the coordination is largely by government. His two main measures of business coordination are interlocking directorates and employers’ wage coordination (Table 3.2, drawing on his Table 4.1). Italy, Soskice describes as ‘a complex case’ but chooses on balance to put it with the CMEs. We agree, although most of Soskice’s own data disagrees. On his measures of business coordination shown in Table 3.2, its similarities are more with the UK and the US (LMEs). We shall see that the same is true in a number of other areas.2 He is right essentially because Italians are masters of informal coordination, between firms as otherwise; see Chapter 7. Japan does not appear in Table 3.2 on the grounds that Japanese company boards do not have external directors (a mild exaggeration; see Allen and Gale 2000). Clearly, however, there are analogous links within kigyo shudan or ‘horizontal industrial groups’, which also provide a high degree of coordination. It is therefore entirely reasonable to classify Japan too as a CME, as Soskice does – one where the coordination is largely within cross-sectoral groups rather than industry by industry. Korea, Soskice puts with Japan in a ‘group-coordinated’ sub-category Table 3.2 Soskice’s measures of business coordination, 1970s–1980s

Belgium Germany Netherlands Austria Finland Switzerland Italy United Kingdom United States

H-index (index of concentration) of directorates

Employers’ wage coordination

Soskice’s Categorisation of Economy

0.30 0.21 0.21 0.20 0.19 0.16 0.11 0.07 0.05

2 3 2 3 3 3 1 1 1

CME CME CME CME CME CME CME LME LME

68

How national systems vary

of CME. We disagree. Korea does indeed have the chaebol, which being conglomerates with an interest in more than one sector could be described, at a stretch, as providing coordination. But this coordination excludes small firms (unlike Japan) and overall the main coordinator in Korea has been very much the central government, whose interventionist approach, as we shall see in Chapter 6, is most closely comparable with that of the French government.3 Taiwan and mainland China, Soskice does not discuss. The role of Taiwan’s state in its development can be described as ‘governing the market’, in the phrase of Wade (1990), but certainly in a much less intrusive manner than South. Korea’s. Taiwan’s industrialisation was driven by ‘guerrilla capitalism’ – by the highly entrepreneurial strategies of small and medium enterprises, which during the 1980s produced about two thirds of its total exports (Clark and Roy 1997; Hobday 1995a). These SMEs were hard for the government to coordinate and were disinclined to coordinate themselves in any formal way. It seems likely that, on Soskice’s criteria, Taiwan would resemble Italy in being informally coordinated – highly successfully. Mainland China has been far less effectively coordinated than its economic successes would suggest: Nolan (2001) shows that its industrial and technology policy largely failed, due to incoherence and bureaucratic rivalries: one might argue that the country is simply too large to be effectively coordinated. One could, however, scarcely call it a Liberal Market Economy. We have thus not two categories plus France, but three categories plus mainland China: 1 2 3

Liberal Market Economies: US, UK, other English-speaking countries. (Government-) Coordinated Market Economies: France, Korea. (Business-) Coordinated Market Economies: Germanic/Nordic countries, Japan, Italy, Taiwan.

We shall see in the next section, however, that Italy and Taiwan need to be separated from the third category.

3.4 The role of employees We have already strayed a long way from owner–manager relationships, the narrow definition of corporate governance, but we have not yet considered one of the strongest candidates for power or at least influence over management – employees. Employee power/influence can be measured in a number of ways. The most popular in the literature is employment protection (OECD 1999; Bassanini and Ernst 2002; Pagano and Volpin 2001). This measure matches the insider/outsider distinction closely: all the English-speaking countries have very low employment protection, and all the other countries have more (see Figure 3.1). However, it is notable that Denmark and Switzerland have not much more, and are closer to the English-speaking group than they are to the rest, which are themselves as different one from another as some of them are from the Englishspeaking group (Pagano and Volpin 2001; Figure 2). Three of ‘our’ economies

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14 12 10

Employee protection

8

Length of employment

6 4

0

USA GBR CAN NZL IRL AUS CHE DMK FIN NDL JPN AUT BEL SWE DEU NOR FRA ESP ITA GRC PRT

2

Figure 3.1 Employee protection and length of employment (sources: Waldenberger (2003: Table 1); Pagano and Volpin (2001: Figure 2)). Notes Employee protection (weighted average of indicators on regular contracts – procedural inconveniences, notice and severance pay for no-fault individual dismissals, difficulty of dismissal, short term contract – fixed-term and temporary, and collective dismissals. Values increase with the strictness of protection). Those of our countries less obvious from the acronyms are: CHE: Switzerland; SWE: Sweden; DEU: Germany.

are not included in Pagano and Volpin’s figure: S. Korea has strong employment protection (Lee and Lee 1994). Taiwan has very little (Buchanan and Nicholls 2003). Mainland China had, as of 1978 (the beginning of the reform programme), a rigid job-for-life system. Since that time employment protection has been steadily eroded, first by the growth of forms of employment (‘township and village enterprises’, and private firms) in which it never existed – by 2002, state-owned enterprises employed less than a third of the urban labour force; second by the change of regulations, and practice, in the state-owned enterprises, to a position where job protection even there is no more than moderate (Cooke 2005). (Recall that in mainland China, unlike the other countries, the period we are most interested in is the last decade.) Legal constraints on dismissal are not really an expression of employee power, merely a constraint on managers’ power. In some countries employees do clearly have a share of power, as guaranteed to them by various kinds of ‘codetermination’ laws – best-known in Germany. The German version, unique in its strength and breadth, involves employee representation on the supervisory board, plus strong works councils. In categorising the other countries, works councils are not very helpful, since they are rather widespread and extremely variable both in legal powers and in practical effectiveness (Niedenhoff 2005). Codetermination at board level, what Niedenhoff calls ‘enterprise codetermination’ (Unternehmensmitbestimmung), is a better indicator – and in any case tends to be associated with strong works councils. It does not exist among our non-European economies, i.e. the US, Japan,4 Korea (Whitley 1992b; Lee and Miller 1999), Taiwan (Han and Chiu 2000) and mainland China.5 Among pre-2004 European Union members it exists only in Germany,

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How national systems vary

Table 3.3 Enterprise-level codetermination: employee representation on company boards,1 c.2000 Equal representation

One-third representation

Other representation

Germany (>2000 employees) Denmark2

Germany (300 employees) Luxembourg

Finland3 Sweden4 Netherlands5

Source: Niedenhoff (2005). Notes 1 Either Main board or Supervisory Board, depending on whether the board system is 1-tier or 2. 2 If employees vote for it; otherwise at least two directors. 3 One employee-director (up to a maximum total of four) for every four shareholder-directors. 4 Two employee-directors for between 25 and 1000 employees; above that, three; always a minority. 5 Works councils share in choice of directors. Works councils are (as in Germany) elected by all employees and only employees.

Luxembourg, Austria, Denmark, Finland, Sweden, and (in a sense) in the Netherlands (Table 3.3). We cannot however exclude Japan from the ‘codetermined’ category simply for lack of legislation. When asked ‘Whose company is it?’, and offered a choice of ‘All stakeholders’ and ‘The shareholders’, virtually all Japanese senior managers chose the former – while of course a large majority of US and UK managers chose the latter, as did substantial minorities in France and Germany (more in France) (Pagano and Volpin 2001, Table 2, drawing on Allen and Gale 2000). Again, when asked whether job security or the maintenance of dividends should be given priority, the Japanese opted overwhelmingly for job security, while the French and Germans only narrowly preferred it. Clearly, even without codetermination or strong employee protection laws, the Japanese manager is strongly influenced by employee interests – or believes he should be. At least for the core workforce in large corporations, ‘joint consultation is linked to collective bargaining, but often covers a very wide range of business decisions and subjects them to information, consultation and sometimes codetermination . . . . employee opinion has considerable importance in the internal promotion of management’ (Jackson 2003: 265). All the other East Asian societies are fundamentally different from Japan, with its decentralised, somewhat ‘feudal’ traditions (Whitley 1992b and Orrù et al. 1997). Thus, in Korea, where most firms are family-controlled, decision processes are centralised at the family level and management has been traditionally authoritarian (Whitley 1992b; Matsumoto 1983). Delegation of power to lower levels is limited to technical issues, and workers’ participation is not significant either through works councils or informally. While Japanese labour unions are predominantly company unions, Korean labour unions have traditionally been organised on an industry basis; job mobility and firm poaching from others in the same industry are much more common than in Japan (Matsumoto 1983, Tables 4.2 and 4.3). If we look at the employment protection and codetermination data together, we can again identify three groups. The first is made up of the English-speaking

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71

Table 3.4 Systems categorised by labour market/labour relations character Category of system

Characterisation

Countries in category

Labour market primacy

Weak employment protection, no codetermination

Strong employee protection

Strong employee protection, no codetermination

Employee inclusion

Moderate employee protection, and codetermination or strong influence (by law or custom)

English-speaking; Switzerland; mainland China and Taiwan France, Italy, Spain, Greece, Portugal, Korea Germany, Austria, Netherlands, Nordic countries, Japan

economies, plus Switzerland, mainland China and Taiwan. Here there is no codetermination, and little employment protection (although mainland China used to have a great deal, and Switzerland has a little more than the rest). The second group is made up of the Mediterranean economies (including France) and Korea. Here there is no codetermination, but a great deal of employment protection. The third group has codetermination, and mostly moderate employment protection. So some countries trust everything to the labour market; some rely heavily on legal interference with it; a third group interfere with it mildly as an adjunct to codetermination. We can sum up our categories (see Table 3.46): 1 2 3

The labour market rules. Strong employment protection. Employee inclusion.

3.5 Our four categories Happily it has turned out that using role of employees as a criterion leads us in the same direction as using type of coordination. We come out with four categories. 1

2

3

Outsider-dominated economies – a.k.a. liberal market economies, with labour market primacy: the English-speaking countries. We can name this category Shareholder Capitalism, for obvious reasons. Insider-dominated economies with business coordination and employee inclusion: the Germanic/Nordic countries and Japan. This category is Stakeholder Capitalism, as employees and other (related) businesses are major stakeholders in firms. Insider-dominated economies with government coordination and strong employee protection: France and Korea. This is State-led Capitalism: while the extent of state ownership varies greatly, the extent of state intervention is distinctive. (Or it was; these two countries’ FCG systems changed earlier and faster than most others.)

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How national systems vary

4

Insider-dominated economies with strong employee protection and varying degrees and types of business coordination: Italy, Spain, Greece, Portugal. This category has to be described, rather clumsily, as Family/State Capitalism. The paucity of large privately-owned business largely accounts for the relatively high degree of state ownership. The central state is not strong or effective enough to provide government coordination.

Three of our 11 economies do not fit neatly into any of these categories. Switzerland stands between our first and second categories. It lacks employee inclusion, and the moderate protection that seems to go with it. On the other hand, it is in the Business-coordinated group, and like the rest of that group belongs to the ‘insider-dominated’ category. We saw in Chapter 1, however, that the insider/outsider distinction is not as reliable as it may seem, and that there are many powerful insiders in the US. Taiwan and mainland China stand between our first and last categories. Like the shareholder capitalist economies, they both, more or less, respect labour market primacy – mainland China less, and only recently. On the other hand they have relatively few large privatelyowned businesses and at least until recently a relatively high degree of state ownership.

3.6 Poles of control; or, where does stakeholder capitalism come from? We now have the four main categories with which we shall work, but before looking in more depth at each of them there is a fundamental distinction among them that is worth noting. In the Anglo-American world, ownership is supreme. Of course, ownership rights are limited by various laws, and every firm has voluntary constraints on its actions in the form of contracts it has freely, and normally temporarily, entered into. But the old rule is still deeply respected: ‘A man may do what he will with his own’. As we have seen, many large firms are now far from that rule, in the sense that the owners – the shareholders – do not directly control the managers. Nonetheless, the supremacy of ownership endures in the sense that the managers are seen as responsible to the shareholders alone. Everywhere else, except for some of the ex-socialist countries of Europe, there is less trust in market forces. Nonetheless, some of the ‘less-trustful’ countries have a key similarity with the US and UK: in Family/State capitalism (Italy, etc.) the state has severely restricted firms’ rights to dismiss employees, but within the field of action which the law leaves open to management, responsibility is to the shareholders alone; indeed this is usually more clearly apparent than in Britain or the United States, through direct shareholder control. The same, to a lesser extent, is true of State-led capitalism. It is only stakeholder capitalism that really challenges the supremacy of ownership. Of course, beyond a certain size, every firm becomes important to others besides its owners: to its employees; to its bankers, suppliers, customers; to local, regional, central government. All these may regard themselves as stakeholders.

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Table 3.5 Corporate governance types by ‘polarity’ of control Number of poles of control

Governance types

Uni-polar

Family/State capitalism Shareholder capitalism State-led capitalism Stakeholder capitalism

Bi-polar Multi-polar

Stakeholder capitalism implies that at least some of the stakeholders listed have a share in control, or some established way of influencing management actions and policies. There are three ways in which they may achieve such a position. First, they may gain by accident or design a strong bargaining position vis-à-vis management. This might apply to a strong trade union, or to a bank facing a firm that desperately needed a new loan, or could not make the payments on an old one. Second, and more generally, the law may decree that they should enjoy such a position. Third, the customs and culture of the firm and/or country may demand it. For all the economies we have selected in the category of stakeholder capitalism – Japan, Germany and Sweden – we shall examine in Chapter 5 how one or other ways to it opened. Here we will venture a preliminary generalisation. When we are looking at the corporate governance system of a country over any substantial period of time, there is some tendency for these three conditions to resolve to the third: a culture that encourages consensus-building among stakeholders. If there is no such culture, the managers and shareholders of a firm will be more inclined to resent and resist union, bank or other ‘intrusion on their affairs’. The managers and shareholders of firms in general will be more inclined to unite to fight against laws that mandate this. We find such consensusseeking cultures in the lands of Northern and Central Continental Europe – the Nordic countries, Germany, the Netherlands, Austria; and in Japan.7 A way of summarising the distinction we are drawing is to say that in stakeholder capitalism there is an acceptance of the principle of multi-polar control, while elsewhere control is regarded as naturally uni-polar. We have to complicate the distinction a little more when we recognise the special circumstances in State-led Capitalism: the large private firms there which are (were) privileged by the state do have, in effect, two masters, their owners and the state, and so we may call control there bi-polar. The only change in categorisation, using polarity of control, is thus that Family/state capitalism joins Shareholder Capitalism in the Uni-polar category (see Table 3.5).

3.7 Directness of control and degree of managerial autonomy We will conclude this taxonomy of corporate governance by returning to two dimensions of control introduced at the very beginning:

74

How national systems vary

•

Directness of control. The two uni-polar categories differ sharply in this respect. Family/state capitalism relies mainly on direct control. Stereotypically, shareholder capitalism relies on indirect control through financial markets, including the market for corporate control, although as we have seen, reality, in the US at least, is more complex. This precise mechanism is not available for stakeholder or state–led capitalism. However, in state-led capitalism a similar distinction can be made between the use of subsidised loans and other favours (indirect control), and state ownership (direct control); on this criterion, Korea has tended more than France towards indirect control. Stakeholder capitalisms vary a great deal in directness of control, with Germany (through the representation of both shareholders and employees on the supervisory board) much more direct than Japan. Degree of managerial autonomy. If top managers are professional managers (not major shareholders) how far are they under anyone’s control at all, direct or indirect? That question, as we have seen, was raised for the shareholdercapitalist United States more than 70 years ago. As we shall see in Chapter 5, it has been raised for some of the stakeholder capitalist countries much more recently. It is a vitally important factor, but one that cannot be used to accentuate the differences among our categories. Instead, we shall be showing how it creates differences within them – among countries and among firms.

•

It is important to recognise – as Soskice, and Pagano and Volpin, for example, do – how recent are whatever categories we might assign. Some ascribe insider domination largely to defective investor protection, and that in turn to the character of the French and German legal traditions (La Porta et al. 1997, 1998, 1999, 2000); but France had more developed capital markets than the United States around 1900 (Rajan and Zingales 2001) and in the nineteenth century the French Code de Commerce and legal practice had many advantages over the Anglo-American legal regime (Pagano and Volpin 2001). Investor protection was highly deficient in the UK until well into the twentieth century; nonetheless British manufacturing firms moved during the twentieth century steadily out of family control, before investor protection improved (Franks, et al. 2003). Our categories are creations of the twentieth century. In the chapters that follow we shall examine how it created them.

3.8 Mainland China,8 Taiwan and Italy The Chinese, as Marco Orrù saw years ago (1997) are remarkably like the Italians. Both countries are extremely diverse in terms of regions. Italy’s regional differences are partly due to political fragmentation in the past; China’s are partly due to political fragmentation now. It is conventional to simplify Italy’s multiple regional differences by talking of three Italies, of which the third (roughly, the North-East) is the most dynamic. It would be almost equally appropriate, as we shall see, to divide China into three and call Taiwan, possibly adding some of the mainland provinces near to it (notably Zhejiang), the third, most dynamic China.

How national systems vary

75

Nonetheless, both peoples have some strong features which apply to them generally. Their modern cultures have been formed by obstructive and remote central governments. The Chinese and Italian businessman by tradition does not expect help or useful guidance from the state: he expects damaging interference, and a strenuous attempt to tax him to death. All he can rely on is the loyalty of his family, and with luck the cooperation of his friends and neighbours. This makes family businesses, relying mostly on the family’s own capital, the predominant part of private business: any other kind depends on institutions that ultimately rely on the trust and trustworthiness of strangers, and/or the protection of the law. The Italians and Chinese generally do not trust strangers, or the law (see the next section). While family business predominates in private business, private business is not necessarily dominant in the economy. The ‘interfering state’ wishes to interfere, and it has the more reason to do so because family business is hard to expand fast and far: if no one else is in a position to build large-scale economic units, the state must step in. So the economy is mostly composed of small family businesses and large state-owned ones. However the quantitative role of the state is not matched by quality. The economy generally lacks ‘good government coordination’ because the government does not have the capability for it. But here is a difference between Taiwan and the other two: Taiwan has for the last 50 years had an effective state controlling an economic unit of manageable size, which has developed such capability. There are also differences in business coordination – Italy and Taiwan having developed strong informal mechanisms, in Taiwan’s case boosted by state support, China not yet having done so in most of the economy. The biggest difference is in employee protection – strong in Italy, weak in Taiwan, with mainland China moving in less than 30 years from the Italian camp to the Taiwanese.

3.9 Family capitalism and what remained of it near the end of the twentieth century We have referred to the key role of ‘family capitalism’ in one of our categories. But the role of families in corporate governance is far more extensive than that. We shall see that the variations in it cut across our taxonomy, and must be allowed for as an extra dimension within it. The default case is family capitalism – this is the natural way for capitalism to operate, the way in which almost every capitalist system began, and most capitalist systems round the world continue. Individuals or partners set up firms, mostly with their own money, and those firms that succeed are owned by their founders; when the founder dies, the firm passes to the heirs. One of the heirs runs it, or failing that, a number of them, probably as non-executive directors, keep an eye on the professional managers they have picked. When the family loses interest, or competence, the firm probably fades – or before it does, they sell it to one whose owners are more vigilant.

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How national systems vary

This simple capitalism is limiting. It limits the firms’ longevity, according to the ‘staying power’ of the family. It limits their growth, because it is unsafe to borrow too much, and they cannot take in much external equity capital: if such capital carries voting rights, that jeopardises family control, and if it does not, the ‘outsiders’ depend on the efficiency and honesty of the family. It may also, as we shall see, limit their dynamism in other ways. But at all events it provides a simple robust control structure in which the firm’s main owners strive to keep the ‘principal– agent’ problem, of a clash of interests between owners and managers, in check. There are of course alternative ways of controlling firms, and as we have seen in Chapter 1 they may work well, whether because managers behave as stewards, or because ways are found, through monitoring or bonding mechanisms, of curbing or channelling their selfishness. Assuming that these ‘alternative ways’ work reasonably well, we can then say that the natural tendency is for family ownership and control to decline over time, simply because it is much easier for a big firm to pass out of family control than for it to pass into it. So the more mature the economy, the less family control one would expect. There are two quite different reasons why family capitalism may nonetheless remain dominant. One is negative: that the more sophisticated control structures required to control non-family firms, work badly. That may be because there is a low level of trust in society generally. (Trust is higher in Northern Europe than Southern, and higher in Japan than in China and South-East Asia. See Table 3.6.) Or it may be due to legal systems that fail to provide effective protection for minority investors (La Porta et al. 1997, 1998) – which fail either because the laws are not strict enough or because they are not effectively enforced. We see from La Porta that this is true – now – in France, Italy and the rest of Southern Europe, and in almost all less developed countries. (As it happens, these countries have a low Table 3.6 Trust, by country Country

Trust

Country

Trust

Norway (96) Sweden (96) Denmark (90) Netherlands (90) Canada (90) Finland (96) Japan (96) Germany (96) Switzerland (96)

65.3 59.7 57.7 55.8 52.4 47.6 46.0 41.8 41.0

USA (96) Italy1 (90) UK (96) Korea (96) Spain (96) France (90) Portugal (90) Turkey (96)

35.6 35.3 31.0 30.3 29.8 22.8 21.4 6.5

Source: Knack (2001). Definition: percentage giving answer ‘Most people can be trusted’ to question ‘Generally speaking, would you say that most people can be trusted or that you can’t be too careful in dealing with people?’ Figures are for 1990 or 1996. Note 1 The Italian figure depends particularly heavily on the distribution of respondents by region, with the figure for the South much lower than the North (Putnam 1993). Knack and Keefer (1997) found a lower value, 26.3.

How national systems vary

77

general level of trust.) This does not in any way prevent high-trust relationships developing among firms, or within them – but it gives an advantage to firms controlled by shareholders with a long-term commitment, which are prepared to take the time needed to build up trusting relationships (Nooteboom 2002). The other main reason for family tenacity is positive: that families really wish to maintain control of ‘their’ businesses. They are more likely to do so within a social hierarchy in which there is no higher position to aspire to than the ownership and control of a business. In most countries at most periods, that has not been true: the highest position has been membership of the landed aristocracy – who most definitely did not run businesses. (Likewise, in pre-twentieth century China the highest social position was within the imperial bureaucracy.) Could one ‘aspire to’ become a landed aristocrat? Some aristocracies have been more open to the ‘new rich’ than others: the British aristocracy has long been notably open. This in a way increased the incentive to make money through business – but having made money a family could only become truly ‘respectable’ by stopping its industrial activities. There have, on the other hand, always been groups that were excluded from the top of the social pyramid, however rich they were: Jews almost everywhere until the twentieth century, Protestants in France, and the wrong sort of Protestants in England9 until the nineteenth century – and it is these groups that threw up the most successful business families; at least until Society softened, and let them in. Switzerland is one of the least aristocratic countries in Europe,10 and so one would expect to see tenacious family control there, in spite of its relatively high-trust culture. We shall now go on to look at the evidence about variations among economies in family control. Before we consider the data, however, we should give a warning: first, there are many different definitions of family control; second, the data relate almost invariably to listed firms, which are the tip of the iceberg. Unlisted firms will in their great majority be under family control, and so the balance between listed and unlisted firms within an economy says as much about the extent of family control as the data on listed firms. For that, see Table 3.7 Comparative stock market capitalization (as percentage of GDP, late 1996) Country

% of GDP

UK Switzerland US Sweden Japan Germany France Italy

152 135 122 103 63 27 38 23

Source: Vitols (2005: Table 2).

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How national systems vary

Table 3.8 Ultimate control of publicly-traded firms, 1996–1999 Country

Number of firms examined

Widely held %

Family-controlled %

UK Switzerland Japan Sweden Germany France Korea Italy Taiwan

1953 214 1240 245 704 607 345 208 141

63.1 27.6 79.8 39.2 10.4 14.0 43.2 13.0 26.2

23.7 48.1 9.7 46.9 64.6 64.8 48.4 59.6 48.2

Source: Faccio and Lang (2002: Table 3), except for Japan, Korea and Taiwan, which are from Claessens et al. (2000).

the data on market capitalisation in Table 3.7, in conjunction with the data on family control in Table 3.8. (Tables 3.8 and 3.9 is based on a definition of family control which relies purely on ownership of equity, assuming that if any one family holds more than 25 per cent of the shares, it has control. Table 3.9 simply shows the percentage of ownership in each category.) Likewise, the figures for South Korea, given the very small sample (of presumably very large firms) are consistent with a high level of family control. We find the three ‘shareholder capitalist’ economies, all mature, leading the field in terms of market capitalisation, unsurprisingly, but with the UK well ahead of the US. Table 3.9 shows that for comparable samples of firms, US family control is far higher than in the UK (This is reflected in the much higher share ownership of US households shown in Table 3.10). So not only does the US have far more family control in listed companies, but unlisted firms, which can be presumed to be under family control, make up a higher proportion of its economy. Part of this difference can be explained by the far higher rate of immigration into the USA during the twentieth century, the immigrants containing their fair share of entrepreneurs and contributing to a faster growth rate, which provided opportunities for entrepreneurs generally. Part however may be due to the cultural factors mentioned above. Those factors may well account for the big difference between the UK and Switzerland – which must have at least as high family control as in the US, once family control via ‘non-financial holdings’ is taken into account (Table 3.9).11 There are similar differences among the ‘stakeholder capitalist’ economies, in which we have described cultures and institutions that should make forms of corporate governance without family control work well. Japan seems to bear this out: its market capitalisation figure shows that listed firms play an important role in the economy, and it appears that families play very little role in listed firms. (There is a caveat, however: there is evidence that in Japan family control can continue with negligible ownership, as shown by the continuing role of the

30 40 34 42 66 54 240 1036

Stakeholder capitalism Austria Denmark Finland Norway Netherlands Sweden Germany Japan

187 16

114 280 687 3070 500 66

Shareholder capitalism Australia Canada UK USA US (largest) Switzerland

State-led capitalism France S. Korea

No. firms

Economy

48.9 19.1

59.4 23.1 26.9 29.9 27.1 28.3 54.0 15.1

24.8 37.0 16.0 21.9 15.8 45.6

Mean largest holder

50.0 12.8

54.5 15.0 20.7 26.9 16.0 25.0 51.7 8.9

17.1 29.7 11.8 16.8 11.0 48.0

Median largest holder

Table 3.9 Ownership concentration and identities in large listed firms, 1990s

25.1 25.0

6.7 25.0 5.9 16.7 6.1 16.7 26.7 5.9

30.7 34.6 17.9 47.3 12.4 33.3

Family holdings

17.6 6.3

23.3 12.5 17.6 23.8 13.6 38.9 15.4 6.6

17.5 19.6 37.0 25.9 43.2 10.6

Financial holdings

51.3 25.0

53.3 25.0 38.2 47.6 43.9 33.3 48.8 58.1

30.7 40.4 15.1 14.6 18.6 42.4

Non-financial holdings

2.3 12.4

16.7 2.5 23.6 7.1 6.1 3.7 7.0 0.2

0.0 3.3 1.8 0.9 0.2 4.6

State holdings

(continued)

3.7 31.3

0.0 35.0 14.7 4.8 30.3 7.4 2.1 29.2

21.1 2.1 28.2 11.3 42.6 9.1

Dispersed holdings

57 11 59

No. firms

45.2 15.8 37.8

Mean largest holder

47.5 5.4 29.1

Median largest holder

3.5 18.2 1.7

Family holdings

40.4 9.1 23.7

Financial holdings

47.4 9.1 57.6

Non-financial holdings

3.4 9.1 8.5

State holdings

5.3 54.5 8.5

Dispersed holdings

Investors on the European continent . . . have made use of a number of mechanisms to separate capital contribution from control . . . Holding companies are important ingredients in many countries, particularly in Belgium and Germany. Closed-end mutual funds and dual class shares have been the prime vehicles of control in Sweden. In Germany and Sweden, and particularly in Italy, pyramiding, whereby chains of firms, sometimes as many as ten or 15, own each other, allowing the ultimate controlling owner to minimise its capital stake without affecting the concentration of control, plays an important role. Proxy votes held by banks on behalf of small investors and crossholdings of shares are other ways of concentrating control in Germany. Voting trusts and special golden shares serve the same purpose in Dutch corporate governance. Despite legal restrictions, corporations in France have complicated crossholding arrangements to ensure concentration of control, and the government has maintained potential influence in large privatized firms through golden shares.

Note In some economies the numbers of firms are disproportionately small in relation to the country’s population. Among our economies, the disproportion goes from greatest in South Korea, through Taiwan, Italy, France, to least in Germany. The effect this has can be seen by comparing the data for the larger and smaller sets of firms in the USA: taking a smaller set (of relatively large firms) sharply decreases family holdings and sharply increases dispersed holdings. If we were to add to the sample for each of these five economies, enough large firms (most or all necessarily unlisted) to even up the proportions, the ones added in each case would be overwhelmingly family-controlled. This might seem to leave Italy still low on family control; but as Berglöf (1997: 102) says,

Source: Gugler et al. (2004: Table 2). Most entries refer to 1995/6; Germany: 1985–2000; USA: 1991–1998; Japan: 1987–1998; UK: 1992–1998.

Family/state capitalism Italy Taiwan Spain

Economy

Table 3.9 continued

How national systems vary

81

Table 3.10 Ownership of listed stocks by sector (as of 31 December)

France

1977 1992 Germany 1970 1993 Italy 1993 United Kingdom 1969 1993 Japan 1970 1993 United States 1981 1993

Households Non-financial corporations

Government Financial Foreign institutions institutions owners

41 34 28 17 32 50 19 40 20 51 48

3 2 11 3 28 3 1 0 1 0 0

20 21 41 39 22 5 2 23 28 15 9

24 23 11 29 14 36 62 35 42 28 37

12 20 8 12 4 7 16 3 8 6 6

Source: Berglöf (1997: Table 5) (as of 31 December).

Toyoda family in Toyota; see Chapter 5.) On the other hand, Germany’s low market capitalisation and high share of family control in listed firms show that ‘stakeholder capitalism’ can also work with family firms in the centre of it. Sweden is intermediate between these two. In the two other types of corporate governance system family control is quite consistently important, although there are striking differences between Italy’s very high level (bearing in mind its very low capitalisation) and Taiwan’s.

3.10 Financial systems and the match with corporate governance We mentioned in Chapter 1 that the first attempts to categorise financial and corporate governance systems had put the emphasis on finance, by distinguishing between bank-based and stock-exchange-based systems. All the systems we have categorised as insider-dominated – the stakeholder-capitalist, state-led capitalist and family-state capitalist categories – were alleged to be bank-based, presumably because they clearly were not stock exchange based. In fact banks and stock exchanges are not the only sources of finance (see Tables 3.12(a) and 3.12(b) later). The main sources of external finance can indeed be divided into ‘stock exchange’: equity shares and fixed-interest securities, and ‘bank’: bank loans and overdrafts. However, external equity finance going into most firms is not raised on the stock exchange, but from the personal resources of the managers, their families and friends (there is also private equity, as we shall see). Loans for many firms come from similar sources. Moreover, most finance for most firms’ investments at most times is internal – recycled profits. So it is not exactly either/or. Let us take our four corporate governance system categories in turn and see whether they can be matched with financial systems.

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1 Shareholder capitalism It is one thing to have a high stock market capitalisation over national income, as the US, the UK and Switzerland do, and quite another to raise a large part of firms’ capital on the stock market (Lazonick and O’Sullivan 1998). The most obvious reason for a stock market listing is for existing shareholders to sell out at a good price. Another is to give the opportunity for acquisitions using the firm’s own shares to pay much or all the price. To pay for organic growth – real investment – by raising equity or fixed interest capital on the stock exchange is much less common. It takes a lot of explaining, and (if equity is used, in the classic manner) the increased supply of shares could easily depress the price – not at all attractive to executives with stock options. It is much simpler to use the firm’s own profits and cash flow to finance investment; that tends to raise the share price, at the expense of dividends. Nonetheless there are some features of financing which follow from the character of shareholder capitalism. Relationships with banks are not close, whether for large firms or for small: so there will not be heavy reliance on bank loans. Large firms will usually find corporate bonds a cheaper form of fixed interest finance, but debt in general will play a limited role, since without supportive banks there is too much risk of insolvency. On the other hand there will be, or can be, an important role for private equity. Private equity comes in two quite distinct categories: venture capital, for start-up and early-stage financing of new businesses in high growth industries, and the rest, put into established (even mature) businesses, typically to facilitate management buy-outs (MBOs). (After an MBO, the equity is normally owned mostly by the private equity firms and partly by the management team, with a large fraction of the capital provided by bonds – the bonds ‘leveraging’ the equity, thus the term ‘leveraged buy-outs’ or LBOs.) As we have seen in Chapter 1, venture capital plays a key role in high-technology industries with a high need for reconfiguration, and arguably private equity in MBOs may play quite an important role in more mature industries which at one point or another have a high need for reconfiguration too. Whatever the type, the role of the private equity provider is normally limited to, or at least focused on, an episode in the firm’s life: the aim is not to be a permanent major shareholder, but (if the firm succeeds) to take out most or all of the capital so as to be able to re-use it in more new firms or buy-outs. (But see Chapter 9 for recent changes.) Here is the connection with the rest of the financial system. To take out one’s capital from a firm, someone else must buy in. The typical occasion for this is an IPO – initial public offering – on a stock exchange. So while the stock exchange even here may fail to provide capital for the growth of firms listed on it, it is still indirectly providing capital – for the growth of firms not yet listed on it. It may play an even more important role in an even less visible way, in informal venture capital – capital provided very early indeed in the life of a firm by business angels, rich individuals usually familiar with the industry in which they are

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83

Table 3.11 Economies by flow of Venture Capital Investment, 1999 Economies

Amount US$ billion

% of GDP

United States United Kingdom Sweden Switzerland Taiwan France Germany Italy South Korea Japan

97.6 12.3 1.4 0.5 0.9 3.0 3.4 1.9 0.5 0.8

1.15 0.98 0.80 0.26 0.25 0.23 0.19 0.16 0.09 0.03

Source: Yang (2002).

investing. Where did they get that money from? Typically from the sale of shares in firms of which they were senior managers and perhaps founders. Again, selling such shares is easier on active, liquid stock markets. We see from Table 3.11 that venture capital is more abundant in shareholder-capitalist economies. 2 Stakeholder capitalism As we have seen, control here is naturally multi-polar: it is accepted that a number of different stakeholders can have some kind of share of control or at least influence over management decisions. This makes room for relational banking: a relationship between bank and borrowing firm in which the bank as an institution, and no doubt one or more individuals within it, engages with the firm, gets to know it and develops firm-specific understanding of it. A big firm that borrows from a number of banks, may have a ‘main bank’ (Hausbank in German) which plays this role on behalf of the others. Clearly a higher gearing (ratio of debt to equity) is manageable in relational banking than it is in the alternative, transactional banking. Typically therefore, stakeholder capitalist economies have relatively large levels of bank debt in industrial firms, and this is associated with a relatively large share of small and medium firms in the economy – for it is such firms that depend most heavily on external finance in general and bank loans in particular. (Big firms have the opportunity to balance cash-negative fast-expanding units with cash-generating mature ones, and on occasion, even in stakeholder capitalist systems, to make share or bond issues.) One way of institutionalising the bank–firm relationship is for the bank to take an equity stake in the firm. This gives it ways of monitoring management and even controlling it that a mere lender does not have while the borrower is solvent. It also allows it to balance whatever downside risk it may be facing, with an upside risk: the gains it will make if the firm makes high profits.

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How national systems vary

Typically, banks will only take share stakes in large firms: the effort of involvement in smaller firms would not be worth while. Once the share stake has been acquired, it will naturally continue regardless of the firm’s status as borrower; so it is perfectly possible for Bank A to be a major shareholder in Firm X even if (with profits above what it needed for investment finance) Firm X has paid back all its loans. If it is, however, it is likely to be much less vigilant than it was if and when a large slab of its loan portfolio was at risk in Firm X. Clearly private equity, in its traditional guise, does not go with the stakeholder-capitalist grain. It involves transient rather than long-term relationships, and it depends heavily on active stock markets. Venture capital, when and where it is provided at all, is usually provided by banks. Getting banks to provide venture capital is akin to getting a dog to become vegetarian: entirely possible in principle, but unlikely to involve real enthusiasm. The essence of banking is minimising risk; the essence of venture capital is wallowing in it, with a view to finding, feeding and fostering a few firms that make very large amounts of money, so that the investor more than makes up for the many that fail. The Deutsche Wagnisfinanzierungsgesellschaft (WFG), founded by 29 German banks in 1975 with government support, provides a horror story of venture capital under bank (and government) control (Mayer 2002). 3 State-led capitalism Banks can play a big role in state-led capitalism too, but in a thoroughly different way from stakeholder capitalism. There is a central state that moves a limited number of pieces around the economic chessboard. A large bank is one such piece, which can be directed (or encouraged) to make loans, on favourable terms, to selected firms for investments which fit into the aims and policies of the government. The firms, and the loans, are naturally likely to be large, since small firms and small projects are beneath the central state’s notice. And how is the risk of such large loans to be contained? Some may not be risky because the ultimate buyer (of a road or harbour, say) may be the state, which will pay enough to give a profit; or it may be for a regulated home market where a profit is virtually guaranteed. And the bank may be stateowned and not required to make a profit. In some cases the state may specifically guarantee a loan. There is then very much a dual economy, where large firms, or the favoured among them, are heavily indebted to large banks, and the others must make do with transactional banking in shareholder-capitalist style. While in the stakeholder capitalist economy, R&D is undertaken quite intensively by a large number of medium firms as well as by the ‘usual suspects’, in the state-led economy it is highly concentrated in a small number of very large firms. The reluctance of banks to lend to smaller firms is partly due to the arms-length relationships large firms have with them. By contrast, Toyota (for example) might encourage a bank to lend to one of its sub-contracting firms; and the bank might not need encouragement, since it might well feel that the relationship with

How national systems vary

85

Toyota made the firm a very good risk. Neither would usually apply to a small supplier to a Korean chaebol. 4 Family-state capitalism Here is another type of dual economy, with a clear-cut distinction between a privileged core of large firms, in this case (almost) all under state ownership and control, and the rest. The extent of privilege varies. In Italy there are regional and local levels of the state that may function well and recognise their responsibilities for assisting small firms, through various agencies. At least in industrial districts where there is a convenient degree of sectoral specialisation, banks lend quite heavily to small firms. At the same time the large state-owned firms have been able to count on generous funding from various sources, including direct state subsidy. Much the same is true of Taiwan, which in addition has had a state sufficiently determined and sufficiently familiar with US models to set up an effective system of venture capital. On the other hand, at least until the last few years, there has been a huge gulf in mainland China between stateowned firms with access to large quantities of very cheap loan capital from state-owned banks, and private firms with little if any access to bank loans. What neither type of firm did to any great extent, in any of those countries, was raise capital on the stock or bond market.

3.11 Financial systems: the evidence The aggregate data for the 1980s (Table 3.12(a), for seven of our economies, and Table 3.12(b) for nine of them) and the 1970s and 1980s (Table 3.12(c), for four of them) confirm some of the contrasts we have drawn. The US and the UK are more than 60 per cent dependent on retentions and shares in both periods, and have ratios of debt to total equity below 2, as does Switzerland. Two of the three ‘stakeholder’ economies, Sweden and Japan, were less than 50 per cent dependent on retentions and shares for net financing in the 1980s. Sweden and Japan both got more than 30 per cent of their net financing from bank loans, as did Japan in 1970–1989. Both had high debt/equity ratios, Sweden’s more than three times that of any of the shareholder economies. The big surprise is Germany. The German figures for the 1980s are less disaggregated than the others but they still indicate a striking deviation from the stakeholder pattern: retentions plus shares contribute more than even in the US and UK. For 1970–1989 the similarity to the shareholder economies is also close – except for less reliance on debt finance! The debt/equity ratio is modest. Of the ‘state-led’ economies, France was less than 50 per cent dependent on retentions and shares for net financing in the 1980s, and its debt–equity ratio was similar to Japan’s, as was Korea’s. We can assume that this conceals higher debt ratios for favoured firms (see Chapter 6). Italy was nearly 60 per cent dependent on retentions and shares in the 1980s, and made more use of trade credit than bank credit, while its debt ratio was moderate,

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How national systems vary

Table 3.12(a) Structure of net financing of non-financial enterprises (percentage: average for period 1980–1990) Source of funds

Country US

Retentions Shares Short-term securities Short-term loans Trade credits Long-term bonds Long-term loans Other5 Total

Japan1

70.6 – 4.9 2.0

39.9 7.7 –

2.7 6.9 14.2 9.0 0.5

15.1 10.1 5.6 21.6 0.0

100

100

France2

UK3

Italy4

73.6

37.0 12.3 –

48.6 12.9

48.9 10.4 –

43.0 6.6 0.0

23.8

26.4

16.3 16.2 0.9 8.2 9.6

5.0 18.1 2.1 6.9 8.7

18.7 7.1 –2.5 16.2 10.9

Germany

100

100

8.1 4.6 2.0 100

100

Sweden5

100

Source: OECD, New Financial Landscape, 1993, Table 2. Notes 1 1982–1989. 2 1980–1989; industrial enterprises. 3 1983–1990; large enterprises. 4 1982–1990. 5 1981–1989. 6 Increase in other accounts payable, net capital transfers received, statistical discrepancy, etc.

Table 3.12(b) Debt to equity ratios, 1980–1991 UK USA Switzerland Italy Sweden

1.480 1.791 1.750 3.068 5.552

Japan Germany France Korea

3.688 2.732 3.613 3.662

Source: Demirguc-Kunt and Maksimovic (1996: 354).

Table 3.12(c) Structure of net financing of non-financial enterprises (percentage: average for period 1970–1989)

Internal Bank finance Bonds New equity Trade credit Capital transfers Other Statistical adjustment

Germany

Japan

UK

USA

80.6 11.0 −0.6 0.9 −1.9 8.5 1.5 0.0

69.3 30.5 4.7 3.7 −8.1 – −0.1 0.0

97.3 19.5 3.5 −10.4 −1.4 2.5 −2.9 −8.0

91.3 16.6 17.1 −8.8 −3.7 – −3.8 −8.7

Source: Corbett and Jenkinson (1996: Table I).

How national systems vary

87

confirming the expectation for family/state capitalism of rather poor firm–bank relationships. The German exception points to the tendency we hinted at above for large firms in stakeholder economies to pay back their loans as their expansion slackens off and their profits and depreciation catch up with their investment.12 From 1978 to 1989 the bank debts of large non-financial firms in Germany declined from 13.7 per cent to 7.6 per cent of balance sheet liabilities (Deeg 1997). The smaller firms, the Mittelstand above all, continued to rely heavily on banks for their external finance. The situation was similar in Japan: the large manufacturing firms which had in the 1950s and 1960s depended heavily on bank loans for their expansion, mostly paid them back during the 1970s and 1980s. (The difference lay in the reckless way in which the Japanese banks found other borrowers: while manufacturing reduced its share of total bank credit from 44.7 per cent in 1970 to 15.7 per cent in 1990, the share of construction, real estate and finance rose from 9.7 per cent to 26.6 per cent (Hanazaki and Horiuchi 2000). When the bubble burst in 1990–1991, these sectors provided many bad loans.) A survey of over 2000 top executives in 22 OECD countries in the early 1990s showed ‘financial constraints to technological development’ ranging from least in Japan, followed by Denmark, Germany, Switzerland, Sweden, the Netherlands and the United States, to worst in Spain, followed by Finland (then in deep recession), Portugal, Greece, Turkey and Italy (OECD 1995). France and the UK were together in the middle. These figures should be treated with caution – the authors’ research in British firms has shown that chief executives often do not feel the financial constraints about which their subordinates are complaining loudly, perhaps because the CEO knows that holding down innovation spend will do wonders for his profit-based bonuses and stock-options. Still, they confirm the relatively comfortable position of the stakeholder capitalist firm.

3.12 Conclusion It turned out that the ‘outsider system’ did not serve very well as a category of corporate governance systems. As a stereotype, or a tendency, it served well enough, but only the UK deserved the title as a label for its whole corporate governance system. The US, on the other hand, had far too much insider power – mostly of founding entrepreneurs and their families – to fit the bill. Moreover, the way that shareholder power was supposed to work in the stereotypical outsider system – indirect control through share price movements and the market for corporate control – seemed to apply less well to the US than to the UK. It was possible to put the US and the UK together in the same category, of Shareholder Capitalism, however, if one defined it as a mature capitalist system in which management was responsible only to shareholders (and no other stakeholders) and in which there was little interference from the state with management’s right to manage. But that category could, more or less, accommodate Switzerland too.

88

How national systems vary

Two other types of corporate governance system were decidedly less mature and accordingly had a great deal more government interference in management. In one of them, Family/State Capitalism, family control was the rule in the private sector, and there government’s role was essentially negative and constraining. Alongside family firms, and to some extent complementing them, were large state-owned firms. This category included Italy, Mainland China and (less comfortably) Taiwan. In the second of these categories, State-led Capitalism, the role of the state was more positive, and it worked with family capitalists more than it acted to constrain them. This category included France and South Korea. The type of corporate governance system most different from Shareholder Capitalism was Stakeholder Capitalism, in which it was accepted that control could be multi-polar. That is, management could and should respond to the pressures and interests of a number of stakeholders – shareholders, employees, customers and suppliers, government. Depending on the country, these stakeholders might have legally-established rights to representation and power, or merely a tacitly-understood right to be heard and considered. In this category belonged the last three of our 11 countries, Japan, Germany and Sweden. Up to a point, one could extend our corporate governance categories to include finance. Shareholder capitalist economies – the US and UK at least – made little use of bank finance. They did not in general make much use of stock market finance either, but for that important segment of their financial and corporate governance system, private equity, the stock market did have an important role to play. Stakeholder capitalist economies did not depend heavily on the stock market. They might not, as a whole, depend heavily on bank finance either – large mature firms were certainly unlikely to do so, being able to manage very well with retained profits – but bank loans played an important role for small and middle-sized firms. Family/state capitalism was certainly not bank-based, if Italy was any guide, nor was it stock exchange-based: in general external finance was hard to find except for state-owned firms. State-led capitalism, judging by France, was not obviously bank-based or stock-exchange based either: the aggregates presumably concealed good access to bank finance for the privileged firms (state and private), and poor access to any finance for the rest. How then can we use our categories in explaining success or failure in technological change? We recall from Chapter 1 that where industries were seriously affected by competence destruction they needed expert finance to be available for new firms, and/or pressure from expert owners for higher value-added in such areas. We found no reason in this chapter to challenge the assumption in the literature that shareholder capitalism should be superior to the other systems in this respect, given its emphasis on stock markets and equity finance. Note the words ‘should be’: active stock markets provide the conditions in which equity investors can develop industrial expertise, and in which such investors can support a spearhead of venture capitalists who require very high expertise (and engagement) indeed. They do not guarantee that this will happen, as we see for Britain in Chapter 4.

How national systems vary

89

Likewise, when industries face high technological opportunity they need large amounts of reasonably expert risk capital to be available on acceptable terms. If firms are already well established in the area, most of the funding (and all the expertise) can be internal. A stakeholder-capitalist firm should have no difficulty here – given that further funding could be bank loans made on a relational basis. Nor should a shareholder-capitalist firm – unless it is under pressure from ignorant shareholders who do not understand what they are going to get from the reinvestment of ‘their’ profits. A family-capitalist firm might well have some difficulty, since the family would be required to tie up ever more of its assets in risky projects – or accept increasing dilution by outside equity (if it could get it), threatening its control. Getting into a high-opportunity area is another matter: the risk capital needs to be external – either external to the firm, as with venture capital, or from other parts of a firm which is diversifying into the area. For capital external to the firm, shareholder capitalism should have the edge, as argued above. For diversification, the issue is much more open. Firms designed to be conglomerates – for example the Korean chaebol – might do well here. So might Japanese kigyo shudan – horizontal multi-sectoral groups – mostly descendants of the zaibatsu conglomerates and still highly cohesive: a small high-technology firm within a kigyo shudan may have been spun off from a larger parent and will then be supported in every sense by the parent. Whatever its parentage, it can expect equity investments from a number of large firms in the group, and both equity and loans from the group bank. Technological opportunity opens a striking gap between the two great stakeholder capitalist systems. Germany has no horizontal groups nor anything resembling them. Moreover it has a very high degree of family ownership and control, while Japan is remarkable for the opposite. Many Japanese firms were torn from family control when the zaibatsu were broken up in the late 1940s, but that cannot account for the size of the difference. It is typical of Japanese entrepreneurs like Soichiro Honda or Konosuke Matsushita to take capital from where they can get it, putting expansion first, financial stability second and personal control last. While they are at the helm they can expect shareholders to defer to their status as founders. Similar deference may extend to their descendants in a firm with a family tradition – thus the Toyoda family long ago gave up a controlling shareholding in Toyota, but nonetheless one Toyoda after another rises to a high position in the firm (Chapter 5). What is not acceptable in Japan – but remains very much so in Germany – is control without managerial responsibility, such as the Quandt family exercises very successfully in BMW on the basis of its shareholdings. Thus, where a new firm, controlled by its founders, faced high technological opportunity in Japan, it would have had no inhibitions about taking external equity capital, at least if it was from ‘stable shareholders’ (other firms and financial institutions) which would not sell to a takeover bidder. A German firm might well have had grave misgivings about the dilution of founders’ shareholdings. Where innovative activities have low visibility and/or a slow pay-off, we saw that management autonomy and/or shareholder/financier engagement was

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How national systems vary

needed. Engagement should be available from the insider shareholders in stakeholder and family capitalism, and the relational bankers in the former (although it is not guaranteed, any more than industrial expertise in shareholder capitalism). Where they disengage, the default is management autonomy. Managers may be autonomous under shareholder capitalism, too, as we pointed out in Chapter 1. It depends on how well they are protected from both the direct and indirect pressures of ‘outsider’ shareholders – protection which varies greatly between the United States and the United Kingdom, as we shall see in Chapter 4. (However, that protection may be used to entrench the power of minority – probably family – shareholders, rather than managers.) State-led capitalism is necessarily rather weak on engagement, except for selected major areas of state interest. The state may well leave the managers of firms it owns or favours, considerable autonomy. Where there are major spillovers in innovation, stakeholder inclusion is needed. Here of course stakeholder capitalism is clearly supreme. ‘Insiderdominated’ firms, in general, have an advantage over ‘outsider-dominated’ firms, because as Carlin and Mayer (2000) point out, managers backed by a controlling shareholder can commit to a cooperative relationship for as long as that shareholder exercises control. A firm that is exposed to hostile takeover bids may withdraw from any non-contractual commitment at any time because control changes hands – or indeed without a change in control, because of the resulting short-term pressures. We now have the tools with which to explain technological advantage, putting together the characterisation of sectors from Chapter 2, with the characterisation of economies in this chapter. In the next four chapters we shall use them.

Appendix Table 3.13 Business enterprise expenditure on R&D (BERD) as a percentage of value added in industry

United States United Kingdom Switzerland1 Germany2 Japan Sweden France Korea Italy

1981

1991

1996

2001

2.3 2.1 1.6 2.3 1.8 2.2 1.6 – 0.6

2.8 2.0 2.9 2.5 2.8 3.0 2.1 – 1.0

2.6 1.8 3.1 2.1 2.8 – 2.1 2.3 0.8

2.9 1.9 3.1 2.5 3.3 5.2 2.0 2.8 0.8

Source: OECD, MSTI database, May 2003. Notes 1 1992 instead of 1991, 2000 instead of 2001. 2 Figures for Germany from 1991 onwards refer to unified Germany.

How national systems vary

91

Table 3.14 Distribution of employment in manufacturing by size class (1999)

United States United Kingdom France Italy Germany Sweden Korea Japan Switzerland Taiwan*

0–49%

50–499%

500+ %

7.7 27.3 30.1 49.1 22.3 23.4 40.4 39.1 36.7

34.4 39.0 33.5 30.6 34.4 30.3 34.3 39.7 41.3

58.9 33.6 36.5 20.3 43.2 46.3 25.3 21.1 22.0