New studies show that while increased competition from China has contributed to an increase in patents in Europe, it has reduced the rate of innovation in the United States. These divergent results are in part attributable to changes in the manufacturing sector.

MUNICH – Globalization encourages innovation, at least that’s what we believe. But new evidence suggests that this assumption, like so many economic arguments, needs to be rethought.

Conventional wisdom is based on a 1991 study by Gene M. Grossman and Elhanan Helpman, who showed that by creating larger and more integrated markets, globalization has boosted efficiency, encouraged specialization, and increased incentives for for-profit entrepreneurs to invest in research and development (R&D;). This has resulted in an increase in the global rate of innovation.

Yet recent research on China’s global impact indicates that the relationship between globalization and innovation is not so clear. On the one hand, Nicholas Bloom and his colleagues find that increased competition from China has contributed to an increase in patents in Europe. On the other hand, David Autor and his colleagues report that the “China shock” reduced the rate of innovation in the United States.

What explains these divergent results? One possible answer lies in the evolution of the manufacturing sector.

Manufacturing has traditionally been where most innovations occur. But in rich countries – especially the United States – the share of output and employment in manufacturing has been declining for decades, as multinational companies shifted their labor-intensive production to low-wage economies, such as China or Eastern European countries. If innovation happens where production takes place, it makes sense that China’s rise as a manufacturing powerhouse correlates with declining innovation in a country like the United States.

However, this result is not inevitable. Whether the loss of manufacturing jobs compromises innovation significantly depends on how a multinational enterprise is organized, in particular on the links between the production and innovation aspects of the enterprise.

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If a company’s production depends on a direct interaction between the two parties, the manufacturing and innovation activities must be located in geographic proximity. Otherwise, innovation is likely to decline. This is often the case for American companies: subsidiaries located further away from their parent company tend to file fewer patents.

If, however, managers facilitate and direct the flow of information between these two groups of workers, the geographic co-location of the two activities may be less important. This would support innovation in advanced economies, even if manufacturing takes place halfway around the world.

My research examining the migration of manufacturing jobs to Eastern Europe after the fall of communism reinforces this reading. In the 1990s, Eastern European countries had low per capita income, but were rich in skills, especially in engineering. This has made them ideal environments for low cost innovation.

This particularly attracted Germany and Austria, two far richer countries located nearby and facing serious skills shortages. Thus, in the years that followed, German and Austrian companies moved not only manufacturing jobs, but also activities requiring specialized skills and significant research, to Eastern Europe.

From 1990 to 2001, the Austrian subsidiaries in Eastern Europe employed five times as many university graduates, as a percentage of staff, than their parent companies. They also had 25% more research staff working in their laboratories. Likewise, the German subsidiaries in Eastern Europe employed three times more workers with university degrees and 11% more researchers than their parent companies.

But there was a major difference between German and Austrian multinationals. German multinationals transferred the organization of the company to subsidiaries in Eastern Europe, and sent German managers make things work. This ensured that the knowledge created in the research laboratories of Eastern Europe returned to the parent company, which thus had more control over the innovation.

In contrast, Austrian multinationals – themselves mostly subsidiaries of foreign companies – adapted the organizational structure of their Eastern European subsidiaries to the local environment and hired more local managers. As a result, their subsidiaries were more autonomous in their innovation decisions. No mechanism has been put in place to ensure that the knowledge created in the subsidiary also benefits the parent company.

Over the past decade, Germany has generally prospered economically, while Austria has suffered from low growth rates and high unemployment. Austria’s struggles may well have their origin in the reverse pattern of specialization in innovation with Eastern Europe. Austria’s skills endowment, measured by the share of the labor force with a university degree, was 0.07 in 1998, compared with 0.14 for central European countries.

As Germany has shown, innovation does not depend on the presence of physical production. In addition, the decline in innovation in the manufacturing sector may be offset, at least in part, by an increase in R&D; in other sectors. This happened in United States: In 2016, the manufacturing sector accounted for just 54% of US patents and 59% of R&D; spending – up from 91% and 99%, respectively, in 1977, with non-manufacturing companies now accounting for 46% of all US patents granted. .

But manufacturing and innovation still complement each other. And, as the very different experiences of Austria and Germany show, offshoring of manufacturing alone does not necessarily undermine innovation. If parent companies implement knowledge acquisition mechanisms created in their affiliates, they can reap the benefits of globalization – including offshoring – without losing innovation.