by Matthew Cherry , Chief Economist, PSR

Sometimes economic history can seem like little more than a litany of innovations.  It is inherent in the very names we give the main prehistoric periods: what are the stone age, the bronze age and the iron age if not a description of how technology evolved.  

Different economic theories of growth all come down to different ways for technology changes to increase the capacity and capability of the economy. Indeed, it is arguable that modern economics itself starts with a description of how the invention of specialised machinery enables a division of labour in the production of pins, upon which rests the wealth of nations: see Chapter 1 of An Inquiry into the Nature and Causes of the Wealth of Nations by Adam Smith. 

Finding better ways to combine the productive capacity of the labour, machinery, natural resources, infrastructure and other resources of a country is what technology, technological change and ultimately economic growth are all about.  At a time when we are seemingly surrounded by more and more technological marvels this might not seem like such a policy imperative.  It is a significant concern though that UK productivity growth over the last decade has been historically slow – as pointed out by Nick Crafts of Warwick University: growth in real GDP per hour worked was over 18% lower at the end of 2018 than if the pre-Global Financial Crisis trend had continued. 

This link between productivity and growth is why the PSR’s duty to promote innovation – one of our statutory duties - is so important.  The current economic situation only accentuates this.   

To address properly the question of the best ways a regulator can promote innovation, it is worth starting by reflecting on what innovation actually is.  Apart from being one of these things we all feel we know when we see it, it is a hard concept to pigeonhole.

The first – and perhaps most fundamental point – is that innovation comes in many different shapes and forms and arises from many different places.  It is worth distinguishing between invention - the creation of new technology or ideas - and their successful implementation which is innovation.  The first steam engine was in the first century: what occurred in the eighteenth century (when the use of steam fuelled the Industrial Revolution) were inventions to improve the basic idea certainly, but more importantly the successful application to the problems of the day.  It is innovation – not invention -which drives benefits to the economy and consumers.  

The sources of innovation are also many and varied.  There is often a popular perception (which conflates invention and innovation) that innovation happens in the garages of geniuses.  This is an easy and attractive view to take, and builds on human interest stories such as the Wright Brothers inventing powered flight in their bicycle repair shop.  Such a view often coincides with the idea that the best thing government and regulators – as unwelcomes sources of red tape - can do to foster such innovation is get out of the way.  All such stereotypes contain a grain of truth, but the truth is much richer and more varied than this.  Both invention and innovation can come from large companies and government institutions too: many of the key elements of the internet and world wide web come from government funded bodies and large incumbent firms.   

The OECD manual on how to measure and analyse innovation, known as the Oslo Manual, distinguishes between product innovations (i.e. new things) and business process innovation (i.e. new ways to make and bring stuff to market).  These activities cover a wide range of different types of activity including R&D, training, marketing, intellectual property related activities, managing innovation activities better, managing and using data.  

All are important components of innovation.  

These different elements of innovation are valuable because of their impact – on productivity and the benefits that consumers see.  This is important to bear in mind when considering what are the right interventions to promote innovation.  It is not the individual innovations or inventions which need to be fostered (the inputs) but rather the benefits they provide (the outputs).   

To make this abstract discussion more concrete, innovation activities involve not just the creation of, say, a new payments app, but also a whole range of other factors to bring it to market.  This includes: linking the app to the processes which make it useful to payers (i.e. appropriately linking it up to the wider financial services infrastructure, such as access to relevant payment systems); pricing it in a way which makes it attractive and useful to both sides of the relevant payments; marketing it to those who will benefit from it; training staff to maintain the app and support customers using it; and identifying how to evolve the intellectual property inherent in the app to create the next product or next iteration of the product.  And then working out how to do all of that better, quicker and cheaper.  It may start with some clever code, but innovation does not stop with just that code.  

This diversity of types and sources of innovation gives a clue to the role of the regulator in promoting innovation.  

A companion blog to this piece provides brief recent history of how regulation and regulatory intervention promoted innovation in the provision of Faster Payments.  This is a real-world example where innovation was assisted by a regulatory intervention: where there were significant benefits to all but not sufficient up-front prospect of return for individual firms investing.   

Payment systems need to be just that – systems which connect payers and payees.  This means that there is a need for common standards, that benefits of greater network use are diffused across all users of the network (what economists call network externalities), and that multiple providers need to connect to each other (i.e. co-operate) to achieve benefits for all.  This all creates situations where private companies with no regulatory intervention may find it hard both to compete and invest in innovations. A related issue is that there can be a mismatch between the benefits of an innovation to the economy as a whole compared to the benefits to the individual innovator.  The Faster Payments situation mentioned above is one example of this.

This should not mean we abandon competition completely as it is also worth remembering that monopolies often do not have a good track record of innovation either.  Some rivalry can be needed to drive a need to innovate – to stay ahead of the competition.  While it needs to be interpreted carefully in practice, there is a powerful idea, with some empirical support, that the relationship between competition and innovation is an “inverted U” i.e. innovation increases from the monopoly case with increasing competition but as competitive rivalry becomes too intense innovation becomes a cost to be cut in order to remain afloat.  Regulation can be an important influence here to ensure that competition occurs in a way that promotes the interests of both existing and future consumers; and that network benefits can be equitably shared between consumers and firms (to create sufficient incentives to innovate in the first place).  

Balancing these different interests in a network industry is a challenge which payments, and payments regulators, share with many other regulated sectors and their regulators.   

Measures which have been used in both payments and other sectors historically include facilitating or determining standards to create network benefits (innovation occurring both collaboratively in the creation of the standard and competitively in how the standard is then used).  Ensuring that existing and new players have fair and non-discriminatory access to allow innovative products to compete on their merits further down the supply chain is another regulatory intervention often used in these types of situations.  An important aspect of this can be ensuring that large, incumbent, network operators genuinely and properly listen to their customers and adapt their provision so that innovative products are not unnecessarily blocked by custom and the way it has always been done.  Again, one element of this can be about ensuring that innovations with wider benefits continue to be developed when individual players – especially the networks at the centre – do not see those benefits but are instrumental in delivering them. Regulatory intervention can sometimes also be required to ensure that returns on innovation investment flow to those making the real innovative leap and not just those with monopoly power.  Sometimes it may also even be true that the best regulation is that which steps back and allows the market to get on with it. 

Looking at the wider benefits of innovation regulators can also be needed to ensure that new products do not disproportionately create risks for some consumers: e.g. having minimum safety standards so that benefits for the majority are not bought at the cost of harming a minority through increased fraud.   

Ensuring that innovation does not create disproportionate risks for consumers also has another aspect: that innovation happens in a way which takes account of those who may be left behind.  Taking account of the needs of vulnerable consumers was high on the agenda of all regulators last year.  The events of this year make this even more important.  Promoting the interests of all consumers needs to include ensuring innovation happens for and benefits those who need it most; and that innovation which benefits us all does not do so at the cost of making the vulnerable even more excluded.  

Looked at through these lenses, what types of regulatory intervention at each level of the supply chain do you think would enable inclusive innovation - to create benefits for all those making and receiving payments? And how do you think the regulator should approach assessing and promoting those beneficial outputs from innovation? And how do you think the regulator should approach assessing and promoting those beneficial outputs from innovation? 

Matthew Cherry is the Chief Economist at the Payment Systems Regulator. The views, thoughts and opinions expressed in this blog are his own and do not necessarily represent those of the Payment Systems Regulator.

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