The End of Innovation (Part 2)?: A New Hope | So Good News
At the end of my last column, the future looked bleak. If the standard theory of economic growth is correct, then: i) R&D spending generates ideas; and ii) ideas lead to TFP growth. In this case, increasing R&D costs when TFP growth is falling necessarily means that ideas are becoming harder to come by. And if ideas are hard to come by, economic growth driven by innovation will be stunted – with all the dire consequences.
Fortunately, new research shows that the standard view of how innovation works is incomplete. So, before concluding that innovation is over, it is important to understand how innovation happens.
For example, think of the wonder drug penicillin. Alexander Fleming discovered the idea of penicillin in his laboratory in 1928. But this discovery remained a mere scientific curiosity for nearly two decades, because the method Fleming used in his laboratory to isolate penicillin could not be scaled up to produce the drug. It took years of engineering work by research laboratories and pharmaceutical firms to turn the idea of penicillin into a real pharmaceutical innovation.
The example of penicillin shows that it is processed ideas, not ideas that create innovation, that stimulate TFP growth. The decline in TFP growth that we observe may be due to a lack of ideas (the standard view) or to a lack of capacity to process the ideas needed to turn the abundant supply of ideas into real innovations.
Processing ideas takes a long time.
A fascinating study of innovation in science by Jay Bhattacharya and Mikko Pakalen makes this point perfectly. They find that even if scientists want to do innovative science, they need to attract external support (eg, a grant and/or an academic position) to continue their career. This leaves scientists with a difficult choice. They may choose long-term projects that generate innovative science but do not provide immediate feedback to universities or foundations. Or they may choose quick-lose projects that demonstrate their expertise to outside parties but are not very innovative. Scientists have shifted over time from innovative strategies to strategies that win quickly (perhaps due to increased competition for funding and positions), and as a result, scientific progress has stagnated.
Firms must also choose between longer-term innovation projects and shorter-term, quick-win projects. Just as scientists should choose their projects based on what rewards universities or foundations will provide, firms should choose their projects based on what financial markets will reward.
If the financial markets function well, that is, if the firm’s accounts reliably disclose key information about the firm, if corporate governance arrangements align the interests of management and shareholders, if the markets are fair, and if the firm’s share price accurately reflects its value, etc. firms can convince the market that a long-horizon approach makes sense. But if the markets perform poorly and it is very difficult for shareholders and other stakeholders to tell whether or not the firm is wasting money, it will be difficult to get shareholders and/or stakeholders to buy into the long-term vision. In this case, shareholders and stakeholders encourage firms to take a quick-win “show me the money” approach instead.
Thus, the efficiency of financial markets has a significant impact on a firm’s choice between a long horizon and a quick-win approach. Because only firms with a long horizon develop the ability to process ideas into innovations, the efficiency of financial markets plays a crucial role in determining the ability of an economy to process ideas.
Now, if ideas are abundant, then average TFP growth is determined by the economy’s ability to process those ideas into innovations. The ability to process ideas is in turn a function of financial market efficiency. So, if this is the case, then the evolution of average TFP growth over time will be a function of financial market efficiency (not a proposition).
To test this proposition, Akshay Kotak, Dimitri Tsomokos, and I devised a way to track financial market efficiency in the US over the period 1899/2019. We observe that the financial market was less efficient during the largely unregulated period of 1899/1930. The stock market crash of 1929 led to major reform in the 1930s, and this effort created the highly efficient post-WWII markets of 1951/1970. Since the 1970s, market efficiency has begun to decline (in our view, regulation has not kept up with market changes). By 1980, market efficiency had returned to its level in the unregulated 1899/2019 period. This period of low market efficiency has lasted until today.
If market efficiency determines average TFP growth, then average TFP growth will rise and fall with market efficiency over time. As you can see from the table below, this is exactly what happens.
The idea processing theory of TFP growth is the only theory that can explain the evolution of average TFP growth over time. Thus, it is at least plausible that TFP growth in the US has declined due to a decline in the ability to process ideas, rather than because ideas have run out.
Of course, this result does not change the fact that TFP growth is still at a low level. But it opens up new ways to tackle the problem of low growth.
I will explore the implications of idea processing for growth policy in my next column.
The views expressed above are the personal opinion of the author.
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