Is Innovation the Key to Growing the U.S. Economy?
Last Updated on Wednesday, 8 July 2009 08:13
Written by dbhalling
Wednesday, 8 July 2009 08:13
Traditional Explanation of Economic Growth
What causes economic growth? One of the common explanations is consumer spending. As a headline on Minnesota Public Radio’s website in October 30, 2008 stated “Consumer Spending Accounts for Two-Thirds of U.S. Economy.” If consumer spending is such a big part of the economy, then all that is necessary to stimulate economic growth is to get consumers spending more. The other one-third of the U.S. economy is government spending, so perhaps by having the government spend more money we can stimulate the economy. The theory of spending causing economic growth is commonly associated with Keynesian economics.
The multiplier effect is one of the more bizarre theories of consumption side economics. The multiplier effect states that for each dollar of government spending, the private economy will spend three dollars. More recent estimates are 1.2 to 1.5 depending on the type of spending. One implication of this theory is if we want ten percent growth in the economy, the government just needs to spend enough money so the multiplier results in a 10% increase in the economy. Therefore, if we want infinite growth, then the government just needs to spend an infinite amount of money.
Say’s Law of classical economics states that production creates its own demand. Modern economists building on Say’s Law propose policies that encourage production. As a result, they focus on low taxes, minimal government spending and incentives for companies and people to produce economic growth. This school of thought focuses on the supply/production side of the economy. A major tenet of supply side economics is the Laffer Curve. The Laffer curve shows that when the marginal tax rate is too high it actually results in less tax revenue than a lower tax rate. As a result, high marginal tax rates are often counter productive.
Logically, supply side economics has a significant advantage over Keynesian economics because it is consistent with the reality of consumption and production. In order to consume something, first one has to produce. Imagine a self-sufficient corn farmer who consumes all his corn including his seed stock. He has maximized his consumption, which should be good, according to Keynesian economics, but he has nothing to grow next year and will starve unless he finds another means to produce food.
Adam Smith and Growth
Adam Smith suggested three ways in which the annual output of a country could be increased. One is an increase the population, second is the division of labor and third is “some addition and improvement to those machines and instruments which facilitate and abridge labor.” An increase in the population or number of workers will increase the output of a nation but does not result in per capita economic growth. This chapter is concerned with what causes per capita economic growth, which improves the life of the average person. Why would the division of labor result in growth? When each person focuses on their particular job, they are able to produce efficiencies that are unlikely to occur when they are a jack-of-all-trades. Interestingly, our income tax discourages the division of labor. Because of the income tax, many people will take on tasks in their personal lives that theoretically would be more economically performed by another person. For instance, a homeowner might repair their washing machine rather than hire a repairman. The after tax cost of hiring the repairman is more than they earn per hour. Without income taxes, it would make more sense for the homeowner to hire the repairman and focus on their own profession. However, there are limits to how efficient people can be in their jobs. Finally, Adam Smith suggests an increase in capital goods and inventions will increase a nation output.
Modern economists have studied this issue and found that increases in capital goods are not nearly as likely to result in economic growth as innovation. Robert Solow won the Nobel Prize in Economics because of his work on the causes of economic growth. His model suggests that fourth fifths of the economic growth of the U.S. is the result of technological progress.
Real per capita increases in income can only be the result of innovation. Adding capital without any innovation associated with the capital will result in elevating every worker to a certain efficiency level, however never above that level. Once every worker has the all the capital resources they can use in their job they have hit a maximum output without innovation.
What if we had exactly the same technology now as we did in 1800? Would we be any better off per capita than the people of 1800? You might think that we would live longer. But, why would we live longer. We would have the same nutrition, sanitation, and medicine as them. We would have no advantages over our ancestors if we were limited to their technology. Our per capita income would be the same as the people of the 1800s.
Real per capita income growth is due to innovation. This is consistent with classical economics and supply side economics but refines our understanding of growth. The sad thing is, most college economics courses do not even discuss innovation. These courses focus on static supply and demand curves. Covering up the discussion of innovation with the Latin phrase “ceteris paribus” – all other things being equal.
The process of innovation, which Joseph Schumpeter called creative destruction, has largely been ignored by economics. However, other economists who have worked on innovation economics, include Robert Solow, Paul Romer and Gregory Clark. From a fundamental point of view in order to consume something it first has to be produced. In order to produce something, it first has to be invented or discovered.
While inventions are the cause of per capita income growth, market feedback mechanisms are still necessary to determine what inventions should receive investment. Without market feedback mechanisms, we might end up in the same position as the USSR. They setout on a program to produce more steel than countries in the west in the 1950s and succeeded. This caused many pundits in the west to suggest that communism was economically superior to western capitalism. However, it turned out that much of the steel was not needed and therefore not production but waste.
The U.S. needs to adopt policies that encourage innovation. However, these policies should be structured to work within our market economy. Encouraging innovation that is not subject to market forces is likely to fail for the same reason that the USSR’s emphasis on production without market mechanisms failed.
Has U.S. innovation declined since 1990? If so why has U.S. innovation slowed?
 O’Rouke, P.J., On the Wealth of Nations, Grove Press, 2007, p. 83.
 Smith, Adam, An Inquiry into the Nature and Causes of the Wealth of Nations, Edited by Edwin Cannan, New York, Modern Library, pp. 373-374.
 Clark, Gregory, A Farwell to Alms: A Brief Economic History of the World, Princeton University Press, 2007, p. 197.
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