The Dismal Science

What Is the Mother of Invention?

Why the American economy is so innovative.

All the bad news in the business section—falling payrolls, rising oil prices, slow business investment, record consumer debt, the specter of deflation, a shaky stock market—shouldn’t obscure the economy’s underlying strength. The productivity of American business and workers continues to surge. And modern growth theory can tell us why: Innovation across the economy is still alive and well.

U.S. productivity—the key to rising incomes and living standards—may be establishing a promising new pattern. In the last five years of the ‘90s boom, productivity grew nearly two-thirds faster than the average for the previous quarter-century. As that boom wore on, productivity did not, as usual, slow down. It stayed strong and even accelerated. Moreover, productivity continued to rise even when the economy headed south last year. And this year, despite the economy’s troubles, productivity will grow at least another 4 percent and perhaps more. Unless unemployment skyrockets, these gains should guarantee reasonable growth.

After several years of heated debate, most economists finally agreed that the key to the productivity gains of the 1990s was the strong investment in, and application of, new information technologies. Studies by fed economists Stephen Oliner and Kevin Stiroh, Harvard’s Dale Jorgenson, and others have shown that more than three-fourths of the increased productivity can be traced to the impact of these innovations and the high rates of investment in them. And Commerce Department economists have found that ‘90s productivity gains were concentrated in sectors that invested heavily in IT.

So why does productivity continue to rise when business investment in IT, as in all equipment, has slowed? One clue is that firms continued to invest in IT services to help them figure out how to make effective use of their new hardware and software. This would confirm analysis by the Commerce Department and others that productivity gains occur when firms change the way they operate in order to make better use of their new IT. You can’t just buy a bunch of new workstations. It’s the combination of innovation in technology and business operations that usually produces the big benefits. And that’s probably why we see no productivity rise in Japan or much of Europe, where IT investment has been nearly as high as here: Labor regulations and other barriers inhibit companies’ abilities to use their new IT to change the way they do business.

All this makes the late boom a convincing illustration of modern growth theory. In the 1970s and 1980s, MIT economist Robert Solow (who won a Nobel Prize for the effort), the late Edward Denison, and others identified the critical factors that explain American growth and productivity gains through much of the last century. Setting aside normal increases in the work force, they found that the most important factor, by far, is not capital or labor but innovation in its various forms. More than half of real productivity growth from 1929 to 1982 can be traced to the development of new technologies, materials, products, and processes; new ways of financing, distributing, and marketing goods and services; and new ways of organizing a business and managing a workplace. (Where does the rest of the productivity gain come from? Click here to find out.)

How does innovation work in practice? Take a familiar recent example. Apple invented graphical interfaces for its Mac operating system, a new technology that enabled an average person to perform complex computer operations. Apple’s small market share limited the impact, so it wasn’t until Microsoft adapted graphical interfaces to its market-leading Windows operating system that the new technology could help boost overall productivity. Firms quickly recognized that a digital workplace could mean higher profits and accelerated their capital investments (purchasing more computers and software) and training programs (teaching workers to use the system). But the bulk of the productivity gains came when businesses with their recently computerized workplaces identified new efficiencies and new opportunities they could exploit and changed their operations to do so—by adopting just-in-time inventories, for example.

If innovation is so critical, why do policy-makers largely ignore it? The reason is that the traditional theory of markets holds that there’s virtually nothing anyone, including government, can do to promote more innovation. Free markets are said to allocate resources so that all available capital and labor are used to produce the highest returns. But if that’s the way it is, no one has any economic incentive to come up with something new because doing so would involve using valuable resources in an effort that may not yield any return. The inescapable logic of traditional economics—and the view of most economists who advise policy-makers—dictates that the most important factor for productivity is “exogenous,” which means it occurs outside the realm of economic incentives and calculation. To hold to the theory of markets, you have to conclude that innovation just happens, as when a genius has a bright idea.

This analysis may well describe how a lone inventor, toiling in his garage or lab, behaves. But it seems a pretty fanciful way to explain why Genentech or General Motors, with a payroll to meet and stockholders to satisfy, invests hundreds of millions of dollars in research and development. Enter “endogenous growth” theory. Drawing on the work of Joseph Schumpeter, Paul Romer of Stanford and others argue that when innovators use resources that otherwise could earn a normal return, they are responding to a normal and very powerful economic incentive: potential monopoly returns. GM is spending on R & D in hopes that its tech wizards invent a more efficient engine or a safer body and give them a monopoly edge, if only temporarily. This analysis may wreak some havoc with the traditional view of the economy because it implies that a growing and productive economy contains not only market forces, but thousands of bubbles of temporary monopoly power. But it does explain innovation.

So if innovation responds to economic incentives, the government should be able to actively promote it, just as it does in education. Subsidies for basic research and development are one obvious way. Another is open trade, which can help avoid redundancy in R & D and gives a country access to the rest of the world’s innovations—witness the enormous productivity gains achieved by the Asian Tiger economies after they opened their markets.

But the most powerful spur for innovation is low long-term interest rates for businesses, which reduce the cost of investing in, developing, and applying new technologies and techniques. Here we see a disturbing difference between current policy and that during the ‘90s boom. The sharp and steady deficit reductions of the ‘90s lowered real long-term rates, but the renewed prospect of red ink for years to come has reversed that trend. While productivity gains remain strong for now, Washington’s current fiscal stance bodes ill for productivity and innovation in the future.