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At a London lunchtime meeting on 20 April, Nicholas Crafts examined economists' new approaches to modelling the growth process which assign a key role to institutions and economic policy. These new theories matter, he argued: they have something important to tell us about the policies we need to achieve higher long-term growth. Crafts is Professor of Economics at the University of Warwick and a Research Fellow in CEPR's Human Resources programme. His talk drew on output from CEPR's research programme on 'Comparative Experiences of Economic Growth in Post-war Europe' (see box?), funded by the European Commission's SPES programme. It includes his Discussion Paper No. 1092, written with Charles Bean, 'British Economic Growth since 1945: Relative Economic Decline... and Renaissance?'.Crafts began by noting that in the traditional model, growth depends mainly on 'autonomous' technological change, not explained within the model itself. In contrast, 'endogenous' growth theory attempts to provide a more detailed analysis of the sources of long-run productivity growth. These new theories emphasize a broad concept of investment at the heart of the growth process; they also stress the role of incentives, and expect policies and institutions to have permanent rather than transitory effects on growth rates. There are different vintages of endogenous growth theory, including the 'broad capital' and 'endogenous innovation' models. The earliest models, based on the broad capital approach, made growth endogenous by dropping the traditional assumptions that capital accumulation is subject to diminishing returns and that total factor productivity (TFP) growth is exogenous. In these models, all growth comes from investment (in people as well as machines) on which social returns exceed private returns considerably. Investment is the key: the growth of output per person can be permanently raised by increasing the incentive to invest; hence, this should be the focal point for policies designed to raise the growth rate. Politicians of the right might see this as strengthening the case for low direct taxes; their opponents on the left might stress instead the need to counteract the underinvestment which, they argue, is typical of capitalist economies. But simple broad capital models are a bad guide for policy-making, Crafts argued. Historical evidence clearly shows that there are diminishing returns to routine investment even in broad capital, and that the industrialized economies did not grow rich without at the same time transforming their technology. Merely investing in more of the same machines and shopfloor skills is not the route to permanently faster growth: poor countries suffer from 'ideas gaps' (the absence of innovation) as well as 'object gaps' (the lack of physical capital). More recent approaches have been based on the concept of endogenous innovation. These models reassert the importance of technological change (the introduction of new goods and processes) as the key to long-run growth. Seeking to explain TFP growth (instead of ignoring it as do the broad capital models), they provide much deeper insights into the growth process, according to Crafts. Technological improvement comes through purposive investment and will be stimulated by policies and institutions which permit successful innovators to appropriate returns to cover their fixed costs. Larger markets, appropriate industrial relations, better quality R&D workers, higher margins and protection of intellectual property all boost growth, as does the assimilation of foreign technology. Foreign investment not only prevents the emergence of an ideas gap, but also offers a way for slower growing countries to achieve catch-up more rapidly, providing they have the 'social capability' to do so. There is a cost to growth in these models, however: in order to create jobs based on new technology, jobs must be eliminated elsewhere in the economy. The growth process cannot take place without such 'creative destruction': hence, the danger of protectionist policies designed to 'support the manufacturing base'. Different models provide conflicting answers to key policy questions, such as what happened to British growth potential in the 1980s? The broad capital approach is pessimistic, citing disappointing levels of investment and missing externalities associated particularly with de-industrialization. The endogenous innovation approach might be somewhat more optimistic, looking to better industrial relations and foreign direct investment as boosting TFP growth and reducing the ideas gap. Both approaches would probably be sceptical of the role played by British capital markets in the growth process. Crafts suggested that endogenous innovation provides the most useful insights for policy-makers today. Slow growth in post-war Britain was the result of badly directed supply side policies, which failed to create the right incentives to encourage rapid TFP growth. Most of the blame rests on 1940s and 1950s policy-making, which was influenced too heavily by the short-termism of politicians and the power of vested interests. In particular, reform of industrial relations was a no-go area, while R&D policies were largely hijacked by the defence establishment. Long-run growth prospects will not be enhanced merely by subsidizing physical investment, protecting existing jobs or pursuing re-industrialization per se, Crafts claimed. Further institutional reform and well-targeted interventions to raise the rate of innovation would be more promising avenues to explore. Populist sentiments which encourage excessive regulation or foster national champions can easily damage productivity growth. Short-term monopoly profits provide a key incentive for productivity improvement, and foreign direct investment is central to technology transfer. Growth policy should be judged by its impact over the long-run. A very successful set of reforms might raise growth eventually by, say, 0.5 per cent per year, but, by their nature, policies to increase endogenous innovation pay off only over the long-term. In the short-term, they may bring little benefit and may also inflict economic and/or political pain. |