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By Henry Hing Lee Chan

Innovation & Economic Growth: A Review of the Productivity Paradox

Mar. 28, 2016  |     |  0 comments


In the government work report delivered at the recently concluded National People’s Congress (NPC), Chinese Premier Li Keqiang declared that “innovation is the primary driving force for development and must occupy a central place in China's development strategy” (“China adopts new”, 2016). In the report, he used the word “innovation” 61 times, nearly double the word’s usage in the 2015 work report. The Premier’s speech at NPC is considered a guidepost for the specific policies in the following year or two. The importance of innovation which the Chinese government puts on economic growth merits a review of the issue and the lesson of productivity paradox in which the US experienced will hopefully shed some light.

Economic Growth

Economic growth is the enduring increase of a nation’s gross domestic product (GDP) over a relatively long period of time. It is a phenomenon that first happened in history in the 19th century alongside the first Industrial Revolution in Britain which later spread to other European countries and the US. Economic growth spread globally after Second World War. According to Delong (2000), the percentage change of GDP per capita per century was miniscule until the 18th century and only started to accelerate to over 90 percent in the 19th century and hit more than 340 percent in the 20th century.

The causality of innovation, either in the technological area or organizational field, in the economic growth process is an accepted dogma in the economics discipline. It is accepted that innovation brings productivity growth which in turn brings economic growth. The productivity growth is expressed as the total factor productivity (TFP) term in the standard economic growth model.

People often assume economic growth is a simple function of technological innovation. That popular belief does capture a lot of the story but not all. For a country in the initial stage of industrialization, technological innovation comes from imported machines embedded with the technology used by advanced countries. Together with market reforms and institutional changes, these factors lead to higher efficiency. The initial phase of economic growth is indeed quite close to technological innovation. However, as a country progresses, this simple source of productivity gains is exhausted. The country must move up the value chain by doing its own research and development, and deepen reforms in the factors market to facilitate migration to next phase of growth. China is now in this stage and the relationship between economic growth and technological innovation is not so simple any more.

The history of the productivity paradox in the US from the 1970s to the late 1990s offers a good historical lesson on understanding the translation of technological innovation to economic growth for countries in the second stage of growth. That historical episode clearly shows that the translation of innovation to productivity gains and subsequent economic growth involves a lot of uncertainty and delay.

Productivity Paradox

The US economy experienced a sharp deceleration of productivity growth between 1975 and 1995, dropping to 1.4 percent from the 1948-1970 average of over 3 percent. Time Magazine in 1982 declared that the computer was the “person of the year,” and the productivity slowdown happened during the digital revolution. Robert Solow, the Nobel laureate in economics, aptly stated the irony (1987): “You can see the computer age everywhere but in the productivity statistics.”


The failure of this massive investment in information technology to boost productivity growth became known as the productivity paradox.



The historical episode in the US from the 1970s to the late 1990s clearly shows that the translation of innovation to productivity gains and subsequent economic growth involves a lot of uncertainty and delay.

The productivity paradox has attracted a lot of attention because technology seems to be incapable of creating the kind of productivity gains that occurred until the early 1970s. Some economists suggested that technology in general is subjected to diminishing returns in its ability to increase economic growth. That kind of pessimism was dispelled in the late 1990s when labor productivity bounced back to the 2.5-3 percent range in the decade before the 2008 global financial crisis.

A good number of reasons have been put forward to explain the productivity paradox:

One hypothesis is that while computers are productive, their productivity gains are realized only after a lag period, during which complementary capital investments and co-inventions must be developed to allow for the use of computers to reach their full potential in economically productive areas. This explanation of the time delay between technological innovation and productivity gains and economic growth is the most widely accepted explanation nowadays and is popularly known as the time lag hypothesis.

Another hypothesis is that the benefits of information technology do not show up in the productivity gain growth accounting based on the mismeasurement of inputs and outputs. Growth accounting separates out the improvement in production output using the same capital and labor resources as input by calculating growth in TFP, also known as the “Solow residual.” While computers have facilitated a lot of office work during the 1980s and early 1990s, the improvements in efficiency have not been translated into increases in output or reductions in input that leave any impact on the computation of the residual. This hypothesis is certainly possible as we note the tremendous quantity of free goods available under the current internet age. A lot of earlier economic activities on information goods are free now (though it was not so clear in the earlier 1980s and 1990s, but the analogy should work), thus depressing the computation of GDP, however, the real consumption of information goods has increased significantly after they became free. The hypothesis of measurement error might not be satisfactory to many but most economists consider it a good way to partly explain the productivity paradox. In any case, directly measuring the contribution of technological progress to economic growth remains a dream today.

Some other hypotheses also proposed to explain the productivity paradox, such as redistribution and dissipation of profits, and the mismanagement of information and technology, all lost credence after the late 1990s rebound of productivity.

Lessons from the Productivity Paradox and Policy Implications

The time lag hypothesis and the idea that productivity will only affect economic growth when innovation is put into use in economically important sectors together explain the productivity paradox. If one looks at how long it takes for a major innovation to develop its practical applications, what people describe as a paradox is no great paradox at all.

Economists never understood well the factors affecting the rate at which technological progress is diffused into production. More often than not, time is required for major innovations to work their way through the economy.

China is facing an economic transition challenge of whether its aggregate productivity growth can be maintained by new, major innovations that will mature in time to overcome the gap resulting from the maturation of the older model. The uncertainty of the impact of innovation on short term economic performance due to the time lag effect means that this Schumpeterian innovation approach to economic growth must be backstopped by other policies to safeguard economic growth. Embracing innovation is an excellent long term growth strategy but the productivity paradox the US faced in the past should not be ignored. China should complement its structural reform efforts that place innovation at the center of its growth policy with cyclical economic stabilization measures to ensure a benign economic environment for the speedy absorption of innovation into the real economy.

(The writer wishes to express his gratitude to Professor John Wong of the East Asian Institute for his valuable input to the paper.)

References

China adopts new strategy to refuel growth. (6 March 2016). Xinhua Net. Retrieved from http://news.xinhuanet.com/english/2016-03/06/c_135160728.htm

Delong, B. (2000). Cornucopia: The pace of economic growth in the 20th century. NBER Working Paper No. 7602.

Solow, R. (July 12, 1987). We'd better watch out. New York Times Book Review, page 36.

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