From Catch-Up to Frontier-Innovation Growth

Philippe Aghion

Questions

How can China avoid the middle income trap and succeed in transition from “catch-up economy” to “frontier innovator”?

Does this also require institutional change, not just policy change?

Rethinking the role and size of the state?

Schumpeterian Paradigm

Long-run growth is driven by (frontier) innovations

Innovations result from entrepreneurial investments (R&D…) which are themselves motivated by the prospect of innovation rentsPolicy of growth

Creative destruction: new innovations make old technologies become obsoletePolitical economy of growth

Schumpeterian Paradigm

A first prediction of the paradigm is that (frontier) innovation requires turnover, i.e reallocation and exit!

A second prediction is that competition enhances frontier innovation and thereby growth

A third prediction is that growth-enhancing policies depend upon stage of development

Frontier innovation vs catch up growth

Catch up growth in China

Partial market reforms and yardstick competition between provincial leaders

Reallocation from agriculture to industry and from SOEs to (credit-constrained) new TVEs and private enterprises (Song-Storesletten-Zilibotti)

Technological catch-up taking advantage of FDI

From catch-up growth to innovation-based growth in China

More reallocation-based growth can be achieved from liberalizing labor flows from rural to urban areas and from developing financial sector

From catch-up growth to innovation-based growth in China

Yet, several reasons for expecting a slowdown:Gains from reallocating resources from

agriculture to industry and from absorption of imported technologies have exhausting effects

Wage increases will reduce comparative advantage of China in what it currently exports

Pillars of an innovation-based economy

First pillar: Competition

Competition/entry is more growth-enhancing for countries or sectors that are closer to technological frontier

Competition/entry is more growth enhancing in countries or states with less regulated labor markets

Three fallacies about competition policy

Competition policy would counteract effects of patent policy: in fact the two policies are complementary

Competition policy goes against any form of industrial policy: in fact the two are complementary

Competition policy works independently of institutions: in fact corruption limits competition

Second pillar: education

Need good primary/secondary education...importance of good PISA performance

To have good graduate education is more growth-enhancing closer to technological frontier....importance of good Shanghai rankings

Primary/secondary education

Quality, not just quantity, of investment matters

Two illustrationsPISA and growthInvesting more in more autonomous

universities, is more growth-enhancing

Autonomy of universities Autonomie

Source : The Governance and Performance of ResearchUniversities: Evidence from Europe and the U.S. – P. Aghion et alii – NBER avril 2009

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Third pillar: Labor market flexibility: “flexsecurity”

Labor market flexibility is more growth enhancing the closer a country is to the technological frontier

Need to combine labor market flexibility with reasonable unemployment benefits conditional upon training for new jobs: flexsecurity!

EPL

                        Variable     eq1             eq2             eq3             eq4             eq5      

                Leader MFP growth   0.02949         0.02996        0.02830         0.02813                     

                    Gap to Leader -0.00858***     -0.00836***                                                

                              EPL -0.00000                                                                    

         EPL, for highest tercile    0.00002       -0.00009**      -0.00011**      -0.00015*** 

          EPL, for middle tercile    0.00004*       0.00002         0.00001         0.00001    

          EPL, for lowest tercile    0.00004       -0.00005         0.00002         0.00003    

     MFP Gap, for highest tercile                  -0.01261***     -0.00816        -0.00547    

          Gap, for middle tercile                  -0.00276        -0.00174        -0.00210    

          Gap, for lowest tercile                  -0.00901***     -0.01095***     -0.01173*** 

    EPL*Gap, for highest tercile                                   -0.00017        -0.00029*   

      EPL*Gap, for middle tercile                                   -0.00004        -0.00003    

     EPL*Gap, for lowest tercile                                    0.00012*        0.00014**  

Leader growth, for highest tercile                                                    0.13600*** 

Leader growth, for middle tercile                                                    0.00817    

Leader growth, for lowest tercile                                                   -0.02597    

legend: * p<.1; ** p<.05; *** p<.01

Flexsecurity

Flexsecurity

Flexsecurity

Flexsecurity

Fourth pillar: Finance

As country moves closer to frontier, needs to rely more on equity finance and stock markets

Reason is that innovative investments are more risky and therefore investors require both, to get a share of upside returns and to get control rights (Aghion-Bolton, 1992; Kaplan-Stromberg 2002).

OLS IV OLS IVStock Market * Financial Dependence 0.065 0.035 -0.008 -0.139

[.026]** [.023] [.058] [.069]**Stock Market * Fin Dep * Dist to Frontier 0.289 1.072

[.327] [.448]**Private Lending * Fin Dep 0.059 0.029 0.059 0.036

[.036]* [.028] [.034] [.027]Private Lending * Fin Dep * Dist to Frontier -0.528 -0.919

[.164] [.243]***Observations 972 661 887 638R-squared 0.3 0.3 0.38 0.36Country & Sector Dummies included.* significant at 10%; ** significant at 5%; *** significant at 1%

Finance, Growth and Distance to FrontierValue Added Growth, 1980-1990

Preliminary results

Fifth pillar: Democracy

Democracy is more growth-enhancing for industries that are closer to the technological frontier

This is not surprising for at least two reasons: Frontier innovation requires free thinking Frontier innovation requires creative destruction,

but lack of democracy favors corruption and in particular collusion between incumbents and (local) leaders.

Reducing corruption or increasing trust enhances growth

Free press reduces corruption

Sixth pillar: countercyclical macroeconomic policy

Two Contrasted Views of How to Conduct Macrooeconomic Policy

Keynesian view (non-discriminatory increase in public spending)

Conservative view (tax and spending cuts)

A Third Way

There is a third way between keynesian and conservative approachesnamely, countercyclical fiscal and

monetary policy to partly circumvent credit market imperfections and thereby help firms maintain their growth-enhancing investments over the cycle.

Fiscal Policy Over the Cycle

17 OECD countries, 45 manufacturing industries

Period 1980-2005 Finding: Countercyclical fiscal

policy enhances growth more in sectors that are more dependent on external finance or in sectors with lower asset tangibility

Fiscal countercyclicality across

OECD countries

From fiscal to monetary policy

More countercyclical monetary policy, i.e with lower short-run real interest rates in recessions and higher rates in booms...

....is more growth-enhancing in more credit constrained or more liquidity-constrained sectors

Conclusion 1:

Moving towards frontier-innovation growth requires:Competition Investing efficiently in education and

universitiesLabor market flexibility and trainingStock market financeChecks and balances to limit corruption

Conclusion 2:

Competitive and independent media supported by rule of law, will spur innovation-based growth for at least two reasons: It will put checks and balances on (local)

leaders, thereby reducing corruption which in turn will foster creative destruction

It will increase China’s attractiveness to foreign researchers, more generally it will enhance China’s “soft power” (J. Nye).

Conclusion 3: Seek higher quality growth

Environment:• State intervention to foster green

innovation and production

Income distribution:• Excessive inequality encourages capture

and undermines competition and trust• The top end stops contributing to public

good provision

Smart State: shouldn’t we all become Scandinavians?

Targeted and well-governed growth investments and wise countercyclical macroeconomic policy

Social dialogue (high unionization rates) favor external and internal labor market flexibility, and enhance trust between firms and employees

Fiscal system which helps deliver on budget balance, growth, inclusiveness, and the environment

Politicians under strict checks and balances (“Toblerone” story in Sweden)