Saving or Innovation?

"Arguing in My Spare Time" No. 21

by Arnold Kling

Sept. 9, 1998

May not be redistributed commercially without the author's permission.



We are going to try to sort out four determinants of economic performance:

1. cylical factors

2. management techniques

3. saving

4. innovation

According to Business Week, the strength of the U.S. economy in recent years reflects superior management techniques and greater innovation. This suggests a permanent increase in the rate of economic growth. The alternative hypothesis is that the recent boom is mostly cyclical, in which case there is no permanent increase in the growth rate.

In a recent bestseller, "The Millionaire Next Door," the authors argue that the traditional route of steady thrift accounts for the wealth of most of the millionaires in the United States today. The typical millionaire is not someone who wrote a hit song or started a business. The typical millionaire is someone who had a steady, middle-class job, spent less than they earned, invested in a diversified portfolio of stocks, and now is rich.

If the traditional model of Calvinist thrift worked perfectly, then most of the millionaires would be farther away from us than next door. On average, consumers in Japan save a much higher share of income than their American counterparts. In Asia, and in many countries outside the U.S. and Europe, the millionaire-next-door strategy has been less than successful in recent years.

In the New Economy view, as espoused in Business Week, recent economic performance reflects a secular phenomenon: the emergence of innovation as a powerful factor in economic growth, and the emergence of the U.S. business sector as the world leader in innovation, due to superior management practices.

According to Business Week, the fact that Japanese save more than Americans is not an issue. We know how to innovate, and Japan does not.

This view of Japan as intrinsically constipated was not always in vogue. Before their stock market collapsed, the term "Japanese-style management" was used by management gurus to describe whatever management fad the author was espousing. For example, in 1990, in Sloan Management Review, Peter Senge wrote admiringly that "Japan illustrates the evolution from adaptive to generative learning." Indeed, if you had surveyed the literature on Japanese business practices when the Japanese economy was at its cyclical peak, you would have found that instead of the Silicon Valley lifestyle, the keys to a culture of innovation were Zen Buddhism, holistic thinking, and unselfish co-operation.

Recently, the management consulting mantra has changed, in a way that would make George Orwell proud. Free-wheeling capitalism good, planning ministries and long-term relationships bad.

If economic trends are secular, and innovation drives growth, then it is difficult to understand how Japan could be so up in 1990 and so down today. The notion that a great national culture found the secret of innovation and then lost it is rather far-fetched. However, once we admit that Japan's weakness has a large cyclical component, then we should be prepared also for the likelihood that U.S. economic strength also has a large cyclical component.

From the traditional perspective, the strong economic performance in the U.S. in recent years indeed appears to be a cyclical economic phenomenon, not a secular one. The explanation is that wages have been growing more slowly than prices, a factor which promotes strong demand for labor, high profits, and high stock prices. This behavior is cyclical, in that it cannot continue indefinitely, and indeed it may reverse.

Within the economics profession, the idea that growth comes from innovation rather than from saving and capital accumulation is called "New Growth Theory." I never studied it, but it seems to me that a central question for a new growth theorist would have to be:

If innovation is such a good thing, why isn't there an infinite amount of it?

In Old Growth Theory, where you need to increase capital in order to grow, the potential for growth is limited by society's ability to save. Even innovation can require saving and investment, because capital may need to be acquired or replaced in order to implement the innovation. New steel-making processes, for example, require new capital.

Saving depends on the amount of output available and on people's willingness to defer consumption. The amount of output available can depend on cyclical factors. As Keynes pointed out, and as Japan may illustrate, a high saving rate can depress output on a cyclical basis.

If growth instead depends on innovation, what limits society's ability to innovate? What factors affect the rate of innovation?

Thinking of innovation as a trial-and-error process, it probably is the "error" part that represents the cost of attempting to innovate. Some new ideas fail, many new businesses fail, and many new innovations succeed in spite of the fact that I can see clearly that they make us worse off (rap music, cable TV, and the vanishing strike zone in baseball, to name a few).

To say that we are in a new era powered by innovation is to suggest that the benefit-cost ratios for innovation have changed somehow. To achieve a given amount of innovative success, one must put up with fewer errors or a low cost-per-error. If this cost-benefit ratio has not changed since 1980, or 1970, then it is difficult to see why innovation ought to be more pervasive now than in the past.

One way in which the cost of innovation may have declined is that less commitment of physical capital is required to implement an innovation. It requires far less capital to design and distribute a new software program than a new automobile.

By the same token, the social cost of innovation may have fallen by less than the private cost of innovation. Because it is less costly to design and distribute an innovation, users face many more choices and are required to deal with half-finished products ("beta" versions and the like). The fact that no one downloads all of the software that is available for a free trial period is proof that there is a cost to the evaluation process. Just as an excess of information means a scarcity of attention, an excess of trial-and-error means a scarcity of evaluation and filtering. As innovation becomes de-coupled from capital, more of the cost of innovation is borne by users. The supply of innovations may increase, but the overall social benefit may increase by less.

Let us grant that the U.S. has a high rate of innovation, although the amount of innovation is not something that is measured, so we really do not know. Let us also grant that U.S. economic performance in recent years has been strong, a claim which is easier to support with statistical evidence. What is being suggested here is that those two phenomena are not as closely related as it may appear.

Much of the economic strength is cyclical. It is possible that once one adjusts for cyclical behavior, long-term economic growth has not increased. In fact, as an earlier essay reported, the evidence suggests that productivity growth has gone down, rather than up, in the 1990's.

The jury also is out on whether American management practices and a high rate of innovation promote growth. Patting ourselves on the back feels good. However, it may be another decade before we know whether there has been any increase in long-term economic growth that can be attributed to a higher rate of innovation.