ISSUE 2006 06 OCTOBER 2006 bruegelpolicybrief A PRIMER ON INNOVATION AND GROWTH by Philippe Aghion SUMMARY In sharp contrast with the post war period over the last 10 years income per head in the EU has begun to decline in comparison to that of the US Against this background the revival of growth and productivity has become an overriding priority of European policymakers While fostering innovation has become a necessity in Europe R D investments alone will not do the job POLICY CHALLENGE Impact of New Firm Entry on Productivity UK firms data 1987 93 shows that entry has a more positive effect on productivity growth in industries close to the technological frontier 0 08 Total Factor Productivity Growth Non Resident Senior Fellow at Bruegel and Prof of Economics at Harvard University philippe aghion bruegel org 0 06 0 04 Industries close to frontier 0 02 Industries farther below frontier 0 0 02 0 0 02 0 04 0 06 Entry Rate of Foreign Firms in the Market Source Aghion et al 2006 To get back on a high growth path Europe needs a comprehensive and coherent strategy which also involves i more competition and entry on the product markets ii more investment in higher education iii more developed financial sectors and markets and more flexible labour markets iv a more proactive macroeconomic policy over the business cycle Finally there should be a clearer recognition that structural reforms may entail winners and losers hence the importance of complementary policies aimed at correcting the inequalities caused by these reforms A PRIMER ON INNOVATION AND GROWTH bruegelpolicybrief 02 OVER the last ten years the average annual growth of GDP per capita in the EU15 has been 0 4 percentage points below that of the US The gap may not seem large but cumulated over long periods such small gaps end up producing large differences in income per capita Furthermore this gap implies that in sharp contrast with the previous decades where per capita GDP growth was much higher in Europe than in the US in the last decade income per head in the EU has begun to decline in comparison to that of the US Against this background the revival of growth and productivity has understandably become an overriding priority of European policymakers But how can we explain this change of fortune and reverse the trend Classical growth theories do not have much to tell us on this question Indeed these theories emphasise capital accumulation and savings rates as the engines of growth However in spite of the US investment revival of the last fifteen years both the capital labour ratio and the investment rate are still higher in Europe than in the US Europe may need to renew its capital stock but it is hard to claim that its growth performance primarily results from underinvestment in physical capital An alternative explanation which underlies the so called Lisbon Agenda is that Europe has not invested enough in research and development R D nor in the knowledge economy As a result the region has not been able to take full advantage of recent technological revolutions particularly in information and telecommunications The Lisbon objectives in this respect are far from being met and high sustainable growth still remains a challenge for EU countries But why is it that technology and R D have suddenly become so important Another frequently mentioned pos sibility is that Europe has failed to tition in the product market large reform overregulated labour and firms financed by banks and by product markets There is indeed a government subsidies educatiosharp contrast between the US and nal systems emphasising primary EU countries in terms of product secondary and specialised underand labour markets regulation but graduate education and rigid again this contrast has been there labour markets that favoured the for a long time it was already accumulation of experience within apparent when firms over mobility Europe was growing across firms much faster than the By the late 1980s US However by the late Europe had largely 1980s the advanced Finally macroecono exhausted capital European countries had mic policy is someti accumulation and largely caught up with mes blamed for the world s best perforbeing too restrictive technological imita mers in terms of the But while there have tion as its main sour capital labour ratio and been episodes of fisproductivity levels they cal consolidation ces of growth were reaching the world and monetary tighttechnology frontier ness the overall policy has not been This in turn implied that Europe had overly restrictive in recent years largely exhausted capital accumulation and technological imitation There is therefore a puzzle about as its main sources of growth and the deterioration of Europe s growth had to turn to an alternative performance The purpose of this source namely innovation that is note is to identify the main reasons the ability for firms and workers to for this deterioration and to suggest move rapidly into new activities or ways to reverse it to improve production processes Section 1 looks at the importance of innovation for EU countries Section 2 examines indirect means of fostering both innovation and growth and Section 3 draws some policy conclusions 1 INNOVATION A NECESSITY In 1945 Europe s stock of physical capital had been largely destroyed and its technological knowledge as reflected by its average level of per capita GDP was far behind the per capita GDP in the US So at that time what Europe needed to do to grow was essentially to accumulate capital and to imitate or adapt technological innovations made elsewhere And this is what Europe did quite successfully during the trente glorieuses with the support of economic institutions and policies that were adapted to those goals in particular limited compe In the meantime the IT revolution resulted in a revival of US growth in the late 1980s and early 1990s Since Europe did not have the institutions and policies to benefit from this new technological revolution the result was a reversal of Europe s approach to the frontier A first way to foster innovation is thus to invest more in R D As we all know EU15 countries have been investing on average about 1 9 of their GDP in R D in the last decade against 2 6 in the US That R D investment becomes more essential when industries move closer to their technological frontier is evident when one analyses the relationship between the distance to the frontier and R D intensity at the industry level Some
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