Vidya Mahambare: The long-term focus

India's public policy should foster innovation and promote R&D to sustain high economic growth

India's public policy should foster innovation and promote R&D to sustain high economic growth.

In the wake of the ongoing global economic turmoil, the concerns of the policymaking establishment have firmly shifted, justifiedly so, to short-term stabilisation. It is nonetheless important not to lose sight of the factors that help achieve sustained long-term growth.

Understanding the process of economic growth has long been a central concern in macroeconomics. Until the 1980s, textbook macro-models assumed that long-term growth is largely determined by technological progress which was assumed to be exogenous. In other words, they did not explain why, when and how technological change occurs. Since technological progress was assumed to be exogenous, economic policy could hardly influence long-run growth in these models.

 

Since the mid-1980s, a new body of literature has evolved dubbed “endogenous growth theory”, which mounted a challenge to the prevailing orthodoxy. The central focus of this literature is to explain the process of technical change. A large majority of endogenous growth models explain technical progress as an outcome of the Schumpeterian process of creative destruction whereby old-lower quality products are replaced by higher quality and differentiated products. In these models, technical progress is not exogenous but it results from the optimal actions of firms and households as they seek to maximise their profits and utility respectively, by developing and consuming new products. As firms seek to develop new products, they invest in research and development (R&D) activities which, in turn, determine the level of innovation and hence, technical progress in the economy.

By making technical change dependent on actions of firms and households, the endogenous growth literature provides a framework in which government policies can influence long-term growth provided they create the right incentives to undertake R&D activities and innovation. These may include subsidies for R&D spending in the private sector, government spending in the area of science and technology, and funding for relevant university-based research.

An interesting question is, whether there is any empirical evidence to support this hypothesis. Studies which test this theory empirically rely on analysing the impact of innovation and R&D activities on productivity growth. A vast amount of empirical literature exists for advanced countries on this topic. A recent study by Madsen et al is among the very few papers which attempt to establish the relationship between long-term growth and innovation in the case of a developing country.* The paper investigates whether R&D activity has played a significant part in raising India’s growth rate since 1980s.

Using aggregate R&D data and various indicators of innovation activity for India during the period 1950–2005, the authors find strong support for the Schumpeterian growth theory. The aggregate level results are also supported by data for 590 firms over the period 1993-2005. The empirical results show that productivity growth in India over the past five decades has been significantly driven by research intensity, which is defined as the R&D expenditure per product rather than the aggregate level of R&D. The underlying idea is that as an economy progresses and new products and firms come into existence, the existing R&D effort is spread over a bigger pie. Therefore, the necessary condition to improve long-term growth is to increase the R&D effort measured on the per unit basis.

To isolate the influence of economic reforms on productivity growth, the paper carefully separates influence of polices such as financial and trade reforms on growth from the impact of R&D expenditure. The analysis not only points to the importance of R&D activities and innovation as the primary factor in raising India’s growth, but also to the fact that an increase in R&D in recent years has facilitated the increasing imitation of technologies from advanced countries.

In a nutshell, the message in short is India’s public policy should focus on fostering innovation and promoting R&D activity along with other reforms in order to sustain rapid economic growth.

The author is senior economist, Crisil
vmahambare@crisil.com

The Indian Growth Miracle and Endogenous Growth, 2009, J Madsen, A Saxena, and J B Ang, Monash University Department of Business and Economics Discussion Paper 0309.
http://www.buseco.monash.edu.au/eco/research/papers/2009/0309indianmadsensaxenaang.pdf