Average TFP growth declined after 1970 due to constraints on idea processing capability, not idea supply, in particular by policies that affect financial market effectiveness

James, Kevin Roger and Kotak, Akshay and Tsomocos, Dimitrios P., Ideas, Idea Processing, and TFP Growth in the US: 1899 to 2019 (July 13, 2022). SSRN: http://dx.doi.org/10.2139/ssrn.4161964

Abstract: Innovativity - an economy's ability to produce the innovations that drive total factor productivity (TFP)  growth - requires both ideas and the ability to process those ideas into new products and/or techniques. We model innovativity as a function of endogenous idea processing capability subject to an exogenous idea supply constraint and derive an empirical measure of innovativity that is independent of the TFP data itself. Using exogenous shocks and theoretical restrictions, we establish that: i) innovativity predicts the evolution of average TFP growth; ii) idea processing capability is the binding constraint on innovativity; and iii) average TFP growth declined after 1970 due to a constraints on idea processing capability, not idea supply.

Keywords: Innovation, Financial Market Effectiveness, Endogenous Growth, Total Factor Productivity

JEL Classification: O44, O43, O47, O16, O51, O31

V Conclusion

An innovation requires both an exploitable idea and an entrepreneur who transforms that exploitable idea into a new product or process. Innovativity—the economy’s ability to create the innovations that drive TFP growth—is therefore determined by both idea supply and idea processing capability rather than by idea supply alone. Examining US innovativity over the last 120 years, we find that it is plausibly the case that idea processing capability is now and has been the binding constraint on US TFP growth. This finding therefore suggests that idea processing capability plays a central role in the growth process and merits further investigation.

Our innovativity framework creates a new perspective on the debate over the future of economic growth by calling the neo-Malthusian analysis of Gordan (2012, 2014) into question. Starting from the premise that ideas drive TFP growth and the observation that TFP growth has fallen since the Peak regime of 1946/1969, Gordon reaches the seemingly inescapable conclusion that TFP growth is declining because we are running out of ideas. And, if we are running out of ideas, it inevitably follows that “future economic growth may gradually sputter out”(Gordon 2012). Needless to say, the end of growth would have profound and terrible consequences for all aspects of economic, political, and social life.

Our analysis offers a way out of this dismal conclusion. We find that the poor TFP growth performance of the US economy since 1980 is not due a lack of ideas but to a lack of idea processing capability. Our analysis further suggests that the economy’s idea processing capability can be (and has been) influenced by policy, and in particular by policies that a↵ect financial market effectiveness. Consequently, the poor TFP growth performance of the US economy may be due to (cheaply) correctable policy failings rather than to a brute fact of nature that we must simply accept and deal with as best we can.

Our analysis here is exploratory. We focus upon endogenizing idea processing capability in a TFP growth model in which both idea processing capability and idea supply play a central role. To do that, we abstract away from important features of endogenous growth theory. We aim to more fully incorporate these features in future work. It may happen that doing so alters some of the conclusions we reach here. But, given the stakes in the future of growth debate, we should find out.