How Technology Affects Economic Growth and Why It Matters for Policymakers

Andrea O’Sullivan

Technology is something to resist. Whether it foments antisocial behavior, cultural polarization, or wide-scale labor disruptions, technological change is a frustrating and perennial struggle facing society. The benefits largely accrue to a few oligarchs. More existentially, digital technologies rob us of our humanity, as automation and machine learning becomes a dangerous master we must serve.

At least, that’s the woeful impression you may get from some critics. Given this bleak view of affairs, it’s a wonder that anyone tolerates modern technology at all. Why allow such traumatic social shifts if nothing worthwhile comes of it?

**Andrea O’Sullivan, director of the Center for Technology and Innovation at the James Madison Institute**

It is true that antipathy to technological change animates many proposals for limitations or outright bans on certain applications of technology. Yet apart from a few odd countries, no governments prohibit technological innovation altogether. Why?

The truth is that many people realize that technological innovation, economic growth, and overall human wellbeing are intricately linked and that stemming our innovative capacity means handicapping our potential to progress. If we don’t allow some disruption today, then our overall quality of life will be much lower tomorrow.

Economists have tried to better understand the relationship between innovation and growth for decades. A new paper by Mercatus scholars James Broughel and Adam Thierer assembles the literature on growth theory and accounting to paint a picture of just how important technology is to long-term growth.

How We Know How to Grow

Interest in measuring and modeling the sources of economic growth increased among economists in the mid-20th century. In 1956, Robert Solow introduced what is now called the “Solow growth model,” which tries to explain economic growth using a nation’s stock of labor and capital, plus a generic technological change variable that was assumed to grow automatically. The model predicted that countries with a smaller capital stock—like underdeveloped or war-recovering countries—would grow faster in the short term than better-capitalized countries. But long-run prosperity hinged on technological change.

Just how potent is technological change? Solow’s model inspired a new field in economics called growth accounting, which attempts to empirically measure the things that stimulate economic growth. Solow estimated that almost 90 percent of US output came thanks to technological change; other studies found effects of similar magnitude.

But these early studies were a bit limited by the fact that they did not measure innovation per se. Rather, they estimated total factor productivity (TFP), which is a broader concept. TFP is a measure of a nation’s output that cannot be explained by measured inputs like labor and capital. So it includes things like scale efficiency improvements that are not new “innovations.”

Later, more fine-tuned analyses estimated that anywhere from one to two-thirds of economic growth comes from innovation. While there remains considerable uncertainty about the underlying causes of innovation, the consensus view today is that innovation is a key driver of growth.

A major limitation of Solow’s model was the assumption of automatic technological change. In more recent years, “new growth theory” has sought to explain the process of technological change that drives growth. This body of work, spearheaded and popularized by Nobel laureate Paul Romer, seeks to explain how and why businesses innovate by examining its components. In particular, ideas and new discoveries are important sources of growth in this modern class of economic growth models.

While Solow’s model saw little role for policy in stimulating or slowing growth, models like Paul Romer’s suggest just the opposite. Policies that encourage experimentation, learning, human capital accumulation, and risk-taking can pay huge dividends in the form of future economic growth.

GDP Isn’t Everything

A bit of a caveat is in order. While it is true that the weight of the economic evidence suggests innovation and economic growth are connected in important ways, there are limitations to how we can measure economic progress.

The most popular measures of economic growth are based on changes in gross domestic product (GDP), or national production. While GDP accounts for the value of final goods and services traded within the US during a particular period of time, it does not include certain important, but hard-to-measure, quality-of-life considerations like leisure time, household production, and environmental effects.

GDP also has difficulty accounting for quality improvements, which is a major form of innovation. The appliances and tools that we use today are much more efficient and capable than the ones our grandparents used. While some adjustments are made to “GDP” to try to account for how, say, ovens now come with more features, sleeker design, and “guided cooking” functionality relative to those in the past, these adjustments are far from perfect.

Nor does GDP capture gift transfers, or valuable things that are given away for free. This is especially relevant to online platforms that offer their services to users at no monetary price. If that platform sells advertisements, those sales will be counted in GDP. But the considerable consumer surplus provided to users free of charge goes uncounted in official growth statistics. Broughel and Thierer point out that GDP probably underestimates the contributions of innovation to growth because so many of its outcomes are unmeasurable.

This acknowledgment goes both ways: GDP may also not calculate many negative social consequences generated by innovation, such as the parade of horribles critics pin on technological development.

It is even possible that innovation is associated with lower GDP growth in the short term. This may have been the case during the Great Depression, which was a time of rapid innovation despite general economic decline. In fact, the introduction of particularly sweeping innovations, called “general purpose technologies,” can be “so disruptive at times that they reduce aggregate production for a period of time until the macroeconomy adjusts,” as the paper notes. For example, it’s not hard to imagine that the spread of electricity or the internet led many old business models to fail.

Regardless of these analytical limitations, the empirical association between innovation and growth is well-established in the economic literature. Policymakers who wish to foster economic growth would, therefore, be wise to foster an innovation culture.

Innovating Is Hard to Do

This can be easier said than done. While economists are confident in the association between innovation and growth, they are far less certain about what actually drives innovation. Many have offered theories describing the conditions that give rise to innovation. But the spark that lights cultural creativity is hard to synthetically recreate.

Economists have a good idea of the general ingredients. According to Daron Acemoglu and James Robinson, a nation’s institutions can make or break its capacity to promote technological change. Good institutions foster innovation, bad institutions kill it. And what do “good institutions” look like? Douglas North and Barry Weingast say good institutions protect and promote property rights, which gives people an incentive to find new ways to improve their lives. Other economists, like Deirdre McCloskey and Joel Mokyr, emphasize the role that culture plays in encouraging innovative entrepreneurship, whether through esteem among the bourgeois class or fostering a pro-innovation intellectual elite culture.

What’s harder is the recipe: how can policymakers shape their nation’s laws and cultures to cook up an environment for innovation?

The United States is actually in an enviable position as a nation that houses a thriving innovation culture. We already have the manna from heaven. Our nation’s higher education and research institutions are the envy of the world. Our nimble capital markets adapt to new investment opportunities. Our planet’s brightest minds flock here to build tomorrow. These serendipitous conditions explain why the US has given rise to some of the most successful companies today.

In our case, then, policymakers must play defense. They don’t need to discover a policy environment that can conjure up the magic of innovation. They just need to make sure our policies don’t mess up a good thing and repeal policies that threaten to do so.

This means refusing to succumb to the forces opposed to technological change. Those who are harmed in the short term by disruptive innovation should not be ignored, but neither should innovation be killed. Doing so would mean effectively eating our own seed corn. Rather, policymakers seeking to secure economic growth in the decades to come should protect and extend our innovative environment.

Andrea O’Sullivan is the director of the Center for Technology and Innovation at the James Madison Institute

Kelechi Deca

Kelechi Deca has over two decades of media experience, he has traveled to over 77 countries reporting on multilateral development institutions, international business, trade, travels, culture, and diplomacy. He is also a petrol head with in-depth knowledge of automobiles and the auto industry

Tags: James Madison Institute, Technology

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