From Catch-Up to Frontier- Innovation Growth Philippe Aghion

Questions How can China avoid the middle income trap and succeed in transition from “catch-up economy” to “frontier innovator”? Does this also require institutional change, not just policy change? Rethinking the role and size of the state?

Schumpeterian Paradigm Long-run growth is driven by (frontier) innovations Innovations result from entrepreneurial investments (R&D…) which are themselves motivated by the prospect of innovation rents Policy of growth Creative destruction: new innovations make old technologies become obsolete Political economy of growth

Schumpeterian Paradigm A first prediction of the paradigm is that (frontier) innovation requires turnover, i.e reallocation and exit! A second prediction is that competition enhances frontier innovation and thereby growth A third prediction is that growth- enhancing policies depend upon stage of development

Frontier innovation vs catch up growth

Catch up growth in China Partial market reforms and yardstick competition between provincial leaders Reallocation from agriculture to industry and from SOEs to (credit-constrained) new TVEs and private enterprises (Song-Storesletten-Zilibotti) Technological catch-up taking advantage of FDI

From catch-up growth to innovation- based growth in China More reallocation-based growth can be achieved from liberalizing labor flows from rural to urban areas and from developing financial sector

From catch-up growth to innovation- based growth in China Yet, several reasons for expecting a slowdown: Gains from reallocating resources from agriculture to industry and from absorption of imported technologies have exhausting effects Wage increases will reduce comparative advantage of China in what it currently exports

Pillars of an innovation-based economy

First pillar: Competition Competition/entry is more growth- enhancing for countries or sectors that are closer to technological frontier Competition/entry is more growth enhancing in countries or states with less regulated labor markets

Three fallacies about competition policy Competition policy would counteract effects of patent policy: in fact the two policies are complementary Competition policy goes against any form of industrial policy: in fact the two are complementary Competition policy works independently of institutions: in fact corruption limits competition

Second pillar: education Need good primary/secondary education...importance of good PISA performance To have good graduate education is more growth-enhancing closer to technological frontier....importance of good Shanghai rankings

Primary/secondary education Quality, not just quantity, of investment matters Two illustrations PISA and growth Investing more in more autonomous universities, is more growth-enhancing

Autonomy of universities Autonomie Source : The Governance and Performance of ResearchUniversities: Evidence from Europe and the U.S. – P. Aghion et alii – NBER avril

Third pillar: Labor market flexibility: “flexsecurity” Labor market flexibility is more growth enhancing the closer a country is to the technological frontier Need to combine labor market flexibility with reasonable unemployment benefits conditional upon training for new jobs: flexsecurity!

Flexsecurity

Fourth pillar: Finance As country moves closer to frontier, needs to rely more on equity finance and stock markets Reason is that innovative investments are more risky and therefore investors require both, to get a share of upside returns and to get control rights (Aghion- Bolton, 1992; Kaplan-Stromberg 2002).

Preliminary results

Fifth pillar: Democracy Democracy is more growth-enhancing for industries that are closer to the technological frontier This is not surprising for at least two reasons: Frontier innovation requires free thinking Frontier innovation requires creative destruction, but lack of democracy favors corruption and in particular collusion between incumbents and (local) leaders.

Reducing corruption or increasing trust enhances growth

Free press reduces corruption

Sixth pillar: countercyclical macroeconomic policy

Two Contrasted Views of How to Conduct Macrooeconomic Policy Keynesian view (non-discriminatory increase in public spending) Conservative view (tax and spending cuts)

A Third Way There is a third way between keynesian and conservative approaches namely, countercyclical fiscal and monetary policy to partly circumvent credit market imperfections and thereby help firms maintain their growth-enhancing investments over the cycle.

Fiscal Policy Over the Cycle 17 OECD countries, 45 manufacturing industries Period Finding: Countercyclical fiscal policy enhances growth more in sectors that are more dependent on external finance or in sectors with lower asset tangibility

Fiscal countercyclicality across OECD countries

From fiscal to monetary policy More countercyclical monetary policy, i.e with lower short-run real interest rates in recessions and higher rates in booms is more growth-enhancing in more credit constrained or more liquidity- constrained sectors

Conclusion 1: Moving towards frontier-innovation growth requires: Competition Investing efficiently in education and universities Labor market flexibility and training Stock market finance Checks and balances to limit corruption

Conclusion 2: Competitive and independent media supported by rule of law, will spur innovation-based growth for at least two reasons: It will put checks and balances on (local) leaders, thereby reducing corruption which in turn will foster creative destruction It will increase China’s attractiveness to foreign researchers, more generally it will enhance China’s “soft power” (J. Nye).

Conclusion 3: Seek higher quality growth Environment: State intervention to foster green innovation and production Income distribution: Excessive inequality encourages capture and undermines competition and trust The top end stops contributing to public good provision

Smart State: shouldn’t we all become Scandinavians? Targeted and well-governed growth investments and wise countercyclical macroeconomic policy Social dialogue (high unionization rates) favor external and internal labor market flexibility, and enhance trust between firms and employees Fiscal system which helps deliver on budget balance, growth, inclusiveness, and the environment Politicians under strict checks and balances (“Toblerone” story in Sweden)