Intangibles and National Income Measurement: Measuring a scientific revolution Leonard Nakamura Federal Reserve Bank of Philadelphia* *reflects solely my opinions and not those of the Federal Reserve System

In social sciences, the ruling paradigm may depend on institutions Invisible Hand or Creative Destruction Humans have always been creative But creativity was only a small proportion of investment and wealth –Private investments in new product development have risen substantially since the late 1970s Does it now change the paradigm of economics? –Does economics need or have a paradigm?

Talk outline A scientific revolution? –Economists are uncomfortable with this notion Measuring the U.S. rise in investment in intangibles (new product creation) Are US economic choices sustainable?

A scientific revolution in economics? John Hicks on “revolutions” in economics, 1976: –“Our special concern [in economics] is with the fact of the present world; but before we can study the present, it is already past. –In order that we should be able to say useful things about what is happening, before it is too late, we must select, even select quite violently. –We must concentrate our attention, and hope that we have concentrated it in the right place.”

Issues in a scientific revolution According to Thomas Kuhn, a scientific revolution is a change in paradigm: –What is to be studied? –How do we define the objects of interest? –How are they to be measured? –What theory is relevant? Along some dimensions the new theories and measurement may be worse than those replaced

The old theory and practice: the invisible hand Solid welfare theory: –Perfect competition good, monopoly bad Price and quantity well-defined (Hicks) Progress is exogenous rather than endogenous (Solow) Inputs equal outputs (Perfect competition) Investments are rival and tangible: private value equals social value (Fisher)

New theory: creative destruction Theory and practice unsatisfactory along several dimensions –Welfare theory unclear (intellectual property rights theory and practice remain controversial) –Price impact of new products depends on measurement of consumer surplus (controversial) –Endogenous productivity growth (predicts accelerating growth) –Monopolistic competition, quality ladders, etc.: markups (inputs may not equal outputs) –R&D investments are risky: many fail (complicates accounting) –Intellectual property is nonrival: private and social valuations typically diverge (require two national accounts?)

Intangibles make income and product hard to measure Measuring inflation and output growth more difficult How to deflate intangible investment –Probably can’t deflate it from the output side, need to deflate it from the input side How to depreciate intangible investment? –Depreciation rate very hard to measure –Many investments fail (should these be written off?) Measuring nominal investment –Expensing of intangibles in corporate accounts makes measuring the size of this investment difficult

Interaction between theory and practice If intangible investment and intellectual property are relatively unimportant, it is easier to ignore the knotty theoretical and empirical difficulties associated with the theory and empirics of creative destruction. Collecting data, even crude data, that shows these investments are rising as a proportion of expenditures forces us to confront the possibility of an economics without the invisible hand.

On the timing of the “revolution” Intangibles became much more important as a consequence of the rise of the personal computer (1977 to 1984) Software investment became much more important R&D: small firms became much more R&D intensive

Since 1978, US nonfinancial corporations have doubled research and development spending

How important are intangibles as part of private business fixed investment? Four views –Old (pre-1998): Only tangible investments are counted, intangibles are 0 % of business fixed investment –Current: Only software is counted, intangibles are 15 % of business fixed investment –R&D satellite account: as of 2002, software and R&D were 27 % of business fixed investment (including R&D) –Total (my est): 48 % including marketing and other expenses associated with new product development Similar estimate by Corrado et al

Has US Business investment been falling or rising over time? Answer depends on how important intangibles are –Including software and business R&D implies rising investment Rising investment would suggest rising US wealth And wealth has been rising!

Household wealth has increased And it hasn’t been high levels of measured personal saving Indeed, measured consumption has risen relative to gross domestic product

Summary In NIA, we are measuring about ¼ of intangibles With R&D satellite, we are measuring close to half of intangibles (but only through 2002) This substantially improves our understanding of business fixed investment Ignoring intangible investment produces a different view of US investment, one that helps explain rising US wealth Also makes creative destruction more central to US economy