Instead, economists generally focus on two main sources of growth: (1) the addition of more inputs (capital and labor), and (2) innovation, technological change, or, in technical economic terms, “total factor productivity” (the increase in productivity of both capital and labor, considered together). For simplicity, one could call these two different strategies growth by “brute force” and “smart growth.” Robert Solow of MIT won his Nobel Prize in economics for showing in the late 1950s that in the United States and a few other industrialized countries, innovation or “smart growth” was more important than brute force (more inputs) in generating additions to output over time (Solow, 1956, 1957). A number of scholars have since confirmed this basic insight and extended it to many countries around the world (see Denison, 1962, 1967; and Easterly and Levine, 2001).
But what is innovation, beyond something new? As we (and others) use the term, it is the marriage of new knowledge, embodied in an invention, with the successful introduction of that invention into the marketplace. Even the best inventions are useless unless they have been designed, marketed, and modified in ways that make them commercially viable. This requires someone who realizes the commercial opportunity presented by the innovation (or even a seemingly small element of the breakthrough), which sometimes is not the purpose the inventor had in mind, and then takes all the steps necessary to turn that opportunity into something many consumers will want to buy. These tasks are inherently entrepreneurial, . . . .
So what determines innovation? In Solow’s model, innovation is like manna from heaven, something that policy makers largely cannot control. Although they may modestly influence it by way of government-funded research or incentives for research and development, the pace of innovation is essentially taken as a given. A growing number of economists have been uncomfortable with that assumption, and over the past two decades they have put much effort into a better explanation of innovation’s role in economic growth. These researchers, using increasingly sophisticated statistical methods, have posited a range of other variables that influence innovation, some of which governments can control (like openness to goods and investment from abroad, spending on research and development, and training of more scientists and engineers), and others of which governments cannot control (like geographic location).
We do not take the position that these factors are unimportant, because many or most of them are. Instead, we suggest that it is more useful to pare down (economize, if you will) the list of suggestions that societies should implement by thinking of economies as potential “growth machines,” which need fuel to operate but which also must have some essential primary parts or components that work in harmony if they are to promote entrepreneurship, innovation (and its dissemination), and growth most effectively. The “fuel” for an economy is the right set of macroeconomic policies: essentially, prudent fiscal and monetary policies to keep inflation low and relatively stable and to prevent economic downturns (or even worse, financial crises) from derailing progress toward growth in the long run. We realize that maintaining macroeconomic stability is far from easy. Indeed, it is the focus of much, if not most, of the attention political leaders give to economic policy. But by definition, economic growth is a longrun phenomenon, and so the much greater challenge is to design and implement policies that foster growth in the long run.
