Aghion’s new Growth Pact for Europe

Schumpeterian models, largely influenced by Philippe Aghion’s work, are a class of growth models that emphasize the role of creative destruction for innovation and human progress. The term  was coined by Joseph Schumpeter (but appeared already in Marx’s Capital). It is the ingenious observation that innovations, and especially the most radical ones, do not only create new production methods and have the power to change whole industries, but they also render old ways of production obsolete and destroy the prospects of those who are not able to adapt to the new economic environment.This process can be brutal and absolutely deserves its menacing name. Even big players aren’t safe from it and often enough it happens that brands we all grew up with go bankrupt because new technologies destroy their business models.

A society has to tolerate these frictions if it wants to enjoy innovation-led economic growth. A very interesting perspective, originating from this literature and popularized by Daron Acemoglu and James Robinson, points to the importance of inclusive political institutions, such as democracies, for creative destruction. A large share of the population has to enjoy secure property rights and sufficient political representation. Then, innovators don’t have to fear to get expropriated and are able to enjoy the fruits of their efforts. Also, no elite class is able block the course of new business models and methods of production because they fear new entrants. It’s this type of environment where new ideas can flourish in a society (with all their dire consequences for some).

It’s probably not a lack of inclusive institutions, at least in core Europe, which stands in the way. But Aghion and Akcigit argue that many of the policies Europe developed long time ago, and learned to love, are not well-suited to stimulate innovation-led economic growth. From World War II until the early 1970s, Europe was in the process of catching-up with the technological frontier of the world (particularly with the US). In a sense, catch-up growth is quite forgiving when it comes to suboptimal policies because you just need to imitate successfully what others have already invented. The case of China shows us that even an autocratic but politically stable regime can be very effective in it.

The picture changes if you want to push the world’s technological frontier yourself. Suddenly, many things have to come together such that an economy can draw on its full creative potential. The authors discuss a few points, specifically relating to Europe, which stand in the way of innovation-led growth.

An egalitarian university system. There is no Harvard or MIT in Europe and most policy makers would probably object to the idea of endowing a small number of elite schools with billions of euros and allow them to pay their top scientists non-regulated salaries. In the past the policy target was rather to make tertiary education available to as many regions as possible and build universities on the green field. These are usually not the places where Nobel prize winners do their research.

Regulated product and labor markets. Product and labor markets need to be sufficiently deregulated such that entrepreneurs can sell their products and find talented employees to produce them. I can already hear the critics saying that this is a very American view. But yes, that’s exactly the point.

No top income equality. Although the relationship between innovation and income equality is an ongoing debate (see the paper for more details on this) one can certainly think of many globalized markets nowadays exhibiting a “winner takes it all” feature. A substantial part of the richest people in the world (Gates, Bezos, Zuckerberg, the Waltons, etc.) became so rich because they were among the few successful entrepreneurs. Many others failed and didn’t make it to the Forbes list. Since opening up an innovative business is so risky, the gains in case of success have to be high to make it an attractive venture. If the state decides to tax away all your profit after you got lucky you won’t even start and look for a government job instead.**

Moderate labor mobility. Europeans wouldn’t object to the idea of labor mobility per se. But if you listen to the people you can recognize that they like the cultural diversity within Europe, love to speak their native languages and prefer that their friends and relatives live close by. That’s all very well and good as long as there is a possibility to choose. But when language barriers and differences in legal systems become borders for entrepreneurs and talented people, a region loses its competitiveness.

A bank-based financial system. In most European countries (except the UK) stock markets are less developed and many businesses still rely on bank financing. In particular, equity financing of young businesses in the form of venture capital is underdeveloped. Equity is more suited to risky ventures because it provides control rights to investors and lets them participate in the success of a company. When it comes to financing start-ups and innovation, sophisticated financial instruments can actually do good for a society compared to the rent-seeking financial companies are often accused of.

The authors argue that Europeans should reassess some of the institutions and policies they grew to love in order to till the ground for innovation-led growth. Although catch-up growth was relatively easy, being a front-runner takes considerably more effort. They propose that some of the funds spent by the EU nowadays could be better used in order to soften the economic hardships (e.g., temporary unemployment) caused by creative destruction. Innovation is the topic of one of the EU’s flagship initiatives. But it’s necessary to realize that spending public money alone is not enough when the rest of the institutional setup is not suitable to foster creativity and let new ideas prosper.