Reverse R&D decline and strengthen IP rights – a recipe to reinvigorate growth

Throughout history, states, empires and principalities have recognised the importance of promoting scholarship and encouraging innovation within their borders. Historically, the overriding efforts of any ruling group was to prevent regime overthrow – whether by external forces or internal usurpers. As such, the promotion of technological and social developments which enhance military prowess and exalt the ruling classes has been paramount.

Alexander the Great built the great library at his newly founded eponymous capital to promote learning and cement his legacy; while Hiero II, the tyrant of Syracuse, generously patronised Archimedes – not only for his work on mechanics, but primarily for his development of defensive weaponry, which was used with great effect to protect the city from sieges. In the Renaissance, the Medici family imported legal scholars and Roman legal texts after the fall of Constantinople to reinvigorate the moribund legal tradition of Western Europe. During the same period, brilliant minds – exemplified by Leonardo Da Vinci – were employed by the rulers of Milan and later the French kings to develop advanced military and siege weaponry and to promote the arts in order to expand the power of the respective regimes. That era also saw the rise of the first universities, which quickly became epicentres of learning, and the discovery of scientific principles – Galileo was a professor in one the oldest universities in Padua. Support for innovation continued through the age of exploration, when British monarchs famously provided a reward for the development of a device which would enable ships to determine longitude more accurately. The result was an advanced chronometer which could maintain its accuracy on the ocean waves and which propelled the British navy, trade and entire economy to the forefront of global power. The British aristocracy also supported astronomical and other scientific-oriented societies which further spurred the growth of scientific knowledge.

This basis of support provided the intellectual groundwork, basic scientific principles and nascent incentive structure upon which further discoveries and new innovative commercial applications were built. Could the world have industrialised without the principles uncovered by Newton? And would Newton and other early scientists have made those discoveries without the universities founded and endowed by the Church and later kingdoms? Likely not.

Spark for Industrial Revolution

Stefan Haber’s recent work Patents and the Wealth of Nations focuses on the role of increased IP rights and economic development. Haber has shown that there is a strong positive (and somewhat non-linear) relationship between the strength of IP rights and per-capita income. Although measuring the strength of IP rights is a subjective exercise, Haber’s analysis demonstrates that each unit of increased IP rights maps onto a $780 increase in per-capita income. Given that global median per-capita income is only about $3,000, this is incredibly significant.

Although the analysis demonstrates a strong correlation between IP rights and per-capita income, it does not demonstrate causality. It is reasonable to question whether strong IP rights in richer countries simply correlate to other policies, levels of education, capital and financial depth, and other advantages which are the proximal driver of higher incomes.

Although pre-modern societies promoted and supported scholarship and innovation with some degree of success, those rudimentary efforts did result in technological innovation, albeit at a relatively slow pace and in fits and starts. This changed radically in the late 1700s, when the Industrial Revolution began in the United Kingdom and spread throughout the Western world. The reason for the rapid increase in technological and ensuing economic advancement has been the subject of substantial debate for decades. Critical roles were clearly played by:

• the solidification of the rule of law and private property rights, which allowed for economic specialisation;
• the evolution of more advanced financial systems, which enabled the faster, more efficient allocation of capital; and
• the institution of corporations, which allowed risk to be spread.

However, all of these developments were expanding at more or less the same level and time throughout Western Europe for centuries before the Industrial Revolution. What was the critical tipping point that occurred at that time – and why was it that industrialisation began in the United Kingdom as opposed to the Netherlands, France, Spain, or wealthy Italian and German principalities?

Studies of the UK patent system find that from the latter half of the 18th century, it did indeed promote innovations leading to the Industrial Revolution. Sean Bottomley demonstrates the correlation between the number of patents and accelerating industrialisation in the United Kingdom during that period in The British Patent System During the Industrial Revolution 1700-1852: From Privilege to Property (2014). Further, until patent systems were established in France and the nascent United States in the 1790s, there were no other functional patent systems in the world. This suggests that development was the critical difference between the United Kingdom and contemporary European and American states. Although the UK system at that time was expensive – and thereby limited the number of inventors which could access patent protection (unless they leveraged the fund-raising capacity of newly developed joint stock companies) – it was unique in requiring a detailed and public specification. This in turn served to disseminate technological information to the public and provided a framework for the imposition of legal remedies, including injunctions, where third parties infringed patents. In addition to legal developments, the growing ecosystem enabled inventors to leverage their newly granted IP rights – including through licences and both direct and indirect sales of patents to other parties that were better able to capitalise on the invention. France and the United States did eventually establish IP systems, the latter finding the concept important enough to enshrine in the Constitution. As in the United Kingdom, the establishment of IP rights in both countries preceded industrialisation, which quickly followed thereafter.

To bolster the case for the importance of IP rights as the impetus for industrialisation, it is helpful to focus on the United States, which became the world’s largest industrial state by the early 20th century. At the time of its founding, the United States’ per-capita income was far below that of its mother country and it was suffering a severe economic depression. However, in the 19th century its economy boomed to such an extent that by the onset of the First World War, its total economy and per-capita income surpassed those of the United Kingdom, which ostensibly had similar institutions, the rule of law, stable government and a powerful military. While some suggest that this is because the United States had access to an open and resource-rich continent, the counterpoint to this argument is that the United Kingdom was in possession of the world’s largest empire and all the concomitant resources at that time. In addition, other land and resource-rich states in the Americas, such as Brazil, failed to industrialise and had achieved only a per-capita income of approximately one-quarter that of the United States by the outbreak of the First World War. Both these examples lend significant weight to the unique achievement of the United States. Again, did IP rights play a role?

The evidence suggests that the answer to this question is yes. Although the United Kingdom established a robust patent system early on, it was notoriously expensive and had other drawbacks. By contrast, the United States advanced and democratised its system. The US Patent Act of 1790, passed shortly after the ratification of the Constitution as one of the firsts acts of Congress, established fees which were only 5% those of the contemporary UK system, allowing far more inventors of modest means to access patent protection. The act also professionalised administrative procedures which provided that patent specifications be readily available to the public after issuance. IP rights were bolstered by the courts. The patent system was continually improved by later legislation, including the Patent Act of 1836, which introduced the examination system still in use today.

Burst of innovation and economic growth

Although governments supported scholarship and innovation from the Industrial Revolution to the Second World War, direct government-supported R&D was dwarfed by both individual efforts and increasingly organised and professionally managed corporate R&D. Advances in that period included:

• steam and ensuing revolutions in rail and shipping;
• electricity and all the labour-saving devices it spawned;
• lighting;
• internal combustion engines and the fuels to power them; and
• aircraft.

All of these disrupted traditional forms of transportation and distribution and expanded power in order to dramatically increase manufacturing productivity. The telegraph, telephone, radio and television began to connect the world; while the development of artificial fertilisers and agricultural chemicals – coupled with antibiotics – allowed an expanding, well-fed population to live longer and in better health than ever before.

However, this growth began to slacken and even halt in the late 1930s – in part because of slowing innovation. Threatened and actual global war induced an ideologically divided world to invest heavily in physics, engineering and other sciences. Relative to private industry, these investments focused more heavily on basic research, which laid the scientific foundation for later commercial and military applications. While actual research efforts were and still are conducted by corporations and universities in additional to national laboratories (which themselves are usually administered by private concerns) – the types of technology underwritten by government-funded basic research would likely not have happened if left solely to private industry and most certainly would not have taken place as rapidly. Because governments do not have to provide returns to investors and have long time horizons, they are particularly well suited to fund and often conduct basic R&D for early-stage technologies with unknown commercial value and time horizons far beyond what would be tolerable for a private firm. The flipside is that competitive pressures and profit motives incentivise private institutions to allocate capital and innovate to provide solutions to market needs far faster and more effectively than governments can achieve.

In the West, private enterprise powered by IP rights and market pressures built upon the basic research groundwork with impressive efficiency. This ultimately outstripped other political economic systems in the decades immediately following the post-war period. The results included the microchip, the Internet, nuclear power and impressive advancements of aircraft, satellite, advanced materials and biotechnologies. Arguably the entire information age was underwritten by these Cold War-inspired R&D investments. These achievements ungirded not only the West’s military prowess, but simultaneously its impressive productivity and overall economic growth.

Innovation to spur growth more important than ever

Today, developed nations face twin economic challenges of stagnating (and ageing) populations and globalisation. Stagnating populations represent a direct headwind to expansion, given that economic growth is a function of number of workers times productivity per worker. Globalisation, while beneficial in many respects, effectively adds billions of workers to the labour pool, usually at lower compensation levels. An increased supply of labour necessarily puts downward price pressure on wage rates within the borders of developed states. As such, it is incumbent upon developed nations that wish to maintain the living standards of their citizenry and their national prominence to accelerate the development of new technologies which will increase worker productivity and provide for wholly new product and service markets. Given that developed countries are already technological leaders, simply importing innovation elsewhere is not possible; it must be homegrown.

Positive link between patents, R&D spend and productivity

Total factor productivity (TFP) is the portion of output that is not derived from labour or capital. It represents the efficiency of how those inputs are used in production and is explained as the contribution originating from technological innovation. In 1956 Robert Solow showed that long-run growth in income per capita must be driven by growth in TFP, in A Contribution to the Theory of Economic Growth. For a long time it was not understood how to pay for the fixed costs associated with innovative development in a perfectly competitive environment. In 1990 Romer solved this problem by linking monopolistic rights granted to the inventor via patents. Given that TFP growth is determined by innovation, it logically follows that subsidies reduce the marginal cost of conducting R&D and, coupled with a strong patent system, therefore increase the rate of innovation and associated TFP. Does the data reflect the theory?

Research conducted by the Congressional Budget Office affirms the link between private R&D spending and improved TFP. Although the R&D relation to TFP is difficult to measure, when calculated as a rate of return on R&D investment, the research shows variable results. However, on average, the finding is that the rate of return on investment is generally between 20% and 25%, which is substantially higher than the average returns on physical capital. What was also surprising from the literature is that firms which devote a larger share of R&D to basic research have higher levels of productivity than those with a smaller share – although the reason for this remains unclear.

Of course, these trends may well be coincidental and do not necessarily prove a link between government-funded R&D (or other forms of R&D subsidy) and TFP. Studies attempting to find a causal link between basic federal R&D spending and long-term economic growth have been inconclusive. Researchers – including Goel, Payne and Ram in R&D Expenditures and US Economic Growth: A Disaggregated Approach (2008) – have examined the relationship between long-term economic growth and federal and private R&D expenditures from 1953 to 2000 and found a strong relationship between this (particularly defence-related R&D spending) and economic growth. However, other studies have failed to find a definitive link between the reduction in R&D spending beginning in the late 1960s and the TFP slowdown which started in the 1970s. Studies that focused on the private return to R&D (and excluded government R&D) tended to find a small or non-existent role for R&D in the productivity slowdown, whereas studies that expanded the definition of R&D capital to include government R&D or assumed substantial spillover effects found a large positive role.

There are several reasons why the link is not obvious in the data. The first is that most studies attempt to link R&D directly to a specific product or technologies that boost productivity. Anyone with even a cursory knowledge of basic R&D understands that it is a brick in the foundation of knowledge on top of which commercial innovations may or may not be built. Second, the delay between R&D and commercial applications is both long and uncertain. It is challenging to directly link a specific innovation to a specific brick. One potential explanation is that R&D, and particularly basic R&D, is subject to spillovers, which are benefits that accrue to other entities – including firms, industries and even other countries – other than those funding and performing the research function. Unlike direct contributions to companies, spillovers are difficult to measure. However, the prospect for spillovers raises the potential that R&D expenditure to improve productivity is disproportionate to its size in the overall economy.

Collapse of government R&D funding and weakening IP rights

Although R&D is imperative to improve productivity, the trends in basic R&D investment and strong IP rights which drive productivity have, frustratingly, been moving in the opposite direction.

The following analysis relies on US statistics as the proxy for developed nations, owing to the transparency and availability of such statistics and figures. As of 2011, US R&D expenditure totalled $424 billion, of which 30% was funded by the federal government and 70% was provided by private industry and other institutions. Given that R&D represents an investment in future productivity improvements, product features and performance and new products, its relationship as a percentage of overall gross domestic product (GDP) provides a better metric on its effect for future economic growth. When looked at from this perspective, total R&D expenditure remains rather healthy, having held at a relatively stable position of between 2.5% and 3% of GDP.

However, this stability in the overarching national R&D expenditure masks a severe and troubling trend. While private industry has profoundly increased its R&D investments (no doubt part of the reason for the rise of patent applications and grants) since the 1960s, the opposite has occurred with government-funded R&D. After exploding upwards during the 1950s to reach nearly 2% of GDP in 1964, the federal portion of R&D expenditure has since dwindled to a mere 0.8% of GDP today and is slated to continue this downward trend.

As pointed out earlier, the government has played a critical role in funding basic research which often has little direct applicability in the commercial realm, but nevertheless serves to provide a foundation for future applied R&D. Alternatively, basic R&D is often too risky for private enterprise owing to a combination of investment size, risk and extended time before commercial realisation and associated returns. However, this research is akin to the seed corn from which new applications will (or could) eventually sprout. According to National Science Foundation statistics, although the federal government provides only a minority of total US R&D funding, it provides an outsized 55% of all basic research funding. It follows that a reduction in federal funding from two-thirds of all R&D in the early 1960s to less than one-third today has resulted in a dramatic decrease in basic R&D. Further, when looking at how the R&D resources have been spent, one can see that the portion focused on life sciences has increased dramatically to over 50% of non-defence federal R&D spending, while that directed at the physical and chemical sciences has wilted. In no way am I suggesting that those funds were misallocated – there are many challenges to overcome associated with neurodegenerative and genetic diseases and cancers which plague humanity. However, given those figures, is it any wonder that biotechnology has rocketed in the past few decades, while energy technology and aerospace have languished?

Figure 1. US R&D expenditure as % GDP

Source: National Science Foundation, National Centre for Science and Engineering Statistics, National Patterns of R&D Resources (annual series)

Productivity, business starts and employment decline

Within roughly a decade of federal R&D support peaking, TFP growth associated with technological innovation also peaked and has since charted a new and lower trajectory since. After growing at an average annual rate of 2% between 1947 and 1972, productivity slowed to an average rate of 0.8% between 1973 and 2015. It is notable from Figure 1 that TFP popped up over the reduced trajectory for a brief period during the mid to late-1990s – nearly a decade after the defence R&D splurge in the mid-1980s. Although the connection between research expenditure and productivity is not always acknowledged, many writers have picked up on the theme of declining technological innovation (and population growth) leading to productivity stagnation. Economist Robert Gordon (author of The Rise and Fall of American Growth), Vaclav Smil and David Edgerton (author of The Shock of the Old: Technology and Global History Since 1900 (2006)) argue that the past innovation waves described earlier were one-off affairs and will not be repeated in the future. Although, as a technologist, I wholeheartedly dispute the historians who suggest that technological advancement is preordained to decline in perpetuity, I do believe that the decline has become a real if not permanent phenomenon in recent decades.

While existing firms naturally enjoy the fruits of new technologies in the form of productivity enhancements and improved products, it is also true that new technological innovation provides the nursery for new companies which exploit advancement in novel ways. Again, data from the Census Bureau shows that the rate of business births has been in decline since the 1970s and for the first time in recent history, business deaths (which include acquisitions) exceed births. The importance of start-ups to job creation cannot be understated and – given that new companies have declined – it is no wonder that labour participation is now on the decline as well.

Figure 2. Business total factor productivity 1947-2015 (natural log)

John G Fernald, “A Quarterly, Utilization-Adjusted Series on Total Factor Productivity”. FRBSF Working Paper 2012-19 (updated March 2014)

Weakening IP rights threaten future private R&D investments

Over the last decade IP rights have also started to erode. In part due to reactions against non-practising entities – often referred to as ‘patent trolls’ – politicians from both right and left have responded by promoting over 50 major legislative changes at the federal and state levels. The America Invents Act, while laudable for bringing US law into line with global norms, also provides for a vastly streamlined method to challenge issued patents. While ostensibly meant to offer a faster, cheaper way to investigate contentious patents without clogging up the courts, the statistics demonstrate how readily inventions have been deemed obvious. Recent Supreme Court decisions have further upended settled notions of what is obvious and pointed to heretofore unused ‘patentability’ language in the law, which opens new and subjective avenues for invalidating patents. Other decisions have called into question the patentability of entire technology domains relating to software and weakened patent holders’ rights by making it easier for competitors to infringe by piecing out portions of manufacturing processes.

Time to restore R&D funding and shore up IP rights

So we find ourselves with a challenging problem. The basic research foundation upon which eventual commercial innovation and productivity growth are based has been undermined for decades and now the IP incentive structure needed for private innovation is beginning to crumble. Clearly, this needs to be reversed if prosperity is to return. Fortunately, some green shoots have the potential to do just that.

Private firms – exemplified by several high-profile technology companies – are leveraging highly lucrative core businesses and investing more resources in high-risk R&D, including autonomous vehicles, space launch systems and advanced medical devices. Others that successfully exited businesses are reinvesting the proceeds in new ventures such as electricity generation, energy storage, transportation and nuclear fusion.

Leading universities are deploying resources from the huge endowments they have accrued towards research efforts and have simultaneously established advanced licensing departments capable of effectively transferring new technologies into the commercial sphere. Corporations are finding new ways to work with universities beyond simply licensing technology to commercialise. They are increasingly funding research, partnering and even embedding corporate researchers in the university setting. Not to be outdone, some large cities have realised the importance of innovative development for local economies and have begun increasing support for R&D infrastructure. New York City recently commissioned a new science and engineering university in conjunction with Cornell and Teknion, to be built on Roosevelt Island. Scholarship is uncovering further evidence of the link between research, intellectual property and growth through advanced econometric modelling.

At the national level, budget constraints will likely not reverse the long-term research funding decline outside of sizeable increased investment in biotechnology and medicine. However, the US federal government has replicated the highly successful Defence Advanced Research Projects Agency programme towards energy research via the Advanced Research Projects Agency-Energy programme. Perhaps later administrations will expand upon this foundation further in other fields. At the same time, resurgent global tensions, for better or worse, will likely reverse the recent defence spending nadir and lead to greater R&D investment in the future.

The backlash against IP rights may have similarly bottomed out. Although many well-publicised legal decisions have eroded rights, recent criticism of the system, focused on trolls, seems to be abating. Simultaneously, increased involvement by research-intensive corporations has recently advanced the understanding of how crucial IP rights are to many fundamental business models. This in turn is helping to convince politicians to shelve legislation aimed at further weakening IP rights – at least temporarily.

In conclusion, the pillars of fundamental research and IP rights which have traditionally supported innovation and its positive impact on society have eroded in recent decades, manifesting in slowing productivity and economic growth. Fortunately, some nascent signs suggest that those trends may be starting to slow and potentially reverse. Although national government funding is unlikely to return to the levels seen at the height of the Cold War any time soon, owing to severe budget constraints, other methods of supporting research are beginning to emerge at the local level, in universities and in corporations. At the same time, recent efforts to weaken IP rights appear to have stalled, while new scholarship is finding more support for the link between innovation, intellectual property and growth. IP and research professionals need to play a role in supporting efforts at all levels to further increase the resources deployed towards innovation and to support efforts to re-energise IP rights.