In the long run, productivity is the key driver of economic growth and improvements in standards of living. In the words of Nobel laureate in economics Paul Krugman, “Productivity isn’t everything, but in the long run it is almost everything.” In recent decades, however, despite the seemingly unstoppable technological progress that surrounds us, aggregate productivity growth has slowed down in most advanced economies, including the United States, Germany, and Japan—erstwhile considered the engines of global growth.
This slowdown is appreciable in both labor productivity and total factor productivity (TFP) growth, and it is not limited to only a few sectors or industries but rather it is widespread across economies. Moreover, the slowdown predates the global financial crisis of 2008, suggesting that it is a structural phenomenon. The literature is rife with efforts to understand and explain the causes of the observed transatlantic productivity slowdown. Several hypotheses have been cast, such as anemic capital investment, slowing technological progress at the frontier, weakening technology diffusion and adoption, and mismeasurement of productivity growth. There’s some truth to all these explanations, albeit to differing degrees.
This paper is occupied with solving a different but related puzzle. Whereas since the end of World War II, Germany and other European nations have roughly caught up with productivity levels in the United States, Japan never completed the catch-up process after achieving partial convergence during the 1980s and 1990s. In fact, the gap between Japan and the United States has widened in the last decade (Baily, Bosworth, and Doshi, 2020). Although both the U.S. and Germany have experienced sharp productivity growth slowdowns since 2004, the Japanese case is vexing because productivity growth decelerated just as sharply there even though productivity levels continue to lag well behind the United States’ and Germany’s.
What could explain the productivity dynamics described above? While the growth literature has identified multiple theoretical and empirical determinants of productivity growth, this paper focuses on one in particular: innovation. This is because innovation is the fundamental source of technological progress, which in turn is the main driver of permanent increases in productivity.
Our analysis points to an interesting finding: While Japan spends more resources on research and development (R&D) and files more patent applications than the U.S. and Germany, the quality of Japanese innovation severely lags behind that of the U.S. and Germany. We posit that this underperformance may be driven by differences in the nature of government incentives for private sector R&D and in the public-private composition of R&D expenditures in the three countries.
The paper is structured as follows. Section 2 introduces a simple conceptual framework to think about the different determinants of productivity, among which innovation stands out. Section 3 presents stylized facts on R&D trends. Section 4 explores possible links between R&D investment and productivity growth, while section 5 theorizes on potential barriers to R&D investment. Section 6 attempts to measure the innovation output of R&D using data on patent quality. Section 7 offers concluding policy prescriptions based on the preceding sections.