The Arithmetic of R&D

Michael Mandel

In a post entitled More Free Lunch Economics from Michael Mandel, PGL on Angry Bear writes:

An increase in government-sponsored R&D might be a very nice thing as Mandel suggests, but he seems to dodge the question as to how we pay for this extra expenditure. Do we cut some form of private or government consumption? If so, then I’d call this saving.

First, I like free lunch economics. The economic history of the past 200 years is basically one long free lunch, with productivity growth far outrunning anything which could be justified on the basis of physical capital investment alone. Since 1948 output per person has grown by 2.3% annually. Out of that, the contribution of physical capital is only 0.9% (see page 6 of this BLS release)

Second, I think PGL misunderstands the arithmetic of R&D. If R&D is an investment, then spending on R&D creates a long-lived asset with a rate of return. If that rate of return exceeds the interest rate on debt, then it is socially beneficial to borrow to fund R&D expenditures. I don't need to find other cuts to fund it.

To put it another way, suppose we were going to do the government budget the right way, and divide it into an operating budget and a capital budget. Then the right policy goal would be to hold down the deficit in the operating budget. R&D, however, would fall on the capital side of the ledger (because it's a long-lived asset) and wouldn't count against the operating budget deficit.

Unfortunately, PGL's misunderstanding is shared by many economists and politicians, which is why R&D spending is vulnerable to cuts when Congress goes looking for money to fund hurricane recovery and the Iraq war.

[Incidentally, I appreciate this debate because it's giving me a chance to get some things clear in my own mind]

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