Investment can boost growth – if it comes with technological progress
Economic theory does regard capital investment as a contributor to economic growth, but there is another essential factor: technical progress, says Paul Ormerod
The need to boost the UK’s rate of economic growth was a central theme of the first budget delivered by Rachel Reeves, the Chancellor.
Reeves emphasised the importance of increasing the amount of investment which takes place in the UK. She sees this as the key way to raise growth.
To this end, she announced major infrastructure investment of more than £100bn over the life of this parliament on things like roads and school and hospital buildings.
The Office for Budget Responsibility (OBR), which the Chancellor herself has virtually raised to the status of a divine oracle, is not impressed. The OBR’s verdict is that the budget will provide a temporary boost to the economy. But growth will be unchanged in the medium term.
Can investment really boost growth?
Modern economic theory does regard capital investment as a contributor to economic growth. Along with increases in labour supply, investment is a driver of growth in the seminal paper, published by the Nobel Laureate Robert Solow, of MIT, in 1956.
But Solow added a third factor, to which he gave the rather gnomic description of “technical progress”.
New inventions can be part of this. The phrase, however, is essentially used by economists to mean the spread of better technologies across the economy. It is not so much about inventing new things, it is about the practical adoption of inventions.
Shortly after Solow published his paper, economists began to use his model to see what the relative importance of the three factors – capital, labour and innovation – was in explaining growth in the developed economies.
Rather surprisingly, at least when the initial results were published, by far the most significant factor was “technical progress”. The adoption of technology is a more powerful driver of growth than either capital investment or increases in the labour force.
The adoption of technology is a more powerful driver of growth than either capital investment or increases in the labour force
The Solow model was rightly seen as a major scientific advance. But it left economists with a major unsolved issue. The main empirical driver of growth, “technical progress”, was not explained in the model itself. It was something which was just assumed to happen.
Things languished in this rather unsatisfactory state until the American economist Paul Romer came up with the concept of “endogenous growth”. His papers on this are amongst the most cited in the whole of economics, and he was awarded the Nobel Prize in 2018.
Without going into the technical details, Romer enabled “technical progress” to be explained within the context of the basic Solow approach.
The key policy point is that some specific types of investment are much more important than others in generating growth. Not all investment is equal. Investment which either develops skills or which promotes the spread of innovation is crucial.
To be fair, the Chancellor has increased the budget for R&D spending, mainly through the Department of Science Innovation and Technology in real terms. But at £20bn – less than one per cent of GDP – in the financial year 2025/26 it is far below what is needed to really transform the UK’s growth rate in the medium term.
It is the translation of both new and existing knowledge into practical applications which is essential.
In manufacturing, for example, there is already a network of institutes which serve this purpose, such as the CPI in Sedgefield, the National Composites Centre in Bristol and the Royce and Graphene Institutes in Manchester.
Incentives within universities need to be changed so that developing applications and start-ups count just as much as papers and research grants when it comes to promotion for academics.
But to achieve growth we need to at least double the budget of the Department of Science and pump the cash into developing and spreading practical applications of new technologies.
Paul Ormerod is an economist at Volterra Partners LLP, a Visiting Professor in the Department of Computer Science at UCL, and author of Against the Grain: Insights of an Economic Contrarian, published by the IEA in conjunction with City PM