Defence spending fuels innovation – but not how you think

Large increases in public spending – typically associated with defence buildups around wars – have often been credited with the development of new technologies. For example, the Manhattan project during WWII led to the development of nuclear energy, the establishment of the US Defense Advanced Research Projects Agency (DARPA) in the late 1950s is linked to the creation of the internet, NASA’s moon-landing programme of the 1960s spurred advances in aeronautics and satellite technology, and military research in the 1970s led to the development of the Epi-pen.

To analyse the link between government spending, productivity and economic growth, London Business School Professor of Economics Paolo Surico and PhD candidate Juan Antolin-Diaz devised a novel method of interrogating data relating to 125 years of US government quarterly data, including newly constructed and digitised series of public spending by main categories (consumption expenditure, equipment and structures investment and R&D), with the goal of identifying the effects of government spending on the US economy at horizons of up to 15 years.

The Long-Run Effects of Government Spending, published in American Economic Review, finds that public expenditure can stimulate economic activities in the medium term whenever its composition is tilted towards R&D, as it is during military conflicts. However, the study also finds that a significant increase in public R&D can have long-lasting effects on output and productivity even when it is not directly associated with war spending.

Indeed, the evidence on large US R&D federal spending programmes, such as the Manhattan project, DARPA, the Moon-landing programme and the ‘Star Wars’ initiative, reveals that they led to a significant boom in US total-factor productivity (a measure of the ratio of aggregate output to aggregate inputs) and innovation over the subsequent 10 to 20 years.

Widely-held belief questioned

The findings query the widely-held belief that wars and associated military spending are “special” because they stimulate innovation. This belief rests on the observation that, during the decades after a war ends, the most significant technological breakthroughs made for the military are adopted by private firms for commercial purposes, and this ultimately boosts aggregate productivity – but inferring from this pattern that wars push the frontier of knowledge is mistaken.

The study finds several examples in US economic history that were characterized by a significant shift in public spending towards R&D at times when no war occurred, but which were nonetheless followed by decades of strong productivity growth.

The research provides novel historical evidence on those public R&D-driven innovations and how they boosted aggregate productivity and promoted long-run growth in peacetime.

The key finding of the study is that, while government spending on the above categories can increase GDP in the short run, defence spending continues to fuel private-sector investment and technological progress long after the initial investment. In other words, defence spending has a long-lasting effect on the economy.

Crucially, the research also identifies the mechanism of this phenomenon: defence spending has large effects on aggregate output because it shifts the composition of public spending towards R&D. This boosts innovation and private investment in the medium-term and increases productivity, GDP and consumption at longer horizons; hence public R&D expenditure stimulates economic activities beyond the business-cycle even, when it is not associated with war spending.

Four main regularities

The paper identifies four aspects of government spending:

• First, fiscal policy can stimulate economic activities persistently when it tilts the share of public spending towards R&D (as it does during military conflicts.) It also finds that an exogenous increase in public R&D expenditure can have very persistent effects on output and productivity, even when it is not systematically associated with war spending.
• Second, in contrast, government investment has shorter-lived effects and the impact of public consumption on output is modest at most horizons.
• Third, while government spending crowds out innovation, private investment and private consumption in the short-run, it crowds them in over the medium-term; feeding into a sustained increase in productivity. As a result, the government spending multiplier on output is significant at longer horizons.
• Finally, whereas the government spending shocks proposed by previous research are based on large and infrequent military outbursts, the R&D spending shock identified by the researchers exploits the acyclical nature of government R&D payments (ie; their effect is independent of the overall state of the economy).

The findings suggest that, when mission-oriented and directed toward research and development, defence spending can serve as a new channel through which fiscal policy can support economic activities in peacetime and have long-term benefits beyond national security.

Indeed, the results of the study featured prominently in the Spring Budget of the UK Chancellor of the Exchequer last March, with Rachel Reeves announcing the government’s determination to transform the defence sector “into an engine for growth” by focusing investment “on where it boosts the productive capacity of the economy, such as investment in innovation and novel technologies.”

The researchers posit that policymakers can use the paper’s insights to design military budgets that not only strengthen defence capabilities, but also drive innovation, economic growth and technological leadership; benefiting both businesses and society as a whole.

Inequality and economic recession | London Business School

 

To read Professor Surico’s research paper, click here.

Professor Surico explains the findings in this short LBS video: How does the defence budget fuel technological advancement and productivity?