The Role of Innovation in Economic Growth & Inequality

Innovation and Growth

Innovation drives economic growth.

This is one of the most consistent findings in macro-economics, and it’s been true for centuries. Two books that I recommend highly on this topic are The Wealth & Poverty of Nations by David Landes (chapter 1 free here) and Knowledge and the Wealth of Nations by David Warsh – they both describe the history of economic development and the research that tells us what we know about it.

As Christian Sarkar correctly points out, there are real challenges in measuring innovation at the national level, and this complicates things. There are also correlation/causation questions, but the bottom line is that more innovative countries grow faster than less innovative ones do.

This raises an interesting question, though: does innovation also lead to economic inequality?

That is the argument put forward by Klaus Schwab (h/t Nilofer Merchant):

But it also must be recognized that the astonishing technological leaps of recent decades have been accompanied by increased inequality. An innovative society may be a less inclusive and more fragmented one. Silicon Valley in California is a beacon of global technological dynamism but, with its sky-high housing prices and nearly a fifth of its population living in poverty, it is also a warning that innovation cannot divorce itself from the society from which it springs.

Schwab’s argument is actually pretty nuanced, and worth reading. But the idea that innovation leads to inequality isn’t so cut-and-dried.

How Do We Measure Inequality?

The best tool for looking at inequality is the Gini Index. There is a good description by Marvin Chester of this here. This is what it looks like:

Chester says:

The Gini Index is zero (full equality) when everyone in the society earns exactly the same as everyone else. In a thoroughly totalitarian society, where all earn nothing except for the leader who earns everything, the Gini Index is 1 (or 100%). Needless to say, no country exists with Gini Index zero or one. Since the extremes are evidently unstable – they cannot persist – there must be an optimum Gini! What principle governs the optimization? I confess to not knowing. In the real world the Index ranges between about .25 (25% or just 25 in the published tables) to .70 (70 in tables).

Does Innovation Cause Inequality?

Now, the question is how does the Gini Index relate to innovation? First off, take a look at the CIA’s list of global Gini Index data here. Remember that higher numbers mean that the level of inequality is higher. There are a couple of things that jump out from this table:

Countries with high levels of inequality are not very innovative. This has been true for a long time, actually. If the Gini Coefficient is higher than about 45, innovation levels tend to drop. The argument for this has been that in societies with high inequality, it is very difficult to achieve a reward for coming up with innovative new ideas. In this situation, the returns from innovation are often seized by those with more money and/or power, which is a strong disincentive for innovation.
The Gini Index and innovation appear to be uncorrelated at lower levels of inequality. If you look up the countries that you tend to think of as innovative, it’s likely that their Gini coefficient is less than 45. However, not every country with a Gini coefficient below 45 is innovative. In other words, having a relatively low level of inequality appears to be necessary, but not sufficient, to support innovation.

This doesn’t support Schwab’s argument that innovative societies are necessarily inequal. In fact, historically, innovation has tended to drive inequality down. Most countries prior to the 19th century had high Gini coefficients – it was economic development innovation that drove these values down.

It was the industrial revolution and the economic boom throughout the 20th century that created middle classes in the developed countries. And it is the existence of a strong middle class that drives the Gini Coefficients down. It is only in the 2nd half of the 20th century that we started to see Gini Coefficients below 40. Through most of this period, the data strongly suggests that more innovative societies were in fact the most likely to have lower levels of income inequality.

However, in the past 25 years, the Gini Coefficients in some developed countries has started to drift back up after 50-100 years of decrease. The income inequality that Schwab identifies is a recent event – and it is not at all clear that it is related to innovation at all. He is correct in saying that we need to understand the societal context for innovation – we absolutely need to pay more attention to this.

But the argument that income inequality is a necessary outcome of high levels of innovation is incorrect. There are plenty of countries innovate quite a bit and still have relatively low levels of income inequality. The level of income inequality in a country is based on societal values and political processes – it is not an inevitable outcome of economic development or innovation.