OXFORD REVIEW OF ECONOMIC POLICY, VOL. 12, NO.

OXFORD REVIEW OF ECONOMIC POLICY, VOL. 12, NO. 2

POST-NEOCLASSICAL ENDOGENOUS
GROWTH THEORY: WHAT ARE ITS
POLICY IMPLICATIONS?

NICK CRAFTS
London School of Economics1

I. INTRODUCTION improvements in technology. Since government

In a speech in the autumn of 1994, the Shadow
Chancellor, Gordon Brown, referred to post-neo-
classical endogenous growth theory. The press
seized upon this phrase and lampooned Mr Brown.
This is unfortunate both since the new growth
economics deserves a wide audience and should be
a vital ingredient in the design of appropriate sup-
ply-side policies and also because it holds out the
prospect that government really can make a serious
difference to the long-term growth rate.
The basic idea of endogenous growth is that long-
run growth in income per head depends on invest-
ment decisions rather than, as in traditional growth
theory, resulting from unexplained or exogenous
policy can influence these decisions both directly
through taxes and subsidies and indirectly via re-
form of institutional arrangements, intervention
might in principle be used to raise investment and
hence the long-run growth rate.
In this context, investment usually refers to a broader
concept than the physical capital accumulation
reported in the national accounts; human capital
and/or research and development expenditures may
well also be included. The key to endogenous
steady-state growth is that there should be constant
returns to this broad capital accumulation. While
this is a common property, the precise way in which
the result is obtained varies considerably across the
many models that have been proposed.

1
I am grateful to Wilfred Beckerman, Steve Bond, Bridget Rosewell, participants at a seminar at the National Institute of
Economic and Social Research, and an anonymous referee for their helpful comments on an earlier version. I am responsible for
all errors.

30 1996 OXFORD UNIVERSITY PRESS AND THE OXFORD REVIEW OF ECONOMIC POLICY LIMITED

Endogenous growth theory needs, however, to be
examined both carefully and critically. In particu-
lar, it is important to distinguish between alterna-
tive models in this tradition which have substan-
tially different policy implications. It should also be
recognized that, at present, the empirical evidence
relating to these models is incomplete and by no
means wholly supportive of the hypothesis that
growth should be regarded as fully endogenous.
This is for two reasons. First, it remains unclear that
stimulating investment of whatever type (in physi-
cal or human capital or research) will not eventually
run into diminishing returns. Second, returns to
investment and growth outcomes are influenced by
the weather, in the sense of the availability of
technological opportunities.
In this paper, I wish to highlight two different types
of endogenous growth theory, namely the broad
capital and endogenous innovation variants. The tivity (TFP), K refers to physical capital, and L to
first of these pays no particular attention to techno-
logical change, whereas for the second it is central.
Both theories stress the importance of microeco-
nomic foundations of the investment decisions that
give rise to growth, but only in the latter approach
is the focus firmly on the incentive structures relat-
ing to the special nature of innovative activity. If
innovation is taken to be at the heart of the growth
process, then a wider range of policy issues arises.
Assessment of the policy implications of endog-
enous growth theory turns on empirical evidence. A
large body of econometric analysis of comparative
economic growth has been undertaken by new
growth economists and there is also useful work in
economic history and in the economics of technol-
ogy which can be consulted. Three specific ques-
tions need to be addressed:
(i) Are there diminishing returns to broad capital
accumulation?
(ii) What have been the proximate sources of dif-
ferences in growth?
(iii)To what extent, and how, can growth of output
per person be influenced by government policy?
In section II a basic outline of key ideas from
endogenous theory is provided, followed in sec-
tions III and IV by an overview of important find-
N. F. R. Crafts
ings in the empirical literature. Policy implications
follow in section V. Section VI concludes.
II. THEORIES OF ENDOGENOUS
GROWTH
The traditional neoclassical growth model of Solow,
and the growth accounting based upon it, has at its
heart a production function characterized by con-
stant returns to scale and positive but diminishing
marginal productivity of factors of production. The
usual version supposes a CobbDouglas produc-
tion function such that
Y = TKaLb ( a + b = 1; 0 < a < 1 ) (1)
where T, a scaling factor, reflects the level of
technology and is often called total factor produc-
labour.
Using basic macroeconomics, let the rate of growth
of the capital stock, K / K = I / K = sY / K . Then it
is apparent that any tendency for the capital stock to
grow more quickly (slowly) than output will result
in capital stock growth falling (rising) as Y/K falls
(rises) so that capital and output growth rates tend
eventually to equalize. In the long run, the rate of
growth is
T / T + bL / L
Y / Y = . (2)
(1 a )
Five important aspects of this formulation are the
following.
(i) In the long run, growth is independent of the
investment rate; policies to promote investment
run into diminishing returns, ultimately affect
only the level of output per head, and have only
transitory effects on the growth rate.
(ii) The share of profits in national income equals a,
the elasticity of output with respect to capital,
and can be used to estimate the impact of capital
accumulation on the growth rate.
(iii)Growth of long-run income per person is pro-
portional to the growth rate of TFP and thus
requires improvements in technology, which is
not determined within the model and cannot be
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OXFORD REVIEW OF ECONOMIC POLICY, VOL. 12, NO. 2
influenced by policy-makers. Growth is exog-
enous rather than endogenous.
(iv)If technological knowledge is universally avail-
able, the level and rate of change of TFP and
steady-state growth rates should be the same in all
countries. Equilibrium income levels would dif-
fer only if capital to labour ratios did not equalize.
(v) Out of the steady state, countries which have
low initial income levels and capital to labour
ratios should grow more quickly for a given
savings rate because they will have relatively
low capital to output ratios.
A very simple, but empirically unpersuasive, way
to obtain a model of endogenous growth would be
to modify this production function to the form
Y = Ka + xLb (a + x = 1).
In this case x represents externalities in the form of
social returns, such as enhancements in productiv-
ity through additional experience, which do not
accrue to the investors. Note also that there is no
exogenous productivity growth (T has disappeared),
profits share underestimates the importance of capi-
tal to the growth process, and there are constant
rather than diminishing returns to investment. Here
an increase in the growth of the capital stock com-
ing from higher investment will be sustained, will
permanently increase the growth rate, and can de-
liver rising incomes per person. Whereas in equa-
tion (1) the marginal productivity of capital is
positive but diminishing, in (3) it is constant and
marginal and average product are equal.2
A more appealing way to arrive at endogenous
growth is to introduce human capital into the pro-
duction function. If
Y = KaLbHc (a + c = 1)
where H is human capital, then the sum of the
exponents on the reproducible factors of produc-
tion, K and H, is one and there will be constant
returns to accumulation given that, as we might
expect, in equilibrium the ratio of K to H is constant.
2
The effect of an increase in the investment rate works through its impact on the rate of growth of the capital stock. For a given
savings rate, s, this can be written as sY/K. With diminishing marginal product of capitalreflected in an exponent on capital less
than oneincreases in s trigger offsetting declines in Y/K and do not permanently raise the growth rate of either the capital stock
or output.
32
This leads us directly to the famous Rebelo (1991)
model of endogenous growth in which
~
Y = AK (5)
~
where A is a constant and K represents broad
capital, a fixed proportions composite of K and H.
Rebelo (1991) not only proposes a model in which
policies to raise the rate of investment raise long-
run growth, but also sees investment decisions in
terms of intertemporal optimizing behaviour. In
equilibrium the return to investment equals the
return to consumption and the rate of interest. A
reduction in the marginal rate of direct taxation on
income from investment (or anything else raising
the net rate of return) leads to more investment in
(3) broad capital and thus to a higher steady-state
growth rate.
While the explicit introduction of human capital
into models of economic growth commands wide
support, this can obviously be done in ways which
do not imply endogenous growth. In another much-
cited paper, Mankiw et al. (1992) argued for what
they termed an Augmented-Solow growth model.
This might be written as
Y = TKaLbHc ((a + c) < 1). (6)
Here growth is not endogenous because the expo-
nents on K and H sum to less than one. Even so, the
introduction of human capital does have important
implications, namely that diminishing returns to
broad capital will be less severe than to physical
capital in the original Solow model, convergence to
the steady state will be slower, and transitory ef-
fects of increased investment rates on growth will
last for longer.
(4)
One important feature of the Rebelo model is that it
suppresses any explicit role for technological
change. This is quite an important limitation as far
as policy-makers are concerned and is certainly
unlikely to appeal to applied economists. As Romer
(1993, p. 562) recently put it,

our knowledge of economic history, of what production
looked like 100 years ago, and of current events con-
vinces us beyond any doubt that discovery, invention,
and innovation are of overwhelming importance in eco-
nomic growth and that the economic goods that come
from these activities are different in a fundamental way
from ordinary objects. We could produce statistical
evidence suggesting that all growth came from capital
accumulation with no room for anything called techno-
logical change. But we would not believe it.
Explicit consideration of technological change has
ramifications both in terms of innovation and tech-
nology transfer. The endogenous innovation vari-
ant of endogenous growth theory has examined the
first in detail, proposing models in which there is
endogenous TFP growth. Grossman and Helpman
(1991) provided the seminal discussion in terms of
a production function
a b d
Y = CK L D (a + b + d = 1)
where C is a constant and D represents an index of
the designs of intermediate goods for use in produc-
tion which embody technological knowledge and
which are augmented by innovative activity. La-
bour can be used either in research with constant
returnswhich is justified by the spillover effects
of increases in the pool of knowledgeor with
diminishing returns, as usual, in production.
In this formulation, the relationship between the
growth of capital and output growth is just the same
as in the traditional neoclassical modelin the
long run capital and output grow at the same rate
and increases in the investment rate have only
transitory effects on the growth rate. Growth is once
again proportional to TFP growth and thus to growth
in D, the variety of intermediate goods, which
increases when more labour is allocated to re-
search.
The distinctive feature of the model is that the
allocation of resources to innovation is determined
within the model on a profit-maximizing basis. To
make innovation worthwhile, it must be possible to
appropriate returns to cover the fixed costs of
research and thus some element of imperfection in
competition is required. In general, anything which
3
An easily accessible algebraic treatment is provided by Gould and Ruffin (1993).
N. F. R. Crafts
enhances the appropriability of returns to innova-
tion speeds growth up.
The GrossmanHelpman model itself allows vari-
ous factors to draw more resources into innova-
tion.3 Innovation and the growth rate depend posi-
tively on the size of the market, the productivity of
labour in research, and the degree of market power
in selling the products resulting from innovation.
These are mostly intuitively appealing features;
thus, a wider market means larger fixed costs of
research can be covered by expected sales and more
talented and/or better educated researchers will
lower the costs of innovation. The neo-
Schumpeterian suggestion that greater market power
is conducive to innovation and growth is, however,
highly contentious.
In models of this kind, once again, government can
(7) affect the long-run rate of growthhere by influ-
encing the scale of resources allocated to the inno-
vation sector. Indeed, the structure of these models
allows a much wider variety of policies to matter.
For example, growth might be influenced through
trade liberalization, competition policy, the relative
attractiveness of research to talented people, or
public procurement policies, as well as the more
obvious routes of subsidizing R & D or modifying
the law on patents. A central aspect is the appropri-
ability of returns to innovation.
The assessment of policy based on an endogenous
innovation and a broad capital endogenous growth
model might differ considerably. A straightforward
example is provided by the Single Market (1992)
programme of the European Union. In an early
article using the new growth economics, Baldwin
(1989) pointed out that, by ignoring the dynamic
effects of 1992, the Cecchini report was potentially
hugely understating the likely gains. Baldwin con-
templated a permanent automatic increase to Eu-
ropes growth rate using a Rebelo-type model;
because 1992 would increase static efficiency it
would raise the output to capital ratio and hence, for
any given savings rate, capital stock growth and
thus the rate of economic growth. An analysis based
on an endogenous innovation growth model would
be more ambivalent. Growth would obviously be
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OXFORD REVIEW OF ECONOMIC POLICY, VOL. 12, NO. 2
enhanced through wider markets but there might
also be adverse effects. For example, the liberaliza-
tion of public procurement could reduce the rents to
be obtained by R & D, or the greater budgetary
spending on social cohesion to make the Single
Market acceptable might draw more talent away
from innovation and into rent-seeking lobbying
activities.
It must be stressed that, while the endogenous
innovation framework is obviously attractive, it
only implies endogenous growth under certain as-
sumptions. In particular, if the assumption of con-
stant returns to labour in R & D is replaced by one
of diminishing returns, then the model would revert
to a kind of Augmented-Solow formulation, as
proposed by Jones (1995). In that case, Solows
basic proposition would return and policy towards
innovation cannot affect the long-run growth rate.
In the traditional neoclassical growth model, tech-
nology is assumed to be universally available. By
contrast, writers in the endogenous innovation tra-
dition argue that nations may fail to become rich, to
catch up leading countries, or to grow as fast as their
peer group because of idea gaps rather than ob-
ject gaps (Romer, 1993). At its simplest, this might
simply mean that flows of information are imper-
fect such that, in terms of equations (1) or (6), T, the
TFP level, varies and so, therefore, does the steady-
state level of income per head. A corollary would be
that if technological knowledge diffused more com-
pletely, initially backward countries would tend to
catch up the leaders not just through factor conver-
gence, as in the traditional or Augmented-Solow
models, but also via TFP convergence.
In a more sophisticated framework, it might be
argued that technology transfer involves similar
investments and incentives to those required by
initial discovery and that, to be successful, coun-
tries need indigenous firms to develop this techno-
logical capability and/or to be open to and attractive
to foreign direct investment (Teece, 1976). Here,
steady-state TFP levels and growth rates may differ
if local institutions, policies, or economic condi-
tions create differences in the rate of endogenous
technology transfer. Economic historians have in-
deed long stressed that catching-up is far from
34
automatic and that the social capability effec-
tively to assimilate new ideas varies greatly (Abram-
ovitz, 1986).
III. EVIDENCE ON BROAD CAPITAL
AND GROWTH
There now exists a substantial body of historical
evidence on comparative economic growth and
income levels. As is well known, in the recent past,
growth rates have differed substantially across coun-
tries and between periods and Table 1 reports some
estimates which provide the background to much
recent discussion of British growth performance.
Table 2 shows some of the factors associated with
the growth outcomes of Table 1. At this stage, it is
sufficient simply to note that there clearly is a
strong correlation between strong growth and a
high investment rate. Such correlations have fea-
tured prominently in the recent revival of empirical
growth economics and the correct interpretation of
these results is central to the assessment of the
endogenous growth literature.
Since the late 1980s, economists have devoted a
great deal of effort to regression analysis of similar
but, of course, much larger international cross-
sectional data sets. Most of the early work was well-
reviewed by Levine and Renelt (1992) who found
that there were relatively few reliable results in the
literature but argued that a robust regression for a
broad cross-sectional sample for 196085 was
GYP = 0.83 0.35*RGDP60 0.38GPO
+ 3.17*SEC + 17.5*INV
where GYP is the growth rate of GDP per person,
RGDP60 is real income per person in 1960, GPO is
the population growth rate, SEC is the secondary
school enrolment rate, INV is the proportion of
GDP spent on investment, and * indicates a statis-
tically significant coefficient. Thus growth is posi-
tively related to investment in broad capital and
there is evidence of catch-up in the sense that,
normalizing for capital accumulation, initially poor
countries grow faster than rich ones. These results
are not inconsistent with Tables 1 and 2.
 N. F. R. Crafts

Table 1
Income Levels and Growth Rates in Selected European and Asian Countries, 195092

Income/head ($1990) Growth rate, 195073

1950 1973 Actual Adjusted
France 5,221 12,940 4.0 5.0
Germany 4,281 13,152 5.0 6.0
Italy 3,425 10,409 5.0 5.8
UK 6,847 11,992 2.5 3.1
Japan 1,873 11,017 8.0 7.7
Korea 876 2,840 5.2 4.1
Taiwan 922 3,669 6.2 5.6

Income/head ($1990) Growth rate, 197392

1973 1992 Actual Adjusted
France 12,940 17,959 1.7 2.7
Germany 13,152 19,351 2.1 2.7
Italy 10,409 16,229 2.4 2.4
UK 11,992 15,738 1.4 2.2
Japan 11,017 19,425 3.0 3.1
Korea 2,840 10,010 6.9 5.2
Taiwan 3,669 11,590 6.2 5.3

Sources: All estimates based on Maddison (1995). Income per head is measured in purchasing power parity
adjusted international dollars; Germany and Korea refer to West Germany and South Korea. Growth
rates are of income per head in per cent per year. Adjusted growth rates allow for changes in hours worked
following the method proposed by Beckerman (1980)see text.
In the traditional neoclassical model, the initial Although it is tempting to interpret correlations
short-run effect of a rise in the investment rate between investment rates and growth in terms of a
translates into an impact on growth as follows. The causal relationship, this also is probably wrong.
change in the savings rate divided by the capital to When the LevineRenelt sample is broken down
output ratio gives the change in the rate of growth into sub-periods and analysed in terms of Granger-
of the capital stock which raises the growth rate of Causality, a statistical test based on leads and lags,
output in line with the exponent on capital. For a it turns out that there is a strong tendency for
capital to output ratio of 1.9, the average in the investment to follow growth but not for growth to
sample (King and Levine, 1994, p. 275), and assum- follow investment (Blomstrom et al., 1996). In
ing that if profits share of national income is a other words, it seems that investment responds to
guide, the elasticity of output with respect to capital better growth opportunities rather than creating
= 0.33, then a rise of 1 percentage point in the them. Both this and the size of the estimated invest-
investment rate should raise output growth by 0.33/ ment coefficient are, prima facie, much more con-
1.9 = 0.174 percentage points. Interestingly, this is sistent with a GrossmanHelpman than a Rebelo-
almost exactly the prediction of the coefficient of type new growth model.
17.5 estimated by Levine and Renelt. In other
words, although a casual glance might suggest Growth accounting has traditionally sought to meas-
otherwise, on close examination this empirical ure the sources of growth on the basis of an equation
growth equation is more in line with a traditional which could be derived from equation (1). TFP
Solow than a new Rebelo growth model. growth is calculated as a residual after working out

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OXFORD REVIEW OF ECONOMIC POLICY, VOL. 12, NO. 2

Table 2
Accounting for Growth

I/ Y K /K Growth due TFPGR Y/Y

to capital
195073
France 23.8 5.3 1.6 3.1 5.0
Germany 26.9 7.3 2.2 3.3 6.0
Italy 24.6 5.2 1.6 2.5 5.0
Japan 32.6 10.2 3.1 3.6 9.2
UK 18.3 5.5 1.6 1.2 3.0
197392
France 21.6 4.2 1.3 0.6 2.3
Germany 22.2 3.1 0.9 1.5 2.3
Italy 21.9 3.2 1.0 1.1 2.8
Japan 30.3 6.6 2.0 1.2 3.8
UK 18.1 3.1 0.9 0.6 1.6
196690
Korea 28.4 13.7 4.1 1.7 10.3
Taiwan 26.9 12.3 3.2 2.6 9.4

Sources: Growth accounting calculations for France, Germany, Japan, and UK from Maddison (1996), for
Italy from Rossi et al. (1992) and for Korea and Taiwan from Young (1995). Estimates for Italy are for
197390. Investment data are from OECD (1995) and from Rodrik (1995).

the contributions of capital and labour.4 The esti- rapid catch-up growth (Basu and Fernald, 1995;
mates in Table 2 are obtained from the expression Rossi and Toniolo, 1996).

Y/Y = a K /K + bL /L + TFPGR.
These estimates do make some allowance for the
quality as well as the quantity of factor input growth
and thus take into account (rather crudely) human
capital inputs in the contribution of the labour
input. In the pure textbook neoclassical world of
equation (1), TFP growth would result solely from
technological change but, in practice, as growth
accountants themselves stress (Maddison, 1996),
this component subsumes much more, including
the effects of improved use of inputs and structural
change as well as perhaps failure adequately to
measure the contribution of human capital. Recent
studies have indeed stressed that the contribution of
pure technological change to TFP growth is prob-
ably quite small, especially during episodes of
(8) The growth accounting of Table 2 suggests that
neither episodes of rapid growth nor international
differences in growth outcomes should be attrib-
uted primarily to investment in physical capital. On
the contrary, TFP growth seems to play a large part
and, in the Asian countries, so do rapid increases in
labour inputs based on rising participation rates and
thus more hours worked per person.
Since the newly industrializing countries of Asia
are often seen as an example of growth success
based on very high rates of accumulation of broad
capital, it is interesting to follow up the discussion
of Table 2 with a Levine and Renelt-style regres-
sion-based analysis of success in East Asia com-
pared with failure in Latin America (Table 3).
Although investment and school enrolment have

4
The evidence summarized in this section suggests that the conventional use of profits share of national income as the estimate
of a in the calculation of TFP growth, which is used in Table 2, is an acceptable approximation.

36

Table 3
Estimated Sources of Differences in Growth Outcomes, 196085:
East Asia (EA) versus Latin America (LA) (% per year)
Investment
Primary enrolment
Secondary enrolment
Population growth
Initial GDP
EA dummy
LA dummy
Actual
Source: World Bank (1993, Table 1.10).
been higher in the Asian countries, the regression
suggests that this accounts for relatively little (0.43)
of the 3.62 percentage points gap in growth rates.
By far the biggest contribution comes from the
positive East Asian and negative Latin American
dummy variables. The implication of this is, in
effect, that TFP growth, which is not captured in the
regression, differed markedly and that, presumably
through differences in policies and institutions,
East Asian countries made better use of their invest-
ments and/or gained better access to foreign tech-
nology. This does indeed seem to be the message of
students of the role of technology in industrializa-
tion (von Tunzelmann, 1995).
A comparison of growth in East Asia and western
Europe, using Tables 1 and 2, is also instructive.
Three points, in particular, deserve emphasis.
(i) Taking 196690 as a whole, it is capital stock
growth rather than investment rates which have
been exceptional in Korea and Taiwan. This
reflects lower capital to output ratios, an advan-
tage which will erode as these countries catch
up and output grows less quickly than capital, as
has happened in Japan.
(ii) Rapid TFP growth tends to be characteristic of
catch-up growth. TFP growth has been less
strong in Korea and Taiwan than in Europe
during its Golden Age in the early post-war
N. F. R. Crafts
EA LA
0.20
0.17
0.06
0.01
0.18
1.71
1.31
3.62
years, but exceeds what the OECD countries
have achieved subsequently. It remains to be
seen whether the East Asian countries can sus-
tain their TFP growth as they catch up the West,
but the Japanese example suggests this will be
difficult.
(iii)To put Asian growth in a proper perspective,
account should be taken of its reliance on in-
creasing labour inputs per person, i.e. forgone
leisure, which contrasts with the opposite ten-
dency in Europe. Table 1 adjusts growth of
income per head to allow for this by valuing
changes in hours worked per person at the
average wage rate in the terminal year, as sug-
gested by Beckerman (1980). The effect is quite
marked and suggests that, on this broader meas-
ure of performance, East Asian growth lies
somewhere between that of France and Ger-
many in the Golden Age.
Recalling the models discussed in section II and
noting the strong showing of the schooling variable
and the implications of the estimated coefficient on
investment, prima facie, the regression results ob-
tained by Levine and Renelt (1992) seem closest to
the Augmented-Solow model. In a straightforward
endogenous growth model, the initial income level
should not affect the growth rate, whereas with
exogenous growth convergence to the steady state
would, of course, lead to an inverse correlation as
found in the regression.
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OXFORD REVIEW OF ECONOMIC POLICY, VOL. 12, NO. 2
An interpretation of cross-section regressions to
explain growth (and also productivity levels) along
these lines has been strongly advocated by Mankiw
et al. (1992). Imposing some additional structure on
their analysis they infer that supposing a production
function of Y = K 0.33L 0.33H 0.33 gives a good ap-
proximation to international experience. Not only
is this inconsistent with endogenous growththe
exponents on K and H sum to less than onebut the
relatively low exponent on K (similar to profits
share of national income) suggests an absence of
externalities to physical capital formation. Mankiw
(1995) has gone on to claim that the traditional
neoclassical assumption of universally available
technological knowledge is also tenable and thus
would see the inverse correlation between income
levels and subsequent growth simply as neoclassi-
cal factor convergence.
Further research suggests, however, that these find-
ings need, at the least, substantial qualification. The
most reliable seems to be the rejection of the hy-
pothesis of substantial externalities to physical
investment.5 Two studies are of particular note. In
the first, Oulton and OMahony (1994), in an econo-
metric analysis of British manufacturing during
195486, found that there was no support for the
hypothesis that weighting capital by profits share
underestimates capitals role in growth, nor any
evidence to indicate that social returns to invest-
ment exceeded private returns.
The second study by Islam (1995) returns to Mankiw
et al.s findings, noting that the ordinary least
squares estimation that they used requires that
investment is independent of the error term, which
is implausible if countries differ in terms of social
capability and thus technology. Islam takes a panel
data approach which permits the investigation of
individual country effects. Two important results
followfirst, that the equivalent of the T term in
equation (6) varies considerably across countries
even within the OECD and, second, that, correcting
the bias in Mankiw et al.s results, profits share still
seems to be an appropriate weight for capital. Islam
also confirms Mankiw et al.s other key result; the
5
This is despite the much discussed study by De Long and Summers (1991) which claims a special role for equipment investment
in growth and a 30 per cent social rate of return to this category of investmentwhich would imply substantial externalities. Their
results appear highly sensitive to the exclusion of one outlying observation and for the subset of OECD countries there is no
evidence that social returns exceed private returns (see Auerbach et al., 1994, and Oulton and Young in this issue).
38
hypothesis of constant returns to broad capital
continues to be rejected.
The Augmented-Solow interpretation of recent
growth experience puts strong emphasis on the role
of human capital, proxied by the schooling of the
labour force, in production. Islam (1995), in his
reappraisal of the evidence, shows both that this
result is not obtained for the OECD countries subset
and that the coefficient on the schooling variable
actually turns negative in all subsets of the Mankiw
et al. (1992) sample once the panel data approach is
adopted. There is, however, a close correlation
between schooling and T, and Islam suggests that it
may be better to view education as an aspect of
social capability impinging on technology transfer
rather than as a direct input into production (1995,
pp. 11602).
In terms of the input of human capital to production,
however, it may well be that it is training rather than
education that really matters. International cross-
sectional data on training are unfortunately not
available. Detailed investigation of the role of la-
bour-force skills in British and German manufac-
turing has, however, been undertaken. In a cross-
sectional econometric study for 1987, OMahony
(1992) found strong effects of relative skills
measured either by vocational qualifications or
wage differentials on relative productivity per-
formance. Her results give weak support to the
hypothesis of positive externalities to skill for-
mation and imply an exponent on broad capital
(K + H) of the order of 0.58 to 0.66very similar
to the production function suggested by Mankiw
et al. (1992) and consistent with an Augmented-
Solow model.
Following on from this, it is also necessary to
reconsider the implications of the finding of a
negative cross-section correlation between initial
income levels and growth rates. Further economet-
ric research suggests both that this is not in fact
decisive evidence against the endogenous growth
hypothesis and also that TFP as well as factor
convergence was involved.

For example, van de Klundert and van Schaik
(1996) find for the advanced countries with long-
run data that this correlation only applies in the
period 195073 and does not hold either before
1950 or after 1973. Similarly, Bernard and Durlauf
(1995) in an analysis of the same long-run time-
series using cointegration techniques, are unable to
reject the hypothesis of no convergence in the sense
that long-run forecasts of trends and levels of output
are not the same. Finally, Milbourne (1995) devel-
ops a test to exploit restrictions implied by the pure
Augmented-Solow model and finds that TFP con-
vergence plays a major role in the post-war OECD
countries growth experience.
As Sala-i-Martin (1994) has pointed out in the
context of the Rebelo model of equation (5), if there
is an episode in which broad capital productivity is
raised by new opportunities for technology transfer
having most of an impact on the economies which
are the least productive, some data sets may demon-
strate strong catch-up without any implication of
long-run convergence, as seems may well be the
case for the OECD countries.
Economic history offers strong support for this
view, given that the inverse correlation findings
appear to result from data sets with starting points
in the Golden Age of Table 1. The catching-up of
this period involved significantly reduced obsta-
cles to the assimilation of American technology in
Europe as market size was expanded through eco-
nomic integration and multinational companies grew
enormously in importance, while the codification
of knowledge and availability of scientific and
engineering personnel were also much enhanced
(Nelson and Wright, 1992). At the same time,
catch-up was promoted by structural change and
reconstruction as the damage from war and inter-
war policy errors was remedied (Dumke, 1990).
Thus far, this review of inferences from macroeco-
nomic growth databases has suggested four main
conclusions.
(i) Contrary to the Rebelo model, there are dimin-
ishing returns to broad capital formation.
(ii) There is strong evidence against the neoclassi-
cal assumption that the aggregate level of tech-
N. F. R. Crafts
nology is the same in all countries, even in the
advanced world, and thus against the pure Aug-
mented-Solow interpretation of growth.
(iii)The episode of catch-up in post-war growth is
not decisive evidence against the endogenous
growth hypothesis.
(iv) The recent growth in East Asian countries,
although very impressive, should not be re-
garded as unprecedented or miraculous.
IV. EVIDENCE ON ENDOGENOUS
INNOVATION AND GROWTH
Whereas the Rebelo model of endogenous growth
puts (broad) capital accumulation centre-stage, the
endogenous innovation models seek to endogenize
rather than to abolish TFP growth. The key issues
are, of course, how well do these models do empiri-
cally in explaining TFP growth and does the evi-
dence suggest that returns to investment in innova-
tive activity can support endogenous growth? In
answering these questions, it is useful to draw
rather more than growth theorists generally have on
the economics of technology literature as well as
contributions from empirical growth economics.
Macroeconomic growth studies have provided some
support. Three recent econometric exercises are
worth noting. First, Verspagen (1996) investigates
the role of R & D expenditures in an aggregate
production function for France, Germany, and the
UK since 1960; he finds that R & D accounts for
around a quarter of labour productivity growth in
the first two countries but cannot reject the null
hypothesis that it had no effect in the UK.
Second, Coe and Helpman (1995) show that TFP
growth in 197190 in European countries has been
highly responsive to increases in foreign R & D
stocks, more strongly so the more open the economy.
Third, Chou et al. (1995) explore the determinants
of industry-financed R & D expenditure in OECD
countries in the 1980s; they conclude that domestic
market size, the degree of international economic
integration, and government spending on research all
have significant positive effects, as would be predict-
ed by standard endogenous innovation models.
39
OXFORD REVIEW OF ECONOMIC POLICY, VOL. 12, NO. 2

Table 4
Industry-financed R & D Expenditure (% of GDP)

1967 1991

Switzerland 1.78 2.07

Netherlands 1.12 0.91
UK 1.00 0.94
USA 0.99 1.36
Germany 0.94 1.57
Japan 0.83 2.13
Sweden 0.71 1.71
Belgium 0.66 1.16
France 0.60 0.99
Canada 0.40 0.59
Norway 0.35 0.77
Denmark 0.34 0.85
Italy 0.33 0.61
Finland 0.30 1.07
Ireland 0.19 0.58
Spain 0.08 0.38
Portugal 0.04 0.14

Source: Patel and Pavitt (1994).

Microeconomic studies in industrial and technol-
ogy economics give further, somewhat qualified,
backing to the endogenous innovation approach.
This body of research certainly stresses that
appropriability of returns is central to innovative
effort and that market size and demand growth have
positive effects; a good study which encapsulates
all these points is Jaffe (1988).
Nevertheless, it may be the spirit rather than the
letter of the new growth models which should be
taken seriously, since some aspects of the models
are less than convincing and it would be unfortunate
if these were taken too seriously by policy-makers.
In particular, the emphasis in the growth literature
on market power and patents as key incentives for
growth needs to be treated sceptically. Empirical
evidence suggests that appropriability is related
much more to lead times over rivals than to patents
(Levin et al., 1987) and that there is no relation
between concentration and R & D in properly
specified regression studies (Cohen, 1995). Moreo-
ver, while large business units may have advan-
tages in research in exploiting learning curves and
spreading fixed costs (Cohen, 1995), rivalry among
big firms is helpful in promoting R & D (Patel and
Pavitt, 1992).
While the notion of endogenous innovation sur-
vives this encounter with the empirical evidence,
the issue of scale effects raised by Jones (1995)
remains as a strong objection to the hypothesis of
endogenous growth. Jones considers OECD (espe-
cially American) growth since 1900 and stresses
that growth rates of output and TFP are not now
higher than ever before. He argues that the rejection
of R & D-based growth models is particularly
strong: The models posit that the growth rates of
per capita output and TFP should be increasing with
the level of resources devoted to R & D, which is
wildly at odds with empirical evidence (1995, p.
519)as a comparison of Tables 1 and 4 confirms.
Jones finds the basic structure of endogenous inno-
vation models to be appealing, but not the endog-
enous growth implications.
This critique is probably not quite so devastating as
might appear at first sight. Three points should be

40
 N. F. R. Crafts

considered. First, as was noted earlier, TFP growth
appears to have accrued historically from a wide
range of sources and, given the relatively low
fractions of GDP spent on R & D, at least until
recent times relatively little TFP growth can have
come from this.6 Equally, the reasons for the slow-
down in TFP growth in the OECD economies may
lie elsewhere.
Second, direct evidence on the potency of R & D is
somewhat mixed and bedevilled with measurement
problems. Griliches (1994) reviews the evidence
and concludes on balance that it is likely that R &
D in American manufacturing had as strong an
effect on TFP growth in 197889 as it did in 1958
73. Furthermore, it may be that our ability accu-
rately to measure TFP growth has declined as the
service sector has grown in relative importance and
that recent official estimates are understated through
inadequate treatment of quality changes.
(iii)TFP growth has been an important component
of past growth but industry-financed R & D has,
at best, underpinned quite modest rates of en-
dogenous growth in the past.
V. POLICY IMPLICATIONS
This section builds on the evidence discussed in
sections III and IV, together with some reflections
on recent British economic history, to draw out
some policy lessons. A general implication of the
new growth economics is that institutions and policy
may have stronger effects on the growth rate than
would have been predicted using the traditional
neoclassical growth model.7 Moreover, it is impor-
tant to take a broad view of the role for policy rather
than restrict the perspective to investment subsidies
and taxation; reform of institutions potentially be-
comes a key aspect of policy-making.

Third, if, as some accounts of long-run technologi-
cal change insist, major changes in techno-eco-
nomic paradigm, such as the switch since the
Golden Age from Fordist mass production to flex-
ible specialization and information technology, in-
volve creative destruction and grave adjustment
problems, then it could be that the initial impact
would be felt in a slowing of productivity growth
while the long-run effect is the opposite (Freeman
and Perez, 1988).
Three further conclusions can now be drawn:
(i) innovative activity is responsive to a variety of
economic stimuli and can be influenced by
economic policy;
(ii) it is unclear whether policies to promote inno-
vation can raise long-run growth or whether
diminishing returns to R & D reassert the
Solovian world of transitory effects only;
The conclusions of the last two sections have sev-
eral broad policy implications. The most important
are the following.
(i) A policy to stimulate investment may not be a
route to permanently faster growth but could
have significant short-term effects. It would
seem desirable to target broad capital rather
than merely physical investment.
(ii) Given that routine investment has diminish-
ing returns, if faster endogenous growth is
feasible, it will result from success in raising
the rate of technological change. Even if the
fears of critics such as Jones (1995) are
overstated, it should be recognized that, real-
istically, policy to stimulate R & D cannot be
expected to have dramatic effects. For exam-
ple, doubling the share of GDP devoted to
industry-financed R & D to 2 per cent would
raise TFP growth by at most 0.4 percentage

6
Griliches (1995, p. 60) regards a social rate of return of about 40 per cent to industry-financed R & D as a reasonable guess.
Applying this to the R & D figures in Table 4 suggests that in the Golden Age a contribution as high as 0.4 per cent per year to
TFP growth would be quite unusual.
7
The severity of diminishing returns can be expected to be much weaker when a broad notion of capital is adopted since (a +
c) in equation (6) will tend to be much larger than a alone in equation (1), even if the conditions for endogenous growth are not
satisfied. Barro and Sala-i-Martin (1995, pp. 368 and 807) offer illustrative calculations that suggest for a model with a = 0.33
the rate of convergence to the steady state will be about 5.6 per cent per year with a half-life of 12.5 years, whereas for a model
with (a + c) = 0.75 the rate of convergence will be about 2 per cent per year with a half-life of 35 years.

41
OXFORD REVIEW OF ECONOMIC POLICY, VOL. 12, NO. 2
points and thus, using the formula in equation
(2), the growth of output by about 0.6 percent-
age points.
(iii)Nevertheless, given the evidence against the
convergence predictions of the Augmented-
Solow model and the possibility that technol-
ogy levels vary substantially, the costs of fail-
ing adequately to exploit opportunities for tech-
nology transfer may be considerable. This sug-
gests a high priority for identifying and remedy-
ing market failures in the area and the potential
importance of policies in the areas of skills
acquisition and foreign direct investment de-
signed to reduce the ideas gap.
(iv)The endogenous innovation literature argues
that attention needs to be given to enhancing the
appropriability of returns. Set in a contempo-
rary British context, this is likely to involve
dealing with various forms of short-termism
resulting in under-investment in both innova-
tive activity and physical investment.
Seen in this light, the general thrust of British
supply-side policy during the years of rapid relative
economic decline from the 1950s through to the
1970s appears most unfortunate. Two general fea-
tures stand out. First, the poor targeting of subsidies
to investment and, second, the failure effectively to
tackle questions of institutional reform. These weak-
nesses did not go completely unrecognized but
governments were generally too weak or too short-
termist to address them (Bean and Crafts, 1996).
There was a strong emphasis throughout on subsi-
dizing physical investment, building up by the
1970s to a focus on selective assistance and further
nationalizations. By contrast, training was rela-
tively neglected, especially prior to 1964. The UK
did establish heavy support for R & D but this
included a very heavy defence-related component
which offered little to the rest of the economy in
terms of externalities, together with the economi-
cally disastrous programmes to support aerospace
and nuclear power.8 Technology policy concen-
trated unduly on aiming to promote radical innova-
8
Government contributions to civil aircraft and engine development from 1945 to 1974 totalled 1.5 billion at 1974 prices and
produced receipts of 0.14 billion (Gardner, 1976).
42
tions and too little on facilitating the diffusion of
improvements and enhancing technology transfer
(Ergas, 1987).
Policy choices were curtailed by continual attempts
to seek the cooperation of the trade union move-
ment to deliver low unemployment without exces-
sive wage inflation. In particular, this generally
precluded attempts to reform industrial relations,
with the exception of the ill-fated act of 1971. Given
Britains idiosyncratic structure of decentralized
bargaining based on multiple unionism and weak
legislative control, this might be expected to have
had adverse consequences for investment and/or
innovation by firms because of worries about the
possible hijacking of returns by workers unable to
commit themselves not to do so (Grout, 1984).
Putting this insight into the context of an endog-
enous innovation growth model would imply fewer
resources devoted to innovative activity and, thus,
lower growth. Empirical investigations give some
support to this for investment (Denny and Nickell,
1992) and for TFP growth, which it is estimated that
the presence during 195479 of multiple unionism
in British manufacturing reduced by between 0.75
and 1.1 per cent per year (Bean and Crafts, 1996).
The early post-war years also saw the emergence of
a new-style capital market in the UK, characterized
by hostile takeover and by short-term, low-trust
relations between managers and shareholders in
which under-investment could be expected for rea-
sons similar to the Grout problem (Dickerson et al.,
1995). In this context, Mayer (1992) found that
large British firms have generally felt compelled to
maintain dividends at the expense of R & D. Al-
though evidence gradually mounted that the merger
and takeover boom of the 1960s did little to promote
productivity improvement (Singh, 1975; Meeks,
1977), policy was informed more by a belief in the
advantages of size and a desire to establish national
champions than by thinking about the implications
for the appropriability of returns.
These imbalances in supply-side policy have been
redressed to some extent in the 1980s and early

1990s, although it is still unclear whether there has
been any substantial impact on the long-run growth
rate. The most obvious success has come in the area
of industrial relations, where initially conduct and
eventually structures were dramatically changed
(Metcalf, 1994) in an era of industrial crisis, accept-
ance of high unemployment, ending of attempts at
social contracts, and high-risk economic policy-
making.9 These changes seem to have led not only
to immediate increases in productivity levels but
also to reduced negative effects of union recogni-
tion on investment (Denny and Nickell, 1992) and
the removal of the adverse impact of multiple
unionism on TFP growth (Bean and Crafts, 1996).
Department of Trade and Industry (DTI) subsidies
to physical capital formation were substantially
reduced, while those to innovation were main-
tained, although redirected during the 1980s (Crafts,
1993, p. 71). As the emphasis on support for physi-
cal investment was reduced, eventually more atten-
tion was paid to reform of education and training;
between 1987 and 1994 the number of economi-
cally active people with a qualification rose by
3.9m and by 1993, 32 per cent of 18-year-olds went
into higher education compared with 12 per cent in
1981 (Robinson, 1994). In 1994, supply-side policy
was consolidated under Michael Heseltines Com-
petitiveness Division at the DTI. The ultimate
effect of these changes remains highly controver-
sial.
Gordon Browns reference to post-neoclassical
endogenous growth theory suggested that supply-
side policy needed further substantial changes and
that, with appropriate intervention, the growth rate
might be appreciably increased. What, then, does
the new growth economics suggest should be the
scope and chief focus of such changes?
First, it is important not to return to 1960s and 1970s
style policies to promote growth. In particular,
relatively less attention should be devoted than at
that time to raising the rate of fixed capital forma-
tion and relatively more to finding effective inter-
ventions to raise human capital accumulation and
innovative activity. This message is reinforced by
9
The size of the shock was largely unanticipated, although the stubbornness with which the policies of the early 1980s were
pursued was both deliberate and surprising. The short-term macroeconomic outcome would almost certainly have led to electoral
rout had it not been for the Falklands War (Price and Sanders, 1994) and the creation of these circumstances could not readily
have been contemplated ex ante by any politician.
N. F. R. Crafts
the much greater likelihood that social returns ex-
ceed private returns in the latter areas than in the
former.
Second, industry-financed R & D is relatively small
in the UK, as Table 4 reports, and there may be a
case for changes in the tax position of R & D which
is less generous than in many other countries. This
would potentially be justified by spillover effects
and by the evidence that the American R & D tax
credit had a strong impact on expenditure (Griffith
et al., 1995). As these authors warn, however,
designing tax incentives for R & D is difficult, not
least in terms of persuading firms that the policy
will be sustained.
Third, it should be recognized that the fundamental
stance in the Competitiveness White Papers (DTI,
1994, 1995) is not inconsistent with many of the
recommendations that might come from the endog-
enous innovation school and is alert to the role of
policy in reducing the ideas gap. In particular, this
applies to the emphasis on fair and open markets
which stresses the value both of trade liberalization
and of inward investment, and which does not
suggest the lurch towards protectionism feared by
critics of the (admittedly unsatisfactory) notion of
competitiveness (Krugman, 1994).
There is, however, a danger that government in-
volvement with competitiveness has led to undue
emphasis on the achievement of intermediate ob-
jectives, which tend to lose their value once tar-
geted by politicians. A possible example is the high
profile given to numbers attaining qualifications of
various kinds whose quality is inadequately moni-
tored. In any event, independent assessment of the
new education and training policies in terms of their
impact on TFP growth is a high priority and cer-
tainly cannot be obtained from (or by?) the DTI.
Fourth, despite the Schumpeterian outlook of many
new growth models, it would be wrong to conclude
that faster growth requires the abandonment or
even the weakening of competition policy, still less
the sponsorship of national champions. The evidence
on innovation in Britain appears strongly to endorse
43
OXFORD REVIEW OF ECONOMIC POLICY, VOL. 12, NO. 2
the view espoused by Porter (1990) that the positive
effects of rivalry in preventing the managerial quiet
life outweigh any impact of reduced expected returns
to successful projects (Geroski, 1994).
It is sensible, however, to recognize the impact of
government policies on the appropriation of returns
to productivity improvements. An important exam-
ple of this occurs in the context of the regulation of
privatized companies. Although British-style price-
cap regulation may offer incentives to management
to pursue cost reductions, here again there are risks
of under-investment in innovation if the regulator
cannot commit not to expropriate ex post. Rees and
Vickers (1995) highlight this point and note that the
main problem in practice may be political interven-
tion motivated by populist pressures. Clearly, the
proposal of windfall taxes on privatized utilities
epitomizes this danger.
Fifth, policies to raise the growth rate need to pay
further attention to institutional reform. Doubts
about the British financial system, in terms of its
excessive reliance on ownership and control by
outside investors and consequent appropriation
problems and under-investment in projects with
long-term pay-offs, continue to be voiced. Changes
to this regime could result from reform of corporate
law and regulation and are unlikely generally to
happen without government intervention given the
coordination problems involved (Jenkinson and
Mayer, 1992).
VI. CONCLUDING COMMENTS
The preceding sections have given a quite intricate
review of recent work in growth economics and on
the basis of this have extracted some cautious
policy implications. Rather than reiterate these
points, I wish to conclude by returning to a broad-
brush style to make more explicit and to emphasize
three basic lines of argument underlying all the
detail.
44
First, it should be recognized that raising the growth
rate is difficult and that a return to the growth rates
of the Golden Age is highly unlikely. Although
there is more reason than once there was to hope
that appropriate government policy can raise the
long-run growth rate, it should also be accepted that
the hypothesis of endogenous growth is controver-
sial.
Second, it is important to take away the right
messages from the Augmented-Solow approach to
growth. The first is that convergence to the steady
state means that in the long run, raising the rate of
broad capital formation without changing TFP
growth will have only a levels effect and not a
growth-rate effect on income. The second is that
historical experience emphatically does not en-
dorse the view that different countries tend auto-
matically to a steady state based on identical tech-
nology. It follows that technology transfer is a key
area of policy concern.
Third, in the long run growth comes from improve-
ments in productivity resulting from better technol-
ogy which involves the use and effective assimila-
tion of new ideas. In principle, it follows that the
chief focus of a policy to strengthen long-run growth
performance should be to address market failures
which weaken social capability rather than to
subsidize routine investment. In practice, reduc-
ing the exposure of the investor to fears of
expropriation, whether by workers, sharehold-
ers, or politicians, will probably have favourable
impacts both on broad capital formation and on
TFP growth.
Finally, as a postscript, it may be as well to bear in
mind that better supply-side policies tend to have
their big pay-off in the far distant future, while
frequently jeopardizing the votes of powerful inter-
est groups initially. Absent effective ways of achiev-
ing pre-commitment, the short-termism of politi-
cians is always likely to be an obstacle to faster
long-run growth.
 N. F. R. Crafts

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