Defense R&D is key to the economy

A large body of empirical research has argued that R&D is a key source of firm productivity growth (e.g. Griliches, 1979) and this notion has long been at the heart of modern growth theory. But there are at least two limitations with the existing empirical evidence. First, it is unclear how much of the association between productivity and R&D is causal and how much reflects unobserved factors which are correlated with both. Improving institutions and technology, for example, could cause countries or industries that experience faster R&D investment do tend to also have higher productivity growth. Despite the importance of this issue, few empirical studies make use of plausibly exogenous sources of variation in R&D.53 Second, even if the association of productivity with R&D is entirely causal, the question remains as to what policies can successfully raise R&D, and whether these policies are socially efficient.54∂ In this paper, we study the impact of public R&D spending on private R&D spending and productivity. We address the potential endogeneity of public R&D by using the defense component as an instrument exploiting natural experiments such as the start of hot wars and the ending of cold wars. We uncover some unexpected intellectual spoils of war. First, our results suggest that government R&D “crowds in” rather than “crowds out” private R&D with a long-run elasticity of around 0.3 (i.e. a 10% increase in government funded R&D increases private R&D by 3%). This affects seems causal – when we instrument public R&D with the arguably more exogenous defense related component, this relationship strengthens, suggesting that (if anything) public R&D is often used to compensate industries facing negative shocks.∂ Second, we find that R&D investment plays an important role in raising TFP and therefore economic output. We uncover estimates of the rate of return to R&D that range between from 0.6 to 0.10. This effect is economically meaningful. Public R&D in general, and defense R&D in particular, account for some of the differences across countries in TFP.∂ Finally, we uncover an interesting pattern of international spillovers. An increase in public R&D benefits other countries through a positive productivity spillover, but we also find that on average these other countries respond by cutting back on their R&D investments (which by itself will reduce their productivity growth). Simple simulations suggest that the first effect dominates, however, and that government-funded R&D by one’s neighbors is to be welcomed rather than feared.