Institutions, Innovations, and Growth

Abstract:     
The fundamental importance of economic institutions for economic growth through their impact on technological change has long been argued by Schumpeter and others. Recent empirical studies have reconfirmed such arguments. However, our understanding of the impacts of economic institutions on R&D and the consequences for growth is still far from satisfactory. In this paper we attempt to fill the gap by examining how financial institutions affect technological innovation and thus affect growth.

For an economy with the soft-budget constraints problem, we show how this problem creates conditions for relatively low economic growth when the uncertainty of risky investment in R&D is high. As a consequence of soft-budget constraints, bad R&D projects do not stop; the risk level of risky investment in R&D is pushed higher; investors choose to invest less in R&D; and the economic growth rate is slowed. In contrast, under hard-budget constraints, a relatively high economic growth can be achieved when the uncertainty of risky investment in R&D is high. This is because bad projects can be stopped; the risk level of risky investment in R&D is reduced; and investors choose to invest more in R&D, which enhances economic growth rate. We also demonstrate that economic growth in soft budget constraints can be high if the risk level of R&D is very low, such as the cases of technological imitation.

Our results shed lights on the debate on the 'East Asia miracle' and the East Asia financial crisis, and on the rise and fall of centralized economies.

JEL Classification: O40, E20, D92

Accepted Paper Series