Investing in R&D spending

Innovation is rapidly becoming the key factor defining America’s economic growth, prosperity, and competitiveness on the world stage. It also has a profound effect on national security, as highlighted in a 2019 report composed by the Council on Foreign Relations (CFR).

There is enough evidence suggesting that American innovation is in a decent shape. Experts point to the lightning-speed rollout of the RNA-based COVID-19 vaccines and an impressive list of ‘fast and frugal’ innovations developed in response to the COVID-19 pandemic. One can also celebrate the unprecedented level of the pandemic-driven cooperation between U.S. academic institutions and private companies. And did not the Global Innovation Index 2020 name the United States the 3rd most innovative country in the world (after Switzerland and Sweden)?

And yet, I see a host of problems, with deep and systemic roots in the U.S. business and political environment, that have a potential to damage American innovation in the long term. One of them is a growing shortage of novel ideas, a shortage made worse by the declining quality of these ideas and the increased cost of getting them.

Government is not the problem. The lack of it is

What’s going on? Why is the well of innovative ideas in the U.S. drying up?

The answer is simple: insufficient R&D funding.

In the decades following World War II, entirely new sectors of the U.S. economy have been created (jet aircraft, modern-day pharmaceuticals, microelectronics, satellites, digital computers, etc.), thanks to a heavy infusion of public money, with the federal government contributing more than 50% of R&D expenses.

Things have changed. Although the total spending on R&D in the U.S. has remained steady for the past years, at 2.5-2.8% of GDP, only 30% of the money now comes from the federal government; 70% is contributed by the private sector. With its focus on rapid ROI, will private sector spend money on fundamental and, therefore, potentially risky R&D projects? No.

The number and quality of innovative ideas are declining because sources of new scientific discoveries in the U.S. are gradually drying up. Yes, the industry can still generate incrementally innovative combinations of old ideas, but it will fail to create breakthrough innovations.

President Biden’s plan to dramatically increase funding for fundamental research is a promising step in the right direction. Unfortunately, there is no institutional protection for the increased R&D budget, which may be easily slashed again by any future administration.

There is one more troubling thing: the lack of a coherent public innovation policy. Previously, I showed that there was a strong correlation between a country’s innovation potential and the level of democratic developments in this country (as assessed by the Democracy Index 2019). Although all five individual components of the Index positively correlated with innovation, the strongest correlation occurred for Functioning of Government. And yet, the above-mentioned CRF report specifically criticized the weak role the federal government plays in shaping the U.S. innovation policy.

Investment vs. expense

It amuses me how different an attitude toward public and private R&D funding can be.

It’s a common place to call private R&D funding “investment.” (An entry to Investopedia reads: “Why You Should Invest in Research and Development (R&D).” At the same time, public funding of R&D is almost always characterized as an “expense” (or “spending”). Note that in the federal budget, R&D funding falls in the discretionary spending bucket. (Investopedia defines discretionary spending as “a cost that a business or household can survive without, if necessary.”) Apparently meaning that as a country we can survive without spending money on R&D.

I can see where this difference comes from. ROI is the principal metric that the private sector uses to assess the effectiveness of its investments. Given that the industry is spending most of its R&D money (at least 70%, according to a popular model) on short term projects, ROI can more or less be easily calculated. Your investment either works or doesn’t, but at least you know what happened to the money.

Not so with public R&D spending. Given that public money goes mostly to basic science, with the outcomes being uncertain for many years to come, measuring ROI becomes more difficult, creating an impression that there is no “return” on public R&D money. No matter what happens to this money, the R&D funding is habitually considered an “expense.” Worse, some folks call it “waste.”

An underused money machine

Benjamin Jones of Kellogg Scholl of Management strongly disagrees. Not only does he argue that public R&D spending is not a “waste”; he insists that the U.S. is greatly underinvest in science and innovation. Jones goes as far as calling this underinvestment a “market failure”.

Market failure? Is Jones serious?

He is. In a recent report pointedly headlined “Science and Innovation: The Under-Fueled Engine of Prosperity” Jones reviews a body of recent research aimed at calculating the so-called social return on R&D investment (by using numerous economic models and applying them to different industries in varying settings). 

Jones’s conclusion is nothing short of an eye-opener. The social rate of return on R&D expenditure in the total U.S. economy appears to exceed 50% (yes, this isn’t a typo. 50%). That means that $1 of public money invested in innovation produces, conservatively, at least $5 in social benefits. (The rate varies over different industries, being, for example, 40% for agricultural R&D investment and exceeding 55% for industrial.)

This is much higher than a typical private return on R&D investment (or on any other investment, for that matter). Not to mention that this is many multiples of stock market returns or the interest on government bonds.

Take, for example, the still fresh in memory Operation Warp Speed. The public investment cost of accelerated COVID-19 development was approximately $25 billion. It is less than 1% compared to the total $3 trillion the U.S. government has spent in pandemic relief through March 2021. And speaking in terms of human lives, the entire cost of the Operation Warp Speed was lower than the cost of losing American lives in one day in December 2020 (as measured by the “value of a statistical life” approach).

In Jones’s words, “the science and innovation system is akin to having a machine where society can put in $1 and get back $5 or more. If any business or household had such a machine, they would use it all the time.”

And yet, this money-making machine is hugely underutilized (justifying Jones’s words “market failure”). Why? First, because of a decade-long habit to view it and “money-burning” machine instead. Second, a lack of clear understanding of how to use this machine properly.

This needs to change, and I’ll get back to both points in my future posts.

Image credit: https://www.wikigallery.org/wiki/painting_304950/%28after%29-Marinus-Van-Reymerswaele/The-Money-Changers

About Eugene Ivanov

Eugene Ivanov is the Founder of (WoC)2, an innovation consultancy that helps organizations extract maximum value from the wisdom of crowds by coordinated use of internal and external crowdsourcing.
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