The Arithmetic of R&D

Posted by: Michael Mandel on October 19

In a post entitled More Free Lunch Economics from Michael Mandel, PGL on Angry Bear writes:

An increase in government-sponsored R&D might be a very nice thing as Mandel suggests, but he seems to dodge the question as to how we pay for this extra expenditure. Do we cut some form of private or government consumption? If so, then I’d call this saving.

First, I like free lunch economics. The economic history of the past 200 years is basically one long free lunch, with productivity growth far outrunning anything which could be justified on the basis of physical capital investment alone. Since 1948 output per person has grown by 2.3% annually. Out of that, the contribution of physical capital is only 0.9% (see page 6 of this BLS release)

Second, I think PGL misunderstands the arithmetic of R&D. If R&D is an investment, then spending on R&D creates a long-lived asset with a rate of return. If that rate of return exceeds the interest rate on debt, then it is socially beneficial to borrow to fund R&D expenditures. I don’t need to find other cuts to fund it.

To put it another way, suppose we were going to do the government budget the right way, and divide it into an operating budget and a capital budget. Then the right policy goal would be to hold down the deficit in the operating budget. R&D, however, would fall on the capital side of the ledger (because it’s a long-lived asset) and wouldn’t count against the operating budget deficit.

Unfortunately, PGL’s misunderstanding is shared by many economists and politicians, which is why R&D spending is vulnerable to cuts when Congress goes looking for money to fund hurricane recovery and the Iraq war.

[Incidentally, I appreciate this debate because it’s giving me a chance to get some things clear in my own mind]


TrackBack URL for this entry: http://blogs.businessweek.com/mt/mt-tb.cgi/

Reader Comments

Kartik

October 19, 2005 09:25 PM

So why can't a panel of intelligent economists go and educate the government about the follies of short-term, left-wing misguidedness?

Basic Research is currently only $52 billion, or 0.5% of GDP. It should be 1% of GDP, or $120 billion. This will generate trillions in new wealth in the years to come, by paying just 0.5% of GDP into this field.

And it is hardly an expenditure. It creates jobs for thousands of top PhDs, who in turn pay back a lot of income taxes already.

knzn

October 20, 2005 12:38 PM

Kartik: “left-wing misguidedness”? In case you hadn’t noticed, there are a lot of right-wing deficit hawks as well. And it is the right that particularly wants to attack the spending side rather than raising taxes. When a budget-busting bipartisan spending bill comes up, the dissenters are typically conservative Republicans. True, Clinton did cut the supercollider, but Reagan made similar cut-the-muscle mistakes in his early years.

I won’t let the left off the hook, though. If we are going to reduce the deficit by cutting spending, the best way to do it is by cutting the sacred cows of the left – entitlements and other benefits. If only those damn left-wingers like George W. Bush didn’t insist on increasing Medicare benefits!

Mike Reardon

October 21, 2005 03:24 AM

One of the advantages to outsourcing a massif tech base to foreign nations, is that they will do more of the heavy lifting in future tech R&D, Intel's investment in India will be fully supported by their education system. We gain by the reduction in the cost of products returned, and they will need to invest more in tomorrow's R&D.

The economics question is supported by R&D, effect on the reduction of product cost. The Federal Reserve sees clearly innovation increases product value, and that effect is counted against price inflation. We need to define only the proper direct for our, R&D investment.

We can not let up, on full support for R&D, in life enhancing health care in our country. More of our R&D's direction must be investing in our nations health care, and now is the right time to support this R&D investment.

Lord

October 21, 2005 02:14 PM

We need an asian country to develop something wonderful like the Soviet Union did with Sputnik in 1957. That would kick up out of our indifference.

pgl

October 23, 2005 07:22 PM

I did not misunderstand anything. You need to cut out your habit of misrepresenting what others have said. Beyond that - I agree with your call for having an operating budget v. a capital budget. But at the end of the day, a dollar spent by the government means taxes now or in the future. To restate the reality of budget constraints is not saying that investment in R&D is a bad thing. I never said it was. When you can recognize that we basically agree on a few things, maybe we can have a more productive dialogue.

Rant off and a recommendation. Dean Baker over at at Maxspeaks has a proposal on pharma R&D. You'll likely agree with at least part of it. Check it out and I'm hoping you provide a post on Dean's recommendation.

Jerrold Winger

December 15, 2007 12:51 AM

It is unfortunate that the government has a poor record in solving social problems or maintaining oversight in major areas, leading to the notion that anything the Government would do is wasted.. There is R&D that can and should be funded via the National Labs where private industry cannot afford the tab for specific areas, especially equipment. More importantly government R&D funding to the private sector is only effective when there exist imaginative goals, such as when JFK kicked off the space race with all the private sector outflow that resulted.

Beyond this I would encourage readers to buy my book entitled "The Delta of Technology" by Jerrold Winger. My news release follows.


News Release
Dec. 2007

The Delta of Technology

By Jerrold Winger

This book is for company executives, security analysts, academics, and investors in technology companies who want to separate the best companies from the rest by an earnings driven, yet simple analysis.

If you think that you don’t need this, then answer the following question by talking with your CFO for the next five minutes.

- Do you have a single benchmarking tool for measuring the impact of R&D on earnings for your company?

The Delta of R&D is that benchmarking tool. The Delta of R&D is defined as the difference between Earnings and R&D as a percent of Sales. This is the first time an aggregate number has been shown to be viable as a benchmarking tool. When the Delta of R&D is greater than four, this differential is large enough to separate the best corporations from the rest in terms of the effectiveness of utilizing R&D to effect earnings. These are called, high Delta companies.

The Delta Model has also revealed that a linear correlation could be developed for these Delta four companies. The correlation holds irrespective of the % R&D/Sales, invested by a company. Only the differential of Earnings minus R&D as a percent of Sales matters.

Dramatically, it was also shown that 20% to 30% of the top 100 American technology corporations met the Delta four criteria and the rest did not. The Delta four companies were largely doing everything right in a given year and the rest were not as evidence by poor earnings or insufficient earnings, or poor deployment of R&D or poor leadership or poor goal alignment or better competition or a host of other factors well explored in the open literature.

Nevertheless, a single figure of merit- The Delta of R&D greater than four, had been shown to separate the best from the rest.

This concept flies in the face of conventional wisdom in academia and among consultants
who claim that R&D has no measurable impact on any of the common business factors, such as Sales, Earnings, Growth or common stock performance.

Furthermore The Delta of R&D is an aggregate number that encompasses the impact of all R&D investments over a given time period, usually a year, regardless of the stage of the projects that are included in the aggregate. This means that while R&D is a leading indicator and Earnings are a lagging indicator, the Delta relationship holds over time.
There are many reasons for this but the simplest are probably the best. The R&D investment year to year is fairly constant as is shown in my book “the Delta of Technology”.

As important, company performance is not just dependant on investments but upon company values. Company values are a cultural event. This is amply covered in my book and ultimately is the factor that separates the best from the rest. Values are all those things which are considered valuable to the core business of the enterprise.

Lastly, is the relationship between R&D and Capital. R&D is an investment equal in importance to the Capital investment in a technology company. For R&D to be effective, Capital must be expended to deploy it in a timely and effective manner. Usually the R&D and Capital budgets are fairly uniform over time, changing by the rate of inflation and in a reasonably fixed ratio. This is a critical factor in the Delta Model and is essential to determining the contribution of R&D, Capital, and all other factors to Earnings. This can be shown in any given year and determines whether a company is Technology driven, Capital driven or Marketing driven.

Ultimately, the market determines the efficacy of the Delta Model, whether it be the market place of goods and services or the equity market of common stocks. When the common stock values are examined from 1995 by looking back five years and then forward five years for the top ten Delta companies and compared to the top ten R&D spenders, it is clear that Delta companies perform two to four times better than the top R&D spenders.

A complimentary copy can be obtained from the publisher, AuthorHouse Inc. Call the Book Order Department at 1-888-280-7715 or email them at bkorders@authorhouse.com.

You need only to confirm that your organization publishes a journal, newsletter or other media device and that you would like to review this new book for your subscribers.

All other copies can be purchased on line at Authorhouse.com or through Amazon, Borders and Barnes and Noble.

Thank you for your interest. This blog is no longer active.

 

About

Michael Mandel, BW's award-winning chief economist, provides his unique perspective on the hot economic issues of the day. From globalization to the future of work to the ups and downs of the financial markets, Mandel-named 2006 economic journalist of the year by the World Leadership Forum-offers cutting edge analysis and commentary.

BW Mall - Sponsored Links

Buy a link now!