Chapter 7. Growth Policy Design for Middle-Income Countries

Reda Cherif, Fuad Hasanov, and Min Zhu
Published Date:
April 2016
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Philippe Aghion

How can middle-income countries enhance productivity growth, helping them to avoid the so-called middle-income trap? This chapter discusses potential determinants of firm-level productivity and productivity growth. It considers potential barriers to growth in firm size, and then revisits the role for vertical targeting (or sectoral policies). Drawing on this discussion, it proposes some elements of a new growth strategy for middle-income countries.

Enhancing Productivity Growth

This section looks at the determinants of productivity growth, based on the following questions. How can it be enhanced in advanced countries versus emerging market economies? And is there anything to learn from observing the big technological waves and their diffusion patterns across countries? We first present a simple framework to discuss sources of productivity growth. We then look at the sources of this growth in advanced countries and emerging market economies. The section closes with an analysis of the technological waves and draws a few lessons from comparing the differences in their diffusion patterns across countries.

A Framework to Think about the Sources of Productivity Growth

Solow (1956) developed a model to show that in the absence of technical progress, there can be no long-term growth of GDP per capita. On the other hand, historical evidence suggests that productivity growth is an increasingly important component of growth (for example, see Helpman 2004). But what are the sources of productivity growth? A useful framework for thinking about productivity growth and its determinants is the so-called Schumpeterian paradigm, which revolves around four main ideas.

First, productivity growth relies on profit-motivated innovations. These can be process innovations to increase the productivity of production factors (for example, labor or capital); product innovations (introducing new products); or organizational innovations (to make the combination of production factors more efficient). Policies and institutions that increase the expected benefits should induce more innovation and thus faster productivity growth. In particular, this means better intellectual property rights protection, research and development (R&D) tax credits, more intense competition, and better-performing schools and universities.

Second is creative destruction. Here, new innovations tend to make old innovations, old technologies, and old skills obsolete. And this in turn underlies the importance of reallocation in the growth process.

Third, innovations may be either “frontier” innovations, pushing frontier technology forward in a particular sector, or “imitative” or “adaptive” innovations allowing a firm or sector to catch up with the existing technological frontier. The two forms require different types of policies and institutions.

Fourth is Schumpeterian waves. This is where technological history is shaped by the big technological waves that correspond to the diffusion of new “general-purpose technologies”—for example, the steam engine, electricity, and information and communication technologies (ICT)—to various sectors of the economy.

Enhancing Productivity Growth in Advanced Countries

To enhance productivity growth in advanced countries, where it relies more on frontier innovations, it helps to invest more in universities to maximize flexibility of product and labor markets and to develop financial systems that, importantly, rely on equity financing.

Aghion, Blundell, and others (2009) show how competition (measured here by the lagged foreign entry rate) affects productivity growth in domestic incumbent firms. We see that, on average, productivity growth in firms that are closer to the technological frontier worldwide in their sector (compared with the median) quickens amid more intense competition. This reflects an “escape competition effect” (such firms innovate more to escape more intense competition). In contrast, productivity growth in firms farther from the technological frontier in their sector worldwide than the median reacts negatively to more intense competition. This reflects a “discouragement effect.” In sum, the closer a country is to the world’s leading productivity level, the higher is the fraction of above-the-median firms, and therefore product market competition is more productivity enhancing. Similarly, one can show that more flexible labor markets, which facilitate creative destruction, foster productivity growth more in advanced economies.

Another lever of productivity growth in advanced economies is graduate education; indeed, frontier innovation requires frontier researchers. Aghion, Boustan, and others (2009) show that research education enhances productivity growth more in states that are relatively closer to the frontier in the United States; that is, those with higher GDP per capita, such as California and Massachusetts. Two years of college education, meanwhile, enhances productivity growth more in less advanced states, such as Alabama and Mississippi. The same is true across countries: higher education, especially graduate education, enhances productivity growth more in countries with higher GDP per capita.

The organization of the financial sector is also important for productivity growth. As Koch (2014) shows, choosing a bank-based financial system enhances productivity growth more in less advanced countries, whereas choosing a market-based financial system enhances productivity growth more in countries that are relatively closer to the frontier.

Aghion, Askenazy, and others (2009) conducted cross-country panel regressions of productivity growth on the share of ICT in total value added, and found a positive significant effect. But interestingly, once they control for product market regulation, the coefficient on ICT becomes nonsignificant. This in turn suggests that liberalizing product markets is key to enhancing productivity growth in developed countries, also because it facilitates the diffusion of the ICT wave through various sectors of the economy. Cette and Lopez (2012), who confirm this result, show that the euro area and Japan suffer from a lack of ICT diffusion compared with the United States.1 Using an econometric analysis, they show that this is explained by institutional factors: a lower education level, on average, of the working-age population and more regulations on labor and product markets in the euro area and Japan. This result means that by implementing structural reforms, these countries could benefit from productivity acceleration linked to a catch-up of the U.S. ICT diffusion level.

Cette, Lopez, and Mairesse (2013) analyze the impact of anticompetitive regulations in upstream service industry sectors on productivity growth in downstream industries using inputs from upstream sectors. Using an unbalanced country-industry panel dataset covering 15 countries in the Organisation for Economic Co-operation and Development during 1987–2007, the authors find that anticompetitive upstream regulations have a significantly detrimental effect on productivity growth downstream, and that this effect operates in part (but not entirely) through R&D and ICT investments in downstream industries.

Productivity Growth in Emerging Market Economies

Hsieh and Klenow (2009), looking at the sources of productivity growth in emerging market economies where adaptive innovation and factor accumulation are the main sources of growth, emphasize the importance of input reallocation effects. In particular, if we compare the distribution of firm productivity in India and in the United States, the latter has a thinner tail of less productive plants and a fatter tail of more productive plants than India. In other words, it is harder for a more productive firm to grow, but also easier for a less productive firm to survive in India than in the United States. Thus, the creative destruction process operates more efficiently in the latter. This difference is attributable to various potential factors; in particular, more rigid capital markets and labor and product markets in India, the lower supply of skills in India compared to the United States, the poorer quality of infrastructure in India, and the lower quality of institutions to protect property rights and to enforce contracts in India. These factors in turn operate on productivity growth through several potential channels. The management practices channel is particularly interesting. Recent work (for example, Bloom and Van Reenen 2010) shows that management practices are far worse in India than in the United States, and that the average management scores across countries are strongly correlated with the level of GDP per capita.

Obstacles to Growth in Firms

A large body of literature discusses firm dynamics and its impact on aggregate productivity growth. On the theory side, state-of-the-art work on the interplay between growth, reallocation, and firm dynamics are papers by Klette and Kortum (2004), Acemoglu and others (2013), and Akcigit, Alp, and Peters (2014). These papers build on the Schumpeterian growth paradigm (see Aghion and Howitt 1992, and Aghion, Akcigit, and Howitt 2013) to model firms as multi-line producers and innovators. Innovation improves a firm’s productivity in producing a particular intermediate input, and it allows an incumbent firm to expand its scope (that is, the number of product lines it operates in). Successful innovation by an outsider on a product line covered by an incumbent firm eliminates that line from that firm’s range of products, shrinking the number of product lines it covers. This framework generates an ergodic steady-state firm size distribution, which depends on the innovation technology, government policy toward incumbent firms and towards potential entrants, and regulatory or credit market characteristics, which will also affect the ability of firms to enter and grow after entry.

In particular, the Schumpeterian framework can account for various stylized facts about firm dynamics and firm size distribution. Some of these facts are:

  • The firm size distribution is highly skewed.

  • Firm size and age are highly correlated (in this framework, new firms are one-line firms, and to become large with sufficient lines they need to have innovated on all these lines and survived creative destruction on a sufficient number of lines that they used to operate on).

  • Small firms exit more frequently (it takes only one outside innovation to eliminate a one-line firm whereas it takes several successful outside innovations to eliminate an initially multi-line firm), but the ones that survive tend to grow faster than average (such a firm is more likely to be an efficient innovator, as well as being able to exploit R&D synergies across its multiple lines).

  • A large fraction of total R&D in the United States is done by incumbents.

  • The reallocation of inputs between entrants and incumbents is an important source of productivity growth.

This framework can also explain why factors that inhibit firm size growth in developing economies also inhibit aggregate productivity growth. For example, Akcigit, Alp, and Peters (2014) argue that in developing economies contractual frictions become more dramatic as firms grow. It becomes increasingly hard to avoid hold-up by firm managers as the number of product lines controlled by a firm increases. This in turn inhibits the growth of the most efficient firms (that is, firms with higher innovation capabilities), and such firms have lower incentive to grow, because firm owners want to mitigate the hold-up problem with their managers. Less efficient firms thus remain active for longer before more efficient firms replace them.

Although contractual incompleteness and lack of trust are obvious obstacles to firm growth, previous studies have also emphasized adjustment costs induced by R&D and advertising of incumbent firms, administrative costs of creating a new firm, and labor market regulations.

Aghion, Fally, and Scarpetta (2007) present empirical evidence on the effect of financial development on the entry of new firms of different size and on the post-entry growth of successful entrants. They use harmonized firm-level data on entry and post-entry growth by industry, size class, and over time for a sample of industrialized, transitional, and Latin American countries as in Bartelsman, Haltiwanger, Scarpetta (2004). They consider two main indicators of financial development: the ratio of private credit and stock market capitalization. In their estimation, they use a detailed set of regulatory indicators that characterize the banking and securities markets as instruments for these financial development variables. Following Rajan and Zingales (1998), to minimize problems of omitted variable bias and other misspecification, they interact different indicators of financial development with the relative dependence on external financing of the corresponding sector in the United States.

The main results in Aghion, Fally, and Scarpetta (2007) are as follows. First, higher financial development enhances new firm entry in sectors that depend more heavily upon external finance. Second, the entry of the smallest firms benefits the most from higher financial development, whereas financial development has either no or negative effect on entry by larger firms. And third, financial development enhances the post-entry growth of firms in sectors that depend more upon external finance, even when controlling for labor market regulations.2

The effect of regulations on firm dynamics and size is itself a fascinating topic that has barely been touched. An interesting paper by Garicano, Lelarge, and Van Reenen (2013) analyzes the static welfare effects of the 50-employee regulatory threshold in France. They point to a significant source of allocative inefficiency (namely, an inefficient concentration of firm size just below the threshold).

Do We Still Need Vertically Targeted Policies?

The Debate

The change of emphasis from industry-level to firm-level competitiveness, the evidence on the relationship between firm-level competitiveness and firm-level productivity, and the discussion on the determinants and policies to enhance productivity growth point toward giving priority to horizontal targeting, that is, to policies (be they competition, labor market liberalization, patent and R&D policies, among others) that enhance productivity growth in all sectors. This approach is the alternative to focusing on vertical targeting (policies aimed at promoting particular industries in the worldwide competition with similar industries in other countries).

Vertical targeting was popular in the aftermath of World War II. The World Bank and other international financial institutions welcomed import substitution policies in Latin American countries, whereby local industries would more fully benefit from domestic demand. Similarly, these institutions supported East Asian countries such as Japan or Korea that engaged in export promotion (for example, through tariffs and nontariff barriers, and partly through maintaining undervalued exchange rates). For some two or three decades after World War II, these policies, which belong to what is commonly referred to as “industrial policy,” remained fairly noncontroversial, as both groups of countries were growing rapidly.

However, vertical targeting has come under increasing criticism since the early 1980s among academics and policy advisers in international financial institutions. In particular, it was criticized for allowing governments to pick winners and losers in a discretionary fashion, and consequently for increasing the scope for capture of government by local vested interests. Empirical studies by Frankel and Romer (1999) and Wacziarg (2001), pointing at a positive effect of trade liberalization on growth, reinforce the case against vertical targeting, as does recent work on competition and growth (for example, Aghion and others 2005, and Aghion and Howitt 2006).

However, three phenomena that have occurred since the 2000s invite us to rethink the issue. First, climate change and the increasing awareness that without government intervention to encourage clean production and innovation, global warming will intensify and generate negative externalities worldwide, such as drought, deforestation, migration, and conflicts. Second, the global financial crisis revealed the extent to which laissez-faire policies led several countries, in particular in southern Europe, to allow the uncontrolled development of nontradable sectors (particularly real estate) at the expense of tradable sectors that are more conducive to long-term convergence and innovation. And third, China has become so prominent on the world economic stage in large part because of its constant pursuit of industrial policy. An increasing number of scholars, particularly in the United States, are now denouncing the danger of the laissez-faire policies that lead developed economies to specialize in upstream R&D and in services, while outsourcing manufacturing tasks to developing economies with lower unskilled labor costs. These scholars point to the fact that countries like Germany and Japan have better managed to maintain intermediate manufacturing segments of their value chains by pursuing more active industrial policies, and that this in turn allowed them to benefit more from outsourcing other segments.

As noted, the most recurrent counterargument to industrial interventionism is the one on picking winners. True, industrial policy is always somewhat about picking winners, but as Vincent Cable, the United Kingdom’s former Secretary of State for Business, Innovation, and Skills, points out, “the ‘winners’ in this sense are the skills we judge we will need for the future, and the sectors they support” (Cable 2010). However, this chapter argues that the picking-winners argument loses bite; first when a government chooses to pick sectors and not particular firms, and second when it uses sectoral interventions in a way that preserves or even enhances competition and Schumpeterian selection within the corresponding sectors.

Another criticism of traditional industrial policy is the risk of capture and rent-seeking behavior. But again, setting clear principles for the selection of sectors and for the governance of support to these sectors (competitiveness, exit mechanisms, and so on) should help address this criticism.

More fundamentally, knowledge spillovers are an important theoretical argument supporting growth-enhancing sectoral policies. For example, firms that choose to innovate in dirty technologies do not internalize the fact that current advances in such technologies tend also to make future innovations in them more profitable. More generally, when choosing where to produce and innovate, firms do not internalize the positive or negative externalities that these factors might have on other firms and sectors. Credit constraints are a reinforcing factor that may further limit or slow the reallocation of firms toward new, more growth-enhancing sectors. One can argue that the existence of market failures on their own is not sufficient to justify sectoral intervention. Even so, there are activities, typically in high-tech sectors, which generate knowledge spillovers on the rest of the economy, and where assets are highly intangible, making it more difficult for firms to borrow from private capital markets to finance their growth. As such, there might indeed be a case for subsidizing entry and innovation in these sectors, and to do so in a way that guarantees fair competition within the sector. Note that the sectors that typically come to mind are always the same four or five: notably, energy, biotech, ICT, and transportation.

Rethinking the Design and Governance of Industrial Policy

A convincing empirical study in support of properly designed industrial policy is Nunn and Trefler (2010). These authors use microdata on a set of countries to analyze whether, as suggested by the argument of “infant industry,” productivity growth in a country is positively affected by the measure in which tariff protection is biased in favor of activities and sectors that are skill-intensive (that is, they use more intensively skilled workers). They find a significant positive correlation between productivity growth and the “skill bias” resulting from tariff protection. Of course, such a correlation does not necessarily mean there is causality—the two variables may themselves be the result of a third factor such as the quality of a country’s institutions. However, Nunn and Trefler (2010) do show that at least 25 percent of the correlation corresponds to a causal effect. Overall, their analysis suggests that adequately designed (meaning, in this instance, skill-intensive) targeting may actually enhance growth, not only in the sector being subsidized, but also in the country as a whole.

Aghion and others (2012) argue that sectoral policy should not be systematically opposed to competition policy. First, they develop a simple model showing that targeted subsidies can be used to induce several firms to operate in the same sector, and that the more competitive the sector is, the more firms will be induced to innovate to escape competition. Of course, a lot depends upon the design of industrial policy, which should target sectors and not particular firms (or “national champions”). This in turn suggests new empirical analyses in which productivity growth, patenting, or other measures of innovation and entrepreneurship would be regressed over some measures of sectoral intervention. These measures would be interacted with the degree of competition in a sector, and with the extent to which intervention in each sector is not concentrated on a single firm, but rather distributed over a number of firms.

To look at the interaction between state subsidies to a sector and the level of product market competition in that sector, Aghion and others (2012) use Chinese firm-level panel data3 for all industrial firms in the Chinese National Business Survey (an annual survey of all firms with more than 5 million sales). The sample period is 1988–2007, and the survey contains information on inputs and outputs, firm-level state subsidies, and so on. Product market competition is measured by one minus the Lerner index, which in turn is calculated as the ratio of operating profits minus capital costs over sales. The authors show that total factor productivity (TFP), TFP growth, and product innovation (defined as the ratio between output value generated by new products to total output value) are all positively correlated with the interaction between state aid to a sector and market competition in that sector. Thus, the more competitive the recipient sector, the more positive the effects of targeted state subsidies to that sector on TFP, TFP growth, and product innovation. In fact, they show that for sectors with a low degree of competition the effects are negative, whereas the effects become positive in sectors with a sufficiently high degree of competition. They also show that the interaction between state aid and product market competition in a sector is more positive when state aid is less concentrated. In fact, if one restricts attention to the second quartile in the degree of concentration of state aid (this refers to sectors where state aid is not very concentrated), then state aid has a positive effect on TFP and product innovation in all sectors with more than a median level of product market competition.

Clean Innovations

Firms in a laissez-faire economy may innovate in the wrong direction, for example, in polluting energy activities, because they have acquired expertise on such activities and have not taken into account the environmental and the knowledge externalities that their choice entails. Aghion and others (2013) explore a cross-country panel data set of patents in the automotive industry. They distinguish between “dirty innovations,” which affect combustion engines, and clean innovations, such as electric cars. They show that the larger the stock of past dirty innovations by a given entrepreneur, the dirtier are the current innovations by the same entrepreneur. This path-dependent phenomenon, together with the fact that innovations have been mostly dirty so far, implies that in the absence of government intervention, economies would generate too many dirty innovations. Hence, there is a role for government intervention to redirect technical change toward clean innovations.

As Acemoglu and others (2012) argue, delaying such directed intervention not only leads to further deterioration of the environment, but also longer delay in the introduction of clean innovations. The dirty innovation machine continues to strengthen its lead, making dirty technologies more productive and widening the productivity gap between dirty and clean technologies even further. This widened gap in turn requires a longer period for clean technologies to catch up and replace the dirty ones. Because this catching-up period is characterized by slower growth, the cost of delaying intervention in foregone growth will be higher. In other words, delaying action is costly.

Not surprisingly, the shorter the delay and the higher the discount rate (that is, the lower the value put on the future), the lower the cost will be. This is because the gains from delaying intervention are realized at the start in the form of higher consumption, while the loss occurs in the future through more environmental degradation and lower consumption. Moreover, because there are basically two problems to deal with—the environmental and innovation ones—using two instruments proves better than one. Here, the optimal policy involves using a carbon price to deal with the environmental externality, and, at the same time, direct subsidies to clean R&D (or a profit tax on dirty technologies) to deal with the knowledge externality. This approach, again, calls for vertical targeting.

One could always argue that a carbon price on its own deals with both environmental and knowledge externalities at the same time (discouraging the use of dirty technologies also discourages innovation in dirty technologies). However, relying on the carbon price alone leads to an excessive reduction in consumption in the short term. Because the two-instrument policy reduces the short-term cost in foregone short-term consumption, it reinforces the case for immediate implementation, even for values of the discount rate under which standard models would suggest delaying implementation.

In sum, the overall discussion in this section suggests that adequately targeted sectoral intervention—for example, to more skill-intensive or more competitive sectors—can be growth-enhancing. We have also argued against concentrating subsidies across firms in a sector. However, this is just the starting point for a much broader research program on how to govern industrial policy to make it more competition-friendly and more innovation-enhancing. In particular, how can industrial policy be designed to ensure that nonperforming projects will not be refinanced? And how should governments update their doctrine and practice of competition policy to factor in the latest thinking on how to design and implement industrial policy? The conjunction of the debate on climate change, the global financial crisis, and China’s new dominance on the world market reinforces our conviction that although market competition is certainly the main engine of growth, specialization cannot be left entirely to the dynamics of laissez-faire. One increasingly realizes that the specialization model, whereby the most advanced economies focus on upstream R&D and services and outsource everything else to emerging market economies, may not be sustainable in the long term.

Implications for the Design of a New Growth Package in Middle-Income Countries

Although improving management in existing firms can achieve more catch-up or reallocation-based growth (as just discussed), further liberalizing labor flows from rural to urban areas, developing the financial sector, and liberalizing capital flows will not be sustainable in the long term. There are several reasons for this; in particular, efficiency gains from reallocating resources from agriculture to industry and from absorption of imported technologies will be exhausted once the reallocation is completed. And wage increases will reduce an emerging market economy’s comparative advantage in what it currently exports to the rest of the world.

Two questions thus naturally arise: How can an emerging market economy avoid the middle-income trap and make a successful transition from catch-up growth to innovation-led growth? And how can such a country achieve higher quality growth in this process? Our discussion on firm-level productivity growth as the ultimate source of competitiveness, as well as on the drivers of productivity growth, suggest four pillars of an innovation-based economy:

  • Competition and creative destruction—Frontier innovation is fostered by competition and free entry to a much larger extent than imitation because incumbent firms at the technological frontier can escape competition and the threat of entry by innovating, and because most path-breaking innovations are made by new entrants. Checks and balances are therefore necessary to guarantee free entry and full competition, because this helps minimize the scope for collusion between local politicians and large incumbent firms.

  • Top research universities (that is, those with very high Shanghai rankings)—Recent work on the subject suggests that to achieve such rankings more investment is needed in the university system, and that universities have autonomy on budget management, wage policy, hiring and firing decisions, and the design of academic programs. This autonomy must come hand in hand with more effective competition among universities as well as researchers. As for other sectors of the economy, upward accountability has to be replaced by more downward accountability and competitive pressure (Aghion and others 2010).

  • A dynamic labor market system—This needs to combine (1) flexibility for firms to hire and fire; (2) a good training system to help workers move from one job to another; and (3) a social safety net with well-developed portable social security and pension rights, and with generous unemployment benefits (in turn conditional on the unemployed worker training and then accepting new jobs). Such a “flexicurity” system, incorporating both flexibility and security, makes creative destruction—and therefore innovation-led growth—work at full speed.

  • A financial system that relies more on venture capital, private equity, and stock markets—Innovative investments are more risky and therefore investors need to get both a share of upside returns and control rights.

Consequently, which organizational and institutional changes (if any) does an emerging market economy need to introduce to move toward full-steam innovation-led growth? Obviously, we do not have the answer to this question, because we lack knowledge on how the current institutional system is organized and how it works in practice.

Yet, empirical and casual evidence suggests that a “smart” state can stimulate the innovation-led machinery by setting up a fiscal system that achieves the triple goal of (1) raising revenue to make innovation-enhancing investments in education, universities, and infrastructure; (2) being redistributive to avoid excessive inequality and poverty traps; and (3) encouraging innovation by not expropriating innovators. In addition, the smart state can achieve this by setting up adequate institutional mechanisms to strengthen checks and balances on the different levels of government to make sure that competition is fully enforced (as already argued), and that state investments aimed at enhancing innovation are properly targeted and monitored.

It would be somewhat paradoxical to recommend that an emerging market economy move from imitation-led to innovation-led growth by simply imitating the institutional arrangements of existing innovation-led economies. Instead, each country must find its own way to reform its state institutions to make the four pillars work fully. It must find its own answers to questions such as: How can they set up fully effective competition policy instruments and mechanisms starting from the current institutional context? Which contractual, organizational, or institutional changes should be introduced, in particular at the regional and local level for the country to gain full momentum in implementing sustainable and inclusive innovation-led growth? How can environmental and social (that is, inclusiveness) dimensions be factored in, in addition to GDP growth, when evaluating regional or local leaders and organizing the yardstick competition among them? How can the tax and welfare system be improved to reach best standards and practices among innovating countries, and, in particular, reconcile the need for redistribution and the need to finance good public infrastructure and services with innovation incentives?


In this chapter, we have taken on board modern trade economics, and, in particular, the idea that a country’s competitiveness boils down to the competitiveness of its individual enterprises. We reported on recent empirical work showing that firm-level competitiveness is related to the productivity of firms and their ability to grow. We then looked at determinants of firm-level productivity and at potential obstacles that may inhibit growth in the size of firms. Finally, we have argued that while enhancing firm-level productivity growth calls first for horizontal policies (product and labor market liberalization, trade liberalization, higher education investments, and so on), there may be a case for vertically targeted (sectoral) policies provided these are properly designed and governed.

To conclude the discussion, we address the delicate issue of macroeconomic policy. Recent studies (Aghion, Hemous, and Kharroubi 2009 and Aghion, Farhi, and Kharroubi 2012) at the cross-country and cross-industry level show that more countercyclical fiscal and monetary policies enhance growth. Fiscal policy countercyclicality refers to countries increasing their public deficits and debt in recessions but reducing them in upturns. Monetary policy countercyclicality refers to central banks letting real short-term interest rates go down in recessions, and having them increase during upturns. Such policies can help credit-constrained or liquidity-constrained firms pursue innovative investments (R&D, skills and training, and so on) over the cycle despite credit tightening during recessions. It also helps maintain aggregate consumption and therefore the market size of firms over the cycle, as argued earlier (Aghion and Howitt 2009, Chapter 13). This in turn suggests that an innovation-based economy would benefit from more countercyclical macroeconomic policies, with higher deficits and lower real interest rates in recessions, and lower deficits and higher real interest rates in booms, to help credit-constrained innovative firms maintain their R&D and other types of growth-enhancing investments over the business cycle.


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The euro area here is the aggregation of Austria, Finland, France, Germany, Italy, the Netherlands, and Spain. These seven countries together represented 88½ percent of the euro area’s GDP in 2012. See Figure 4 in Cette and Lopez (2012).

Previous work on the subject includes Beck and others (2008), who find that financial development is more growth enhancing for industries that rely more on small firms (measured by the share of small firms in the respective U.S. industry). In the same vein, Beck, Demirgüç-Kunt, and Maksimovic (2005) use a firm survey to assess firms’perceptions of financial constraints. They find that small firms tend to be more affected by financial as well as legal and corruption issues than larger firms.

Data showing how much state aid each sector receives are not available for European Union countries.

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