Implications of the Recent Financial Crisis for Innovation

William Milberg and Nina ShapiroNew School for Social Research and Saint Peters College, respectively

Paper prepared for Ford Foundation Project on Finance for Innovation

Ford FoundationDecember 6th , 2012

Purpose of the research

Most discussion of the financial crisis has been on its excesses: the prominence of Ponzi-like finance and the underestimation of systemic financial risk.

This research focuses on the effects of finance on the real economy – the productive capabilities of firms and the innovations they develop.

Conclusion

What finance finances matters, perhaps even more than its excess: Only when finance finances real investment are there new technologies and products to develop and commercialize. Because it did not in the 2000s, there is justifiable concern about the long-term nature of our current economic stagnation.

Outline of the talk

1. Function of finance and the kind of finance innovation requires: equity vs. debt finance.

2. “q” theory and the relation between stock prices and innovation.

3. Comparison of 1920s/1990s/2000s. 4. Long-term consequences of

financialization.

The role of finance in production Finance is a prerequiste for economic

growth, i.e. for increases in production (Keynes) or for the introduction of new products and processes (Schumpeter).

Production can be financed in one of three ways:

(1)out of sales revenues.(2)through bank loans or other forms of debt. (3)through equity issues or other asset sales

(VC).

Innovation Finance: Debt or Equity?Innovation cannot be financed out of its

own revenues (doesn’t have any). That leaves debt or equity.

Debt

1. Bank loans not suited to innovation (contra Schumpeter):

Profit from innovation is indeterminable, too risky.

New ventures/start-ups have no collateral to offer.

Equity

Equity finance is only alternative to government finance in case of new venture:

Provide incentive needed for innovation financing (e.g. VC has prospect of return both from innovation and from capital gain through incorporation – IPO).

More suited to uncertainties of innovation than bank credit because they are open-ended and unconditional with no term limit.

Summary

Innovation has special financing requirements

1. Requires outside finance since innovation by definition can’t be self-financed.

2. Equity finance because risks of innovation too great for debt financing.

3. This equity financing can be provided (a) through internal equity or (b) through external equity (stock issue, VC or other).

Stock markets and innovation Stock market booms increase funds for

new ventures (capital gains more likely when stock prices rising).

Uncertainty of profits from new technologies can produce a stock market boom (and drive overinvestment).

Firms profitable enough for innovation don’t need funds from stock market, but can gain from speculation in the market, whose return rises with stock prices.

“q” theory

Stock market values firm assets and when this valuation rises above replacement cost (q>1) firm will increase capital investment (Tobin).

“q” theory critics

Overstates ability of stock market to value innovations to neglect of the role of management.

Fails to adequately evaluate firms’ human capabilities.

Empirical support is uneven.Nonetheless, q theory highlights critical

feature of capitalist economies: the dependence of their performance on the operation of the stock market.

1920s/1990s/2000s

Positive correlation between stock prices and innovative effort in the 1920s and 1990s, but not in the 2000s.

Two-way causality between stock prices and innovation in the 1920s and 1990s

“q” correlation disappears in the 2000s. 2000s marked by “financialization,”

including of non-financial firms, who turned to financial market speculation rather than innovative effort.

1920s: Technical Change and Roaring Equities (1) Scientific and technological developments in

1920s (along with continued R&D in 1930s) produced wave of productivity-enhancing innovations in chemicals, railroads, electrical machinery, aviation (Field, 2003).

Non-residential investment/GDP very high and a “Schumpeterian bunching of investments” in electrification, radio, telephone, chemicals and motor vehicles (Gordon and Veitch, 1986, Devine, 1983)

Stock Prices and Patents, 1910-1940

1920s: Technical Change and Roaring Equities (2)

O’Sullivan (2007) stock market role in financing of new firms in aviation and radio.

Nicholas (2007): Industrial innovation drove up stock prices.

1990s: Dot-Com Boom and Bust As in the 1920s, positive correlation between

stock price indexes and investment. Minskyan investment boom (9.4% annual

growth in pnrfi from 1992-1999), combined with financial innovation (new market valuation—”mind share” not net income).

Causality runs both ways (Fazzari vs. Perez) Stock price boom correlated also with boom in

innovation effort (R&D), dominated by “younger” firms (Brown, Fazzari, Peterson). Bull market can even encourage startups.

Stock Prices and Investment as a % of GDP, 1985-2011

Stock Prices and R&D Spending as a % of Profits, 1991-2007

2000s: Boom/Bust/Financialization Correlation between stock price boom and

investment/innovation breaks down. Instead, financialization. (A) Finance’s share

of US corporate profits reaches 40%. (B) historic highs in financial holdings of non-financial corporations, reaching 50%.

NFC share buybacks and dividends explode. Bull market not associated with innovation in

way q theory, and history, would predict.

Finance: Share of US Corporate Profits, 1950-2011 (%)

NFC Financial Assets as share of Total Assets, 1952-2012 (%)

Net Dividends and Share Buybacks as a share of Internal Funds, 1951-2012 (%)

NFC financialization as shiftin managerial strategy

Gradual shift to goal of short-term capital gain through stock price increase takes precedent to goal of increasing profits through investment in real assets.

Executive compensation in stock options gave managers greater incentive to focus on short-term movements in share price.

Expansion of low-cost productive capacity overseas gave management ability to focus on “core competence” and reduce domestic investment.

R&D Expenditures, Stock Prices and Housing Prices, 1990-2012

Conclusions

1. Innovation has special financing requirements, best suited to equity finance: can’t be financed out of own revenues, and returns too uncertain for debt financing.

2. Internal equity not available to new ventures and existing ventures have access to internal equity, but can also distribute profits rather than reinvest.

3. Stock market booms in 1920s and 1990s positively associated with growth in investment and innovation (direction of causality debated).

Conclusion

4. Financialization of the economy affected NFCs and they became more like financial concerns, with speculation rather than enterprise driving their investment.

5. This changed the relation between innovation and stock prices by the 2000s.

6. Finance failed to finance NFC investment and innovation, and there is justifiable concern about the long-term nature of the current economic stagnation.

Additional slides

NFC Financial Assets, End 2011 ($billions)

NFC Acquisition of Financial Assets, 1950-2011 ($ trillions)