Innovating in a Downturn

David M. Warm, Bharat Rao NYU-Poly, Polytechnic Institute of NYU, Management Dept., Six MetroTech

Center, Brooklyn, NY 11201

Abstract

Large multinational companies typically look to grow market share and expand globally

by scaling up R&D investments. The goal of these investments could include new

processes or technologies resulting in new products and services. When revenues are

high and capital is readily available, these investments are seen as a route to achieve

growth and stay competitive. But when revenues are down, prices are falling and credit

markets dry up, large investments in R&D and new innovations seem counterintuitive.

Should companies stop making these types of investments and only look at cutting

costs, downsizing staff and scaling back operations in order to survive a downturn? Or

are there ways to continue innovating, not only to withstand the current downturn, but

also to create a competitive advantage that could help propel the company into its next

wave of opportunity and growth?

This paper reviews the existing literature on the phenomenon of business cycles to see

whether innovation can occur during recessionary times and economic booms and what

role it has played in impacting the business cycle. It provides numerous examples of

successful innovations that occurred during economic downturns in the past and

identifies key attributes that made them successful.

Introduction

At its simplest core, “Innovation” is defined as “the introduction of something new” [11].

Using this broad definition, we would expect that large multinational companies should

be able find a way to create new products or processes even under the most difficult

economic downturns, like the global recession we are facing today. But as we assess

the tumultuous times that have befallen both the United States and the rest of the world,

perhaps seen since the Great Depression of 1929, there are critical questions

underlining the future of innovative activity. Do CEOs and other corporate business

leaders, who are now so focused on cost cutting measures such as employee

downsizing and spending reductions to improve cash flow and stay in business, have

the time, funding or inclination to even consider doing something new and innovative.

And why would they? – innovation has been associated and practically coalesced with

“growth”, a term that normally is associated with higher revenues and market share,

capital spending on new equipment and facilities, global expansion, new projects and

increasing employment within the corporate world [22].

In this paper, we assert that innovation can not only occur during an economic downturn

or recession, but is the very path corporations collectively around the world need to

consider to lift themselves out of this period of economic contraction and back on the

road to growth, profitability and financial stability. Through innovation, a period of

protracted financial and economic depression could be diminished or avoided, and lead

to eventual economic recovery. We are not suggesting that innovation alone will help

firms rise out of a global economic downturn – there are a host of political, social and

other complex economic factors that come into play, however it is an important factor for

individual companies to consider. In fact, in may be the only factor firms have direct

and effective control over.

In the following section, we review the existing literature on innovation and economic

downturns for some hints of how downturns occur, how economic theory explains them,

and what role innovation plays in the recovery process.

Economic Business Cycles and Innovation

The idea that innovations can actually help pull corporations out of the downward spiral

of an economic recession is not be that hard to conceive given that history

demonstrates the world operates in repeating economic cycles. Extensive research has

been done on these so-called Kondratieff cycles of capitalist development, which last

around 55 years each [24]. Reviewing economic trends over a time period of 150

years, the Russian economist Kondratieff suggested a connection between

technological innovation and the cycles of prosperity and recession. The Kondratieff

cycle is a period of prosperity, followed by recession, depression, and finally revival. A

number of innovations during the period of revival lead to considerable prosperity, which

in turn leads to reduced costs. Demand goes up as production capacity increases and

we move from a seller’s to a buyer’s market. Eventually a huge capital market develops.

In the period of recession, the economy reacts to saturated markets by cutting back on

R&D. Recession is followed by depression as unemployment sets in [21]. Other well-

known economists, including Arthur L. Burns, Joseph A. Schumpeter, Simon S.

Kuznets, Ernest Mandel and Walt W. Rostow, agree with many of the assertions

Kontradieff makes. These streams of thought have added to the discussion on business

cycles, which can be traced back to the period of 1787 to 1842, the era of the industrial

revolution. They generally agree that long, wave-like fluctuations of economic activity

do seem to exist, however there is disagreement as to which specific economic events

actually occur within these Kontradieff cycles and on the underlying reason these

activities seem to occur in cycles [24]. For the purpose of this paper, we assume that

there have been cyclical economic waves that have been controlled through uneven

economic, political-institutional and technological development factors and that these

economic swings have caused crises followed by recoveries.

These cycles are further described by Schumpeter as “the circular flow” – “an economic

process that goes on at even rates or, more precisely, an economic process that merely

reproduces itself” [6]. What the literature seems to conclude from Schumpeter’s

research is this is that during “the circular flow”, that there are simultaneous interactions

that support equilibrium theory, meaning periods of stability and inter-temporal

interactions that support dynamic theory, or the development of “disruptions” that move

the cycle from its equilibrium state into a new phase of the cycle. These disruptions can

be both endogenous and exogenous, meaning they can arise from within a firm or can

be caused by external factors such as consumer tastes, population growth or other

social factors that companies have no control over, but can have an effect on how slow

or fast economic activity may occur [6]. Schumpeter further argues that disruptions that

occur endogenously are initiated by entrepreneurs, who act as change agents and

foster “clusters of innovation”, which are essentially many different innovations that get

started at almost the same time and place. A cluster of innovation starts with a single

innovation, which is perceived as one that opens new opportunities for profit and

growth, but then begins to perpetuate others to try to innovate and replicate the same

beneficial results. This “snowball effect” continues until the economy grows to the point

of saturation such that the potential for profits are reduced and the economic expansion

finally exhausts itself, leading to a new state of equilibrium [6]. Once the economy

reaches “growth saturation”, there is no place left to go but downward, such as what

occurred in the stock market crash in 1987, the tech bubble burst in the late 1990s and

most recently the housing bubble burst towards the end of 2007, the latest casualty of a

peak in economic expansion that proved to be unsustainable and which further proves

that the “the circular flow” economic cycle Schumpeter describes does indeed exist [17].

It is important to reiterate that even though innovation seems to be a key component to

disrupting the equilibrium in an economic cycle that facilitates the movement of the

cycle forward, such as out of a recession and into a period of growth and recovery, that

there are many factors at play and innovations themselves may not be enough to make

this happen. In addition, these disruptions in the cycle do not occur at regular intervals

even when the same ingredients are present. For example, political-institutional factors,

such as those explained by Marxist theory like those related to unproductive state

funded social or military programs may have an effect on how much a innovation cluster

can disrupt the cycle [24]. Even with these considerations, if companies can create

clusters of innovations, like many sparks working in unison that together ignite into a

flame, the foundation of a technological revolution may be started which can be

disruptive enough to carry out major changes in the status quo. These would typically

be measured by the extent of industrial restructuring, growth within industries, and the

creation of new markets that considerably can alter the economic and political

organizations that prevail in society, bootstrapping the business cycle’s movement into

the next phase, towards a recovery [24].

Figure 1 - Business Cycle [20]

Business cycles as they are known today were analyzed more thoroughly in a book by

Arthur Burns and Wesley Mitchell, Measuring Business Cycles (1946), that explained

that economic indicators move together in groups that are called “booms” which are

periods of expansion and growth and “downturns”, periods of depression where outputs

of goods and services decline [20]. Business cycles actually are not “cycles” at all, but

rather “periods” of economic stability followed by an upswing towards a “boom” or a

downswing into a “trough” or bottoming out of the economy, which happen at irregular

intervals and for varying durations. These business cycle changes occur due to a

disruption of one form or another. For example, booms can be caused by an increase

in private or public spending, while monetary policy, such as the Fed raising interest

rates, can cause the economy to slow down as the amount of borrowing and investment

is reduced due to the higher cost of funds [24].

R&D Investments During Recessions

As discussed earlier, a cluster of innovations all occurring around the same time and

place might spark the start of a technological revolution, which can cause enough of a

creative disruption that it precipitates the change in the business cycle needed to move

us out of a trough and upward towards our next peak. One obvious way companies can

foster innovation and help create this disruption is through increased R&D spending.

Developing new innovations through the use of R&D is inherently inefficient and

therefore it seems reasonable that during a recession it would be an ideal time for

managers to foster the innovation of new ideas and products, while productivity is less

of a concern since demand is lower and there is a reduced need to produce as much. In

order for this to work, there needs to be a reallocation of resources (e.g. people,

computer resources, etc.) from production areas to areas like product development,

thereby increasing R&D investment [3]. Although this train of thought makes sense,

empirical evidence shows the complete opposite is true. During recessionary periods

that have been tracked over the last 50 years, it has been shown that R&D spending at

US companies tends to fall in line with the declining growth rate, as measured in terms

of GDP, according to a report by the Chicago Federal Reserve. This study was based

on aggregated data captured by the National Science Foundation (NSF) and is

illustrated in Table 1 [3].

Table 1 – NSF Graph of US GDP and R&D Spending During Recessions (Gray Bands)

Source: Reference [3]. The data are from the Bureau of Labor Statistics.

Note: The series graphed is the seasonally adjusted civilian unemployment rate for those age sixteen and over. The shaded areas

indicate recessions.

One obvious conclusion one might draw is that companies have cash flow and credit

constraints, as we see in this recession, that effect how much they can investment in

R&D during a downturn. This is indeed a concern since R&D requires capital

investments up front, with a payoff that only comes sometime in the future, if at all.

When a company needs to borrow money in order to make a R&D investment and does

not have good credit, the cost might be prohibitive or relatively high versus the potential

return and risk involved. Gadi Barlevy, a senior economist and economic adviser

working in the research department of the Chicago Federal Reserve Bank, felt that all

companies would not have the same credit constraints and decided to review balance

sheet data on major, public US corporations in Standard and Poor’s Compustat

Database to see if his assumption was true and if so, whether there was another

explanation for the low investment in R&D during recessions by credit worthy and

relatively “unconstrained” cash flow companies [3].

Barlevy was able to identify a number of firms that had large amounts of ready cash or

credit lines they could borrow from, so he plotted these firm’s R&D investments on the

same graph as the NSF graph, overlaying the R&D amounts with the recessionary

periods. Ironically, R&D spending dipped even more for this set of firms (Table 2),

which seems totally irrational even in times which fiscal policy eased the ability for these

firms to borrow. Barlevy posits that an explanation for this behavior is that firms are

shortsighted and too focused on the immediate profits. R&D takes time to develop

innovations and once developed, need to be implemented in order to reap any profits.

The issue is that the implementation has its own time table and additional cost, which

may be too costly to undertake during a recession; many firms are reluctant to invest

heavily in R&D when they can’t immediately fund the implementation of an innovation

they conceive. For example, a product innovation that is patented with a detailed

description of the new product may be mimicked in some way relatively quickly by a

competitor if not implemented and brought to market quickly by the inventing company,

so as to gain a first mover advantage before others enter [3].

Table 2 - R&D Spending During Recessions (Gray Bands) – Unconstrained Firms

Source: Reference [3]. The data is from the S&P Compustat Database.

Additional arguments are made regarding strategic R&D investments during recessions

by Keith Roberts, a managing director of Profit Impact of Market Strategy (PIMS). He

equates R&D spending to “good costs” especially during a recession, because

successful, new product innovations that are created during a recession are critical to

providing a strong recovery in profitability and growth. This theory is supported by a

PIMS study done of a 1,000 British businesses over the past 30 years that concluded

companies that spend more on innovation during a downturn saw a return on capital

employed rise during the recovery, versus those who slashed spending [19]. “Good

costs” refer to costs that should be increased during a recession, “Bad costs” are those

that should be cut during a recession, and “It depends costs” are costs that may be

increased or decreased based on the strategic position of individual businesses. In his

study, Roberts used three metrics for measuring success: Average profitability during

recession or return on capital employed (ROCE), change in ROCE during first 2 years

of recovery, change in market share during first 2 years of recovery.

Table 3 – New Products Driving Strong Recovery

Source: Reference [13]. Footnote to table: ROCE is defined as “Return on Capital Employed”

Examples of Innovations During Downturns

To further the notion that R&D spending towards the goal of developing innovations is

important if not crucial during a downturn, here are some specific examples where this

type of investment paid off either very quickly once the innovation was introduced into

the marketplace or led the company to much larger market share gains and increased

profitability quicker than its competitors once the recession ended and the recovery

period ensued. The first two examples are from the UK, to illustrate that this is not just

a US phenomenon, but impacts other developed nations as well.

Midland Bank’s launch of First Direct in late 1989 was right at the start of a recession in

the UK, which continued into the early 1990s. Midland (now HSBC) developed the first

completely telephone-only banking service prior to the Internet taking off, with the

promise of banking without branches – truly innovative at that time. Not only did it rank

highest among banking consumers back then (80% approval) it completely

overshadowed its main competition who was Barclays (42% approval). They have

continued to innovate through recessions since and now have internet and mobile

banking, still continuing to attain high customer retention and approval ratings, despite

any downturns [19] [7].

Similarly, Gillette introduced a new product innovation called the Gillette Sensor brand

of products in 1990. Prior to its introduction, the health and beauty aid industry had a

“me too” mentality and lacked innovation in how products were packaged, what

ingredients were used and even how they were formulated, so they all seemed the

same. By the end of the year, Gillette Sensor became the dominant brand in the

category; its 12-week drug stores volume of $9.4 million was more than twice that of the

No. 2 brand in the category, Gillette's own Good News Disposable [19] [15].

Another example of a firm that proved this point was Procter and Gamble. Two years

after the start of the Great Depression, while P&G sales fell to almost half of what they

were - from $194 million to $94 million, they made some bold investment decisions:

initiate a brand management system and also to refuse to lay off workers and instead

reallocate them. These decisions fueled two innovations shortly thereafter in 1933: a

national radio soap opera and the first synthetic detergent named Dreft [16].

Besides R&D spending, one other key ingredient that was alluded to earlier in how

innovations get started during recessions is through a rise in entrepreneurship. In the

period from Jan 1973 to Dec 1974, the world experienced a major stock market crash,

with the US feeling it in a big way, partially thanks to the collapse of the Bretton Woods

fixed currency system. The country went into a deep recession as gas prices doubled

(“1970’s Energy Crisis”) and we lost faith in our government as first the Vice President,

Spiro Agnew (Oct 1973), and our then fearless leader, President Richard Nixon (Aug

1974), resigned. With all of these terrible things happening with the US economy, one

good thing began to happen in the background – the rise of the entrepreneur and the

creation of new innovative business models, products and processes to deal with the

prevailing economic environment. Entrepreneurs who started companies like

Southwest Airlines, Microsoft, Fedex, Genetech, Apple and Oracle in the mid 1970s, all

emerged during this period and positioned themselves for the recovery by making huge

technological advances in the areas of computers, biotechnology and transportation

despite the existing downturn. Creation of these companies illustrates the “cluster of

innovations” concept discussed earlier in this paper. These firms transformed the

economic crisis into an opportunity by applying new and innovative technologies that

allowed them to rise from the ashes into powerful players, in markets that in some case

didn’t even exist prior to their existence. These companies continue to have a strong

competitive edge due to their continued investments in innovation during future

recessionary times [12].

Other innovations that took place during the recession in the 1970s tapped into more

intangible factors that changed the service or delivery paradigm. For example, Chrysler

invented the first “car rebate” in order to move a large 136 day inventory of cars it wasn’t

selling while General Motors retooled one of its factories to build a fuel efficient

subcompact called the Chevy Chevette; Charles Schwab offered the first discounted

trading commissions, while new financial products like interest-bearing checking were

being introduced; Procter and Gamble showed us that something as simple as making

potato chips exactly the same size and shape so they fit in a reduced size packaging

“tube” called Pringles could be a great innovation. It saved money on shipping and

storage and it boosted revenues due to their novelty [2]. Pringles sells in as many as 11

different flavors today, a sign of their popularity and the vagaries of demand [18]. In the

“post 9-11” (September 11, 2001) environment, innovations continued to flourish and

help the economy rebound. Steven Jobs released the first iPod only 42 days after the

worst disaster in US history occurred and although it was not an instant success, it

eventually recreated the marketplace for portable media and music in conjunction with

its iTunes store [2].

As [19] shows, businesses that increased expenditure on marketing, quality and new

products/innovation were as profitable as those that cut or maintained these costs

during recession (good costs). However, during the first two years of recovery, the

companies that increased expenditure in these areas were clearly more profitable and

their market share increased at a higher rate. On the other hand, investing in fixed

assets and manufacturing and high administrative overheads could generate costs and

decrease profitability (bad costs). Strategies like cutting output capacity, aggressive

pricing and outsourcing, are highly dependent on the market position and priorities of

individual businesses, and their success is not guaranteed for all firms. A bold investing

strategy that relies on improvements in marketing, customer quality and innovation

seems to be a strategic path to follow during a recession, assuming that other

immediate challenges have been overcome.

Conclusions

As the above examples show, there seems little doubt that innovations can happen

during recessions. But just because we concluded that innovations occur during

downturns, will they all be successful?

Of course not – as already noted, the process of developing innovations is inherently

inefficient and does not always yield the desired results, however this should not

dissuade forward-thinking business managers. If you do not try to innovate, it has been

proven you are less likely to do as well as your competition in the recovery.

Investments in R&D and the nurturing of entrepreneurial ideas are key ingredients to the

innovative process. One successful innovation will likely attract others to innovate and

before you know it, there will be “innovation clusters” that spur momentum towards

economic recovery. Managers must look past the short term impact the economy is

having on their balance sheets and although cutting costs and layoffs may be necessary

to stay afloat, and they should use a scalpel instead of an axe when deciding what to

trim and how, especially around investments related to innovation if they want to be

ahead of the game when the recovery finally arrives.

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