According to Schumpeter’s theory of “creative destruction,” R&D should be countercyclical to the business cycle. Empirical evidence, however, consistently contradicts this view.
A new paper, co-authored by David Audretsch, Wolfgang Drobetz, Eva Elena Ernst, Paul Momtaz, and Silvio Vismara, presents a novel approach to reconcile the empirically observed procyclicality (the tendency of financial variables to fluctuate around a trend during the economic cycle) of innovation activity with the countercyclicality of innovation predicted by Schumpeterian theory.
David and colleagues argue that economic downturns increase the equity risk premium (ERP), which increases the “hurdle rate” or cost of (equity) capital that is applied to R&D project budgeting decisions, thus stifling corporate innovation. In this post, they discuss the findings of their study.
ERP is a crucial determinant for investments in innovation
Several studies attempt to explain the cyclical patterns of technological innovation. The present study offers a novel explanatory approach: Based on empirical evidence indicating that the ERP significantly affects corporate investments, it explores the relationship between the ERP and corporate innovation — measured by patenting activity — for a large sample of U.S. public firms over the 1977-2018 period.
The ERP is the excess return investors require for investing in risky equity compared to risk-free assets. It reflects the price of risk in the equity market and varies counter-cyclically over the business cycle. The ERP arguably affects corporate patenting activity through the “hurdle rate” or the cost of (equity) capital applied to innovation project budgeting decisions. During recessions and periods of financial crises, the ERP rises, thus stifling innovation by raising the bar for R&D projects to pass the hurdle rate in corporate project budgeting decisions. Consistent with this argument, the study documents strikingly strong negative correlations between the ERP and the aggregate number of patent grants (correlation coefficient = –0.69) and the aggregate value of granted patents (correlation coefficient = –0.75).
The significantly negative effect of the ERP on patenting activities also emerges in firm-level regressions that control for a wide range of potentially confounding factors. The study also provides some evidence that the negative ERP-patenting relation is causal by exploiting state-level R&D tax credits as a source of exogenous variation in the external cost of capital for innovative projects across U.S. states in a difference-in-differences analysis.
Notably, high-ERP periods hurt patenting activity more in R&D-intensive industries.
The study further reports significant moderating effects for:
- Financial slack: Firms that are relatively less affected by financial constraints and have better access to the public equity market are less affected by the negative hurdle-rate effect on R&D activity.
- Institutional ownership: The presence of blockholders attenuates the ERP’s negative effect by mitigating short-termist pressure or motivating self-oriented managers to invest in innovation.
- Product market competition: Innovation in more competitive product markets fluctuates more with variation in the ERP because the margin of error for R&D projects in relatively competitive industries is smaller.
Moreover, firms engaging in exploratory research suffer less during high-ERP episodes than firms engaging in exploitative research, which to some extent reconciles some empirical patterns with Schumpeter’s opportunity costs hypothesis.
Policy implications for government-driven crisis interventions
The study not only contributes to solving the discrepancy between the countercyclicality of innovation in theoretical models and the cyclicality in empirical evidence but also provides policy implications on how institutions and the public can support innovation in and out of times of crisis. More specifically, institutions need to be designed, and regulations need to have the flexibility to be able to stimulate innovation in times of crisis. Monetary policy measures that could lead to an increase in the ERP should be taken with due consideration of the negative ramifications for economic growth through foregone innovation. With uncertain economic prospects abreast, our study provides clues for policymakers as to how to navigate the impending crisis so to minimize its detrimental impact on R&D.
Read the paper: A Hurdle-Rate Theory of Inventive Procyclicality
Post by Eva Elena Ernst.
About the authors
David Audretsch is distinguished professor and Ameritech Chair of Economic Development at Indiana University, where he is also the director of the Institute for Development Strategies.
Wolfgang Drobetz is professor of corporate finance and asset management at Hamburg University, Germany.
Eva Elena Ernst is a graduate student at Hamburg University, Germany.
Paul P. Momtaz is professor of entrepreneurial finance at TUM School of Management at the Technical University of Munich, a graduate researcher at UCLA Anderson School of Management at the University of California at Los Angeles, and a research affiliate at University College London’s Centre for Blockchain Technologies.
Silvio Vismara is professor of corporate finance and vice-chancellor for research at the University of Bergamo, Italy.