Do financial markets reward innovation?

Financial markets are driven by the ‘real’ economy, and in turn can have profound effects on it through impacts on the process of innovation and the way firms in different sectors exploit innovations. Findings on comparative industrial development from the FINNOV (Finance, Innovation and Growth) project strongly suggest that the governance and organisation of business enterprises varies significantly across different EU Member States, and at times even within the geographical borders of these nations.

According to FINNOV, national, and in some cases local, institutions related to governance, employment and finance that influence the operation of companies also vary across geographies. For example, employment relations and employee participation in corporate governance vary markedly across nations such as France, Germany, Italy and the United Kingdom. Similarly, financial institutions range from UK-style shareholder capitalism to various forms of stakeholder capitalism. Policy intervention at the EU, national, and local levels should recognise these differences, and be targeted in terms of desired outcome and flexible in terms of implementation.

The nature of the relationship between investment and innovation is complex. A decision to invest in research and development (R&D) can be a risk as not all firms investing will gain either innovative or financial rewards from their investments. Evidence from FINNOV research suggests that in fact only a small subset of firms reap any growth benefit from their R&D spending and that this growth differs across lines of business. For example, the vast majority of firms in the biopharmaceutical sector incur losses while a few firms are very profitable. And overall, medical devices tend to experience faster and more profitable growth than biopharmaceutical drugs.

Highly liquid stock markets encourage financing by venture capital and private equity. However, these markets tend to be highly speculative and the ease with which investors can ‘exit’, i.e. appropriate returns by selling their equity stakes through these markets, may actually undermine rather than support the financial commitment that product and process innovation require. FINNOV research suggests, therefore, that too much reliance on the stock market as a source of finance for innovative firms may not achieve the desired outcomes. Instead, FINNOV advocates financial institutions that encourage venture capitalists, technology specialists, corporate enterprises and government agencies to provide financial commitment for productive investments rather than seek financial liquidity through the appropriation of premature returns. For example, public subsidies to private investors in technology would be contingent on successful innovation.

In times of financial stress, innovative firms are put under greater financial pressure than their non-innovative counterparts, regardless of any differential in their future economic potential. FINNOV has found evidence of capital market failure, in that younger firms tended to suffer from a shortage of external financial resources. This shortage can restrict the growth of firms, especially those with fast growth potential. It appears that credit markets fail to select and thus sustain more dynamic firms. Surprisingly, FINNOV research suggests that larger firms are actually at greater risk of default than smaller firms. Although larger firms are more likely than small firms to survive default events, defaulting is costly, generating losses for owners and employees. Finding that small-medium enterprises are as good as larger ones, if not better, in avoiding conditions of extreme financial distress suggests that the ability of bigger firms to survive does not imply, by itself, any gain for the economy as a whole, nor any improvement in market performance.

FINNOV goes further, finding that financial performance measures, such as credit ratings used to determine the likelihood of firm default, can be improved significantly by including measures of real firm activity, such as productivity and profitability. As a consequence, one can suggest that the accuracy of standard risk assessment devices – such as official credit ratings or risk management procedures internally maintained by financial institutions – tend to devote too little attention to some important, real, rather than financial, factors. Such a tendency can be seen as one of the reasons behind the ‘financialisation’ and short-termism which have been suggested as some of the causes of the current financial crises. Financialised companies put emphasis on financial performance measures, such as quarterly earnings per share, that can undermine investment in innovation, rather than performance measures that reflect the ability of the company to produce higher quality, lower cost products on a sustainable basis.

Understanding the dynamics of bubbles and financial crisis

The unique properties of financial technology (e.g. trading technology) and innovation (e.g. securitised financial instruments) played a role in generating the recent financial crisis. A key inherent difference between financial and non-financial technologies is that most technologies function due to their intrinsic design, but financial products function because of shared collective acceptance of their functionality. Their increased uptake can lead to complex feedback loops that cause them to act unexpectedly (e.g. assets used to manage and hedge risk become correlated which means a return to one asset is integrally dependent on a return to another asset). This can then lead to catastrophic failure of the financial system.

To understand the operation of the economic system in a crisis, FINNOV researchers have also been evaluating the nature of financial crises, through agent based modelling techniques. Models have been developed that can reflect a self organised economy, one capable of generating stable aggregate dynamics, punctuated by sudden crises. Evidence suggests that it is the quality of bankrupting firms, rather than simply the number of failures, that determines the extent of the negative impact on the economic system.

Key policy messages

The results from the first 18 months of FINNOV research provide a number of key messages to policy makers. These include:

  • Market selection operates on a broad mix of firm characteristics rather than on innovation per se. Understanding what these characteristics are, and how they differ between sectors, is crucial for innovation-led growth targets.
  • Financial reform should aim to help credit markets create valuation tools which reward the most efficient firms, rather than penalise them, as has often been the case. In particular, the tradition of linking the economic and financial soundness of a business activity to a single ‘rating’ measure should be abandoned in favour of more structured assessment devices.
  • The ‘credit crunch’ created by financial crises tends to penalise the most innovative firms. In order to make sure that post-crisis growth is achieved, financial reform should aim to ensure the most innovative firms can access credit during the post-crisis recovery.
  • Especially in the US, stock buybacks have been at the expense of investments in innovation. Prime beneficiaries have been top executives with their ‘unindexed’ stock options that enable them to gain from stock-market speculation and manipulation. For the sake of innovation, the EU must ensure that this highly financialised business model cannot take root in Europe.
  • In terms of the relationship between financial markets and innovation, the key lesson is that one size will not fit all the important actors in this policy space. Policy must be guided by models which adequately take heterogeneity into account, and which study the co-evolution between heterogeneity and the competitive selection mechanism.

FINNOV – Finance, Innovation and Growth: Changing Patterns and Policy Implications (duration: 1/3/2009 – 28/2/2012) is a Collaborative Project funded under the 7th Framework Programme for Research of the European Union, Theme 8: Socio-economic-Sciences and Humanities, Activity 1 - Growth, employment and competitiveness in a knowledge society.

See: http://www.finnov-fp7.eu/

Contact: Professor Mariana Mazzucato, m.mazzucato@open.ac.uk