Policy Brief No. 1: Innovation Policy and the Business Cycle: Innovation Policy’s Role in Addressing Economic Downturn

Summary of results and recommendations

Traditionally, the term “innovation” has mainly been restricted to novel technological developments. Innovation policy must, however, take account of innovation in a broader sense as defined in the OECD Oslo Manual. Adopting a systems of innovation approach helps innovation to be understood more holistically (see Section 1.2). The following section provides the briefest of answers to the three overarching research questions framing this document. A brief discussion of key arguments relating to the condensed answers is included for each research question. These brief discussions draw from theoretical, empirical and case-specific evidence presented in the Policy Brief.

Question 1: What is the pattern of private research, development and innovation (R&D&I) activities during the cycle?

Evidence in brief: Private R&D&I activities have tended to be pro-cyclical. The pattern of private R&D&I activities in the current financial and economic crisis seems to differ in that respect.

To answer this question the annual growth rates for GERD (excl. BERD) , BERD and GDP of 13 countries were analysed over a period of almost 30 years and used as a proxy for the cyclicality of public and private R&D&I activities . This long-term observation clearly indicates the pro-cyclicality of R&D&I activities for EU Member States as well as Non-Member States. The majority of empirical studies that deal with the cyclicality of private R&D&I activities support the pro-cyclicality of R&D&I activities in particular those of the private sector. Insufficient availability of financial means is commonly quoted as the main reason for reducing R&D&I activities during economic downturns in these studies. In line with this result, firms in the IW Future Panel survey, SMEs in particular, regard the non-availability of financial means as the main obstacle to R&D&I activity in the current financial and economic crisis. Insofar, when considering the long-term perspective, policy-makers are right in assuming pro-cyclicality of private R&D&I activities as the interviewed experts with backgrounds close to policy-making also did.

However, when one turns from these general findings regarding long-term patterns to the current crisis, a new picture seems to emerge. Eurostat data and Innobarometer 2009 survey responses indicate that firms’ behaviour in the current financial and economic crisis potentially differs from the assumed pro-cyclical pattern, i.e. firms are keeping their R&D&I activities stable or increasing them despite the economic downturn 2008/2009. IW Future Panel (firm-level) data further verifies this finding. More than a quarter of German firms increased their innovation investments in the period 2007 to 2009. The main drivers for increasing investements as identified by firms were customers and competitors. The industry experts interviewed for this Policy Brief agreed, that in a globalised world, one cannot afford to cut back on R&D&I investments even in economically difficult times.

In sum, the evidence gathered supports the finding that private-sector R&D&I activities may be more anti-cyclical in the current financial and economic crisis than one would have assumed given past long-term patterns of R&D expenditure. Nonetheless, drying up cashflow and banks’ risk-aversion during the current crisis may leave firms still no other choice than to cut back on R&D&I.

Question 2: Can policy instruments whose objective it is to encourage private R&D&I during a recession help foster economic recovery?

Evidence in brief: Innovation policy can provide short-term incentives to encourage private R&D&I activities during a recession. The focus of these measures should be to support companies in continuing their ongoing innovation projects which may be at risk otherwise. Ideally, short-term measures during a crisis can have a two-fold impact: they trigger additional private R&D&I spending (short-term economic stimulus), and at the same time reduce the risk of negative long-term impacts on the competitiveness due to cancelled or delayed innovation activity.

Although innovation policy is fundamentally long-term in nature, there is also evidence in support of innovation policy’s short-term effect. Innovation policy can provide (short-term) incentives to encourage private R&D&I activities during a recession. As private-sector R&D&I investments are likely to dry up in an economic and financial crisis, public support is an appropriate tool for keeping these investments at a socially optimal level even during the crisis. The focus of such measures should be to support companies in continuing their ongoing innovation projects which may be at risk of being cancelled otherwise. Ideally, short-term measures during a crisis have a two-fold impact:

1. they provide a stimulus to trigger economic activity (short-term impact), and
2. they reduce the risk of negative impacts on the competitiveness due to cancelled or delayed innovation activity (long-term impact).

Short-term perspective. The empirical studies presented in Chapter 3 indicate that public investments can trigger private R&D&I investments even during economic downturns. The studies reviewed concur in their assessment of this “stimulus effect”. The consensus is that of 1 Euro of public support triggers between 0.4 and 1 Euro additional private R&D&I spending. Since innovation has been identified in economic theory as one of the driver of economic growth (Chapter 2), a stimulation of R&D&I activities during economic downturns is also likely to foster recovery. Consequently, increasing financial support for private R&D&I activities, in particular for SMEs suffering most in economic downturns, is a promising avenue for innovation policy-makers.

Long-term perspective. Besides triggering economic activity, a major objective of innovation support measures during a crisis is to prevent long-term negative impacts on the competitiveness due to cancelled or delayed innovation activity. This aspect creates links short-term initiatives with a longer-term perspective.

Notwithstanding the proposed rationale for specific short-term measures during the crisis, the importance of a well-functioning innovation system as a whole should not be underestimated for the effectiveness of such measures. The innovation systems approach contrasts the “linear model of innovation”, i.e. the simple link between input of R&D and output in the form of innovation. The simple, linear model implies that by increasing input (e.g. R&D expenditure) one will directly increase the output (such as the number of new technologies or other innovations). In a systemic view, innovation is seen as the result of a complex interaction between various actors and institutions on all social levels. The cultural and social environment shapes the innovation system.

Innovation policy needs to build on the innovation system in order to be effective. The Finnish case study most convincingly supported this fundamental insight. The sound innovation system in Finland made its economy more resilient to the economic crisis at the beginning of the 1990s and enabled a restructuring process that led to quick economic recovery. Therefore, innovation policy’s main focus should be on the long-term evolution of the innovation system. All experts interviewed for this Policy Brief subscribed to this insight. Consistently, they regarded other policy fields (labour market, economic or welfare policies) as more significant than innovation policy for fostering economic recovery in the short-term. Short-term financial support measures for innovation, if necessary, are likely to show greater impact than when there is a weak innovation system.

Question 3: Which instruments are most appropriate for use in an anti-cyclical innovation policy on the EU level?

Evidence in brief: It is mainly supply-side monetary instruments which have the potential to generate direct short-term impacts on private R&D&I activities during economic downturns.

Supply-side measures such as subsidies, loans and venture capital for innovative firms are likely to have a positive impact on R&D&I activities in the private sector. As argued above, the focus of these instruments should be on providing sustained funding for promising ongoing projects. While subsidies and loans provide a quick influx of money into new and current projects, venture capital supports a select group of high-potential start-ups, which can have a disproportionate impact on economic recovery. Such support measures have also been evaluated positively by firms in the IW Future Panel.

In sum, two main conclusions regarding an innovation policy that will enhance Europe’s ability to withstand economic downturns can be drawn. First, all empirical evidence supported the importance of innovation policy’s long-term stability i.e. stabilising and improving the innovation system to the benefit of all actors involved thereby enhancing Europe’s resilience. Second, it has been underlined that there is also potential for innovation policy-makers to react flexibly in the short-term using direct financial support measures to keep private R&D&I activities at a desirable level. In essence, Europe’s innovation policy should be stable but flexible.

For the long-term perspective, desirable key characteristics of successful innovation systems can be drawn from theoretical, empirical and case study evidence presented throughout this Policy Brief. They indicate some potential for improvement on the Euroepean level. All regulations with relevance to R&D&I activities should enable fair and open competition. For instance, the Finnish case study analysed in this Policy Brief highlighted the positive effect appropriate standardisation can have on the competitive environment. With this in mind, European Standards are an example of an area in which more work still needs to be done. Besides competition, cooperation emerged as a key component of successful innovation systems. This includes all types of cooperation amongst and between public and private partners on all social levels. Thus, fostering interactions and knowledge exchange should be essential objectives of Euroepean innovation policy.

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INNO-Grips Policy Brief No. 1: Innovation Policy and the Business Cycle: Innovation Policy’s Role in Addressing Economic Downturn