Download 3.Milberg-Shapiro-Ford-Dec-6-2012

Implications of the Recent
Financial Crisis for Innovation
William Milberg and Nina Shapiro
New School for Social Research and Saint Peters College, respectively
Paper prepared for Ford Foundation Project on Finance for Innovation
Ford Foundation
December 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
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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
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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
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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
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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)

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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

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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
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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 shift
in managerial strategy
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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)