There is by now a fairly large literature arguing that modern financial markets are very important drivers of innovations in the real economy. Efficient financial markets should allocate capital towards up-and-coming sectors, promising companies, and exciting business ideas but away from declining industries. This role is easy to see when it comes for instance to venture capital, which supports innovative start-ups, but should also hold when looking at established companies.
A few years ago, Philipp Hartmann of the European Central Bank and others calculated the speed of capital reallocation from declining to rising industries for a number of countries (Hartmann et al 2007). They argued that this reallocation happens faster in countries where financial development is higher (measured by the size of the financial markets, for instance). The lag in productivity growth experienced by continental Europe was thus a symptom of the sluggishness with which resources were shifted from old to new industries which in turn could be traced back at least in part to less efficient financial markets.
In new research with Philipp Ehmer, we reinforce this innovation-finance nexus (Mayer and Ehmer 2011). In fact, financial markets continue to be a defining force for innovation even through the peak of the financial crisis. These results are based on a detailed analysis of 1,200 companies worldwide.
Our study calculates the R&D elasticity which measures how much higher a company’s stock-market capitalisation is depending on its investment in research and development – other things being equal. To avoid comparing apples to oranges, it benchmarks each company to the industry average. All in all, it finds that companies which spend for example 50% more than the industry average on R&D (relative to sales) have a 14-21% higher market capitalisation. This is a substantial reward to those owning the firm. In other words, the R&D elasticity measures the extent to which financial markets set an incentive to invest in R&D.
This does not mean that business models without a strong research focus are necessarily unsuccessful. In the pharma industry, for instance, there are very research-intensive firms that produce high-end drugs but there are also firms that specialise in generics and spend little on R&D. Both are legitimate business models, though the former typically have a higher market valuation which captures the growth options of R&D.
In principle, this is not a particularly new result. Griliches (1981) already found that R&D spending boosts company value; Hall and Oriani (2006) add more recent evidence. Jaruzelski et al (2005) are rather sceptical but their findings might be blurred by an overly-broad industry classification.
What is new in our study is that we measure country-specific R&D elasticities and relate those to indicators of productivity and financial development. There is a clear correlation: countries with a higher R&D elasticity have had on average faster productivity growth (see Figure 1). The UK and the US, for instance, are among the countries with the highest R&D elasticity and had also substantially faster total factor productivity growth than, say, Germany or Japan.
Evidently, the incentive to invest in R&D set by financial markets has had a positive spillover effect to the real economy. Moreover, countries with a high R&D elasticity also have on average more venture capital investments. This makes sense because a high R&D elasticity means that research-focused start-ups (those are more likely to be funded by a venture capitalist) fetch better prices once they go public or are sold to a strategic buyer.
The study also documents how the R&D elasticity responded during the financial crisis. Financial markets in Britain, for instance, slashed the R&D elasticity while there were only small adjustments in Germany and Japan. The change in the R&D elasticity meanwhile corresponds neatly with changes in actual R&D investments (see Figure 2). As it happens, financial markets did send a clear signal during the crisis, to which the companies paid heed. Technically, the financial crisis is also a type of natural experiment which illustrates that the innovation-finance nexus does not only hold across countries but across time, too.
The financial crisis has tested our confidence in the benevolence of financial markets. But the analysis presented here reinforces the notion that modern financial markets are indeed key to innovation in the real economy and thus contribute to overall technological progress. Innovation policy is thus also capital market policy and continental Europe in particular has some catching up to do. The current changes to the regulation of the financial systems should carefully balance the need for reform with preserving the market’s ability to finance innovative companies.
Griliches, Zvi (1981), “Market Value, R&D, and Patents”, Economic Letters 7, 183-187.
Hall, Bronwyn H and Raffaele Oriani (2006), “Does the Market Value R&D Investment by European Firms? Evidence from a Panel of Manufacturing Firms in France, Germany, and Italy”, Journal of Industrial Organization 24(5):971-993.
Hartmann, Philipp, Florian Heider, Elias Papaioannou and Marco Lo Duca (2007), “The Role of Financial Markets and Innovation in Productivity and Growth in Europe”, ECB Occassional Paper No 72.
Jaruzelski, Barry, Kevin Dehoff and Rakesh Bordia (2005), “Money Isn’t Everything”, Strategy+Business 41.
Meyer, Thomas and Philipp Ehmer (2011), “Capital markets reward R&D”, Economics 83, DB Research.