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For Official Use DSTI/STP/TIP(2011)15

Organisation de Coopration et de Dveloppement conomiques Organisation for Economic Co-operation and Development 30-Nov-2011___________________________________________________________________________________________

English - Or. EnglishDIRECTORATE FOR SCIENCE, TECHNOLOGY AND INDUSTRY

COMMITTEE FOR SCIENTIFIC AND TECHNOLOGICAL POLICY

Working Party on Innovation and Technology Policy

TIP THEMATIC WORKSHOP ON FINANCING R&D AND INNOVATION IN THE CURRENT

MACROECONOMIC CONTEXT: ISSUES PAPER

7 December 2011, OECD Conference Centre, Paris

Delegates will find attached the Issues Paper for the TIP Thematic Workshop on Financing R&D and Innovation

in the Current Macroeconomic Context to be held at the OECD Headquarters on 7 December starting at 9:00.

Delegates may wish to note that a second paper on "Entrepreneurial Financing of R&D and Innovation"

prepared for the TIP project on "Financing, Transferring and Commercialising Knowledge", which complements

this background paper, will be made available under reference code DSTI/STP/TIP(2011)14.

N.B. This document and any map included herein are without prejudice to the status of or sovereignty over any

territory, to the delimitation of international frontiers and boundaries and to the name of any territory, city or

area.

Contacts:Caroline Paunov, Email: [email protected], Tel: + 33 1 45 24 90 40;Dominique Guellec, Email: [email protected], Tel: + 33 1 45 24 94 39

JT03312490

Document complet disponible sur OLIS dans son format d'origine

Complete document available on OLIS in its original format

DSTI/STP/TIP(2011)15

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INNOVATION IN THE CURRENT BUSINESS CYCLE

Summary

1. This background document to the TIP Thematic Workshop on Financing R&D and Innovation in

the Current Macroeconomic Contextdraws an initial picture of the impacts of the current business cycle on

innovation. The discussion is organized around eight key questions; below is a summary of the preliminary

answers the document provides:

Question 1: What to expect for innovation as a result of the crises? Innovation might both thrive and suffer during downturns in reaction to the decrease in demand, the

lack of liquidities in the financial system, increased uncertainties and the tightening of public budgets.

A lot of the evidence on past recessions points to negative impacts on innovation activities.

Question 2: What has happened to innovation?Innovation activities decreased during the global financial crisis; this is the case for firm-level

indicators as well as aggregate statistics on private-sector R&D, patenting and trademark registrations.

However, there is some evidence pointing to an increase in innovations aimed at enhancing efficiency.

Question 3: Did the global downturn lead to creative destruction?Substantial firm exit has not been accompanied at the same time by entry. The result has been a

persistent increase in unemployment levels and, in consequence, a break-down of the creativedestruction process as new innovative businesses have not entered markets (yet).

Question 4: What has happened to innovation financing?Innovators had a harder time in accessing external financing independently of whether they sought

access to banking credit or venture capital during the global financial crisis. While the situation

improved subsequently problems resurfaced in the second half of 2011.

Question 5: What about the role of low demand and substantial uncertainties?The declines in consumer demand and uncertainties as to the recovery were probably substantial factors

behind firms weak innovation performance.

Question 6: Will there be impacts on the global distribution of leadership in innovation?

The strong growth performance of some emerging economies compared to developed countries hasgiven them the opportunity to catch-up in terms of innovation continuing a trend that pre-dates the

crisis.

Question 7: Is there a risk of long-term effects on innovation-based growth?With sluggish growth and substantial uncertainties potential long-term consequences become

increasingly likely. While there is no evidence as yet on harmful disruptions to innovation investments

or loss in leadership, potential losses in skills that are essential for innovation already constitute a risk.

Question 8: What about innovation policy at present?While strong innovation performance contributes to raising growth prospects high levels of public

spending in its support might be a challenge for tight public budgets. Innovation policies at present need

to i) foster positive long-term trends in innovation performance, and ii) avoid possible long-term

damages to innovation systems caused by the crises themselves.

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Introduction

2. The collapse of Lehman Brothers in September 2008 led to a major global economic crisis that

was unprecedented in its magnitude in at least half a century. World GDP retracted as did industrialproduction, trade collapsed even more substantially and unemployment increased in many of the worldsmajor economies. A moderate short-lived recovery took off by the end of 2009 which continued with some

notable exceptions in 2010 and the first half of 2011. Market speculations over the sustainability of

sovereign debt and the challenges involved in negotiating fiscal consolidation lowered expectations for a

fully-fledged quick recovery of the world economy. Because of the substantial impacts on the worldsmajor economies output, on global financial institutions (which hold a central role as intermediaries forbusinesses and their innovation investments) and on public finances (which provide key support to

innovation systems) the current business cycle downturn cannot be disregarded when it comes to

innovation. Innovation performance is certainly mainly the result of underlying structural rather than

business cycle factors. The exceptional nature of the current macroeconomic context, however, renders the

impacts of the business cycle much more important for innovation.

3. Overall the global financial crisis has led to a sharp decrease in innovation investments. The

evidence also suggests that the process of creative destruction whereby more innovative busines ses enterand the least innovative exit has broken down with the onset of the global financial crisis. Notably,

persistent high rates of unemployment point to a substantial waste in resource deployments. The global

financial crisis rendered business access to banking credit more difficult and available venture capital

financing decreased substantially. There are early signs to suggest the 2010 recovery process of innovation

was but short-lived specifically but not only for Europe. The intensity and prolonged nature of the

downturn raises serious concerns over potential long-term scars on innovation systems: the substantial

increase in long-term unemployment rates threatens to reduce available skilled human capital even after

the downturn. The 2010 recovery in private R&D for the worlds leading businesses suggests, however,that their R&D processes were not fundamentally damaged after the slowdown of 2009. Moreover, both

crises have affected developed countries much more strongly than some of the emerging economies; thisseems to have facilitated pre-crisis trends in catching-up in terms of their innovation performance. Finally,

public policies are not powerless and should, in particular, aim at reducing potential threats for long-term

innovation-based growth. This has to also involve addressing long-term unemployment rates. With

constraints on public finances answers will not be easy and probably require smart ways of making more

out of less and relying on partnerships with the private sector to design innovation-based recovery

processes.

4. This background document to the TIP Thematic Workshop on Financing R&D and Innovation in

the Current Macroeconomic Contextdraws a first picture of the impacts of the global financial and public

debt crises on innovation. It builds on the 2009 study Policy Responses to the Economic Crisis: Investingin Innovation for Long-Term Growth (OECD, 2009). The discussion is organized around eight key

questions where preliminary answers are provided based on what we know from past crises and theavailable statistical evidence. The OECD and the TIP in particular can play a substantial role in identifying

policy priorities for STI policy in this evolving context. The Workshop will provide an opportunity for

corresponding discussions to inform the forthcoming Science, Technology and Industry Outlooks chapteron innovation in the current business cycle.

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Question 1: What to expect for innovation as a result of the crises?

5. What does not kill you makes you stronger. Nietzsche is credited for a popular quote which, if

applied to the current context, reflects a somewhat less pessimistic outlook. In fact, Joseph Schumpeter hasfamously argued that a process of creative destruction while painful is precisely what fosters innovationsand progress as the old and familiar has to be left behind for the new and better. From that perspective the

downturn might have offered opportunities for innovators and innovation systems. Before turning to what

to expect for innovation below, Box 1 briefly discusses the three dimensions of the global financial and

sovereign debt crises that are most essential for innovation.

Box 1: The global financial and sovereign debt crises: Effects of relevance to innovation

Three aspects of the present context warrant caution over simplified confidence in merely marginal impacts of thecurrent downturn on innovation:

First, innovative businesses in many developed economies have been confronted with lower demand for their

products and substantial uncertainties over future trends in consumption. The shock of the global financial wasunprecedented in its magnitude in at least half a century and even beats some negative records established bythe Great Depression (Almunia et al., 2009, Reinhart and Rogoff, 2009). Innovators were not exempted from thedownturn: high-tech companies saw their revenues decrease substantially also due to the fact that the demand forhigher quality innovative products trends to decrease during recessions (Lien, 2010, Piva and Rossi-Lamastra,2011). Subsequently to the global financial crisis most developed economies have known but a short-lived andoften incomplete recovery. By the end of 2011 substantial uncertainties over quick recovery prospects had risen inresponse to increased concerns over sovereign debt and limited opportunities for consumption to recover quicklydue to deleveraging. The historic evidence also points to a slow recovery process (Reinhart and Rogoff, 2009).

Second, public support for innovation faces potential challenges as fiscal consolidation has become a top priority.High levels of sovereign debt and markets speculations over potential sovereign default re strain the scope forpublic policy interventions. Fiscal consolidation has not only been at the forefront of policy discussions in Europebut also in the United States and Japan. Moreover, population ageing will likely over the medium-run add further

pressure on pension and health budgets and challenge governments possibilities for prioritising investments inlong-term growth, including factors in support of innovation such as education, innovation projects andinfrastructure.

Third, fragilities in the banking sector pose a threat to innovative businesses opportunities to receive externalfinances. The 2008-2009 global financial crisis exposed substantial vulnerabilities in the global financial system(Reinhart, 2011). The stability of the banking sector in Europe and beyond remains fragile with markets speculatingover sovereign default risks (IMF, 2011a,b). The quick expansion of investment credit in China for 2009-2010 hasalso led some to question the quality of some of the financed projects adding to other challenges of the Chinesebanking system (IMF, 2011a).

6. The global financial and sovereign debt crises as described in Table 1 have had four types of

effects on the private sector: i) a reduction in the demand for products, ii) a reduction in liquidities in the

financial system, iii) an increase in uncertainties as to future developments as well as iv) impacts on

innovation policy. These can via several mechanisms, as described in column 2, have impacts oninnovation performance and investments. Column 3 shows implications for innovation can both be positive

and negative. While few exceptions (Nickell et al., 2001, Francois and Lloyd-Ellis, 2008), the pro-

cyclicality of R&D and innovation has been observed over various business cycles and for a variety of

countries (e.g. Griliches, 1990, Broda and Weinstein, 2010, Barlevy, 2002, 2007, Comin and Gertler, 2006,

Fatas, 2000, Francois and Lloyd-Ellis, 2009, Rafferty, 2003, Walde and Woitec, 2004).

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Table 1: Potential expected effect of various aspects of the global financial and public debt crises on R&D, innovation and entrepreneurship

Direct effects Mechanism how innovation is affected as a result Impact on innovation including examples and evidence from past downturns

Reduceddemand forgoods andservices

Demand Effects - Ambiguous impact oninnovations as the downturn likely reduces thedemand for innovative goods as these are oftenmore expensive and/or durable goods whosepurchase can be more easily postponed butdownturns possibly also increase demand forcertain innovative products specifically thoseoffering lower prices and/or responding better to

altered demand during recessions

Innovation: Negative for certain product innovationbut positive for processinnovations as well as product innovations aimed at reducing costs/prices (e.g.low-cost airlines grew out of the recession in the early 1990s)Entrepreneurship/ Firm Dynamics:Fewer market opportunities exist for younginnovative firms except for those with business model aimed at responding to demandfor lower priced goods. High-potential entrepreneurs react more to the presence ofgood business opportunities (than marginal entrepreneurs who are more likely torespond to labour market conditions). They will affect innovation performance

(Koellinger and Thurik, 2011).

Competition Effects - Competition might increaseas gaining other firms market shares is the only wayto maintain sales levels

Innovation: Impact on innovation depends link between product market competitionand innovation, trade-off between rents from less competition and incentives forinnovation to escape competition (Schumpeter, 1942; Nickell,1996; Aghion et al.,2005a)Entrepreneurship/ Firm Dynamics:Competition leads to creative destruction processes and the failure of incumbent

less innovative firms. It can facilitate opportunities for entrepreneurshipimproving aggregate innovation performance (Hall, 1991, Mortensen andPissarides, 1994, Caballero and Hammour, 1994, 1996 and Gomes, Greenwoodand Rebelo, 2001). Evidence in support: Bailey et al., 2001, Foster et al., 1998.Disney, Microsoft, Hewlett-Packard, Oracle and Cisco were created duringdownturns.

However, young firms with substantial innovation capacities in the futuremight be forced to exit during recessions before they have fully developed theirpotential, crushing possible set-up costs spent in building up firms innovationsystems (Ouyang, 2011).

Cash Flow Effects - Firms cash flows are possiblyreduced, fewer internal resources are available to

cover operational expenses

Innovation: Negative for innovation activitiesif external financing is notavailable, specifically small and young firms might lower investments as they face

greater risks of being forced to exit and face stronger financing constraintsEntrepreneurship/ Firm Dynamics:

Exit of innovative businesses can resultif external financing constraints exist(Barlevy, 2002). Evidence for such effects during recessions includes Sawnson andTybout, 1988, Eslava et al., 2010, Baden-Fuller, 1989, Nishimura et al., 2005,Hallward-Driemeier and Rijkers, 2011.

However, layoffs and lower wage and/or force firm exit reduce opportunitycosts of entrepreneurship, increase individuals willingness to take on greaterrisks and increase the availability of qualified labour during downturns (Koellinger,2008, Audretsch, 1991, 1995)

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Direct effects Mechanism how innovation is affected as a result Impact on innovation: examples and evidence from past downturns

Inter-temporal Resource Allocation Effects -Firms opportunity costsof investing ininnovation at the expense of spending on theproduction of output are lower with low demand(Caballero and Hammour, 1996, Cooper andHaltiwanger, 1993, Aghion and Saint Paul, 1998),Private payoffs for innovations are higher whendemand is at its peak (Barlevy, 2007)

Innovation: Firms invest more in innovation and less on production during thedownturn to reap higher payoffs in the future i.e. at the peak of the recovery - butkeep innovations for the future. The time lag between investment and private payoffsto innovation will ultimately determine whether the recession should have positive ornegative effects on innovation.Entrepreneurship/ Firm Dynamics: Entrepreneurs might postpone entry withinnovations as to when markets recover and demand is higher

Reducedliquidity of

the financialsystem

Reduction in loans due to deleveraging affects alltypes of investments, notably of SMEs (as they rely

more on financing from loans than large firms).Market failure in credit markets might be worse aslower cash flows mean firms have less collateral(Bernanke and Gertler, 1995).

Investors have fewer resources to allocate acrossinvestment projects

Innovation: Lack of financing negatively affects innovation during downturns(Aghion et al., 2005b, 2008; Krozner et al.,2007; Dell'Ariccia et al., 2008). Evidence

on variation in the volume of venture financing with the business cycle (Gompers andLerner, 1998, 1999, Kaplan and Schoar, 2005).Entrepreneurship /Firm Dynamics: Reduces innovative start-ups entry (Lerner,2011). Evidence on negative firm dynamics due to insufficient entry Caballero andHammour, 1994, Parker, 2009, Bailey et al., 1992

Uncertaintiesaffectingdemand andfinance

Uncertainties might reduce the number of riskyinvestments by investors, banks and firms,specifically as sunk costs of such investmentsprovide incentives to postpone them (Pindyck, 1991)

Innovation: Firms might be less willing to face uncertainties and risks associatedwith introducing new products and/or processes since the latter might compromisesurvival if demand evolves unexpectedly (Fernandes and Paunov, 2011). Entrepreneurship/ Firm Dynamics: Limited firm entry can also be caused by

uncertainties. Entrepreneurs will wait prefer to wait for greater certainty as to therecovery of demand as well as financial markets.

Publicbudgetarysituation

Policy makers do not address challenges posed byinnovation given other priorities and/or lower publicresources or alternatively focus specifically oninnovation

Innovation as well as Entrepreneurship / Firm Dynamics: To the extent thatbusiness innovation and R&D are positively linked to public R&D and support, theywill vary in the same direction.

Recovery packages vs. fiscal discipline affect publicexpenditure as it relates to innovation

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Question 2: What has happened to innovation?

7. The available evidence on firms shows innovation activities declined. Among 4,238 European

firms a larger share decreased their innovation spending at the onset of the global financial crisis compared

to the pre-crisis period (26.7% relative to previous 10.8%). However, more than half of the interviewed

firms maintained their levels of innovation spending (Archibugi and Filippetti, 2011). Furthermore,

evidence from the World Bank Financial Crisis Survey for 2008-2009 on firms across six countries -

Bulgaria, Latvia, Lithuania, Hungary, Romania and Turkey shows that R&D investments wereprocyclical during the global financial crisis (Mnnasoo and Merikll, 2011). Also, among more than

1,500 Latin America firms one in four stopped innovation investment projects in response to the global

financial crisis (Paunov, 2012). The same pattern is true for the worlds top R&D investors; their R&Dspending decreased by 1.9% in 2009. It recovered in 2010 increasing by 4% to 456 billion (EC, 2011).

8. Aggregate innovation performance indicators similarly reject the hypothesis that the downturn

fostered innovation. Patenting activity if PCT filings are considered decreased compared to 2007: Figure 1and Table 2 show worldwide trends and trends for a selection of countries: the decline was specifically

pronounced for some of the major contributors including the United States, Canada and Germany. For

some countries as e.g. the United States 2010 marked a further decrease relative to 2009 whereas for others

including Germany there was a recovery although 2007 levels were not attained. China and South Korea,

by contrast, continued to increase filings substantially in 2010. Preliminary statistics for 2011 indicate a

substantial recovery with, however, some notable exceptions including the United States and the United

Kingdom. The global financial crisis also led to persistent below-trend trademark registrations (Figure 2).

Similarly businesses R&D spending declined in 2009 compared to 2008 for some of the major economies(Figure 3).

Figure 1: Trends in the number of PCT patent filings for selected countries

(2007 = 100)

50.0

75.0

100.0

125.0

150.0

2004 2005 2006 2007 2008 2009 2010 2011*

USA Japan

Germany Korea

Total

Source: WIPO Statistics Database

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Table 2: Trends in the number of PCT patent filings for selected countries

(2007 = 100)

2004 2005 2006 2007 2008 2009 2010 2011*

United States 80.3 86.8 94.9 100 95.6 84.4 83.2 86.8

Japan 73.1 89.6 97.4 100 103.7 107.4 115.9 137.0

Germany 85.4 89.7 93.9 100 105.8 94.3 98.6 101.1

China 31.3 45.9 72.3 100 112.2 144.8 225.4 330.1

Republic of Korea 50.2 66.3 84.2 100 111.8 113.7 136.9 144.1

France 79.0 87.5 95.4 100 107.8 110.3 110.4 123.5

United Kingdom 90.9 92.0 92.0 100 98.6 91.0 88.3 87.7

Switzerland 75.8 85.9 94.5 100 99.1 95.8 97.3 112.1

Sweden 78.0 78.9 91.3 100 113.2 97.6 90.6 101.3

Netherlands 96.6 101.5 102.7 100 98.4 100.7 91.7 75.4

Canada 73.0 80.4 89.4 100 103.4 87.8 93.7 108.7

Italy 74.1 79.7 91.6 100 97.9 90.0 90.2 99.9Others 77.6 87.1 92.3 100 107.3 100.7 106.0 107.8

Total 76.7 85.5 93.6 100 102.1 97.2 102.7 113.1 Note: 2011 data are obtained on using linear projections for August-December 2011

Source: WIPO Statistics Database,

Figure 2: US gross domestic product and trademark applications at the USPTO, 1999-2011

Comparing cycles, by type of trademarks, percentage deviation from the long-term trend

-3.75

-2.50

-1.25

0.00

1.25

2.50

3.75

5.00

6.25

7.50

8.75

-30

-20

-10

0

10

20

30

40

50

60

70

Goods trademarks Services trademarksFinance, insurance and real estate trademarks US gross domestic product (right-hand scale)%

%

Source: OECD (2011a)

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Figure 3: Trends in business enterprise expenditure on R&D for a selection of countries

(2007 = 100)

70

75

80

85

90

95

100

105

110

115

2004 2005 2006 2007 2008 2009 2010

Canada

Finland

France

Germany

Israel

Italy

Japan

United

Kingdom

Note: The following data points are provisional: Canada - 2010, Germany - 2009, Israel- 2009, 2010, Italy - 2009, 2010, UK -2010. The following statistics are national projections or estimates: France, 2009 Finland -2010. Note that data for Israelacross all years exclude the defence sectors spending.

Source: OECD MSTI Database 2011-1

9. However, innovations aimed at improving efficiency have possibly increased in response:

Among respondents to a survey of about 1,500 Latin American the number of firms that introduced process

innovations from 2008 to 2009 increased (Paunov, 2012). This might indicate that firms sought efficiency

improvements in their production processes to face the economic crisis. Also, some respondents to asurvey of 532 senior executives by McKinsey said that while the global financial crisis led to reductions in

R&D it also allowed for efficiency improvements in the way R&D was conducted: This included

improving the accountability for performance and spending, increasing collaboration with outside R&D

groups and the streamlining of core R&D processes (McKinsey, 2010).

Question 3: Did the global downturn lead to creative destruction?

10. Creative destruction - a process whereby economic downturns force incumbent less innovative

firms to exit and allow entry of more innovative firms can play a powerful role in improving overallinnovation performance (see also Table 1). In consequence, it matters substantially for growth (Aghion and

Howitt, 1992). The available evidence suggests the creative destruction process has broken down with

the onset of the crisis. Figures 4 and 5 provide information on enterprise creation and bankruptcies fromofficial business registries for a selection of countries. There is a clear decrease in the rate of enterprise

creation that tends to be most pronounced in the first half of 2009. The downward trend differs somewhat

across countries with larger declines for Australia, France, Denmark, Spain and Norway than for Finland,

Germany, Italy and the United Kingdom. Only few countries manage to return to levels attained in the pre-

crisis period: the U.S. rate of enterprise creation continues to be below the 2006 rate and there is an

apparent absence of recovery in firm creation for Denmark and Spain. At the same time bankruptcies also

increased substantially in some of the countries with weak firm entry, the United States and Denmark stand

out as clear examples.

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Figure 4: Enterprise creation

(2006 = 100)

50

60

70

80

90

100

110

120

130

Q12006

Q22006

Q32006

Q42006

Q12007

Q22007

Q32007

Q42007

Q12008

Q22008

Q32008

Q42008

Q12009

Q22009

Q32009

Q42009

Q12010

Q22010

Q32010

Q42010

Australia

Finland

France

Germany

ItalyDenmark

Figure 5: Number of bankruptcies

(2006 = 100)

50.0

100.0

150.0

200.0

250.0

300.0

350.0

Q12006

Q32006

Q12007

Q32007

Q12008

Q32008

Q12009

Q32009

Q12010

Q32010

Australia

Canada

Japan

Denmark

Finland

50.0

100.0

150.0

200.0

250.0

300.0

350.0

Q12006

Q32006

Q12007

Q32007

Q12008

Q32008

Q12009

Q32009

Q12010

Q32010

FranceNetherlands

Norway

United Kingdom

USA

Source: OECD (2011b)

11. High exit, but low entry results in a substantial increase in unused resources, notably of labour,

this represents a costly downside to recessions. The global financial crisis led to a rise in unemployment

rates with no or only moderate returns to pre-crisis unemployment levels. Ireland, Spain, Greece and

Hungary have had unemployment rates in the double-digits since mid-2009. While the increase has been

more moderate for other countries unemployment rates have often remained at pre-crisis levels; this is for

instance the case for Canada, the United Kingdom and the United States. Korea, Norway and particularly

Germany are notable exceptions. Figure 6 shows that for Spain, the United Kingdom and the United States

the unemployment rate of workers with tertiary education also increased.

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Figure 6: Annual unemployment rate for workers with tertiary education for selected countries

0.0

2.0

4.0

6.0

8.0

10.0

12.0

14.0

2005 2006 2007 2008 2009 2010 2011*

Spain

United Kingdom

United States

Note: Data for 2011 are based on information for the first half of 2011 only.

Source: ILO Department of Statistics, November 2011

Question 4: What has happened to innovation financing?

12. A lack of available external resources to finance innovation activities especially when cash flows

are reduced is one of the major explanations for pro-cyclical innovation investment patterns (Table 1). It is

well known that the specificities of innovation investments render obtaining external financing more

challenging (Hall and Lerner, 2009, for a comprehensive overview). Interestingly, Lerner (2011) suggests

the efficiency of venture capital investments could be improved if the reverse was true since these

investments appear to be deployed much less effectively during boom periods.

13. With regards to venture capital markets, Figure 7 shows a sharp decline in the numbers of

venture capital deals for the United States as the global financial crisis set in. A comparable trend was

observed in Europe. Funding for new entrepreneurial endeavours from other sources during the creditcrunch has proven to be nearly impossible as a consequence of the financial markets collapsing with

pension funds, (university) endowments and wealthy individual investors reluctant to fund ventures.

Moreover, increasingly risk-adverse investors were reluctant to commit to new obligations (Lerner, 2011).

While by last quarter of 2009 a recovery process set in the market has not returned to its 2008

performance. The pattern applies similarly across different industries.

Figure 7: Venture capital investments in the United States across by sectors: Number of deals

(Quarterly, 2006 3rd

quarter of 2011)

0

200

400

600

8001,000

1,200

1,400

Qtr12006

Qtr22006

Qtr32006

Qtr42006

Qtr12007

Qtr22007

Qtr32007

Qrt42007

Qtr12008

Qtr22008

Qtr32008

Qtr42008

Qtr12009

Qtr22009

Qtr32009

Qtr42009

Qtr12010

Qtr22010

Qtr32010

Qtr42010

Qtr12011

Qtr22011

Qtr32011

Other Sectors Computer and ICT

Media and Entertainment Industrial/Energy

Medical Devices, Equipment and Healthcare Services Biotechnology

Source: PricewaterhouseCoopers/National Venture Capital Association MoneyTree Report

based on data from Thomson Reuters

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14. Banks lending activities have also changed during the global financial crisis. Evidence from theOctober 2011 European Central Banks (ECB) Bank Lending Survey indicates banks enterprise creditstandards tightened widely with the global financial crisis. It is also worth noting the upward trend in the

third quarter of 2011 (Figure 8). It will matter to understand the underlying reasons for such changes in banks lending behaviouras this plays a role when it comes to designing policies in support of thefinancing for innovation. Responses to the same survey indicate that one reason is banks liquidityposition. The uncertainties about general economic situations, however, are also part of the explanation.

Figure 8: Changes in credit standards applied to the approval of loans or credit lines to enterprises

(net percentage of banks reporting tightening of credit standards)

-20

-10

0

10

20

30

40

50

60

70

Jan-06

Apr-06

Jul-06

Oct-06

Jan-07

Apr-07

Jul-07

Oct-07

Jan-08

Apr-08

Jul-08

Oct-08

Jan-09

Apr-09

Jul-09

Oct-09

Jan-10

Apr-10

Jul-10

Oct-10

Jan-11

Apr-11

Jul-11

Oct-11

Overall Loans to small and medium sized enterprises

Loans to large enterprises Short-term loans

Long-term loans

Source: ECB Bank Lending Survey

15. There is no evidence yet as to the impacts of financing constraints on innovation. To the extent

that similar factors affected innovation as export performance, the findings by Chor and Manova (2010)

which show U.S. exports declined more substantially in sectors with greater financing needs supports the

hypothesis that financing constraints have played a substantial constraining role in constraining firmsactivities.

16. Beyond questions of access to banking credit, strong uncertainties and volatilities in stock

markets in the current business cycle pose challenges for alternative financing opportunities, as well. There

is the open question as the high market valuation of high-tech companies stocks. Substantial volatilities infinancial markets also relate to the recently much-debated question how financial markets activities relate

to expectations about companies or investments long-term growth prospects.

Question 5: What about the role of low demand and substantial uncertainties?

17. The declines in consumer demand and uncertainties as to the recovery were probably substantial

factors behind weak innovation performance. Responses to the ECBs Bank Lending Survey suggest firmsdemand for loans from banks decreased substantially during the global financial crisis (Figure 9). Also,

more than 70% of firms in each of the six Eastern European countries (Bulgaria, Hungary, Lativa,

Lithuania, Romania and Turkey) interviewed for the World Banks Financial Crisis survey said theprimary impact of the crisis was a drop in demand for their products (Ramalho et al., 2009). Finally, asked

about major challenges a larger percentage of firms were preoccupied about factors related to product

marketsi.e. finding customers and competitionover access to finance. Figure 10 shows responses for

SMEs; the evidence on large firms is closely similar on that dimension.

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Figure 9: Changes in demand for loans and credit lines to enterprises

(net percentage of banks reporting positive loan demand)

-35

-30

-25

-20

-15

-10

-5

0

5

10

1520

Jan-06

Apr-06

Jul-06

Oct-06

Jan-07

Apr-07

Jul-07

Oct-07

Jan-08

Apr-08

Jul-08

Oct-08

Jan-09

Apr-09

Jul-09

Oct-09

Jan-10

Apr-10

Jul-10

Oct-10

Jan-11

Apr-11

Jul-11

Oct-11

Overall Loans to small and medium sized enterprises

Loans to large enterprises Short-term loans

Long-term loans

Source: ECB Bank Lending Survey

Figure 10: Most pressing problem faced by SMEs in the Euro area

(percentages)

27

14

17

9 9

5

14

4

2423

1213

88

12

1

28

15 15

11

13

78

3

25

14

1614

13

7

9

2

0

5

10

15

20

25

30

Finding

customers

Competition Access to

finance

Costs of

production or

labour

Availability of

skilled staff or

experienced

managers

Regulation Other Don't know

1 2009 2 2009

1 2010 2 2010

Source: ECB Survey on the Access to Finance of SMEs

Question 6: Will there be impacts on the global distribution of leadership in innovation?

18. As described in Section 1 while the global financial crisis certainly had global repercussions in

developed and developing economies alike particularly, Asian economies as well as certain other countries

including Brazil continued to grow in 2009. The sovereign debt crisis had an even more pronounced

differential effect on developed compared to developing economies with corresponding differences in the

impacts on innovation systems. Moreover, OECD growth forecasts predict Brazil, China, India and

Indonesia will have much higher growth rates than the OECD in 2011 and 2012 (OECD, 2011c). Such

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differential macroeconomic circumstances might facilitate further catching-up specifically of the BRICs in

terms of their innovation performance.

19. Effectively, a comparison of the worlds leading R&D investors shows that the recovery patternof 2010 R&D was highly unequal with much more substantial R&D investments for China (29.5%), SouthKorea (20.5%), India (20.5%) and Taiwan (17.8%) compared to more moderate increases of 6.1% and

10% for EU and U.S. companies (EC, 2011). Moreover, while the statistics below should be considered

with due caution, it is interesting to observe in Figure 11 evidence that China s and South Koreasperformance differs substantially from that of the United States that has known a substantial decrease in its

share of PCT filings with the onset of the global financial crisis. The evidence on pre-crisis years shows the

decline reflects a trend that predates the downturn. However, it remains to be seen whether the crisis

effectively facilitated in particular Chinas positioning. Notably, Chinas specialisation in lower quality

production helped reduce negative impacts of the global downturn; this might in reverse cause more

substantial losses during the recovery (Berthou and Emlinger, 2010). This potential negative demand shock

on Chinese goods might (due to diverse mechanisms as described in Table 1) in turn have negative effects

on innovation in China.

Figure 11: Country shares in total PCT filings (%), 2000 July 2011

40.8 39.8 37.4 35.6 35.4 3 4. 3 3 4. 3 33.8 31.6 29.4 27.4 26.3

10.3 11.0 12.7 15.1 16.5 18.2 18.117.3 17.6 19.2 19.6 22.4

13.5 13.0 13.0 12.7 12.4 11.7 11.2 11.1 11.6 10.8 10.7 9.9

0.8 1.60.9

1.1 1.4 1.8 2.6 3.43.7 5.1 7.5 8.5

1.7 2.12.3

2.6 2.9 3.44.0

4.44.8

5.2 5.95.74.4 4.3 4.6 4.5 4.2 4.2

4.2 4.14.3

4.7 4.44.25.2 5.1 4.9 4.5 4.1

3.7 3.4 3.5 3.3 3.23.0 2.8

23.4 23.1 24.2 23.8 23.0 22.7 2 2. 3 22 .3 22.9 22.5 21.620.2

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

100%

2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011*

Others

UK

FRA

KOR

CHN

DEU

JPN

USA

Source: WIPO Statistics Database,* Note that information on 2011 contains information up to July 2011 only.

Question 7: Is there a risk of long-term effects on innovation-based growth?

20. The magnitude of costs of the global downturn will be much higher if innovation systems aremore permanently affected. With sluggish growth recovery performance and substantial uncertainties

potential long-term consequences (which are referred to as hysteresis effects) are increasingly likely. The

fact that downturns specifically if related to financial crises can bring about long-run negative costs to the

economy has been established by a variety of studies (e.g. Abiad et al., 2009, Cerra and Saxena, 2008,

Calvo et al., 2006, Rafferty, 2003). Evolutionary approaches to the economics of innovation following

Nelson and Winter (1982) describe the potentially substantial hysteresis effects of shocks (Metcalfe et al.,

2006, Dosi et al., 2010).

21. Five factors could, if affected, cause long-run effects on innovation systems: i) negative long-run

effects on human capital, ii) disruptions to investments that affect efforts of future innovations, iii) negative

impacts on technological leadership, iv) changes in attitudes towards innovation projects in financial

markets, and v) permanent changes to public support systems for innovation. At present it is difficult to

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provide a verdict about the latter two aspects since both financial markets and public innovation policy are

currently subject to substantial debate; potential implications on trends in innovation should be considered

when corresponding policy decisions are taken.

22. First, as to negative long-run effects on skillsa central element for innovation (OECD, 2010)the global financial and current crises have led to increased unemployment rates including among the

skilled involved in innovation activities (from firms that decide to downsize innovation-related activities in

particular in addition to innovative businesses that are forced to exit). Longer-term innovation effects from

lay-offs can arise in two ways:

Skilled human capital might be reduced if capacities and up-to-date knowledge are lost as isthe case for the long-term unemployed. In fast-paced high-tech sectors such as pharmaceuticals,

aeronautics and IT long spells of unemployment lower exposure to technology and, in

consequence, deplete available workers skills. High unemployment rates of college graduates

also pose a challenge since early-career unemployment can permanently scar integration into

the workforce along the entire career path.

At the business level dismissals can lead to permanent scars for innovation processes if laid -offemployees hold tacit knowledge which will be lost to firms as they leave. Such factors could

bring about a much slower recovery in innovation performance as new employees first need to

acquire such knowledge.

By contrast, a factor that might act as a counter-weight is an increase in training for those unemployed.

23. Substantial uncertainties over recovery processes suggest employment will not be quick to

recover; the potential risks for long-term effects due to unemployment are, therefore, important. In a

survey of 532 senior executives conducted by McKinsey some respondents worried that changes to R&D

could weaken available talent for future R&D activities (McKinsey, 2010). The current downturn mightalso accelerate long-term trends towards more flexible employer-employee relationships. As has been

widely noted information and communication technologies (ICTs) have altered work processes. More

specifically, they allow segmenting production processes increasingly and this includes highly-skilled tasks

which can be executed by short-term assignments. An advantage of such processes is that businesses face

no labour termination costs and, therefore, might be much less hesitant to re-hire. The question whether

such flexible employment relations support and/or weaken innovation processes needs to be tested.

24. Second, innovation investments that are not made in the present might likely have effects on

innovation performance in the near future as with limited investments the pool of opportunities for

successful innovations is reduced. Moreover, if businesses interrupt innovation investment projects then

resuming such activities might require larger upfront costs. This can in turn lead to a slower recovery of

innovation investments. The loss of tacit knowledge and the costs involved in establishing newarrangements for innovation can also slow down investments. At least for the worlds leading R&Dinnovators the substantial recovery of 2010 suggests that the shock of 2009 had not affected underlying

innovation investment capacities (EC, 2011). Yet the uncertainties of 2011 might pose challenges

particularly for smaller businesses. Finally, to the extent that some innovative firms exited overall

innovation investments might be lower at least until entry of comparable innovative businesses takes place.

The latter is as described above not the case at present.

25. Third, technological leadership would be at risk if key businesses relocated to form a cluster of

activities abroad in response to prolonged low demand in local markets, difficult financing conditions and

other challenges for operating their business. Such relocations might turn out to be irreversible and,

therefore, have an effect beyond the downturn if businesses find returning to their previous location not

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optimal even with a recovery. However, it would seem that a very long and severe recession only could

bring about such relocation even if the increasingly global nature of innovation and ICTs might change

dynamics of clusters.

Question 8: What about innovation policy at present?

26. Many governments implemented stability packages in reaction to the global financial crisis and

these often included substantial measures in support of innovation (OECD, 2009). Figure 12 illustrates

three distinct post-2008 trends in government expenditure on R&D: For the United Kingdom and Canada

spending remained at comparable levels to 2007, for Finland there was a notable increase in spending

while the reverse was true for Ireland. In the present context innovation policies have to succeed in striking

a balance: While strong innovation performance contributes to raising growth prospects high levels of

public spending in its support can be a challenge for tight public budgets. The way forward might consist

in exploring some of the following i)seeking greater efficiencies in public sectors innovation support, ii)concentrating funding in sectors of strategic relevance, and iii) exploiting co-operative arrangements in

support of innovation with the private sector.

Figure 12: Trends in government intramural spending on R&D (GOVERD) for selected countries

(2007 = 100)

80

90

100

110

120

2004 2005 2006 2007 2008 2009 2010

Canada

Finland

France

Germany

Ireland

Italy

Japan

United

Kingdom

Note: The following data points are provisional: Ireland - 2009, 2010, Italy - 2009, 2010, UK - 2010. The following statistics arenational projections or estimates: France 2009, Finland - 2010. Data for Israel across all years exclude the defence sectorsspending. Data for Germany include other classes as is also the case for the 2010 data for Finland.

Source: OECD MSTI Database 2011-1

27. Innovation policies at present need to focus on two objectives: the first consists in fosteringpositive long-term trends in innovation performance. In fact, in the United States the slowdown in new

business entry predates the global financial crisis (Haltiwanger, 2011). Across the OECD a productivity

slowdown also set in well before (Dupont et al., 2011). Therefore, low economic growth in the current

context might partly reflect deterioration in fundamentals and point to a need for structural support

policies. Similarly, low growth in some of the Southern European economies possibly also reflects well-

known weaknesses of prevalent innovation systems. At the same time the downturn has, as described

above, had impacts on innovation. The second objective, therefore, has to consist in avoiding possible

long-term damages to innovation systems caused by the crises themselves.

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28. The following seem important priorities at present:

Enhancing performance of public institutions in charge of innovation further

Avoiding costly and inefficient disruptions of innovation processes

Exploring regulatory changes in support of framework conditions for innovation

Addressing demand uncertainties to unleash innovation investments

Identifying effective ways for financing innovation and entrepreneurship

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