Economists sometimes argue that recessions promote activities that ultimately contribute to long-run growth. But evidence suggests research and development, one important source of economic growth, falls rather than rises during recessions, even for firms that do not appear to be credit constrained. The author discusses an alternative explanation for this pattern.Research and development

Gadi Barlevy

English

Research Papers in Economics

Chicago Fed Letter
Why don’t recessions encourage more R&D spending?
by Gadi Barlevy, senior economist and economic advisor
Economists sometimes argue that recessions promote activities that ultimately contribute to
long-run growth. But evidence suggests research and development, one important source of
economic growth, falls rather than rises during recessions, even for firms that do not appear
to be credit constrained. The author discusses an alternative explanation for this pattern.
ESSAYS ON ISSUES THE FEDERAL RESERVE BANK NOVEMBER 2005
OF CHICAGO NUMBER 220
1. R&D growth over the business cycle
percent percent
NOTES: The growth rate of real R&D expenditures is measured as the growth rate
of current dollar expenditures on R&D minus the growth rate of the Consumer
Price Index. The shaded regions correspond to recessions as defined by the
National Bureau of Economic Research.
SOURCE: National Science Foundation.
Growth rate, real GDP (right scale)
Growth rate, real R&D expenditures (left scale)
Growth rate, number of full-time equivalent R&D
scientists and engineers (left scale)
1954 ’60 ’66 ’72 ’78 ’84 ’90 ’96 2002
–.10
.00
.10
.20
.30
.40
–.12
–.08
–.04
.00
.04
.08
In recent years, econ-
omists have revived
the notion, often as-
sociated with the late
economist Joseph
Schumpeter, that eco-
nomic downturns play
an important role in
promoting long-run
productivity growth.
In this Chicago Fed
Letter, I report on my
work in Barlevy
(2005), which exam-
ines how recessions
affect one particular
channel for growth—
namely, research and
development (R&D).1
The modern formula-
tion of Schumpeter’s
idea builds on the ob-
servation that produc-
tion is less profitable
during recessions. As
a result, recessions are
an ideal time for firms
to engage in activities that enhance
their productivity but tend to interfere
with production. Examples of such ac-
tivities include retraining workers, re-
tooling a shop floor, upgrading capital
equipment, and experimenting with
ways of providing better products at
lower costs. If slack periods encourage
firms to undertake needed improve-
ments that they were reluctant to start
earlier, these periods will lead to high-
er eventual productivity.
The reallocation of resources from
production to enhancing future pro-
ductivity can occur both within firms—
whereby resources are redirected from
the production floor to improving in-
novation—and between firms, as some
firms shed workers who are in turn hired
by budding entrepreneurs developing
new ideas and trying to start up compet-
ing firms. Since product development
requires support staff as well as skilled
labor, it is not unreasonable that the
production workers who are let go by
some established firms will be of value
to emerging firms that are developing
new products.2
Following this logic, one would expect
that more resources should be allocated
to formal R&D during recessions. In
particular, as noted by Griliches (1990),
recessions do not seem to affect the
ability of researchers to come up with
new ideas, at least as measured by the
number of new patents that result from
a given research effort.3 If production
suffers during recessions while R&D
does not, then recessions should be an
ideal time to actively seek out and de-
velop new ideas and products.
Nevertheless, the empirical evidence
shows that R&D tends to fall during
recessions, not rise. The primary data
source on R&D activity in the U.S. is
the National Science Foundation (NSF),
which compiles data on annual R&D
expenditures by sector and by source
of funding. Figure 1 plots the growth
rate of R&D expenditures identified2. R&D growth, aggregate vs. Compustat firms
percent
NOTES: This figure is reproduced from Barlevy (2005). The shaded regions corre-
spond to recessions as defined by the National Bureau of Economic Research.
SOURCES: National Science Foundation and Standard and Poor's Compustat
database.
by the NSF as financed and performed
by private industry, adjusted for the rate
of overall inflation. It also plots the growth
rate in the number of full-time equiva-
lent scientists and engineers employed
by private industry, which is one of the
primary inputs into R&D. Although the
latter series only captures a part of R&D
activity, it has an advantage in that it does
not depend on the price of R&D inputs.
This is important, since inflation adjust-
ments to nominal R&D expenditures
may not accurately reflect changes in the
price of R&D. The two data series track
each other closely, suggesting changes in
inflation-adjusted R&D expenditures tru-
ly reflect changes in the extent of R&D.
To appreciate how R&D activity varies
over the business cycle, figure 1 also de-
picts the growth rate of real gross domes-
tic product (GDP). The shaded regions
correspond to recessions as defined by the
National Bureau of Economic Research
(NBER). As can be seen in the figure,
periods of economic growth are associ-
ated with a more rapid increase in R&D.
In almost all recession years, at least one
measure of R&D activity falls. The one
exception is the early 1980s, when R&D
activity continued to grow at the same
rate as just before the recession. Thus,
there is no evidence that recessions
encourage R&D, and there is some ev-
idence that they actually discourage it.
Credit constraints
One possible explanation for why R&D
falls during recessions involves credit
constraints.4 Accord-
ing to this argument,
firms would indeed
like to concentrate
innovative activity
such as R&D during
recessions. However,
like all investment,
R&D entails an ini-
tial expenditure for
labor and equipment,
and this expenditure,
if it pays off, will only
do so in the future.
Unless the firm has
ready cash to pay for
its R&D, it will have to
borrow against future
profits in order to cov-
er these costs, and so
its R&D activity will
depend on credit
market conditions.
During recessions, when profits are low,
firms tend to have less available cash
at their disposal. Consequently, firms
have to turn increasingly to outside
funding to finance their planned R&D.
At the same time, credit is typically
scarcer during recessions, as households
respond to income losses by drawing
down their savings. These two forces
will act to increase the cost of borrow-
ing for firms, and firms may face more
difficulty in securing the funds they
need to cover their R&D costs. There-
fore, firms that have already initiated
R&D projects might be forced to sus-
pend them, while firms that have yet
to begin R&D projects might decide
not to initiate them.
To gain insight on the importance of
such credit constraints, I analyze data
on the R&D expenditures of individual
firms. In particular, if firms were pre-
vented from undertaking more R&D
during recessions because of credit
constraints, one would expect that firms
that are relatively less credit constrained
would tend to concentrate their R&D
expenditures during recessions. Fortu-
nately, the Standard & Poor’s Compustat
database contains detailed balance-
sheet information on publicly traded
companies, including R&D expendi-
tures. I use this data set to get at pre-
cisely this prediction.
I should note at the outset, however, that
the Compustat database comprises dis-
proportionately large firms compared
with those that make up the economy
as a whole. How representative of over-
all R&D are the R&D expenditures of
the firms in the Compustat database?
Figure 2 shows two data series. The blue
line represents the growth in inflation-
adjusted R&D expenditures by private
industry reported by the NSF, the same
series as in figure 1. The black line rep-
resents the unweighted average growth
rate of inflation-adjusted R&D expen-
ditures each year across all Compustat
firms that report some spending on R&D.
Note that the two series are quite similar
to one another. This reflects the fact that
large firms account for the bulk of R&D
expenditures. For example, between
1957 and 1998, the NSF estimates sug-
gest that 81% of all R&D expenditures
financed and performed by private in-
dustry were undertaken by firms with
at least 5,000 employees. The fact that
the R&D expenditures of publicly traded
firms do not look very different from
total R&D expenditures already raises
doubts as to whether credit constraints
can entirely account for why recessions
fail to encourage R&D spending, since
publicly traded firms are less constrained
in their ability to raise funds than the
typical private firm.
Even among the publicly traded firms
in the Compustat database, some firms
seem less financially constrained than
others. In particular, some firms have
large amounts of ready cash they can
use to finance R&D or have consider-
able net worth against which they can
borrow. So, are the firms that are less
credit constrained more likely to under-
take R&D during recessions? Figure 3
plots the unweighted average growth
of inflation-adjusted R&D expendi-
tures among all firms that had at least
$50 million in cash in the year in which
they undertook R&D. It also shows the
unweighted average growth rate of in-
flation-adjusted R&D expenditures
among all firms with a net worth of
$150 million in the year in which they
undertook R&D. These cutoffs roughly
correspond to the top one-third of the
firms in my sample in each category.
There is considerable overlap between
the two, i.e., firms with a high net worth
also tend to have a high cash flow, al-
though the overlap is not perfect.
As shown in figure 3, the tendency for
R&D growth to dip during recessions
is even more pronounced among firms
1954 ’60 ’66 ’72 ’78 ’84 ’90 ’96 2002
–.10
.00
.10
.20
.30
Compustat universe
Aggregate (from NSF)Michael H. Moskow, President; Charles L. Evans,
Senior Vice President and Director of Research;  Douglas
Evanoff, Vice President, financial studies; David
Marshall, Vice President, macroeconomic policy research;
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research;  William Testa, Vice President, regional
programs and Economics Editor; Helen O’D. Koshy,
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Molloy and Julia Baker, Production Editors.
Chicago Fed Letter is published monthly by the
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3. R&D growth in relatively unconstrained firms
percent
NOTES: Cash flows and net worth are measured in 1996 dollars. The shaded regions
correspond to recessions as defined by the National Bureau of Economic Research.
SOURCE: Standard and Poor's Compustat database.
1954 ’60 ’66 ’72 ’78 ’84 ’90 ’96 2002
–.10
.00
.10
.20
.30
Lagged cash flow > $50 mil.
Lagged net worth > $150 mil.
that are less likely to be credit con-
strained. For example, the average
growth rate in R&D for such firms falls
during the two recessions of the early
1980s, when aggregate R&D expendi-
tures continued to grow at the same
rate as before.
Figure 3 suggests credit problems can-
not entirely account for why firms fail
to take advantage of recessions to un-
dertake more R&D. To put it another
way, a policy that serves to ease borrow-
ing conditions during recessions may not
be able to reverse the tendency of firms
to reduce their R&D activity during re-
cessions, since even firms that have easy
access to credit appear to cut back on
their R&D during recessions.
An alternative explanation
If credit constraints do not entirely
explain the pattern of reduced R&D
spending during recessions, what does?
One explanation I explore in Barlevy
(2005) relates to firms’ tendency to
act in a shortsighted manner, focusing
on the immediate profits they can reap
from a successful innovation. This is
driven by the fact that when an entre-
preneur discovers a new idea, rival
producers can learn from his original
insights and build on them. This is es-
pecially true if the new idea is patent-
ed, since a patent requires a detailed
description of the new insight to avoid
duplication. Over time, rivals may be
able to use the patent to come up with
their own ideas, which they can use to
cut into the profits of the original in-
novator or even displace the original
innovator altogether.
Entrepreneurs, fear-
ing they will only earn
profits on an innova-
tion over a relatively
short period, might
be reluctant to allocate
significant resources to
R&D during a reces-
sion, especially if re-
cessions herald weaker
economic conditions
in the near future.
According to this logic,
growth-enhancing
activities that do not
involve spillovers to
other companies,
thereby cutting into
the originating firm’s
profits, would be concentrated in reces-
sions. Examples of this type of activity
might include upgrading to a machine
that is already widely available or train-
ing workers in some established skill.
Francois and Lloyd-Ellis (2003) cite
various studies that show that these sorts
of activities—retooling, retraining, and
reorganization—do in fact appear to be
concentrated in recessions.5
Shleifer (1986) already pointed out that
firms would find it in their best interest
to introduce innovations during boom
periods.6 However, he drew a distinc-
tion between when firms conduct R&D
and when they implement these ideas,
i.e., when they make them public and
allow rivals to learn from their inven-
tions. In particular, he argued that
firms would wait until the economy
was booming to introduce their ideas.
However, this does not imply that R&D
activity would itself occur in booms. As
Francois and Lloyd-Ellis (2003) point
out, when firms delay implementation,
it is optimal for them to engage in R&D
during recessions—when it conflicts
less with production—and to wait until
economic conditions improve before
introducing them. But in practice, it
seems that, for various reasons, firms
prefer not to delay implementing their
new ideas. As Griliches (1990) observes,
innovators tend to take out patents very
early in the research process, soon af-
ter discovery. Given that firms plan to
reveal their ideas immediately, they will
choose to both research and roll out
their new ideas during booms in order
to enjoy higher short-term profits.
Conclusion
Even though many firms prefer to con-
centrate R&D during booms, including
those firms that do not seem forced to
do so by financial constraints, it should
be understood that this pattern is proba-
bly not in society’s best interest. In par-
ticular, it leads society to devote more
resources to R&D when R&D is most
disruptive to production rather than
when it is least disruptive. The actions
of private entrepreneurs thus make
productivity growth more costly than it
needs to be. This suggests there may
be some scope for policy intervention.
One possible remedy is to subsidize R&D
during recessions. Of course, there are
many caveats to implementing such a
policy. Firms may try to take advantage
of these subsidies, especially when it is
difficult to anticipate whether a partic-
ular research program will be successful.
Entrepreneurs may have an incentive
to pocket the subsidy and not invest
serious efforts in making progress on
their research while economic condi-
tions are weak. An ill-conceived subsidy
program could easily end up doing
more harm than good.
At the same time, the evidence above
does caution against relying on easing
access to credit to encourage more R&Dduring recessions. The data suggest that
the bulk of R&D is carried out by large,
well-financed firms, and even among the
firms with ready access to funds, R&D
spending appears to decline during
recessions. Allowing recessions to prop-
erly serve as an incubator for new ideas
should probably not be seen as the re-
sponsibility of financial overseers who
can affect credit market conditions.
1 G. Barlevy, 2005, “On the timing of inno-
vation in stochastic Schumpeterian growth
models,” Federal Reserve Bank of Chicago,
working paper, No. WP-2004-11, revised
August 9, 2005.
2 For example, the National Science Foun-
dation reports that 40% of wage payments
in R&D go to support staff.
3 Z. Griliches, 1990, “Patent statistics as
economic indicators: A survey,” Journal of
Economic Literature, Vol. 28, No. 4, December,
pp. 1661–1707.
4 See, for example, P. Aghion, G. M.
Angeletos, A. Banerjee, and K. Manova,
2005, “Volatility and growth: Credit con-
straints and productivity-enhancing in-
vestment,” National Bureau of Economic
Research, working paper, No. 11349.
5 P. Francois and H. Lloyd-Ellis, 2003, “Animal
spirits through creative destruction,”
American Economic Review, Vol. 93, No. 3,
June, pp. 530–550.
6 A. Shleifer, 1986, “Implementation cycles,”
Journal of Political Economy, Vol. 94, No. 6,
pp. 1163–1190.

Why don't recessions encourage more R&D spending?

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Why don't recessions encourage more R&D spending?

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