Research
19 May 2011

Businesses should be rewarded for innovation

European governments need to devise policies that enable financial markets to reward rather than penalise innovation and thereby encourage longer-term investment planning, research coordinated by the Open University warns.

Evidence suggests that companies who engage in riskier and more innovative ventures are being penalised by banks through high interest rates and by governments through tax measures when compared with their less innovative counterparts.

The research highlights how the tendency to penalise innovation is leading to businesses focusing on short-term profits rather than long-term growth, which creates a situation in which the processes that connect the price and fundamental value of an asset fail to self-correct. As the research explains, such a malfunction causes “price and value to diverge to the point that the pricing mechanisms undergo a catastrophic failure” – known as a financial bubble.

The increasing trend for companies to buy back their own stock, to keep stock prices high, also reflects the focus on short-term profits rather than long term growth. These stock buybacks often occur at the expense of research and development spending.

The findings come in the second of a series of policy briefs published by FINNOV (Finance, Innovation and Growth), which is a three-year study to understand the sources, implications and management of positive and negative changes in financial markets. The Open University leads FINNOV, coordinating a consortium of institutions from across Europe, including the Economics Institute in the Czech Republic and the University of Cambridge, in conducting the research.

Open University Professor of the Economics of Innovation and FINNOV project coordinator Mariana Mazzucato said: “Financial markets are creating a very short-term set of goals, which is stifling innovation and creating huge problems for our economy. Rather than being rewarded for innovation, businesses are penalised.”

The latest European policy brief, Innovation, Uncertainty and Bubbles, will be launched at a conference in Prague this week (19 - 20 May), where leading academics and economists will put forward solutions for reforming the European economy.

The policy brief states that the pricing failures that create bubbles are increasing in regularity and becoming more damaging.
It argues that self-correcting financial markets are a myth and unless governments take action to introduce mechanisms to reward investment, such as through tax benefits and subsidies, the situation could worsen and increase the prevalence of bubbles.

Professor Mazzucato said: “The financial crisis gives added weight to the argument that industrial policy needs to return after decades of taking a back seat and it also signals the economic and political imperative for understanding financial bubbles.

“The coalition government’s cuts are hurting the ‘animal spirits’ that deliver the confidence to experiment with brave new ideas and are shattering any likelihood of turning the UK into a hotbed of innovation. We need policies to reward innovation, along with targeted state investment that will encourage companies to take bold steps to focus on longer term goals. Ploughing more cash into innovation is the key to recovery.”

FINNOV has devised a list of essential steps needed for financial reform in order to allow financial markets to reward rather than harm innovation, helping the economic system to better withstand the next financial crisis.

These include:

• The time any private equity investment must be held before the gains from sale can be exempt from Capital Gains Tax, should be raised in the UK to at least five years (currently only two, previously 10 in 2002). This would help prevent the ‘take the money and run’ approach in green tech, which has characterised investments in biotechnology companies, most of which remain ‘product-less’

• State investments in radical technology, which have fostered the growth of computers, biotech and green tech today, should be better rewarded for this risk-taking activity, especially if these types of investments can survive in the future

• The EU should ensure that business corporations under its jurisdictions do not imitate US corporations in making stock buybacks to manipulate stock prices and giving corporate executives stock-based pay. Such activity has had the sole goal of boosting stock prices, at the expense of long-run investments in innovation

• Credit ratings should better reflect the industrial performance of companies, such as their productivity, and investments in innovation, rather than focusing solely on financial performance measures

• Short-termism is especially problematic in contexts in which radical technological change is needed. The greater uncertainty in such areas, such as in new green technologies, has caused venture capital and other forms of private equity to be too risk-averse, and hence not play a leading role. Given the lack of private investments, the UK government should step up and increase its ‘green’ budget. In the US, the stimulus packages included 11.5% of the budget devoted to green investment, South Korea 80.5%, China 34.3% and France 21%, but in the UK the figure is only 6.9%. The 2010-2011 budget saw £85 million cut from the UK’s Department of Energy and Climate Change (DECC) budget. If the UK wants a share of the Green Tech Boom, it must play a much more active role

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