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How Financial Frictions Hinder Innovations

June 17, 2024

A recent study co-authored by Wharton’s Thomas Winberry reveals that financially constrained firms face a trade-off between investing in existing ideas and pursuing new ones.

When it comes to funding, existing projects tend to take precedence over innovative ideas, according to a study by Wharton and University of Maryland experts. The researchers analyzed project funding patterns at publicly listed U.S. firms between 1975 and 2018 and developed a model to explain their findings. In their paper, “Capital, Ideas, and the Costs of Financial Frictions,” they delve deeper into this discovery.

“Financial markets tend to fund the implementation of existing ideas or investment-intensive projects but often fail to adequately fund the discovery of new ideas,” said Wharton finance professor Thomas Winberry, who co-authored the paper with Pablo Ottonello, an economics professor at the University of Maryland.

While innovative ideas are abundant, securing funding for them can be challenging. “If you have a revolutionary new product idea, it’s relatively easy to attract investors and scale up,” Winberry explained. “However, if you’re still exploring ideas and don’t have a tangible product to showcase, you’ll need to rely on internal resources or alternative financing sources, which can be harder to come by and more costly.”

Making the case for business innovation

In the long run, economic growth is driven by new ideas that push the technological frontier, the paper noted. While new firms bring many of these ideas, existing firms also play a significant role. However, they face a trade-off when choosing between scaling up production using existing ideas and innovating with new ideas. As these two spheres compete for funds, firms must make choices based on their financial constraints, shaped by internal resources and the frictions they encounter when raising money from banks or public markets.

According to Winberry, the distinctive feature of their study is its exploration of the competition between investment and innovation within firms. Most growth models focus on innovation financing in isolation, without considering the competition for funds from other activities, he noted.

“There hasn’t been enough focus on how imperfections in financial markets can hinder growth,” Winberry continued. “We’re trying to make the case that financial markets do indeed impede growth significantly. If we can identify ways to address these imperfections, it could have a pro-growth effect on the economy.”

Firms balance the trade-off between investing in tried-and-tested projects and innovative ideas based on the financial frictions they face. Financial frictions can take various forms; the paper focuses on the limits of firm borrowing against collateral. Other frictions might include debt-equity ratios guiding bank lending, the creditworthiness of a firm’s management, or psychological biases against specific industries or types of firms.

“We’re trying to make the case that financial markets do indeed impede growth significantly. If we can identify ways to address these imperfections, it could have a pro-growth effect on the economy.”

The study examined how financial frictions distort the mix of investment and innovation at both the firm and economy levels. It tracked investment-intensive activity in physical assets like plant and equipment, and innovation-intensive activity using R&D expenditure and patenting activity as proxies.

Firms attempt to overcome financial frictions with internal resources; the paper uses net worth as a measure of these resources. “Firms with low net worth are more likely to be affected by financial frictions, as they need to borrow more to finance their investments than firms with higher net worth,” Winberry explained.

The pecking order of growth

The authors found evidence of this in their empirical study of publicly held firms. “Empirically, we find a pecking order of firm growth: Firms are investment-intensive when small and have low net worth but become more innovation-intensive as they grow and accumulate net worth,” Winberry said. The paper’s model supported this finding.

In addition to studying the effects of financial frictions on firms, the authors also assess the macroeconomic impact. Without financial frictions, the economy’s growth rate would be about 40 basis points higher per year, or approximately 0.4%, according to their model. Assuming a 2% annual GDP growth rate, the absence of financial frictions would increase it to around 2.4%.

“That’s because more firms are innovating, more new ideas are being discovered, and more new technologies are emerging. Ultimately, that’s what drives long-term growth,” Winberry said. “If you accumulate 2% growth versus 2.4% growth over 20, 30, or 40 years, those are significant differences in terms of GDP.”

Winberry traced the evolution of small firms with low net worth into a state where they are ready for innovation-intensive investments. “Over time, they build up their productive capacity and eventually reach a natural scale. Then it makes sense for them to start looking for their next idea.”

The paper does not offer specific policy recommendations, but Winberry suggested that removing or reducing financial constraints can spur innovation. Policymakers can achieve this by subsidizing innovation expenditure or enabling innovation by requiring fewer financial resources from firms, he said.

He noted that over the past five or six decades, the U.S. has made it easier for firms to invest with increases in investment tax credits and depreciation allowances. “We’ve changed a lot through the tax code to provide an implicit subsidy to investment. The more you do things like that, the more innovation you’ll get, and ultimately, higher growth.”

For all your financial planning needs, reach out to Omni360. Their expert team is ready to assist you with personalized financial strategies tailored to your unique goals. Contact Omni360 today to secure your financial future with confidence.

By: Knowledge@Wharton.com

© 2024 Horsesmouth, LLC. All Rights Reserved.



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