RIETI Report June 2009

Economic Policy Initiatives during the Crisis

The OECD is undertaking two major initiatives that are directly related to the global economic crisis. The first initiative is focused on restoring the global financial system and strengthening long-term growth performance while the second initiative, which commenced prior to the onset of the crisis, involves research into policies that improve innovation performance.

Dirk Pilat, who is the Head of the Structural Policy Division in the Directorate for Science, Technology & Industry at the OECD, recently made a presentation at RIETI in which he gave a general overview of the two major crisis-related initiatives before highlighting some of the details surrounding them. In addition to pointing out the favorable impact of innovation performance on positive growth and the unfavorable impact of negative growth on innovation performance, Pilat also discuses various factors that are having an impact on innovation performance during the crisis. R&D spending, global trade, government stimulus programs and government bailouts to name a few are all impacting innovation performance in a variety of different ways.

"The Impact of the Crisis on Innovation and Long-term Growth: Evidence, implications and policy responses"

May 19, 2009
Speaker: Dirk PILAT,
Head of Structural Policy Division, Directorate for Science, Technology & Industry, OECD

Mr. Dirk Pilat, a Dutch national, is Head of the Structural Policy Division in the OECD Directorate for Science, Technology and Industry (DSTI). He is responsible for the OECD's Committee on Industry, Innovation and Entrepreneurship, which aims at the development of good policy practices in these areas. He joined the OECD in February 1994 and has worked on many policy issues since then, including how to draw greater benefits from information technology for economic growth, how to strengthen growth performance in OECD economies (the OECD Growth Project), how to strengthen the performance of the services sector, as well as work on climate change, labour markets, product market regulation, innovation, productivity and entrepreneurship. He was Head of the Science and Technology Policy Division from 2006 to January 2009. Mr. Pilat holds a PhD in Economics from the University of Groningen, in the Netherlands.

For an overview of what the OECD is doing regarding the current crisis, there are two large initiatives currently being undertaken. The first is the OECD's Strategic Response to the Economic Crisis which cuts across the organization and looks at two aspects of the crisis. The first aspect is dealing with getting the financial system back in operation. Much of that work is linked to what the IMF and other international institutions are doing, but the OECD is focusing on a number of additional aspects in this respect, including corporate governance and tax systems. The second aspect is how the OECD can deal not only with the immediate problem, but what can be done to strengthen long-term growth performance. Looking back to where the crisis came from, productivity growth in many OECD countries began showing declines before the crisis. Some root causes of the crisis and the decline of economic growth were happening prior to the crisis; the crisis only made this fact more clear. In order to emerge from the crisis in a stronger position, policies that can strengthen long-term growth must be considered.

The second area of work that is being undertaken by the organization was started before the crisis based on a request by member countries to once again look at policies to improve innovation performance. As mentioned, economic performance and productivity growth was declining in many OECD countries. Many countries had policies to improve innovation performance. For example, Europe had been following the Lisbon strategy for some time as it attempted to strengthen innovation performance in Europe. The Lisbon strategy has not had a big impact and many other countries in the OECD area were also struggling with how to improve growth and innovation performance. The question is whether more can be done to address this problem, including better policy recommendations and a coherent strategy to improve economic performance through innovation.

The idea of focusing on innovation came from both a need to strengthen economic growth and the fact that innovation itself was changing. Typically, innovation policies around ten years ago focused on science, technology and hard technological innovations. Many other types of changes in innovation were being ignored. The role of organizational change in innovation performance, which is necessary to make technology work well, was nonetheless ignored by many countries. Also, the focus in many countries was on pushing technology into the workplace, but not looking at market conditions and consumer demand for innovative products. The focus is quite different now because it takes a broader perspective on what innovation is. This may translate into changes in policies to strengthen innovation performance.

Innovation is typically thought to suffer in downturns. Variations in GDP growth and indicators of innovation, including patenting, research and development (R&D) and trademarks reveal that these factors fluctuate with the business cycle. If the economy goes down, certain types of innovation indicators will also go down. This is partly because much of the spending on R&D is dependent on cash flows. If cash flows decrease, companies cannot spend as much on R&D. The question is whether or not this will happen in the current crisis, which is primarily a financial crisis. Many companies that spend heavily on R&D entered the crisis with good cash positions. Quite a few companies thus have not yet cut back on R&D spending, though they may do so in the future. Also, looking at other aspects of innovation performance like investment and venture capital, there is a clear decline. There has been a fairly strong decline of venture capital in the United States, partly due to difficult financial markets. Moreover, difficult market situations also make it very hard for companies to enter markets.

R&D investment is now falling in some large companies and many have announced that R&D investment will be reduced. A reorientation is occurring with a growing focus on development rather than long-term research. However, according to a McKinsey & Co. survey, many companies admitted to reducing R&D spending and changing the types of R&D that they are undertaking. At the same time many companies were increasing R&D spending due to a perceived benefit of taking advantage of the current weak position of competitors. This exemplifies how crises occur in times when economies renew themselves and creative destruction takes place. Many big firms today, like Nokia, were created during downturns. A problem lies with smaller firms that are much more affected by the financial situation than such larger companies. The cash flows of many of these firms are drying up and there has been a sharp increase in bankruptcies and insolvencies in such firms around the world. New firms face similar dangers due to difficult market entry and exit conditions.

World trade is also a major factor affecting global innovation. Trade is an important determinant of all economies, and world trade has fallen sharply in the current crisis. This has had an impact on innovation and long-term growth performance because as economies become more global, global innovation networks will suffer as well. Demand decreases in certain industries that feed through to firms in different sectors. With these conditions, protectionist risks increase. Overall, since many large companies operate globally, there is a greater risk to growth and innovation.

Environmental innovation has been increasing in recent years, though with current price conditions there is a reduced incentive to continue pursuing this kind of innovation. Consumers are buying less expensive goods, and thus environmentally friendly goods that generally come with a price premium are becoming less popular. Firms also find it more difficult to come out with new products and services that are more environmentally friendly but also more expensive. The falling price of oil has eroded financial incentives for environmental innovation. While GHG emissions are decreasing due to the U.S. economic slowdown in particular, the situation has been drawing more attention to environmental innovation. The overall situation for environmental innovation is a difficult one.

It has become clear that many industries that found themselves in trouble in the crisis were already in trouble before, with the crisis only serving to reveal longstanding problems. The automobile industry, for example, had large supply surpluses with many manufacturers running on unsustainable business models. The crisis has made these problems clearer. The crisis has also evolved from an event that initially hit only financial markets in affected countries to an economic crisis that has spread to countries with significant manufacturing industries.

Part of governments' responses to the crisis were stimulus packages. A mixture of bailouts and tax cuts attempted to revitalize both consumer and business spending. Most OECD economies have implemented such packages and several others have introduced legislation, with the largest being the $800 billion U.S. stimulus package. Stimulus package overall range from 0.3%-8.0% of GDP. Some non-OECD countries, including China, Russia and Brazil have also given strong boosts to overall spending, but the U.S. and South Korea have the largest packages as a percentage of GDP.

The packages implemented by most OECD countries were a mixture of stimulus and tax cuts, though some countries responded almost exclusively with spending cuts. Much of the money included in such packages was already allotted to certain projects or programs, so it is difficult to compare stimulus packages. The OECD is working to analyze what is in the packages to stimulate long-term economic growth. Many countries are focusing on infrastructure improvements as it has a large multiplier effect in terms of both short- and long-term growth performance. The infrastructure improvements happening now include both traditional and more modern types of infrastructure like broadband connections, smart electricity grids and others. There is also a focus on improving the quality of infrastructure.

Support for R&D and innovation is increasing because countries see these areas being affected by the crisis. There is more of an appreciation for investments in these areas. Investments in human capital have increased in connection with the focus on R&D and due to the higher unemployment caused by the crisis. There is also a need to help unemployed workers find new jobs and retrain them. Green technologies are making up an important element of stimulus packages in different countries, while entrepreneurial innovation is also receiving strong support. Generally, the largest category of investment in stimulus packages is infrastructure followed by human capital, and R&D.

At the same time there are many non-financial measures underway. Some countries do not have much room to maneuver fiscally, so there is a focus on improving governance, hastening administrative procedures, implementing measures to improve the efficiency of public administration and others. These measures are devised to complement fiscal measures in stimulus packages. Many countries are trying to implement double-dividend actions that stimulate both short-term demand and long-term growth. Some examples of this type of measure include investments in infrastructure, spending on training and the labor market, and easing market entry for new firms.

The long-term element of these actions improves the credibility of government actions. Using stimulus packages to improve both short- and long-term prospects allows the economy to come out of the crisis stronger than it was going into the crisis. The OECD has emphasized that the crisis is an opportunity to make changes which are normally difficult to make. The scope for policy changes is bigger during crises because the need for change is more apparent.

Investments in innovation can be of strategic importance for long-term growth. Most growth comes from improvements in efficiency, new technologies, new types of innovation, and doing things better. The crisis causes some of these types of investments to fade away, but governments are trying to cushion the fall in private R&D spending through support for private R&D. Many countries are investing in research infrastructure because it can be a double-dividend improvement. Many countries are also trying to connect spending in research, development and innovation to the market. Government policies are trying to connect innovation policies to new social and economic needs because this is where future markets will be located.

Financing for small and innovative firms is also being provided. These firms are important because they bring radical ideas and approaches. Without these firms much will be lost in terms of innovation performance. A number of governments are trying to reduce payment delays for public procurement in order to make it easier for such companies to receive cash. Changes to tax payments and export credits are also being implemented. There is much policy development in the way of enhancing access to capital and liquidity for these firms by extending loans and providing loan guarantees. France is mediating between banks and small firms in order to increase access to liquidity.

Governments are also providing support to industries in need, sometimes indirectly. German government support for the car industry is an example where the government provides credit for consumers trading in inefficient cars or ones that pollute the air for newer models. Direct support programs for such industries come with high risk because they tend to lock into established economic structures, even if that structure is going through difficulties. General Motors, for example, is being looked at by the U.S. government in terms of how change and innovation can be stimulated in the firm. Another risk is that if existing companies receive too much support, it may cut into the opportunities for new companies with new ideas and new business models to thrive.

If governments are to provide support for companies in trouble, that support must be made conditional on restructuring and it should be limited in time. This will allow the firms to quickly emerge from bad financial situations and turn their businesses around. This could fuel protectionism as other countries may do the same thing, therefore it must be exercised carefully.

Environmental innovation is being incentivized during the current crisis and focus is being put on how to address climate change in the future. Some of the OECD work has focused on the crisis providing opportunities to increase efficiency. Some options in this regard include removing subsidies on fossil fuel energy production and consumption, and cutting trade barriers on environmentally friendly products. It is important, however, to send a clear, long-term signal to investors and the public about climate change. The International Energy Agency reports that while large firms are prepared to deliver environmentally friendly options to governments, the firms need clear signals from governments indicating their intention to move toward such technologies in order to reduce the risk of the investments that the firms will have to make.

While stimulus packages are important, implementation is key to the packages' effectiveness. It is not yet known how many of the countries' packages will play out as many of them are in the implementation phase right now. The dilemma faced by many countries is the need to stimulate the economy in the short run, which leads to actions that may not necessarily be the best for long-term growth. International coordination of stimulus packages is difficult, but it is an ideal course of action. With the growing role of government, the quality of government intervention is key. Evaluation of measures and coherency of the overall strategy are two major elements in this regard.

New opportunities have opened up with the crisis, specifically opportunities for OECD countries to think again about their futures, how economies can be reformed, how performance can be increased and other goals. The OECD is working toward a fairer, cleaner and stronger economy in the future. In that sense, the long run is not a time that will come in the future; it starts now.

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