Financial Markets and Investment
Stephen Bond, Dietmar Harhoff and John Van Reenen (2003) test for the importance of cash flow on investment in fixed capital and R&D using firm-level panel data in Germany and Great Britain between 1985 and 1994. They find that financial constraints are more significant for investment and R&D in Britain that they affect the decision of firms to engage in R&D rather than the level of R&D spending. Consequently the British firms that do engage in R&D are a self-selected group where financing constraints tend to be less binding.
Investment, R&D and Financial Constraints in Britain and Germany.
For more of our work on reforming financial markets in the light of the crisis see our 2010 election analysis on financial regulation and The Future of Finance, The LSE Report.
The LSE Growth Commission focused on financial constraints to investment and innovation.
See the paper on Private Investment for more detail underlying the main Growth Commission Report.
Luis Garicano and Claudia Steinwender (2013) analyse a rich panel data set of Spanish manufacturing firms before and after the financial crisis in 2008 to quantify the effects of the 'credit crunch' on investments (specifically, the shift from long term to short term investments). They find that credit constraints are equivalent to an additional tax rate of around 11% on the longest lived capital.
Survive Another Day: Using Changes in the Composition of Investments to Measure the Cost of Credit Constraints.
The role of uncertainty
An alternative explanation is that higher uncertainty ('Boom and Bust') is a culprit.
Nick Bloom and John Van Reenen (2002) analyse data on over 200 major British firms since 1968 and show that patents matter for firm productivity and market value. While patenting feeds into market values immediately it appears to have a slower effect on productivity. This generates valuable real options because patents provide exclusive rights to develop new innovations, enabling firms to delay investments. Higher market uncertainty, which increases the value of real options, reduces the impact of new patents on productivity. Government policy to reduce uncertainty is likely to increase the productivity of Britain's knowledge capital.
Patents, Real Options and Firm Performance - published in The Economic Journal, 2002.
After a long period of decline, the Great Recession increased uncertainty. We have been developing new models of analysing investment under uncertainty to address these questions drawing on advances in theoretical models of 'real options' and in the power of computers to numerically simulate complex models.
We summarise some of these models in Stephen Bond and John Van Reenen (2003), Microeconometric Models of Investment and Employment - published in the Handbook of Econometrics - and propose new ways of modelling investment.
Uncertainty and Investment Dynamics - Nick Bloom, Stephen Bond and John Van Reenen (2005), published in The Review of Economic Studies.
The software for these models is available at http://cep.lse.ac.uk/matlabcode/
We have also been looking at the impact of large uncertainty shocks - such as the 9/11 terrorist attack - on the economy. Nick Bloom (2006) finds big short-run effects from fear and uncertainty: a temporary drop in GDP as everyone pauses and the economy freezes. But six months on from one-off incidents like 9/11, the uncertainty effects are much more muted as firms resume activity and make up for lost time.
The Impact of Uncertainty Shocks: Firm Level Estimation and a 9/11 Simulation
The Economic Impact of 9/11
Taking a more macro-approach, Nick Bloom and co-authors (2013) incorporate uncertainty shocks into business cycle analysis. They demonstrate that microeconomic uncertainty is robustly countercyclical, rising sharply during recessions, particularly during the Great Recession of 2007-2009. Then they quantify the impact of time varying uncertainty on the economy in a dynamic stochastic general equilibrium model with heterogeneous firms. They find that reasonably calibrated uncertainty shocks can explain drops and rebounds in GDP of around 3%. Moreover, increased uncertainty alters the relative impact of government policies, making them initially less effective and then subsequently more effective.
Really Uncertain Business Cycles.