Financial crises and innovation

Abstract

Financial crises are accompanied by permanent drops in economic growth and output. Technological progress and innovation are important drivers of economic growth. Using cross-country panel data on patenting at the industry-level, we connect these facts and show that financial crises have large and long-lasting impacts on innovation (measured by patenting) for sectors dependent on external finance. This effect is driven by banking crises, which have both immediate and long lasting impacts — upwards of 8 years. This is consistent with firms both losing funding for new projects (reducing patents in the long-term) and needing to liquidate existing projects to meet immediate financing pressures (reducing patents in the near-term). This compares to stock market crashes, which see an immediate decline followed by a compensating increase, consistent with projects being “shelved” and redeployed later. Banking crises are thus unique in their impact on innovation, providing a link between them and the observed patterns of persistently lower long-term growth. The effects are larger if the banking crisis was preceded by weak or leveraged banks. We do not observe a decline in patent quality during banking crises. This financial channel of innovation is not operative for currency crises, but we do find evidence for a trade channel, whereby higher exporting industries increase their patenting following the accompanying terms of trade improvement.