Why Don't Recessions Encourage More R&D Spending?
Barlevy, Gadi, Chicago Fed Letter
Economists sometimes argue that recessions promote activities that ultimately contribute to long-run growth. But evidence suggests research and development, one important source of economic growth, falls rather than rises during recessions, even for firms that do not appear to be credit constrained. The author discusses an alternative explanation for this pattern.
In recent years, economists have revived the notion, often associated with the late economist Joseph Schumpeter, that economic downturns play an important role in promoting long-run productivity growth. In this Chicago Fed Letter, I report on my work in Barlevy (2005), which examhies how recessions affect one particular channel for growth-namely, research and development (R&D).1
The modern formulation of Schumpeter's idea builds on the observation that production is less profitable during recessions. As a result, recessions are an ideal time for firms to engage in activities that enhance their productivity but tend to interfere with production. Examples of such activities include retraining workers, retooling a shop floor, upgrading capital equipment, and experimenting with ways of providing better products at lower costs. If slack periods encourage firms to undertake needed improvements that they were reluctant to start earlier, these periods will lead to higher eventual productivity.
The reallocation of resources from production to enhancing future productivity can occur both within firms-whereby resources are redirected from the production floor to improving innovation-and between firms, as some firms shed workers who are in turn hired by budding entrepreneurs developing new ideas and trying to start up competing firms. Since product development requires support staff as well as skilled labor, it is not unreasonable that the production workers who are let go by some established firms will be of value to emerging firms that are developing new products.2
Following this logic, one would expect that more resources should be allocated to formal R&D during recessions. In particular, as noted by Griliches (1990), recessions do not seem to affect the ability of researchers to come up with new ideas, at least as measured by the number of new patents that result from a given research effort.* If production suffers during recessions while R&D does not, then recessions should be an ideal time to actively seek out and develop new ideas and products.
Nevertheless, the empirical evidence shows that R&D tends to fall during recessions, not rise. The primary data source on R&D activity in the U.S. is the National Science Foundation (NSF), which compiles data on annual R&D expenditures by sector and by source of funding. Figure 1 plots the growth rate of R&D expenditures identified by the NSF as financed and performed by private industry, adjusted for the rate of overall inflation. It also plots the growth rate in the number of full-time equivalent scientists and engineers employed by private industry, which is one of the primary inputs into R&D. Although the latter series only captures a part of RM) activity, it has an advantage in that it does not depend on the price of R&D inputs. This is important, since inflation adjustments to nominal R&D expenditures may not accurately reflect changes in the price of R&D. The two data series track each other closely, suggesting changes in inflation-adjusted R&D expenditures truly reflect changes in the extent of R&D.
To appreciate how R&D activity varies over the business cycle, figure 1 also depicts the growth rate of real gross domestic product (GDP). The shaded regions correspond to recessions as defined by the National Bureau of Economic Research (NBER). As can be seen in the figure, periods of economic growth are associated with a more rapid increase in R&D. In almost all recession years, at least one measure of R&D activity falls. …