EU growth, innovation, entrepreneurship and the role of SMEs

Reinhilde Veugelers

University of Leuven, MSI

Outline

The importance of SMEs for post-crisis growth potential Pivotal role of SMEs as drivers of Growth:

Churning process (entry, growth, exit), entrepreneurship, innovation Especially young highly-innovative companies (YICs)

Impact of the crisis on the SME-growth nexus

Assessing SMEs’ potential for driving post-crisis growth in the EU: Assessing pre-crisis role of SMEs/YICs in EU growth: structural

weaknesses ? A role for government intervention in the EU? How?

Long-term economic growth driven by innovative entry by entrepreneurs, even if they destroy the value of established companies: the many faces of Joseph Schumpeter

Large firms operating in concentrated markets are the main engine of technological progress.

New (often small) firms, not being blocked by incumbency, leverage the innovation process to challenge established firms: “Gale of creative destruction”

Financial system enhances productivity by accelerating capital reallocation in the process of creative destruction: “the banker authorizes people, in the name of society, to innovate”

A Schumpeterian look at growth and innovation

Decomposing aggregate productivity growth into (i) contribution from entry, (ii) expansion of more productive

firms, (iii) scaling down and exit of less efficient firms;

Churning process (entry & exit) is important for aggregate growth; Studies from the nineties, suggest that the net contribution from

entry and exit account for between 20 and 50% of productivity growth

Churning (entry & exit) is associated with experimentation;

Experimentation with novel approaches typically comes from smaller entrants, young radical innovators not infected by incumbency.

Experimentation involves high risk, but also higher growth rates upon success;

A Schumpeterian look at growth and innovation

Heterogeneity among SMEs: Majority of SMEs: not innovation active Also many adopting SMEs: acquire, adapt, apply technology new to the firm A few Leading SMEs: develop innovations that are not only new to the firm, but

also new to the market Particularly Young Innovative Companies (YICs) are more likely to create radical

breakthrough innovations, whose further developments are done by large firms:

Beyond direct also indirect contribution: In interaction with large incumbents, SMEs are even more promising actors in

the Schumpeterian dynamics, esp YICs With their radical innovations young innovative companies create the scene on which

other firms build further, enhancing their breakthroughs and adding to their overall usefulness (Baumol (2002)).

A Schumpeterian look at growth and innovationSMEs are at the hart of the churning process,

constituting most of the entry, exit and fast growth, but

Young Innovative Firms and their contribution to radical innovations

On the basis of 1342 innovation-active companies responding to the German CIS-4 survey YICs defined as <6 age, <250 employees, RDI >15%

(see EC State Aid Rules for Young Innovative Enterprises)

Superior YIC performance confirmed in econometric analysis, even after corrections for firm size, age, sector, R&D inputs

Source: Veugelers (2009) A lifeline for Young Radical Innovators, Bruegel Policy Brief

Problems appropriating the benefits from innovation SMEs, and especially Young Innovative Companies, are

less able to appropriate the surplus created by own and subsequent innovations

Effectiveness of IPR regime Problems accessing finance

Incomplete, imperfect and asymmetric information create financial market failures;

Imperfections in capital markets usually affect small innovators more than large ones (Hall, 2005).

Young radical innovators, lacking collateral, reputation and with high-risk profile, even more affected by imperfections in capital markets

Barriers to innovation for young and small firms

Having SMEs and especially young, highly innovative firms, impeded to play their role may have an important direct and indirect impact

on an economy’s overall innovative and growth performance

Impact of the crisis on the SME-growth nexus

Financial markets for innovation and growth

King & Levine (1993) Better financial services expand the scope and improve the

efficiency of innovation by Evaluating prospective entrepreneurs, funding the most promising

ones and monitor their performance; Aghion (2008)

The growth enhancing effect of financial markets runs mainly through relaxing the credit constraints on small and new firms.

The growth enhancing effect of financial development depends on business cycle

Credit constraints reduce R&D investments especially during recessions

Investments in R&D are long-term and therefore require firm’s survival of SR liquidity shocks.

While necessity entrepreneurship is more pro-cyclical, opportunity entrepreneurship, especially innovative entrepreneurship, is a leading indicator of the business cycle

Firms that have more difficulty to access external financing because of their high risk profile, will be affected disproportionally by a financial crisis

Young radical innovators, have a high risk/bankruptcy profile and are credit constrained

Since the effect of the current downturn is compounded by a severe financial crisis, young, radical innovators currently are getting a double whammy, leaving the economy with a seriously reduced likelihood of getting new radical innovations, that lay the foundations for growth in future.

The impact of the current crisis on the SME-growth nexus:

Assessing the potential of SMEs for driving post-crisis growth in the EU:

Assessing pre-crisis role of SMEs (YICs) in EU growth: structural

weaknesses ?

EU productivity performance pre-crisis European (labour) productivity had been catching up

with the US frontier for 50 years… …but since 1995 US productivity accelerated again

away from Europe, with consistently lower productivity growth rates in the EU Lower contributions of ICT & MFP to EU growth

The contributions of ICT and MFP to growth weaker in the EU than in the US

2000-2005

-1.0

-0.5

0.0

0.5

1.0

1.5

2.0

2.5

3.0

United States EU15 (1) United Kingdom France Italy Germany

%

Labour input ICT capital Non-ICT capital Multi-factor productivity

Source: O’Mahoney & Van Ark (2007), The Conference Board

ICT-using services were unable to drive growth in continental EU countries

-0.5

0

0.5

1

1.5

2

2.5

Italy France Germany Japan UK Canada USA

ICT-producing manufacturing ICT-producing services ICT-using services Other activities Residual

1996-2002

Source: O’Mahoney & Van Ark (2007), The Conference Board

Factors behind the low productivity growth: a failing creative destruction process?

The churning process in the EU Gross turnover rate (entry & exit) is higher in the US

EU exit rates between 0.1 and 0.3 of US rates EU entry rates represent between 0.4 and 0.8 of US rates

High positive correlation between entry and exit across sectors in the US (while insignificant in the EU):

Entry size larger in EU than in US

The contribution of churning to growth in the EU The effect of exit on productivity growth is always positive, both in

the US and the EU, confirming that the least productive firms are exiting, but there is less exit in the EU

Low survival rate for very small entrants in the US, but better post-entry performance for successful entrants

post-entry growth at 7 years for manufacturing is in France 6% of the US rate, in Finland 17% and in the UK 60%.

Lower EU post-entry growth than in US

Net employment gains among surviving firms at different lifetimes (net gains as a ratio of initial employment)

Source: “Comparative Analysis of Firm Demographics and Survival”(2003) by E. Bartelsman,

S. Scarpetta,and F. Schivardi, OECD Economics Department WP 348.

Churning differential between US and EU is explained by experimentation

US entrants being more small scale experimental Upon survival, US entrants have a stronger post-entry

growth Exit occurs faster in the US , at smaller scale This entry-experimentation process plays particularly in

high-tech/high IT intensive sectorsRole played by SMEs in the churning process is different in the EU: the

lack of young experimenting enterprises behind the gap in growth performance between the EU and the US;

Source: Aghion, Bartelsman, Perotti, Scarpetta (2008)

What’s wrong with EU SMEs?

Problem of EU SMEs is not their number. But underperformance in terms of: Average productivity

relative to large firms, SMEs have lower labour productivity (57% for manufacturing in the EU). This is more marked for the EU than for the US.

Growth post-entry growth at 7 years for manufacturing is in France 6% of the US rate, in Finland 17% and in

the UK 60%. Innovation

relative to large firms: less R&D intensive, less innovation intensive, less cooperation active relative to US SMEs: EU SMEs less R&D intensive (average R&D intensity of SMEs is 0.34% in EU,

0.53% in US)

Composition problem: we are missing the experimental type of SMEs: young, highly innovative enterprises, esp in high-tech, high-growth sectors: ICT services

Some evidence on Europe’s missing young firms among leading innovators

The graph is based on a sample of 226 companies, obtained from matching firms in the FT Global 500 (2007) with the 2007

EC-IPTS Top 1000 R&D scoreboard companies. Leading Innovators are thus

defined both by the size of market capitalization and R&D expenditures. The

US has 80 companies in the sample, Europe 86 and other countries 60.

Young is defined as founded after 1950; US has 24 young leading innovators in sample, Europe 7;

The total is the sum of all 226 leading innovators in the sample.

Source: Bruegel Policy Brief: A lifeline for Young Radical Innovators, Veugelers (2009)

What the US has but the EU lacks: YolliesYollies = Young Leading Innovators created after 1975

There are fewer EU-based than US-based Yollies

Sources: Bruegel/European Commission JRC-IPTS on the basis of the EU IndustrialR&D Investment Scoreboard (European Commission, 2008).

Why missing Yollies matter

The lower R&D intensity of EU Yollies is the largest factor responsible for the total EU-US R&D intensity gap (55%)

Sources: Bruegel/European Commission JRC-IPTS on the basis of the EU IndustrialR&D Investment Scoreboard (European Commission, 2008).

Risk-taking financial markets Segmented product markets

Early users/lead markets (Re-)entry & exit costs Flexible labour markets Insufficient linking in “innovation system”

Industry science links Large incumbents and small new entrants Public Private partnerships

Government policy Funding Procurement Competition policy

IPR regime

Why Europe is missing Yollies?

Well known stories

Cost of patenting: EU vs US

European (EPC - European Patent Convention), US and Japanese patent costs Firm size Total cost (€2000)

Large 49 900 EPC (typical application, 8 Member States)

SME 49 900

Large 10 330 US SME 8 015

Large 16 450 Japan SME 12 450

Note: The US has a 50% reduction of fees for SMEs. This concerns only official fees (does not apply to agent's and translations fees). Japan has also reduced fees, but with conditionality (e.g. proven lack of funds, R&D dedicated SME)

A role for government intervention? How?

Despite incomplete knowledge, what can be said about?

Policy Do’s Policy Don’ts

Policy Don'ts

Keeping ailing firms in ailing sectors alive: exit barriers Protectionism for SMEs: no shielding from market

discipline Creation of thresholds in legislation with “lock in” effects

for SMEs growth “Ad-hoc” solutions to claimed SME problems not

reflecting a market failure. Risk of government failure

Policy Do's Financial Markets Restructuring Framework Conditions

more efficient market functioning: more integrated and more contestable

reform of bankruptcy law: faster, cheaper exits and not preclude new starts

integration of capital markets, particular emphasis on venture capital,

improvement of Europe’s IPR systemReduction of administrative burdens

Targeted Innovation Policy

How to design innovation instruments for young innovators

Since young innovators need to find a symbiotic overall innovative environment to interact with in ‘co-optition’, a specific policy must be part of an overall innovation and growth policy.

A specific policy approach should tackle the specific barriers faced by young highly innovating firms, at least those rooted in market failure and where governments can redress these without inflicting new barriers Getting the target right: Young Radical Innovators A specific policy implies first and foremost dealing with the

financial constraints. Subsidy programmes for young radical innovators must

be carefully designed in order to reward the risk-taking inherent in radical innovations.

Increasing the efficiency and reducing the cost of intellectual property (IPR) protection is also essential for young radical innovators.

Given that we still know very little of which ‘cures’ work, more emphasis should be put on evaluation of policy initiatives.

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Thank You For Your Attention

Veugelers, R., 2008, The Role of SMEs in Innovation in the EU: A Case for Policy Intervention?, Review of Business and Economics, 53, 3, 239-262.

Veugelers, R. and M. Cincera, 2010, Europe’s Missing Yollies, Bruegel Policy Brief 2010/06, Bruegel Brussels

Veugelers, R., 2009, A lifeline for Europe’s Young Radical Innovators, Bruegel Policy Brief, 2009/01, Bruegel Brussels.

http://www.econ.kuleuven.be/msi/members/veugelers.htmhttp: //www.bruegel.org