EU growth, innovation, entrepreneurship and the role of SMEs

1. EU growth, innovation, entrepreneurship and the role of SMEs Reinhilde Veugelers University of Leuven, MSI

2. 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?

3. 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

4. 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

5. 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 innovation SMEs are at the hart of the churning process, constituting most of the entry, exit and fast growth, but

6. Young Innovative Firms and their contribution to radical innovations Source: Veugelers (2009) A lifeline for Young Radical Innovators, Bruegel PolicyBrief 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

8. 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 Having SMEs and especially young, highly innovative firms, impededto play their role may have an important directand indirect impact on an economy’s overall innovative and growth performance Barriers to innovation for young and small firms

9. Impact of the crisis on the SME-growth nexus

10. 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.

11. 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:

12. 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 ?

13. 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

14. The contributions of ICT and MFP to growth weaker in the EU than in the US 2000-2005 Source: O’Mahoney & Van Ark (2007), The Conference Board

15. ICT-using services were unable to drive growth in continental EU countries 1996-2002 Source: O’Mahoney & Van Ark (2007), The Conference Board

16. 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%.

17. Lower EU post-entry growth than in US

18. 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 sectors Role 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)

19. 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

20. 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)

21. What the US has but the EU lacks: Yollies Yollies = 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 Industrial R&D Investment Scoreboard (European Commission, 2008).

22. 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 Industrial R&D Investment Scoreboard (European Commission, 2008).

23. 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

24. Cost of patenting: EU vs US

25. A role for government intervention? How? Despite incomplete knowledge, what can be said about? • Policy Do’s • Policy Don’ts

26. 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

27. 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 system Reduction of administrative burdens Targeted Innovation Policy

28. 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.

29. 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.htm http: //www.bruegel.org