At the recent Federal Reserve meeting in Jackson Hole, one of the more talked about economics papers presented was describing the interplay and correlations between monetary policy (Fed interest rates) and various measures for innovation (patents, VC funding, R&D spend). The main conclusion of the paper is that increasing interest rates (i.e., increasing the cost of capital) reduced R&D investment and innovation spending. This is hardly surprising given that higher interest rates reduce investment in almost everything (except bonds perhaps). With innovation, the impact can be more long-term because start-ups (especially non-software, capital-intensive ones) are more likely to go bust and not recover. The paper does a decent job in its review of past economic opinions on this subject and on the short term vs long term effects of interest rates on innovation. The main issues presented, including a few I add, are:
History:
Schumpeter argued in the 1940s that recessions, where capital / investments became more expensive due to higher interest rates, are good for a strong economy by eliminating the weaker firms relying on financial gimmicks. This stress to perform in a recession can also breed innovation since savings are sought throughout the company.
Also in the 1940s, Mises and Hayek argued that cheap money (low interest rates) or monetary infusions into the economy encouraged malinvestments and speculation which tend to have better returns due to bubble behavior than real economic development. That is, if a government wants to develop its real economy, printing money and distributing it to citizens or banks will not reach the real economy.
In the 1970s, Robert Lucas argued that investors knowledgeable of the business cycle and past effects of monetary policy would not rationally expect monetary policy to be a solution (e.g., to a recession).
Positive aspects of “free money” for innovation:
Increases VC investments in new firms with new products ( this aspect is criticized by the malinvestment theory / economists above)
Increases patenting, mostly in some so called “important” sectors (others would argue that innovation continues regardless of whether captial is available to spend on patents)
Increases demand including for new / untried products, thus, providing a market for innovation
Lowers the cost of capital for capital intensive businesses that are foundational to innovation (e.g., manufacturing, testing facilities, energy, mining, etc.)
Negative aspects of “free money” for innovation:
Not a targeted policy, but rather a blunt instrument that has other negative side effects (e.g., saving weak firms that do not innovate, creating bubbles)
Increase the demand for junk products that do not represent innovation
Reduce the value of economic viability signals that firms can use to guage new products
These aspects are mostly short term and not all covered in the paper, but quite apparent to anyone in the innovation space. The paper also argues that short term effects of high interest rates (reducing the positives above) can turn into long term effects where innovation is reduced long term. For example, when VC investment decreases 25% due to higher interest rates, some important technologies can be starved of needed dollars and go bust. The progress made by a terminated start up may continue if it is acquired or simply disappear. The paper argues that stabilizing money flows to innovation is important for these long-term reasons, even if monetary policy isn’t the best instrument. I worry about any artificial stabilization even for innovation for the same reason that Schumpeter worried about financial “stabilization” - stabilizing almost always allows weak / hopeless firms to continue.
While the paper fairly presents some of the various trade offs of free money for innovation, it misses (likely intentionally) the major negative aspects that low interest rates (ZIRP) can have on innovation by inflating asset prices. The Federal Reserve doesn’t like to talk about how it’s monetary policy inflates assets for the wealthy while not contributing to real economic growth. In other words, when money is free, non-productive businesses consume far more materials and labor than when money is not free (e.g., crypto using energy supplies). Inflating asset prices, especially home prices, industrial equipment, raw materials, and energy, makes working in the real economy far harder than in the fake economy. In the short term, this difficulty to grow a productive company vs a non-productive company leads to malinvestment. Long term, the assets remain inflated (without a serious re-pricing event) especially with stabilizing monetary policy and so the productive economy becomes uncompetitive. Long term, then, firms invest in financialization rather than hard R&D, which is readily apparent from long term R&D spend graphs for the U.S.
So to build out the negative long term effects on R&D from low interest rates and high asset prices, which the paper ignores, see below:
higher home prices drive higher labor prices, which makes productive business such as manufacturing less competitive, which makes R&D directed towards manufactured products less attractive (yes even if you manufacture elsewhere)
higher tooling costs due to higher input costs due to demand from unproductive firms makes R&D directed towards capital intensive industry less attractive
high development costs (land prices, permits, construction labor) anywhere near a city with a sizeable skilled labor market makes manufacturing less competitive.
corporations needing to compete in short-term bubble markets against competitors that raise stock prices via financialization (stock buy backs funded by cheap debt) means less long term investment in real internal investment (e.g., in PPE).
energy prices force productive economy to compete with bubble economy, which short-term it cannot.