When credit dries up, so does innovation

Credit: Sebastien Thibault

Martin Daks | May 07, 2020

Sections Economics

While innovation is crucial in business, it’s expensive. Companies must continually update offerings and introduce new product lines to stay competitive, but researching, developing, and introducing these products often requires large initial investments and cash outlays, the fruits of which are reaped only years later.

When borrowing sources constrict, as they did during the Great Recession, the rate of radical new-product innovation tends to decline significantly among credit-constrained businesses, particularly smaller and younger ones, according to Chicago Booth’s João Granja and Northwestern’s Sara Moreira. Their findings could provide a glimpse of possible innovation patterns in the wake of the COVID-19 pandemic. 

The researchers make a distinction between two types of innovation: radical and incremental. Radical innovation is outside the scope of a business’s current operations, such as a new product in an entirely new line. By contrast, incremental innovation is a new product offering within a product category that the company already offers.

Radical new products are more disruptive and account, on average, for a larger share of a company’s future sales. They are also less likely to cannibalize the company’s existing products and tend to be associated with larger productivity gains. But radical innovation costs a lot more, as it requires greater investment in areas such as knowledge acquisition, product development, machinery, and inventories.

Granja and Moreira looked at what happened during the Great Recession, when US small-business lending dropped by half. To see how restricted credit access affected innovation, they started with product-introduction data from the Nielsen Datasets at Booth’s Kilts Center for Marketing. They merged these with loan-market data from Thomson Reuters and small-business lending data, to track how access to credit affected new product offerings. 

The pullback in bank lending accounted for as much as 40 percent of the decline in the rate of radical innovation by credit-constrained businesses between 2007 and 2010, the researchers find. Moreover, when credit-constrained companies introduced new products during the crisis period, these products were less likely to embody never-before-seen product attributes. Companies with credit constraints “are more likely to take precautions and avoid going all in on a brand-new product,” Granja says. 

The researchers also followed the sales performance of the companies’ new product offerings over time. They find that new products introduced during the crisis by companies that were more exposed to credit disruptions generated 20 percent less sales within four years than other products introduced in the same product lines by companies unexposed to the crisis. 

Granja and Moreira’s findings suggest that credit shocks lead to lower investment in product development and innovation, which can stunt both a company’s near-term performance and future growth potential.

But will the economic havoc driven by COVID-19 curtail investment in research and development? Granja notes that most US companies are likely to cut back on all their nonessential R&D spending as they strive to preserve cash that might help them weather the storm. The researchers’ analysis of the patterns of product innovation during the Great Recession demonstrates that following a steep decline, the rate of introduction of new products recovered, although it didn’t exceed the precrisis rate. 

“This time might be different,” Granja says. “It is possible that the post-COVID-19 world will see significant changes in consumer preferences and shopping behaviors. We think that companies will try to adapt to such changing consumer tastes with new products that cater to these needs. I will not be surprised if we see an increase in the rate and a shift in the composition of product innovation in the aftermath of the pandemic.”