Questions and answers about coronavirus and the UK economy
Questions and answers about coronavirus and the UK economy

What will coronavirus mean for innovation by firms?

While some firms have introduced some important innovations in response to the crisis, the experience of past recessions suggests that innovative activities by the private sector are likely to be dampened for several years following the pandemic.

We have seen some great examples of product innovation during the pandemic related to ventilators and personal protective equipment. But it is unlikely that this spirit of innovation will persist. As in previous recessions, economic uncertainty and financial constraints are likely to have a dampening effect, and lead to falls in innovation activity.

But the current crisis is also having other effects on firms’ activities, for example, the requirements to change ways of working to preserve some degree of social distancing between employees and between staff and customers. There may be growth in innovation in how firms practically manage their businesses.

What happens to innovation when crisis strikes?

Innovation is the introduction of new products, services and ways of doing business. It will be a critical element of the recovery after Covid-19. But innovation is always risky, with 40-90% of innovation projects failing either in full or in part (Rhaiem and Amara, 2019). Evidence from the 2008/09 recession suggests that cash-constrained firms will be less willing to make such risky investments and that any recovery in innovation will take some years.

But one factor that is different in the aftermath of this recession is that some firms have to innovate in order to remain in business. We are likely to see an increase in new ways of working as firms figure out the most efficient and effective way of operating while keeping their employees and customers safe.

The last major recession in the UK was the one that followed the global financial crisis of 2008/09, which sharply reduced the availability of bank finance and made it more difficult for firms to borrow. This effect is similar to now in that many businesses are either using up cash reserves during lockdown or taking out loans to finance business over the last few months.

Studies of Europe, the United States and Latin America all suggest that after the global financial crisis, these cash constraints sharply reduced firms’ investments in research and development (R&D) and innovation. In other words, R&D and innovation investments are strongly ‘pro-cyclical’, rising in periods of growth and falling in periods of crisis (Kabukcuoglu, 2019).

Other studies have suggested that the pro-cyclicality of R&D spending is more pronounced in smaller firms. Small firms reduced their R&D spending more than large companies after the global financial crisis (Schmitz, 2014). This led to a growing gap between the R&D and innovation of small and large firms, with implications for longer-term productivity gaps and the position of smaller firms in the ‘long tail’ of less productive companies.

Changes in innovation investments also influence firms’ ability to introduce new products and services with implications for growth and productivity. One study of the US consumer goods sector during the period 2007-13 suggests that the rate at which products were replaced fell by a quarter during the 2008/09 global financial crisis (Argente et al, 2018). Firms that were able to buck the trend and maintain their introduction of new products during this period benefitted from increased productivity.

What happened to innovation in the UK after the 2008/09 recession?

The UK Innovation Survey (UKIS) is the main source of data on innovation in UK firms. The survey is conducted every two years. One wave of the UKIS covered the period during and after the global financial crisis, from 2008 to 2010, with the previous wave covering the pre-recession 2006-08 period. Subsequent waves of the survey provide an overview of post-crisis behaviour.

The UKIS provides three key indicators of the extent of innovation activity across the population of UK firms (with more than ten employees): the percentage of innovation-active firms; the percentage of product/service innovators; and the percentage of process innovators. Figure 1 summarises the main trends in each measure:

  • The percentage of innovation-active firms – those either innovating or investing in innovation – fell by around a third in the recession period and has yet to recover fully (Roper, 2020).
  • The proportion of UK firms reporting product or service innovation fell by 26.6% to the crisis period and only recovered this level of activity by 2014-16, six years after the recession.
  • Levels of process innovation activity dropped by around a fifth between 2006-08 and 2008-10, and rebounded significantly more quickly than product or service innovation.

Figure 1: The percentage of innovating firms in the UK

Graph showing how many types of innovating firms there are in the UK

Sources: Statistical Annexes for the UK Innovation Surveys, 2009, 2011, 2013, 2015 and 2017. 

The sharp fall in innovative activity in 2008-10 occurred in almost every sector and region (Roper, 2020). But recovery rates differed markedly. More traditional manufacturing sectors, agriculture and financial services innovation have never fully recovered. Innovation in some northern regions of the UK also remains at or below the level in 2008-10. Any effects on innovation from the coronavirus crisis seem likely to exacerbate these already substantial sectoral and regional disparities.

So what can we expect looking forwards?

The Covid-19 crisis shares two significant similarities with the 2008/09 recession. First, both resulted in sharp and unexpected reductions in activity, rather than the usual business cycle fluctuations that firms will anticipate to some extent.

Second, both led to sharp reductions in liquidity (the amount of cash that firms could draw on): the 2008/09 recession through a sharp reduction in the availability of commercial finance; and the Covid-19 crisis through sharply reduced turnover. In both cases, financial stringency (that is, firms facing difficulty obtaining the finances they need) forces firms to make rapid strategic decisions about areas of spending and potential savings.

The evidence from international research and UK trends suggest that R&D and innovation are strongly pro-cyclical, and we should therefore expect sharp falls (perhaps a third) in the proportion of innovating firms, with only a slow recovery to previous levels of innovative activity.

These effects will not be uniform across firms. The evidence from the last recession suggests that firms that entered the crisis with stronger cash positions may also emerge more strongly. Continuing to invest during the crisis gave the cash-rich firms a competitive edge that would continue into the recovery period (La Rocca et al, 2019).

Having financial slack – or cash at hand – when a crisis strikes gives firms a considerable advantage in both the short and longer term. The implication is that the financial position of firms pre-crisis will influence longer-term outcomes, particularly among small and medium-sized enterprises (SMEs) and those sectors where pre-crisis margins were already low.

Sustaining innovation during a crisis may be more difficult in smaller firms, which may find it the most difficult to access finance. But evidence suggests that SMEs benefit significantly from R&D and innovation investments if they can find the cash, both in terms of survival and profitability (Castillejo et al, 2019).

Can policy support help to prevent these falls in innovation?

Austerity – and the centralisation of innovation policy in England during the period 2010-12 – meant that innovation policy responses after the last recession lacked coherence (Vanino et al, 2019). We are better positioned this time around with UK Research and Innovation (UKRI) – the UK’s relatively new cross-disciplinary research council – taking a lead in funding a range of Covid-19-related research projects to combat the virus and its effects.

This is backed by a clear government commitment to raise levels of R&D and innovation investment in the UK. Innovation policy itself has also developed with the development of the Catapult network of technology intermediaries and the growth of R&D tax credits.

But the scale of the challenge is substantial. A recent survey of holders of UK government R&D and innovation grants, for example, suggested that around a third of firms were planning to cut their R&D spending by more than 50% over the next three months.

The UK government has recently published an R&D roadmap intended to set strategic guidelines for supporting R&D and innovation after Covid-19. The report reaffirms the ambition to raise R&D spending to 2.4% of GDP by 2027, but this target looks all the more challenging given the likely effects of Covid-19 on business R&D and innovation spending.

Additional funding for innovative firms has also been announced with a £1.5 billion loan and grant package for the UK’s most innovative companies, as well as additional loan funding for equity-backed firms. Whether these measures will be sufficient to offset the pro-cyclicality of firms’ R&D and innovation decisions in the UK and move us closer to the long-term target only time will tell.

Where can I find out more?

The UK government’s R&D roadmap provides an overview of targets and policy initiatives for the next decade; it has been revised and republished during lockdown.

International sectoral R&D trends after the global financial crisis: what can we learn for current policy? International comparisons of trends in R&D after the financial crisis, which serve to emphasise the greater diversity of sectoral and regional experiences in the UK than elsewhere.

Covid-19 and the implications for future innovation: an early blog post on the innovation benefits and costs of Covid-19.

When credit dries up, so does innovation: the Chicago Booth Review reports on the innovation activities of firms in the United States over the last recession.

Who are experts on this question?

Authors: Stephen Roper and Joanne Turner
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