Rate hikes and the damage to our national productivity
Last year, I wrote a short series of posts on the lack of productivity growth in developed countries. One of the areas of concern I singled out back then was declining research productivity. We spend more and more money on research and development (R&D) with fewer tangible results. Now imagine a future where we spend less on R&D.
Over the last two years, central banks have engaged in one of the most aggressive rate hike cycles ever. We needed to get runaway inflation under control and that meant increasing the price of money to such an extent that businesses will curb investments and households will curb consumption. So far that didn’t work as well as hoped, but one area where we do see a decline is in investments in R&D.
Investment growth in intellectual property assets (R&D)
Source: Liberum, Bloomberg
If you think about it, this makes sense. If businesses face tighter budgets because they cannot borrow money as easily as they used to, they must cut investments somewhere. One conceivable way to reduce investments (though I would argue a short-sighted and ultimately doomed one) is to cut investments in the future, otherwise known as R&D.
Yueran Ma and Kaspar Zimmerman examined the impact of rate hikes on corporate spending on R&D. They found that a 100bps increase in Fed Funds Rates reduced R&D spending by about 1-3% in the following one to three years. Venture Capital, which relies much more on debt capital than established businesses saw its spending decline by 25%.
The result is a drop in innovation in the two to four years after the rate hikes which ultimately results in lower productivity growth and slower job creation. The damage of the rate hikes of 2022 and 2023 will be felt in 2025 and 2026.
To counteract this unintended consequence of rate hikes, the best policy is to support R&D efforts through fiscal policy measures. This is why the Inflation Reduction Act and the CHIPS and Science Act in the US and similar policies in the EU are so beneficial. They provide strong incentives to invest in R&D at a time when these investments are facing significant challenges. Countries like the UK, which do not provide such fiscal incentives are likely to fall behind countries that do in a couple of years and will see lower productivity growth going forward.
And that also has consequences for the stock market. As I have discussed here, companies that cut R&D spending in a downturn take longer to recover their profitability when the economy accelerates again and are more likely to lose market share, with correspondingly negative effects on their share price. As investors, it is thus particularly important to look at what businesses did in 2022 and 2023 in their R&D budgets. If they kept R&D spending unchanged or even increased it, they are likely to outperform their peers in the next couple of years.
"The best policy is to support R&D efforts through fiscal policy measures."
But to do that, you need to keep the debt/GDP ratio under control. And to keep the debt-GDP ratio under control, you need to keep inflation under control. And to keep inflation under control, you need to maintain efficient free trade. And to maintain efficient free trade, you need to ease international tensions. And since debt is useful for everyone, the conclusion is that either the large economies cooperate, or whoever is in charge ends up losing power in a bad way. And since no one likes to lose power, I think they will come to terms. An example for me is Saudi Arabia, which with the prospect of losing importance of oil is getting closer to Israel to strengthen its position.
Real experience: my wife works in a software company in R&D. The company, which had already gone through two transfers from investment funds without affecting the staff, was sold again to another fund in 2021. An investment that I think was around 100 million dollars. 2 years later, in 2023, radical cuts were decided for R&D, with the prospect of investing again if the product were to produce acceptable cash flows. My wife was not fired but decided to resign knowing that the goals are impossible. And in fact, in a month she will start working in the R&D of a strategically autonomous company, albeit participated by funds.