A crowd gathers outside a failed bank in New York, in June 1931. A new study links a drop in independent innovation during the Great Depression with local bank distress. (Photo: FPG/Hulton Archive/Getty Images)

How an economic crisis impacts innovation: lessons from the Great Depression

New research finds that the 1930s fundamentally altered the course of American innovation, shifting it from independent inventors into companies. What does that mean post-Covid?

Eric Jaffe
Apr 9, 2020 · 7 min read

The Covid-19 health crisis has inspired a great deal of local innovation focused on fighting the disease. But the accompanying economic crisis has slowed down promising independent entrepreneurs who’d been on the rise before the outbreak. It’s also brought urban life to a halt — stalling out the chance encounters, face-to-face exchanges, and creative networks that help make cities such powerful engines of innovation.

This question of just how a prolonged economic crisis impacts innovation and entrepreneurship is at the heart of a new study from a trio of business scholars, released as a working paper last week. Analyzing patent trends before and after the Great Depression, the research suggests that such crises can be “both destructive and creative forces for innovation.”

On the destructive side, independent inventors suffered greatly after 1930, according to the work. The number of patents they filed declined significantly during the Great Depression — and didn’t recover even decades later — likely because bank closures made it harder for local investors to fund new ventures. On the more positive side, overall innovation weathered the storm, in large part because established companies with in-house R&D efforts scooped up many of these independent inventors.

“In fact,” write the authors, “our results suggest that while periods of severe and prolonged financial distress may cause declines in the quantity of patents filed by start-up like enterprises, innovation as a whole appears to be quite resilient.” The paper authors are Tania Babina of Columbia Business School, Asaf Bernstein of the Leeds School of Business at the University of Colorado-Boulder, and Filippo Mezzanotti of the Kellogg School of Management.

Though historical in nature, the work remains unfortunately relevant today. Comparisons have been drawn between the current crisis and the Great Depression, at least with respect to massive unemployment rates. And the independent inventors of the early 20th century are structurally similar to modern startups in terms of their reliance on locally driven, early-stage capital.

Let’s take a closer look at what the research found — and what it might mean for post-Covid entrepreneurs.

In the early 20th century, independent inventors were America’s primary source of innovation. They accounted for 70–80 percent of all U.S. patents in the 1920s. The patents they filed during this time were also of a very high quality, as measured by future citations.

To study the impact of the Great Depression on this state of American innovation, the research team studied patent filings over many decades across the 20th century. They grouped each patent by type of grant: independent inventor or company. Sure enough, during the years of the Great Depression (defined for this study as 1930–1939), annual patents filed by independent inventors fell in half. Over the same period, patents filed by companies dipped a bit but ended the decade where they began.

During the Great Depression, the annual number of patents filed by independent inventors (blue) plummeted while those filed by U.S. companies (red) remained steady — setting a new course for American innovation. (Babina et al, SSRN working paper, 2020)

So why did independent inventors get hit harder than companies? The researchers believe it had to do with the fact that — like startups today — these entrepreneurs relied heavily on local, early-stage investors to get their ideas off the ground. Then, as now, inventors and investors ran in similar circles. “In this regard, as in the early 20th century, personal contacts and local investors’ networks are still key for the process of raising funds,” write the study authors.

The reliance of independent inventors on local investors in turn made them reliant on local banks at a time when capital exchange was a local affair. Banks at that time weren’t just lenders — they were information networks, passing on word of a promising inventor or potential investor. As local banks failed during the Depression, local investors had less access to capital for new ventures, and local inventors lost their independent pipeline.

Simply put, the Depression destroyed the ecosystem of early-stage financing that made independent innovation possible.

To study this connection more carefully, the researchers linked each patent to its county of origin. Then they compared patent trends in counties with banks that suspended service or failed — a proxy for local economic distress — with counties whose banks remained active.

Before the Great Depression, there was no significant difference in patent trends across these counties. But during the Depression, independent patents from economically distressed counties dropped, on average, 13 percent more than independent patents from places whose banks stayed active — suggesting a strong, direct role of local distress on independent innovation.

That wasn’t the case for companies. According to the research, a county’s economic distress had no impact on company-filed patents. That makes sense, given that then — as now — larger companies had in-house R&D departments that weren’t exactly immune from economic trends, but certainly didn’t rise and fall at the hands of angel investment.

The trend away from independent invention persisted for decades. In counties that suffered bank distress during the Great Depression, the researchers found evidence of a decline in independent patenting up through 1990. In that sense, the crisis didn’t just represent a blip on the innovation radar — it fundamentally altered the course of American innovation across the 20th century, away from entrepreneurs and toward companies.

While the research paints a bleak picture for independent inventors, the evidence suggests that the overall ecosystem of local innovation remained resilient in the years following the Great Depression.

For starters, the quality of independent patents seemed to rise after the crisis. Despite a decline in total independent patents, the researchers found no post-Depression drop-off in total citations for independent patents — even in the counties suffering economic distress. In other words, future inventors cited post-crisis patents more often than they cited pre-crisis patents, suggesting that the greater competition for investment led to higher-quality ideas.

“Therefore,” write the researchers, “while technology entrepreneurs were forced to reduce their activity in response to the shock, inventors with high quality technologies were still able to succeed in the marketplace.”

Additionally, companies didn’t experience a post-Depression decline in innovation. In fact, company patenting seems to have increased in economically distressed areas, compared with non-distressed areas, over the long run. The researchers document a clear reason for this stability: independent inventors got jobs in firms, with inventors in economically distressed areas more likely than those in other areas to join a company in the decade after 1930.

What’s more, firms in distressed areas produced higher-impact patents (as measured by citations) in the longer term. Talented independent entrepreneurs may have decided it was in their best financial interest to join a company after the Depression, and that company became more innovative as a result. As further evidence of this local shift away from independence and toward company, the researchers found no brain drain (defined as inventors moving away) in counties suffering from economic distress.

In all likelihood, the independent inventors stayed in town — they just stopped being independent.

It’s unclear how well the study findings apply to modern times, despite the similarities between independent inventors of old and startups today. The Great Depression does seem to have reshaped innovation for at least a generation, but it’s too soon to know whether the Covid downturn will have the same lasting impact. (The researchers do conclude that their lessons can “apply to modern economics,” but they don’t mention the recent outbreak.)

With that in mind, a few insights seem fair to draw. The first is that local shocks, while perhaps less impactful than they were a century ago, are no doubt still an important factor on the quantity and quality of innovation.

For sure, banking and communications are now global in nature. Inventors or startups in Place A should be able to secure investors or sources of funding in Place B with far greater ease than they could have during the Great Depression. But proximity still matters greatly for innovation, with frequent in-person interaction between investor and inventor a known predictor of venture success. And it’s worth recalling that during the last financial crisis — the Great Recession — big tech clusters not only survived, they became more powerful afterward.

Given those enduring trends, in addition to the research insights, it’s possible that the places with local funding networks or local anchor companies could end up emerging from Covid stronger than places more reliant on remote funding or startup employment. That outcome seems even more likely if travel restrictions (or travel behavior) keep investors and inventors physically apart for a prolonged period.

In this scenario, it becomes even more important for some collection of local players — whether city government, businesses, non-profits, research institutions, or a combination thereof — to establish early-stage venture funds designed specifically to support local entrepreneurs and startups. Given what’s known about the potential quality of ideas that can emerge from independent endeavors, supporting them is in the whole economy’s best interest.

Even with such efforts in place, there’s clear value in a city or locality attracting large anchor companies with in-house innovation programs. Those companies shouldn’t get giveaways, and they should work to support community priorities. But such companies serve as a sort of innovation safety net: they’re employers of last resort for enterprising minds, should their idea fail to take off or their household fall on harder times. As such, they can help ensure that today’s crisis doesn’t slow tomorrow’s progress.

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