Financing constraints and a firm's decision and ability to innovate: establishing direct and reverse effects

The paper analyzes the existence and impact of …nancing constraints as a possibly serious obstacle to innovation by …rms. Direct measures of …nancing constraints are employed using survey data collected by the Banque de France and Eurostat, which overcomes the problems with the traditional approach of trying to deduce indirectly the existence and impact of …nancing constraints through the signi…cance of …rm wealth variables. The importance of using direct as opposed to indirect measures of …nancing constraints has been illustrated recently by two articles in this Journal (Moyen (2004) using a synthetic sample methodology, and Hennessy and Whited (2007) through the method of simulated moments). The econometric framework we employ in our study is the simultaneous bivariate probit with mutual endogeneity of direct indicators of …nancial constraints and innovation decisions by …rms. The pa- per discusses the important identi…cation issue of coherency conditions in such LDV models with endogeneity and ‡exible temporal and contemporaneous correlations in the unobservable error terms. Our novel methods for establishing coherency condi- tions allow us for the …rst time to estimate models hitherto classi…ed as incoherent through the use of prior sign restrictions on model parameters. We are thus able to quantify the interaction between …nancing constraints and a …rm’s decision and ability to innovate without forcing the econometric models to be recursive. Hence, we obtain direct as well as reverse interaction e¤ects, leading us to conclude that binding …nancing constraints discourage innovation and at the same time innovative …rms are more likely to face binding …nancing constraints.