Capital, Ideas, and the Costs of Financial Frictions

We study the role of financial frictions in determining the allocation of investment and innovation. Empirically, we find that firms are investment-intensive when they have low net worth but become innovation-intensive as they accumulate more net worth. To interpret these findings, we develop an endogenous growth model with heterogeneous firms and financial frictions. In our model, low net worth firms are investment-intensive because their returns to capital are high. Financial frictions slow the rate at which firms exhaust the returns to capital and shift towards innovation. Calibrating to the US economy, we find that the resulting lower growth implies large GDP losses even though capital misallocation is small. In other words, financial markets effectively fund the implementation of existing ideas, but do not adequately fund the discovery of new ideas. If innovation has positive spillovers, a planner would not only raise innovation but also lower investment expenditures among constrained firms.