Figure 1: Shares of the US financial industry in total value added, compensation, and employment 1970 – 2007.

Entrepreneurial spirit and innovation are key factors in recovering from the crisis and in a paper published on Monday by Germany's Kiel Institute for the World Economy, asks if the US is better equipped than Europe? It is suggested that Europe’s "extreme" export-orientation may be problem.

The Kiel Institute says that the current crisis will cause far-reaching changes in the real economy. Human, material, and financial capital will be withdrawn from sectors with excess capacity and be used in new sectors demanding these resources. The ease with which this structural transformation takes place will determine the rate of future economic growth.

The Kiel Policy Brief entitled “Adjustment after the Crisis- will the Financial Sector Shrink and Entrepreneurship Boom?” by Frank Bickenbach, Eckhardt Bode, Dirk Dohse, Aoife Henley, and Rainer Schweickert, all researchers at the Kiel Institute, comes to the conclusion that the US has better chances to return to a higher rate of growth than Europe due to three factors:

First, America’s colossal financial sector will push many highly qualified employees into other sectors where they will become innovative. Fewer highly-skilled workers will become available in Europe because its financial sector is not as oversized as America's. Second, America’s traditionally strong market for venture capital investments will help young businesses grasp opportunities to apply innovative business ideas and accelerate the structural transformation. Europe’s market for risky capital investments is still in its fledgling stages, and companies are not as youthful as in the United States. Finally, the macroeconomic environment is more conducive to growth in America than it is in Europe.

Europe’s "extreme export-oriented business attitude," compared to the US, dampens innovation prospects because of uncertainty associated with future exports, especially when taking current exchange rate instabilities of both the dollar and euro into account. This problem pertains particularly to Germany.

The authors say open economies faced with uncertain world market price due to exchange rate uncertainty reduce long-run risky investments such as in R&D because they lose more with falling prices than they may gain with rising prices because of increasing costs of production. This negative effect of exchange rate volatility might be mitigated by a well developed capital market which allows for hedging these risks. However, the capacity of the financial system for smoothing R&D investment is undermined by the economic crisis or critically depends on appropriate regulation.

Moreover, exchange rate volatility and, therefore, uncertainty of exchange rate changes also affect economic growth via the trade channel. With increased competition among firms operating in monopolistic markets across countries, the uncertainty of exchange rates drives a wedge between the values of revenues earned by firms located in different markets. Hence, in the short run, stability of exchange rates is crucial to export oriented firms as they affect their profitability.

The paper says these these results raise red flags for a post-Lisbon economic reform agenda: Europe will lose sight of its goal of becoming the strongest knowledge-based region in the world if the innovativeness of the European economy suffers even more in the wake of the crisis. However, the study does point out that negative impacts, especially if due to the second factor, can be contained through appropriate political measures; the EU Commission must take the criticism geared towards the intended regulatory measures for the private venture capital sector seriously, and not subject this sector to the same rules as hedge funds, or real estate or raw material funds, which all bear significantly more systematic risk.