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Economic Review

Economic Review
C O N T E N T S
Fourth Quarter 2002/Volume 87, Number 4

Economic Review articles are posted on the Web as they become available. Page numbers in the PDF file posted here may not reflect the page numbers of the printed version.

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PRESIDENT
JACK GUYNN

SENIOR VICE PRESIDENT AND
DIRECTOR OF RESEARCH

ROBERT A. EISENBEIS

RESEARCH DEPARTMENT
THOMAS J. CUNNINGHAM
Vice President and
Associate Director of Research

GERALD P. DWYER JR.
Vice President, Financial

WILLIAM ROBERDS
Vice President, Macropolicy

LARRY D. WALL
Research Officer, Financial

JOHN C. ROBERTSON
Assistant Vice President, Regional

ELLIS W. TALLMAN
Assistant Vice President, Macropolicy

TAO ZHA
Assistant Vice President, Macropolicy

PUBLIC AFFAIRS
BOBBIE H. MCCRACKIN
Vice President

LYNN H. FOLEY
Editor

NANCY PEVEY
Managing Editor

CAROLE L. STARKEY,
PETER HAMILTON, AND JILL DIBLE
Designers

ALISON BOUNDS
Marketing and Circulation

CHARLOTTE WESSELS
Administrative Assistance

The Economic Review of the Federal Reserve Bank of Atlanta, published quarterly, presents analysis of economic and financial topics relevant to Federal Reserve policy. In a format accessible to the nonspecialist, the publication reflects the work of the Research Department. It is edited, designed, produced, and distributed through the Public Affairs Department.

Views expressed in the Economic Review are not necessarily those of this Bank or of the Federal Reserve System.

Material may be reprinted or abstracted if the Review and author are credited. Please provide the Bank’s Public Affairs Department with a copy of any publication containing reprinted material.

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ISSN 0732-1813

Preface—Venture Capital and Technology: What’s Next?
Anna Copeland Wheatley

During the 1990s venture capitalists transformed entrepreneurs into corporate entities, and these companies in turn have funded increased productivity that has helped to accelerate U.S. economic growth. This success has spawned an interest in tracking information about the industry. These new resources provide an important perspective for understanding how venture capital works.

This issue of the Economic Review features three articles that examine the impact of venture capital on technological innovation, economic growth, corporate development, and other issues. These papers were among those presented at the Atlanta Fed’s 2002 Financial Markets Conference, “Venture Capital and Technology: What’s Next?” co-sponsored with New York University’s Stern School of Business in May.


Corporations and the Financing of Innovation: The Corporate Venturing Experience
Paul A. Gompers

During the past forty years, the media and academics have frequently maligned corporate investments in venture capital and highlighted visible failures. Many corporations’ best ideas have languished, whether because of internal resistance or an inability to execute on the initial insight. In other cases, more nimble companies, often venture-backed start-ups, have turned corporations’ innovative ideas into commercial successes. So how can companies best stimulate innovation in a corporate setting and replicate the success of the venture capital industry?

This article explores the history, structure, and performance of corporate venture programs in the United States over the past forty years. The study shows that the U.S. corporate venture capital market has gone through three waves of activity that track the overall independent venture capital market.

The author’s analysis, using detailed microlevel data, finds that corporate venture investments are increasingly made in related industries. In addition, contrary to previous assumptions, corporate venture capital investments have, on average, been more successful than independent venture capital investments. This success is exclusively associated with strategic corporate venture investments. This study concludes that corporations appear to be learning many of the best practices from the independent venture capital sector.


On the Fundamental Role of Venture Capital
Thomas Hellmann and Manju Puri

The venture capital industry experienced its biggest decline ever in 2001. The National Venture Capital Association reports that, in the fourth quarter of 2001, investments by venture capital firms were at approximately a third of the level the year before and the amount of money raised by these firms had dropped 80 percent. Many people question whether this trend signals the eventual demise of venture capital.

However, according to the authors of this article, it is important to put these numbers in perspective. In terms of total dollars invested, 2001 ranks as the venture capital industry’s third-best year, and the developments of 2001 are simply an anomaly in an otherwise exceptional growth curve. The article examines the significance of this difference between short- and long-term performance.

Using the findings from the Stanford Project on Emerging Companies, an interdisciplinary research project that analyzed 170 technology start-up firms, the authors discuss the effects of venture capital on both the market position of the start-up and on internal operational issues. Their research supports the conclusion that venture capitalists provide value-added services that enhance the value of their portfolio companies. The article concludes with some thoughts on the evolution of the venture capital industry in the nineties.


Boom and Bust in the Venture Capital Industry and the Impact on Innovation
Josh Lerner

After more than two decades of dramatic growth in the venture capital industry, the recent sharp decline in venture capital activity has raised concerns about the implications for technological innovation. This article argues that venture capital may have a powerful impact on innovation, but this effect is far from uniform.

The author uses a supply and demand framework to consider the cyclical nature of the venture industry and explore why shifts in opportunities often do not rapidly translate into increased fund-raising. The discussion shows how the structure of venture funds and the information lags in the venture investment process may increase the tendency of the venture capital supply, when it finally adjusts to shifts in demand, to react excessively.

In considering the implications of these shifts for innovation, the author considers both field-based and statistical evidence. This analysis shows that venture capital’s impact on innovation is positive overall but is likely to differ at various times in the cycle.

The study concludes that, although venture capital has made important contributions to technological innovation and economic prosperity, effective government policies should not seek merely to spur venture financing. Instead, the author urges policymakers to encourage private investment and address gaps in the private funding process, such as industrial segments that have not historically captured the attention of venture financiers.


Reserve Requirements: A Modern Perspective
Scott E. Hein and Jonathan D. Stewart

The discussion in many money and banking textbooks would suggest that the Federal Reserve requires depository institutions to hold a minimum level of non-interest-earning reserves because (1) reserve requirements are a monetary policy tool that allows the Fed to expand the money supply and lower interest rates, and (2) reserve requirements improve the safety and soundness of depository institutions. This article argues that this “conventional wisdom” view is too narrow.

The Fed often uses reserve requirement changes, the authors contend, to achieve non-monetary-policy objectives, as it did in 1992 to improve the profitability of depository institutions and ease the credit crunch of that time. The authors also challenge the notion that higher reserve requirements necessarily lead to greater safety and lower default risk for depository institutions.

The article examines the relationship between reserve requirement changes and monetary policy, with the aim of demonstrating the recent, limited usefulness of reserve requirements as a monetary policy tool. The article proposes a more modern view of reserve requirements as a tax on depository institutions, ponders who really bears this tax, and summarizes a large and growing literature suggesting that perceived bank profitability is inversely affected by announced changes in reserve requirement ratios. The article also provides new evidence that the 1992 reserve requirement reductions were not associated with an increase in default risk for financial institutions that issue reservable instruments, as the conventional view would suggest.