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Risky Business

February 1, 2013 by Carl J. Schramm

Experts commonly invoke the “entrepreneurial eco-system” to explain how new businesses come into existence. The assumption is that localized environmental conditions make new businesses possible. But it may well be that much larger forces are responsible. Worrying about localities may be misplaced if the question is how to get more firms started in America. Even the content of the term “entrepreneurial eco-system” is hardly settled. It seems to suggest some features of a local economy (money, mentors, minds, and magic) that, when working together in some optimal way, produce more new businesses than might otherwise be expected. Since some places grow (e.g., Austin, Texas) and some contract (name any “rust belt” city), there is always an audience to hear why the former are more congenial to entrepreneurs. Michael Porter’s cluster theory, which holds that pre-existing conditions explain everything, is often invoked, as is Richard Florida’s notion of inducing more “creatives” to relocate by changing conditions such as “tolerance” and the inventory of loft housing. (The assumption, certainly open to question, is that people inclined to inventing new companies prefer such housing.) But it may be that place and other local ingredients seem important simply because they appear amenable to change. Porter’s and Florida’s theories actually might not have much to do with aggregate rates of new firm formation. Focusing on local characteristics and not on the macro forces influencing new firm creation is like looking at medicine rather than public health. In medicine, the patient in front of the doctor is the focal point; in public health, the whole population is of interest. Research initiated by the Kauffman Foundation in 2008 enables us to develop a “public-health” perspective on the nation’s entrepreneurial activity. At long last, a perspective on the nation’s entrepreneurial eco-system is beginning to emerge. Perhaps the single most important indicator of the level of entrepreneurship is the raw number of new firms being formed every year. Historically the number was largely a guess. With new data resources, however, it appears that the number of new businesses started in any year had been extraordinarily stable. For at least a decade, without apparent regard for economic contractions and expansions, the annual number stood at roughly 700,000. But in 2009 the number started to fall precipitously. It is now estimated to be about 500,000 starts per year. This decline provides a very important new perspective on, among other things, economic recovery, because new firms are so important to the creation of new jobs. New firms, prior to 2009, routinely created approximately seven new jobs during their first year. In 2011, the number fell to roughly five. Were 2007 patterns to obtain today, America could have had at least 400,000 new jobs in 2012 that weren’t created because 200,000 fewer firms got underway. The data also permit us to speculate about a very important question: Why are fewer people starting new firms? Let me propose a link between new firms and the general level of economic activity. Recently many economists, helpless to explain how to get our economy growing again, have defaulted to what might be called the “tectonic-shift” thesis. As they see it, the whole economic landscape suddenly changed in 2008. They argue that we will never see full employment at 5% again. Get used to it — the 8% nominal rate is the “new normal.” (For readers not versed in economics, 5% unemployment is viewed as equivalent to full employment — at any given time, 5% of the working population is moving from job to job. This is known as “frictional” unemployment, and it is nothing to be alarmed about; it is indeed normal.) This default thesis may explain the unprecedented casualness (at least in my view) with which politicians and economists have dealt with unemployment during the last four years. They behave as if 8% unemployment is “normal,” or at least not really so bad. The media have done a good job of telling people not to expect much better, ever again. Politicians appear to want to believe that the current nominal rate of 8% is really the new frictional rate. But if we are trying to explain why fewer entrepreneurs are starting businesses, the difference between the old 5% rate and the “new normal” 8 percent rate tells all. Would-be entrepreneurs are particularly sensitive to the unemployment rate, more so than might have been imagined. Put differently, entrepreneurs — who are alleged to have more finely tuned market intuitions than other people who make their livelihood in business — appreciate that, if their new business fails, their personal economic risk increases exponentially as the unemployment rate goes up. This is how their calculus likely works. As the nominal rate goes up and then becomes chronic (as it is now), the real number of people who drop out of the labor force altogether goes up at a much faster rate. Right now we see the nominal unemployment at 8%, but we know there are at least another 8% of people who would work if they could get a job, but have just given up (at least for the time being). These people are not counted as “unemployed” in the official government statistics. If they were, the real unemployment rate, not the nominal one that the government reports for consistency and political reasons, is right now estimated to be 16%. The entrepreneur, who could have taken a conventional job if he or she could have found one, knows that the difference between the normal 5% unemployment rate and the current nominal rate of 8% is more severe than just three percentage points. Indeed, from the entrepreneur’s perspective the chances of recovering from the risk of starting a company that fails is measured as some multiple of the current three percentage point difference between full employment (5%) and the current rate of 8%. Let us call this multiple the entrepreneur’s risk exposure index: It is the number that holds back entrepreneurs from taking the risk of starting a new company. Assume, for example, that the entrepreneur’s risk exposure index is a multiple of 4. At 8% unemployment, the entrepreneur’s calculation is that if he or she starts a company and it fails, it will be something like 12 times harder to find a way to enter the labor market as an employee of an existing business. (Moreover, their personal financial risk is compounded if they are, as is likely, burdened with business debt from their failed start up.)  For comparison, at full employment (a 5% unemployment rate) the entrepreneur’s risk exposure rate would fall to zero, adjusted for debt, because he or she could readily find a job in an existing company. The accompanying exhibit suggests the shape of the entrepreneur’s exposure risk curve.

Figure 1: Entrepreneur’s Risk Exposure IndexThe entrepreneur’s risk exposure index may be helpful to framing policy and to posing a whole new series of questions about individuals’ decisions to start new businesses and who it is that is inclined to undertake such risks. At the macro level, economists must pay attention to how policy encourages or discourages entrepreneurs. Industrial policy as practiced in Europe, and as it is emerging in the U.S., is never sympathetic to entrepreneurs. Big companies — as they capture the government and assume the role of rentiers, whose interests are protected by the political class — resist the intrusions and threats that entrepreneurs pose. They want government to be the instrument of protection. When new businesses face extraordinary regulatory burdens, it is often because big businesses have sought them as a barrier to entry for new firms.

Today our government faces a choice. It cannot protect inefficient established companies and obsolete technologies on the one hand, and applaud the importance of entrepreneurs on the other. We either tie ourselves to crony capitalism or to entrepreneurial capitalism — they are diametrically opposed approaches to managing the economy. The former is orderly but always connected to slow growth; the latter is messy and more likely to produce growth — not just of aggregate wealth but also of opportunities for individuals. Entrepreneurs who are certain that their idea is so good that the market will have to yield to their designs are likely to start companies against all odds. They will go forward even at, say, 9% nominal unemployment rates. Those who start companies at 5% might be less passionate, less driven, and less successful. All of us, however, are likely better off with 700,000 new starts at 5% unemployment than we are with 500,000 new startups at the altogether unacceptable  “new normal” rate of 8% unemployment.


Author

Carl J. Schramm
Carl J. Schramm

2012 Economic Growth Fellow

Carl J. Schramm is recognized internationally as a leading authority on entrepreneurship, innovation, and economic growth. Currently he is university professor at Syracuse University. For 10 years he served as president of the Kauffman Foundation, making it into the world’s premier organization dedicated to the development of high-growth firms and understanding the role they play in economic growth. He serves as a visiting scientist at MIT and as a fellow of the Bush Institute. He is a Batten Fellow at the University of Virginia’s Darden School of Business and is a member of the Council on Foreign Relations. Schramm's most recent book, "Better Capitalism" (co-authored with Robert Litan) was published by the Yale University Press in September 2012. He has written several other books, including “Good Capitalism, Bad Capitalism” and “The Entrepreneurial Imperative.”

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