New Businesses and Unemployment

There’s an excellent post from Carl Schramm at th 4% Growth Project on the link between high unemployment and decreased rates of new business formation:

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.

I’m not so sure that’s the determinating factor. High-impact new establishments tend to be started during economic slumps. During the 1930s the economy eliminated many businesses but lots of new ones started up, particularly new businesses that exploited the new technologies that were coming along. Effectively, the economy went on a diet, shedding fat and adding muscle.

I think today is very different. The sectors that are growing are the ones with the most government intervention. We’re adding fat at the expense of muscle, the opposite of what we need to be doing.

19 comments… add one

  • steve

    I have seen a few people suggest that 8% might become the new normal. I havent seen economists or politicians trying to convince folks to just accept 8%. That said, he otherwise makes an important observation. The sudden drop off suggests a real shock. The continuation suggests that entrepreneurs are sensitive to the weak economy and are unwilling to expand into an economy with no demand for a new entrepreneur’s product/services. Pretty much confirms the small business polls showing that lack of sales is their number one concern.

    Steve

    Steve

  • Drew

    “The continuation suggests that entrepreneurs are sensitive to the weak economy and are unwilling to expand into an economy with no demand for a new entrepreneur’s product/services.”

    Lets parse this canard.

    Weak economy. Well, its a circular argument. Chicken and egg. As an investor and business operator I’d suggest that business creates GDP, not the other way around.

    No demand. In fact, aggregate demand exceeds the pre-2008 recession levels. Its mostly consumer, and despite claims of deleveraging they are spending their future, so lets get a clue. And I say this with all due respect to natural population growth etc.

    And what every liberal (read: Steve) refuses to acknowledge is the proposition that if an entrepreneur invests and wins, his gains now may be 50-60% of what they would be a few years ago, and if he loses. Tough shirt.

    That reduces economic activity. Only doctors, already wealthy investors, wealthy book writers etc can accept that bargain……….the Average Joe needs some KY jelly, the poor bastard. Steve, I see a business opportunity………

  • The continuation suggests that entrepreneurs are sensitive to the weak economy and are unwilling to expand into an economy with no demand for a new entrepreneur’s product/services.

    That might be the case, steve, but let me explain why I don’t think it is. Consumer spending comprising 70% or more of GDP is a very recent phenomenon—see here, third graph down. Historically, business investment has been a significantly higher proportion of GDP.

    The one absolutely certain conclusion that can be drawn from this is that consumer spending comprising 70% or more of GDP isn’t a law of nature. That in turn means that once upon a time entrepeneurs invested with lower rates of return and less demand than there is now. We should be looking at how we can encourage that to happen again.

  • Andy

    I talked with my brother this past weekend (Owns/runs a construction business specializing in commercial interiors) and is extremely busy – busy enough that he’s hiring two more people – a 20% increase in staff. Considering his clients are businesses that could be a good sign, at least for the Denver area.

  • That might be the case, steve, but let me explain why I don’t think it is. Consumer spending comprising 70% or more of GDP is a very recent phenomenon—see here, third graph down. Historically, business investment has been a significantly higher proportion of GDP.

    The one absolutely certain conclusion that can be drawn from this is that consumer spending comprising 70% or more of GDP isn’t a law of nature. That in turn means that once upon a time entrepeneurs invested with lower rates of return and less demand than there is now. We should be looking at how we can encourage that to happen again.

    Good point. In other words, we see that the new business start ups was around 700,000 and it was relatively stable. Even when consumer spending wasn’t such a large chunk of GDP. So can a shifting downwards of consumer spending from 70% explain the decrease in new businesses? If the answer is yes, how do you explain the past?

    One possibility is that there is something else at work that is also discouraging investment spending. Hmmmm…what ever could that be? Hint.

  • steve

    This started in 2009. What increased risk to return suddenly occurred? What tax increase? What policy? Why didnt those higher rates stop people in the 1990s? Isn’t someone not buying your stuff at all a bigger risk than tax rates. Furthermore, when I look at nonresidential fixed investment spending on the BEA site (I trust this a reasonable metric to use), I see that investment as a share of GDP is roughly the same now as it was in the slowdown of 91-92.

    “So can a shifting downwards of consumer spending from 70% explain the decrease in new businesses? If the answer is yes, how do you explain the past?”

    I think you are looking at it wrong. Consumption increased as a share of GDP as US debt, mostly private, increased. We had a credit splurge which financed everything. We can’t borrow like we used to do. While I dont necessarily buy into the 8% UE as the new normal, I would say that we really do not know what our economy can do without debt financing.

    Steve

  • TastyBits

    I suspect that the increase in consumer spending is due to increased consumer debt, and if so, the only way to increase consumer spending is to increase consumer debt. Unfortunately, there are far more people who should not be given credit, and without that debt, consumer spending will lag.

  • This started in 2009.

    As indicated in the graph to which I linked in the comment above the sharp rise in consumer spending started well before 2009—nearly 20 years ago and reaching its fruition in the early Aughts. As both you and TastyBits are suggesting, consumer spending needs a rest. The possible alternatives are government spending, business investment, and exports.

    Government spending would be a possibility if we hadn’t been so profligate over the last 30 years and, especially, over the last 10 years. Business investment has plenty of room to grow if properly incentivized. So do exports.

    However, we’ve got to get off the green kick. As an economic engine it’s been a flop everywhere—here, Europe (especially Spain), and China all have nice, green bubbles.

  • jan

    I wonder if the 8% UE norm that is bantered around might be a consequence of not only a weak economy, but also a work force which has been seasoned to becoming more comfortable being out of the work force.

    For instance a young man who works for us, has a mom who has been off work because of a medical problem. She has worked her entire adult life, enjoys her job, and in the beginning couldn’t wait to get her medical clearance enabling her to go back to work. But, today her son said, after being off for a couple months, she’s liking it, and doesn’t want to go back to work. I was surprised to hear this. However, with the long-term UE benefits, people can cultivate different habits and/or goals. If they find a way to exist without the daily grind, or with just temporary employment, I wonder how many are opting for this lifestyle course.

    “This started in 2009. What increased risk to return suddenly occurred? What tax increase? What policy? Why didn’t those higher rates stop people in the 1990s? “

    The 1990’s had a booming dot com economy, yielding high income and revenues, which could withstand higher rates. When the economy is weak, though, you don’t overtax it by raising tax rates (Obama said that himself, following the ’10 midterms). It’s akin to a strong immune system being able to cope better with an infection than a weak one.

    In 2009 the Bush tax cuts were near sun-setting. Congress then, like it’s doing now, waited until the last minute to formulate a plan on how they would go forward. At that time they extended the cuts for another 2 years. But, 2 years doesn’t inspire much confidence to risk a long term investment. So, the business economy just idled along, with little growth and sputtering job creation.

    Maybe because I’ve heard so much about the ‘fiscal cliff,’ I’ve become more desensitized to the catastrophic effects that people are predicting will happen. One thing for sure, I’m tired of hearing Obama rail against the ‘rich,’ 24/7. He goes from venue to venue using his campaign trail class warfare speeches, making it all about taxes and nothing about spending cuts. Oh sure, he says he will compromise, but never spells out what that means. And, while people expect the republicans to have a detailed plan, in triplicate, they just dreamily accept the crumbs of ‘words’ and divisive rhetoric, from this reelected POTUS, without question.

  • steve

    I was referring to the decrease in new jobs forming starting in 2009. Never post on two hours sleep I guess.

    Steve

  • What increased risk to return suddenly occurred? What tax increase? What policy? Why didnt those higher rates stop people in the 1990s?

    Obamacare, that deficits continue to remain high and will likely remain high for the foreseeable future, the Great Recession, the fiscal cliff in 2011, the fiscal cliff in 2012, Social Security revenue falling below outlays are all things that could add to economic policy uncertainty.

    I see that investment as a share of GDP is roughly the same now as it was in the slowdown of 91-92.

    Okay, so during the latter stages of an expansion you see that non-res investment is about the same as non-res investment during a recession. You don’t see a problem with such a comparison? In other words, investment is down.

    I think you are looking at it wrong. Consumption increased as a share of GDP as US debt, mostly private, increased. We had a credit splurge which financed everything.

    That doesn’t explain it steve. It still leaves the current period unexplained. PCE is still around 70% of GDP. Granted, it isn’t going up like it did in the past several decades, but given that PCE is still over 70% it rings rather hollow when people keep harping constantly on aggregate demand and insisting that economic policy uncertainty plays zero role at all. Here is an instructive exercise for you. Go to BEA, get the GDP data from 2002 to most recent. Take PCE and divide it by total GDP then graph it. Take non-res investment divide it by total GDP and graph it. Tell me if the two graphs look the same. here is what I see:

    PCE for every quarter from Q1 2009 is above its historical predecessors (i.e. for 2010 Q2 if you compare it all previous Q2s 2010 outside of 2009 forward exceeds those values). When I make a similar comparison for non-res investment I don’t see a similar pattern.

    Now, maybe GDP is below potential, so PCE is below potential too. So yeah maybe aggregate demand (of which 70+% is PCE) is also below potential too. But this also applies to investment, both res and non-res. And non-res investment is taking longer to recover. In fact, I’d say the problem with aggregate demand is the lack of non-res investment.

    Now you can sit there and blah blah blah about aggregate demand but to me it looks like we have a problem with businesses reinvesting some of those retained earnings they are sitting on.

    And this fits well with Micheal’s observation about the stock market. What happens to the price of a stock of a firm that is sitting on a growing pile of cash?

    While I dont necessarily buy into the 8% UE as the new normal, I would say that we really do not know what our economy can do without debt financing.

    A firm sitting on a pile of cash from retained earnings, in a less uncertain economic climate, would likely have little trouble securing loans and investing in its operations.

  • Oh and it doesn’t help that the recovery is as old as it is. Business people are not stupid, and they are forward looking. I’m sure a good number of them are noting the age of our expansion (and its anemic nature) and the various things likely to raise uncertainty about the future I noted above and think, “Hmmmm….I don’t know…..”

  • However, we’ve got to get off the green kick. As an economic engine it’s been a flop everywhere—here, Europe (especially Spain), and China all have nice, green bubbles.

    I completely agree with this. The claim about new jobs is total bullshit because it should be about net new jobs. If it is more expensive to use LNG to fuel cars then that will almost surely result in fewer net jobs. Sure there might be some new jobs in producing LNG, but there will likely be a larger number lost.

    And the lost jobs don’t have to be all in refining. They could be everywhere. To see the problem consider a rise in the price of a good. There are two effects from that price increase. A substitution effect and an income effect. The substitution effect is what will likely cause a drop in jobs are oil refineries. The income effect will cause fewer jobs economy-wide and are thus much harder to measure. But we know there is an income effect and thus there is almost surely going to be a guy who had a job at say Target, but no longer does because of some political mandate.

    And for all the economic idio…errrr ignorami, I’m not claiming that implementing various green mandates will cause some sort of economic spiral into oblivion. What I’m saying is that there is no free lunch and one of the things with green policies is that they often tend to cost more. If the economy were humming along (say like in 1995) then implementing green policies might be a great idea. But the economy isn’t and maybe we need to get our economic house in order first.

    That last, IMO, was and is Obama’s biggest failure. Instead of doing everything he could to get the economy going he used the crisis to implement policies that in hindsight may very well be seen as making the situation worse/longer lasting. And he is continuing to do it (e.g. his dubious negotiating regarding the fiscal cliff).

    Oh, and interesting article.

  • Drew

    “Hint.”

    Steve Verdon for President.

    I’ve been making this point for years. No one listens, except perhaps for Steve V, but then again – oh, that’s right – he’s actually an economist!!

    Look where we are for ignoring the fundamentals. Sad.

  • steve

    “Now you can sit there and blah blah blah about aggregate demand but to me it looks like we have a problem with businesses reinvesting some of those retained earnings they are sitting on.”

    When you look at the specifics, businesses actually are investing in equipment and software. It is mostly real estate that is lagging. We dont need to invoke uncertainty to explain that.

    ” he’s actually an economist!!”

    That would be the profession that completely missed the subprime crisis? That has correctly called 9 of the last 4 recessions. Where 50% are certain we have a demand problem and 50% a supply problem with the other 50% sure it is both? whike they still have value in some areas, we might as well admit that economists have zero credibility when it comes to predicting macroeconomic outcomes.

    However, let me give you kudos for recognizing the existence of both the substitution effect and the income effect. Conservatives dont recognize the existence of the latter, which confirms your libertarian credentials.

    Steve

  • Oh one last thing steve, businesses investing…that is part of aggregate demand.

    Your kind of error is what happens when you are not well versed in economics. Aggregate demand is demand for everything in the economy. The aggregate demand curve/function represents televisions, dvd players, cars, lathes, computers, telephone poles, light bulbs, stethoscopes, chairs, 2x4s, toilets, and everything else you can think off. Everything. So, if business investment is a problem then that could be your problem with aggregate demand.

    But you can’t look at aggregate demand and say, “Oh, stimulus.” Because what drives business investment might be very different than what drives purchases kitty litter. I’ve been trying to get you to put your brain into thinking mode for awhile here by saying periodically, “Aggregate demand does not exist.” It doesn’t. It is, at best, a convenient fiction that macro economists use to simiplify the math in their models. But the danger is if you treat aggregate demand as a real thing and the “quantity demanded” as just like push-pops, then you can very, very easily get the wrong policy response to a drop in “aggregate demand”.

    Now to tie in economic policy uncertainty (uncertainty for short)…businesses look at investment based on the reward. The less the reward the less investment. They also look at the volatility of investment, the more risky an investment the less likely they are to want to invest if the risk premium does not go up. This is especially so if we factor in loss aversion instead of risk aversion. So, economic policy uncertainty could negatively impact “aggregate demand” by making businesses less willing to invest.

    In other words, it does not have to either/or. That is, the idea of economic policy uncertainty and weak aggregate demand can actually both be true at the same time–i.e. the former is one of the reasons for the latter.

  • That would be the profession that completely missed the subprime crisis? That has correctly called 9 of the last 4 recessions.

    Actually, I was discussing the weak economy well before it was called.

  • However, let me give you kudos for recognizing the existence of both the substitution effect and the income effect. Conservatives dont recognize the existence of the latter, which confirms your libertarian credentials.

    Would you be offended if I said, “Fuck you”?

  • When you look at the specifics, businesses actually are investing in equipment and software. It is mostly real estate that is lagging. We dont need to invoke uncertainty to explain that.

    Oh noes! My initial metric was found lacking! Let me look around till I find something that supports my position!

    How many of your patients did you kill last year steve?

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