Growthology

Cleantech Loses Its Mojo?

I spoke yesterday on a venture capital panel in San Francisco at the Green:Net event about the confluence of cleantech and information technology. It was a fine and well-attended event, but an entrepreneur friend tweeted me the following afterward:

It struck me today how corporate Cleantech has become. No longer has the Valley vibe - lots of suits and ties and corporate speak.

That comment bothered me. Here's why: I too got the sense that entrepreneurs and investors there were less prone to enthusiasms, and the thinking had become more pragmatic. There was much less talk of world-changing energy innovations, and much more talk of smart meters, iPhone apps for tracking home power usage, a little solar, plus lots of Big Company People noshing about business development relationships with Big Company People.

Now, there is (mostly) nothing wrong with that. The brief flirtation among cleantech investors with capital-intensive projects seems over, at least according to the most recent data I have seen. And that should provide some reassurance to those of us convinced it would end very badly, if it continued. After all, the venture industry is ill-equipped to provide project financing, with the combination of long cycle-times and large amounts of capital toxic to already crushed venture capital returns.

And, to be fair, there is very cool stuff happening at the confluence of green and IT. Here is an example from Greentechmedia, who also attended the event:

AquaCue has effectively created a cellular modem that straps onto water meters that provides municipal water agencies data about water consumption. The data can then be analyzed and mined for patterns about consumption. Potentially, it could even be exploited to inform high-consumption customers that they use far more water than their neighbors.

This sort of thing is great, but we still don't want early energy rigor mortis to set in. Energy is still an emerging category for entrepreneurs and venture investors, so having it become too staid, too soon will be counter-productive, making cleantech less likely to deliver the kinds of entrepreneurial experimentation and waste (more on that in an upcoming paper) that lead to genuine innovation. We want entrepreneurs to be enthusiastic, hyperbolic and generally messing about; we don't want them to fall early into the trap of gradualism, adulthood and diminished expectations.

Can anything be done? I don't know, and I worry about it. In the absence of progress, wealth creation and real successes entrepreneurs -- and investors -- will be ground down to realism, which is never the best place from which to start an entrepreneurial revolution in new territory. After all, as most entrepreneurs I know like to say, "If I had know how hard this would be I might not ever have started".

3.2 percent ain't good enough

The advance number for Q1 growth was released today: 3.2 percent (this link is to a WSJ summary of economist opinions).  Three-point-two would be good in normal times, but it's not enough to catch-up to where the U.S. economy "should" be. 

I'm skeptical this is a solid recovery. I'm skeptical there won't be a double dip. Why?  Because interest rates are very low and have to rise sometime soon, because federal spending stimuli are fading, because I believe in a place called California, and because so much of the durable consumption seems driven by cut-rate deals (Toyota in Q1 offered zero-percent financing for the first time in history). Thin ice.

This would be a good time to reread Mankiw's argument that this is a Unit Root recession, not a Trend Stationary recession. A rebound to normalcy would be nice, but we all know better than to believe the housing bubble defined normalcy. It's time to shelve fantasies that a stimulus, any stimulus, can or should get America back to artificial prosperity.

Who Declared War on Entrepreneurs?

Nick Schulz over at the Enterprise Blog draws our attention to an apparent crackdown by the IRS on the flexible employment arrangements used by many independent contractors and small businesses. It's not clear what impact this will have but, anecdotally at least, there have been reports that many new and young businesses in this recession have been turning more and more to freelancers and contractors. And we've seen the average size of new companies shrink over the past few years by about two employees--as noted in the story above, this likely indicates increasing use of such flexible arrangements.

Put this together with the anti-angel provisions in the Dodd bill (which I think may have been slightly diluted recently), and it seems as if someone has declared a war on startups. Which is, in other words, a war on job creation and economic growth.

An Exciting Day

I just received in the mail a copy of Matt Ridley's forthcoming book, The Rational Optimist. I was fortunate enough to be able to attend a seminar last year at which Ridley discussed the book and solicited input and ideas.

Based on that discussion and Ridley's extraordinary intelligence and writing ability, this book will be stupendous, no doubt about it. Check out his blog here; good stuff.

Lean Startups

Starting IT companies is getting cheaper.  Naturally, it's a new business model.  Cool article in NYT describes the trend.

Technology animates the lean start-up process. Free open-source programming tools and easily distributed Web-based software drive down the cost of developing new products and services. The early companies embracing the principles live largely on the Web, which makes it possible to measure and track customer behavior constantly and to invite suggestions and criticism.

I wish our 1998 startup enonymous.com had used lean-startup approach. We went for VC gold, and won it. But it did not translate to long-term success.

Grading the Presidential Summit on Entrepreneurship

I was curious what being a delegate to a Presidential summit would be like, and now I know. It's like being a passenger on very slow roller-coaster ride, but with awesome fellow passengers. The panels have been pretty typical conference fare, with way too much happy talk about dream fulfillment. But it's important. Really important. In ten years, the most important outcome of the summit will simply be there was a summit at all. I'd venture to say the very idea could not be topped by the substance, no matter how good. 

Consider the "Force of Fortune," recently reviewed in Foreign Affairs:

Renowned Middle East expert Vali Nasr's bestselling The Shia Revival profoundly transformed the debate about the Iraq War by unveiling how the Sunni-Shia rift was driving the insurgency. Now, in Forces of Fortune, Nasr presents a paradigm-changing revelation that will transform the understanding of the Muslim world at large. He reveals that there is a vital but unseen rising force in the Islamic world—a new business-minded middle class—that is building a vibrant new Muslim world economy and that holds the key to winning the cold war against Iran and extremists. His groundbreaking analysis will utterly rewrite the wisdom about how the West can best contend with the threat of Islamic extremism, as well as about what we can expect from the Muslim world in the future. The great battle for the soul of Iran, the Arab world, Pakistan, and the entire region will be fought not over religion, Nasr reveals, but over business and capitalism.

So after one full day, here's my report card:

Title: A
Think about it. They could have had a summit on "Development" or on "Peace" which would have been instantly forgettable gatherings. This topic has some bite to it, and it's something tangible and deep enough that all Americans should be cheering the President. I tried to find out who coined the term, and have been crediting Esther Lee or Secretary Locke at Commerce, but she says it was one of President Obama's speechwriters. If you believe in the transformational power of market capitalism, you believe in this summit.

Team: A
The Obama administration is playing its first string team on this one. Secretary Gary Locke kicked things off, Melody Barnes was on a panel, the President himself gave a long speech today (including a rope line and numerous shout-outs to delegates, though he called me the Governor of Virginia for some reason). Tomorrow Secretary of State Clinton will speak. Arne Duncan. Rajiv Shah. There are many more. To be fair and balanced, I'm not sure all of the White House folks get entrepreneurship and you get a sense some want to talk about social entrepreneurship instead. Believe me, the delegates from the Middle East noticed, and one would-be entrepereneur commented to me that, "We need help creating wealth before we start talking about giving it back." Regardless, they appreciate the symbolism and ceremony of having the President's A team show up, and it means a lot. 

Agenda: B
The panels have been good. Missing so far is an objective accounting of which countries are getting which policies right. Where are labor regulations most efficiently reformed? Who is solving the problem of access to capital and middle-tier loans? Maybe we'll get into the nuts and bolts tomorrow, but I doubt it. That's not the point and/or that point is very much alive without being on the podium, if you know what I mean. Besides, the hallway conversations are excellent. These delegates are players. Biggest surprise of the day was that a lot of folks recommend betting on pro-market reforms in ...Syria.  Young Syrians, apparently, are ambitious capitlists agitating for growth.

Finally, I don't think it's appropriate to simplify a presidential speech with a letter grade. But I thought President Obama's remarks were excellent. I can't find a transcript, but will link to it tomorrow when I can.

Like 99% of you, I don't agree with the Obama administration on everything. But this summit deserves our full-throated support.

My PBS NBR commentary on the Summit on Entrepreneurship

Last week (April 22), I offered a video commentary on PBS' Nightly Business Report: 

SUSIE GHARIB: For many economies around the globe, start up businesses are the little engine that could, creating jobs and revenues. But you might be surprised where some start up businesses are taking root. Here's commentator Tim Kane. He's senior fellow of research and policy at the Kauffman Foundation.

TIM KANE, SR. FELLOW, THE KAUFFMAN FOUNDATION: Next week, President Obama is hosting a summit for more than 50 countries with sizable Muslim populations and it's a summit on entrepreneurship. Maybe that sounds like small potatoes compared the big nuclear summit the White House hosted last week, but I think it's even more important. World peace will have economic roots. Muslim economies are eager to shift away from oil and they know a startup culture is key. Actually, these countries are already changing. The reality of this century is that economic growth is flowering almost everywhere, not just exotic places like China and Cupertino.

A big reason progress has been so measurable is simple. There's something to measure. Since 2004, the World Bank has been publishing the "Doing Business Report", which compares national economic policies across the globe. And according to the 2010 edition, nine out of 10 Middle Eastern and North African countries made at least one reform making it easier to do business, say start a company or hire a worker, with less regulation getting in the way.

Here's an example. In 2004, it took 42 days to start a company in a typical Middle Eastern country. Last year, 21 days. In the U.S., it took six days. But get this, in Saudi Arabia it took only five days to start a company. In fact, two of the top economic reformers in 2010 were Egypt -- fancy that -- and the United Arab Emirates. Saudi Arabia now ranks as the 13th best place to do business in the world. Who's number one? Let's just say the summit should arguably be held in Singapore, not Washington. I'm Tim Kane.

From "Brain Gain" to Brain Circulation

[Cross-posted from Progressive Fix]

A recent post highlighted the importance of new and young companies to job creation in the U.S., implicitly raising an important question for policy makers: How can we increase the number of startups? Assuming it can be done, such an increase would not solve all of the economic challenges facing this country, but it would certainly help. New companies not only create millions of jobs across all sectors of the economy — they also introduce product and process innovations, boosting overall productivity.

Saying startups are important is one thing, of course; actually designing policies to increase their number is something else entirely. Before making any recommendations, for example, we need to know more about the universe of startups. Are they more prominent in some sectors than others? Does the impact of new companies differ across sectors or geographic regions? Should policy focus on encouraging more new firms, or on enhancing the growth of those already in existence? How would any such policies affect established companies, large and small?

Policymaking around entrepreneurship is evidently not clear-cut as there is still quite a bit we do not understand regarding startups. In the coming weeks we will try to explore these questions and illuminate the world of startups for policymakers. We’ll start with the lowest-hanging fruit of all, though one that may seem like poison to some in Washington: immigration.

It’s commonly accepted that the United States is a nation of immigrants, settled and populated by those fleeing persecution, seeking commercial opportunities in a new land or looking for a fresh start. We have always recognized the important contributions of immigrants to the U.S. economy, from entrepreneurs like Samuel Slater (textile mills) to Andrew Carnegie (steel) to Andy Bechtolsheim (Sun Microsystems) to the laborers and workers who built this country with their hands.

Recently, researchers have begun to paint a broader picture of the economic role of immigrant entrepreneurs. For example, Vivek Wadhwa and his research team have found that, from 1995 to 2006, fully one-quarter of new technology and engineering companies in the U.S. were founded by immigrants. In Silicon Valley, the figure was one-half. These firms constitute only a sliver of all companies, yet contribute an outstanding number of jobs and innovations to the economy.

It makes sense, then, that if we are seeking to increase the number of new companies started each year in the U.S., we might look to immigrants. It turns out that Sens. John Kerry (D-MA) and Richard Lugar (R-IN) are thinking precisely along these lines, introducing the StartUp Visa Act (PDF) in the Senate. This bill would grant a two-year visa to immigrant entrepreneurs who are able to raise $250,000 from an American investor and can create at least five jobs in two years. Without question, such a visa is a good idea and this legislation hopefully paves the way for future actions that would reduce the pecuniary threshold and focus more on job creation.

Quite naturally, however, the promotion of immigrant entrepreneurs arouses suspicion among those on the right who harbor nativist views, and those on the left who perceive progressive immigration policies as a threat to American labor. Such views take the precisely wrong perspective: immigration, as we have seen, is a core American value. Immigrant entrepreneurs, moreover, come to the U.S. to make jobs for Americans, not take them.

Further, many of those who promote immigration as a way to boost economic growth narrowly focus on “high-skilled” entrepreneurs, those who might start technology companies. Clearly, as Wadhwa’s research indicates, such companies are important to American innovation. But we exclude non-technology entrepreneurs at our peril — every new company, including those founded by immigrants, represents pursuit of the American dream. By closing our borders to immigrants in general or welcoming only those with certain skills, we leave out many who will start new firms in other industries. If not in the United States, they will go elsewhere to start their companies and create jobs.

Entrepreneurs are implicit in Emma Lazarus’ poem: “Give me your tired, your poor/Your huddled masses yearning to breathe free.” Entrepreneurs start from nothing and work endlessly to build their companies, expressing their individual freedom through commerce. Why should we want to exclude them from the home of entrepreneurial capitalism?

ADDENDUM: Ben Wildavsky's new book, The Great Brain Race, will be released soon and I highly recommend it to anyone interested in higher education, globalization, and immigration. It is a fantastically written book and, as noted in the title of this post, Ben posits this wonderful notion of "brain circulation." When discussing globalization and immigration and job creation in the very recent past (and, for that matter, still in the present), we have usually spoken in terms like "brain gain" and "brain drain," implying a zero-sum contest between countries and regions. Ben's book makes quite clear that we are moving into a world of brain circulation, wherein people circulate among countries and institutions, starting companies, creating jobs, propagating innovations--adding to the economies of many countries at once. 

Missing the Trees for the Forest, Jobs edition

Read Tyler Cowen's post of the nature of job loss in this recession.  Summary: Aggregate demand (i.e. the business cycle) explains most of the job loss, sure, but there are structural dynamics, too. Not to mention, bad policy fixes which add rigidities.  My thoughts below.

... I would start with the fact that output has bounced back more robustly than employment has.  AD theories per se do not explain that differential. 

... It's also the case that the rate of new job creation has been especially low.  Yet the nominal wages on those jobs-to-be are not constrained by previous contracts or agreements.  Tell stories as you may, but it's hard for me to see that as exclusively an AD problem.

... I don't want to oversell the minimum wage hike + unemployment compensation extension + means-testing hypothesis here, but surely it deserves a mention as one relevant factor.  Those are real factors too.  (There's more, read here)

First, the "jobless recovery" phenomenon is relatively new.  Media coverage seems to have fallen for stories that post-recession job growth is always slow. Not true. The first hint of this phenomenon was after the 1991 recession, which was worse after the 2001 recession, and appears to be worse again this time. There is something qualitatively different about how the modern economy heals. It might be structural, but the predominance of service work (17 in 20 jobs) and flex-time / part-time implies more labor market flexibility, not less. An alternative explanation is new economic institutions. Non-compensation costs of an increasingly regulated labor market may be making employers increasingly averse to hiring until growth is robust. Uncertainty may be a factor as well -- about the recovery, about new laws and regulations. I've said it before: even if health reform turns out to be good long-term policy, enacting it came with an uncertainty cost which is amplified in a down economy.

Second, the minimum wage increase was terribly timed. Economists need to look beyond the lump of labor in AD theories and recognize the unemployment rate is multiples higher for less-skilled workers. Young men, especially young black men, suffer an unemployment rate that should blow your mind. Workers aged 16-19 have an unemployment rate of 23.7 percent today, compared to 19.9 percent a year ago (March 2009). For African-Americans aged 16-19, it is 41.1 percent today, ten percent higher than a year ago. For all of us pedigreed, older workers, this recession is not about us. But imagine if it were because the Legislative Branch made it illegal for us to work at our current salary (mandating to our employer that we be paid 50 percent more, or laid off). Would you blame your layoff on weak aggregate demand or the U.S. Congress? 

Third, Unemployment Insurance destroys jobs. Menzie Chinn points to some Fed research (Valletta and Kuang) showing the UI extension had a minor impact on unemployment duration. Minor is greater than zero. "extended UI benefits account for about 0.4 percentage point of the nearly 6 percentage point increase in the national unemployment rate over the past few years."  Keep in mind, that's just for the UI extension, so the effect of UI itself as currently designed is even worse. Are you comfortable with a program whose mere extension is responsible for destroying 600,000 jobs?

Tax Rates Just Might Matter

I am new to experimental econ, but have been working on some experiments that will help me understand the shape of the Laffer curve. As a starting point, nobody should doubt that the Laffer curve exists, only what shape it is. Nevertheless, most commentary (like mine about the gas tax earlier this week) uses the static assumption that tax rates do not affect behavior.  For example, the top marginal tax rate has been lowered, even though the rich are getting richer. But which caused which?

Greg Mankiw comments on just how big that mistake might be to assume incomes are unrelated to taxes:

Over the past half century, the top marginal tax rate has fallen from 91 percent in the 1950s and early 1960s to 35 percent today.  Thus, the amount a person gets to keep at the margin has risen from 9 percent to 65 percent, that is, by a factor of 7.2.  If the elasticity of taxable income with respect to 1-t is one, as some studies find for high-income taxpayers, then the incomes of the rich would have risen by a factor of 7.2 as well.  If the elasticity is one-half, then their incomes would have risen by a factor of 2.7.  In either case, the change in pretax income attributable to the tax cuts is substantial.

The pickle is that self-employment seems to rise along with tax rates.  That may seem counterintuitive, but it makes sense if you consider tax avoidance. Employees can't hide income, entrepreneurs sometimes can. Think about the next time you see a small restaurant offer discounts to cash customers.

Tax Rates Just Might Matter

I am new to experimental econ, but have been working on some experiments that will help me understand the shape of the Laffer curve. As a starting point, nobody should doubt that the Laffer curve exists, only what shape it is. Nevertheless, most commentary (like mine about the gas tax earlier this week) uses the static assumption that tax rates do not affect behavior.  For example, the top marginal tax rate has been lowered, even though the rich are getting richer. But which caused which?

Greg Mankiw comments on just how big that mistake might be to assume incomes are unrelated to taxes:

Over the past half century, the top marginal tax rate has fallen from 91 percent in the 1950s and early 1960s to 35 percent today.  Thus, the amount a person gets to keep at the margin has risen from 9 percent to 65 percent, that is, by a factor of 7.2.  If the elasticity of taxable income with respect to 1-t is one, as some studies find for high-income taxpayers, then the incomes of the rich would have risen by a factor of 7.2 as well.  If the elasticity is one-half, then their incomes would have risen by a factor of 2.7.  In either case, the change in pretax income attributable to the tax cuts is substantial.

The pickle is that self-employment seems to rise along with tax rates.  That may seem counterintuitive, but it makes sense if you consider tax avoidance. Employees can't hide income, entrepreneurs sometimes can. Think about the next time you see a small restaurant offer discounts to cash customers.

10 Most Important Books

What are the 10 most important books you have read in your life?  (Tyler Cowen actually recommends that we list the most influential). Anyway, here are mine:

1. The Worldly Philosophers: The Lives, Times And Ideas Of The Great Economic Thinkers
2. Leading Lever of Riches by Joel Mokyr
3. The 2007 Index of Economic Freedom
4. Brave New World by Aldous Huxley
5. The End of History and the Last Man by Francis Fukuyama
6. The Diamond Age by Neal Stephenson
7. The Mighty Avengers, Issue # 160-177
8. What It Takes: The Way to the White House by Richard Ben Cramer
9. Capitalism, Socialism, and Democracy by Joesph Schumpeter
10. The World Book Encyclopedia

I don't have links, but here is one I highly recommend: goodreads.com.  I keep a list of the books I read, with my notes, and also keep tabs on my friends.

Why these 10?

World Book. It was this encyclopedia that taught me two terrible things that deeply affected me.  First, when I was 4th grade, I learned that JFK had been assassinated. Before reading about it in the encyclopedia during library time, I believed Kennedy was still alive. He was a hero to me. It was the 1970s, more than a decade after his death, but I felt like he had been killed that very day.  The second thing I learned is that Saturn is mostly liquid, which scotched my plans to be the first astronaut to walk on the planet. Saturn is still my favorite planet, so maybe I'll just have to swim there ...

Leading Lever of Riches by Joel Mokyr. This is the substance behind "Guns, Germs, and Steel" (which is also a fine book). I read it while working on my dissertation, and can learn something new about history and development every time I crack it open. 

The 2007 Index of Economic Freedom. This is a cheat, since I wrote this one.  My team changed the methodology of measuring economic freedom and reshaped the design of the Index as well.  Like they say, you don't really know a subject until you teach it. Or write a book about it. 

Brave New World by Aldous Huxley. The most insightful dystopia, and probably the most accurate prediction of modern ills (soma, especially). It has flaws, in terms of literature and economics, but Huxley towers over the other dystopians.

The End of History and the Last Man by Francis Fukuyama. The 1989 essay, more than the book, forever shaped the way I see the world. As a cadet preparing for Cold War service and beginning to see the failure of communism (and its hollowness as an economic threat), reading Fukuyama was a thrilling validation of dangerous ideas. And he was right, and the Wall fell. Taught me to have confidence in identifying what is inevitable versus what is noise.  

The Diamond Age by Neal Stephenson. This is probably my favorite SF novel, but also the one that makes me think the most about human potential and education reform.

The Mighty Avengers, Issue #177.  Comic books were a big part of my youth, so this issue is symbolic.  Avengers were my group, at a time when the FF was popular and X-men were trendy. I started following the series but had a summer break, and when I biked to the local 7-11, this culmination of a long story was sold out. It took me something like 10 years to track it down. Comics also, by the way, taught me my first economics lesson: price inflation! That's a big deal when you're on a fixed income and your only luxury triples in price over a decade. 

Capitalism, Socialism, and Democracy by Joesph Schumpeter.  I was a double-major in political science and economics at the Air Force Academy for the simple reason that neither major could satiate my curiousity about communism. Professors in each department pointed to the other when I asked questions of much depth. Fortunately, somebody decided to put me in a special readings class as the only student where I was assigned three books. It was my two degree (junior) year. That's when I met Schumpeter.

What It Takes: The Way to the White House by Richard Ben Cramer. As a student of the presidency, this summary of the 1988 election is the best of all election books, hands down.

I was tempted to list any daily newspaper. I have to admit that the daily paper is the only thing I can remember my Grandfather reading. Every day. Every day. It's a part of my life, the precursor to the Internet.

The Accumulation of Firms and the Predominance of New and Young Companies

This is a sequel to last week's post about moving from Paul's drunkard's walk to the accumulation of firms over time. Basically, the message of those two posts is that the internal dynamics of the American economy--lots of new companies founded each year, the exit of firms at all ages, the persistent predominance of young firms as the economy moves through time--make it highly probable that job creation will come from new and young companies rather than older, more established companies. (In these data that we're using, a firm is no longer classified as "young" once it reaches age 6, so the term "older," perhaps imprecisely, includes firms ages 6 and up.) Thus, when we say that new and young firms account for most net job creation in the U.S. economy, we are partly describing the reality of these firm dynamics.

This doesn't diminish the importance of these companies or the jobs they create. After all, the reality of these dynamics is premised on four things: a more or less steady inflow of startups; more or less consistent survival rates from year to year; comparable gross job creation and gross job destruction in older companies; and a higher number of jobs created at young firms (4 versus 1). These are not functions of what might be perceived as mathematical inevitability--they are the reasons behind the mathematical probabilities we are describing. If the level of firm formation were more volatile, if older companies created more jobs than they destroyed, if young firms were somehow suppressed in their hiring (through, perhaps, bailouts of larger, older companies; just speculating here)--if these variables changed, the dynamics of firm age through time, and subsequent job creation, would be different.

But, in recent history, these variables have all held and together they have created a picture that does, in fact, resemble something like mathematical inevitability, but which is probably more accurately described as a likelihood, or something of higher probability. In any given year over the past three decades, young firms (startups [age 0] and firms ages 1-5) have constituted the largest demographic of firms in the United States. Starting an economy at t=0, going out 25 years, the influx of new firms and the survival rates of firms over time generate this outcome. And, we might expect (provided the other variables are true) that the largest demographic sector will create the largest number of new jobs. This says nothing, of course, of innovation or productivity, subjects for another day.

Here, I want to supplement last week's post, which used average figures calculated from the Business Dynamics Statistics data, with the actual numbers from that dataset, which covers 1977-2005. That is, did reality conform to the stylized numbers we used last week? (The charts will not follow precisely the same format because last week's charts extrapolated out beyond 5 years on an annual basis, while the actual data aggregates firms into 5-year age categories after the fifth year: 6-10, 11-15, and so on.) We'll start, first, with the U.S. economy starting de novo in 1977, with only firms that came into existence that year. How, over the next 28 years, did the composition of firms by age change?

Here, startups (age 0, new firms founded each year) are broken out separately while all other firms are combined into 5-year categories. The data generally track the accumulation pattern revealed in last week's post: in any given year, young firms (ages 1-5) will quite naturally comprise the largest sector in terms of firm demographics. Note how few firms in 2005 are included in the 26-28 age category--these firms were founded in 1977-1979. By 2005, 19% of the firms founded in these three years remained. That may be more than expected, but using the survival line for firms founded for 1977 we can trace a slowly declining line of survival out two decades. If we imagine that the line continues on that downward slope for the next two decades, it appears as if very few firms in the economy survive more than four decades. Either those firms we all delight in describing as "dinosaurs" should properly be seen as remarkable achievements, or firm failure (over time) is a much more dominant force in the economy than we perhaps imagined. Probably both, and I'm probably simplifying here.

The advantage of using the real data from BDS is that we can include the "left censored" firms in our calculations, those companies founded prior to 1977 but for which we don't have age information. In 1977, then, these firms could be anywhere from age 1 to age 100. But we can track their survival after 1977 against all firms founded after that year. How long do these companies persist?

I included a brief explanation within the chart itself, but you can clearly see how these pre-1977 firms gradually decline in number over time, while new and young firms in any given year gradually get bigger in comparison. By 1988 (the circle), the pre-1977 firm group has shrunk such that it is now smaller each subsequent year compared to cohorts of new and young companies. By 2005, these firms still number 1.5 million, accounting for about one-fifth of all firms in the economy. This is a lot, but is an aggregate of every year before 1977, so there are probably a good number from the 1970s, a proportionately smaller number from the 1960s, and so on. 

Now, we can include these pre-1977 firms in our overall chart of firm demographics over time and compare firms of all ages:

This is actually an incredibly interesting chart, as the text insert fleshes out, but I'll repeat it here so you don't have to open the image itself. It shows two different ways in which firm composition changes and in which new and young firms consistently account for the bulk of firms in the economy. In 1977, the t=0 moment here, the economy is composed  of a class of startups (age 0) and all other firms existing that were founded before 1977. As the economy moves through time, you see four things happen. First, age 0 firms and age 1-5 firms account for a steady slice. Second, the overall number of firms accumulates. Third, the pre-1977 firms gradually decline in number. Fourth, post-1977 firms that age through time also diminish in terms of their numbers as fewer survive in subsequent years. So new and young firms dominate the economy (numerically) by two mechanisms: gradual disappearance of older firms and gradual disappearance of firms as they age. Same thing, different pathways (on this time scale).

Finally, we'll move to the percentage shares of each firm demographic (excluding pre-1977 firms here):

Once we get to a point where we have firms older than age 6 (and remember, the pre-1977 firms account for the missing shares here) in 1983, new and young companies account for between 30 and 40 percent of all firms in the economy. This percentage naturally falls over time, albeit slowly, as the overall number of firms grows, but this demographic of firms nonetheless comprises the largest demographic slice--a plurality, if you will--in each year, and this would persist over time.

So what, if anything, does this all mean? It means that new and young companies account for most new jobs in the economy in part because they are the largest demographic category of companies. It also means that job creation may actually be a secondary story here because this reality is a reflection of underlying dynamics that have been remarkably persistent over the past three decades. The United States has enjoyed a more or less steady level (and rate) of firm formation and survival rates for those firms have also been rather steady. Older companies, moreover, experience roughly equal levels of gross job creation and destruction, meaning their net job creation approaches zero.

It is entirely possible that these are transitory phenomena. As far as I can tell from the desultory data and research on firm formation prior to the 1970s, entrepreneurship (and subsequent survival rates) across the entire twentieth century have been remarkably consistent (I mention this, with an accompanying citation, in a forthcoming paper, so I'm not simply making this up). According to some Census data, for example, the number of new business created each year doubled from the 1940s to the 1990s--yet the country's population also doubled so the per capita rate of firm formation remained steady. Over the past thirty years, moreover, entrepreneurship rates have been remarkably steady, not declining as some have alleged. 

Yet we surely can't assume that the dynamics beneath such factors are immutable. The preponderance of research concerning firm demographics in many European countries, for example, holds that firm exit is a much smaller factor and that, consequently, unproductive firms simply continue to exist and new firms are dissuaded from entering. Large companies enjoy favorable policy and so the above charts might look quite different for other countries and clearly indicate that the dynamics can change. Even if part of what the above charts do is describe a mathematical reality, it could be considered progress if policymakers in Washington and elsewhere spoke in terms of this reality rather than giving undue attention to the largest companies in the economy (which, incidentally, often seek regulation as a means of protection from competition from startups). What this all means is that startups and young companies are no less important than we thought before--they are a robust and enduring dimension of the U.S. economy. It would be foolish, however, to assume that this is somehow a natural or permanent state of affairs--policy could easily be made to alter these dynamics for the worse.

Who's scared of a Value Added Tax?

There's a lot of chatter about the U.S. adding a Value Added Tax (VAT) to solve its looming fiscal crisis.  The Feds need to tax more and spend less to bridge the trillion dollar annual deficits, right?  Here's Bob Carroll and Alan Viard in TaxNotes:

Recommendations that a VAT be considered have been more common than outright endorsements of the tax. The idea surfaced briefly as a possible source of revenue for healthcare reform.6 House Speaker Nancy Pelosi, D-Calif., recently commented that ‘‘it’s fair to look at’’ a VAT, and Senate taxwriter and Budget Committee Chair Kent Conrad, D-N.D., has said that a VAT should be on the table in future tax policy discussions.7 Two former Federal Reserve chairs have made similar statements: Paul Volcker has referred to a VAT as a ‘‘possible approach,’’ and Alan Greenspan has said that it must be considered as a possible way to reduce the deficit.8

The fact is the U.S. is the only advanced economy that doesn't have a VAT. Americans have no appetite for adding another tax.  But they might just be willing to trade for one. So which tax would the pro-VAT crowd be willing to give up?  Corporate is probably the leading candidate, because it raises far less revenue than other major taxes, it is sensitive to recessions (generating half as much during busts as booms), and because it is really bad for growth.

CBO lists these major revenue sources for the federal government in FY 2009:

• $915 billion ... Individual Income Taxes
• $891 billion ... Social Insurance Taxes
• $138 billion ... Corporate Income Taxes
•  $62 billion ... Excise
•  $23 billion ... Estate and Gift

Based on this paper (HT Marginalrevolution.com), a VAT raises revenue at under half its rate in GDP terms, meaning that a 10 percent VAT historically brings in around 4 percent of GDP in revenue.  Since corporate income taxes raise 1-2 percent of GDP in the U.S., then a revenue neutral VAT replacement would, I think, be roughly a 4 percent tax on consumption. 

But why stop there?  Conservatives (and some liberals) hate the estate tax.  Offer to eliminate it along with the corporate income tax in exchange for a VAT of 5 percent, and everybody's happy.  Right?

But why stop there?  If a grand tax bargain is in the works, why not put a serious gas tax on the table?  Jim Hamilton tells us that the U.S. consumes 12 billion gallons of gasoline in a typical month.  That's a Gross Billion a year (144 for math geeks). A one dollar gas tax would (ceteris paribus) yield $144 billion a year.  Make it six bucks a gallon, and you could kill the form 1040 forever.  I like it.  In fact, I like this little fantasy a lot better than doing my taxes tonight ...

VCs are Down! VCs are Up! The Compression of Risk Capital Commitments

There are two instructively contradictory data points out in venture capital land this morning:

• First-quarter 2010 VC fund-raising was the worst since 1993 (Source)
• Sequoia Capital's new  $1-billion fund is oversubscribed by a reported $3-billion (Source)

How can that be?, some might ask. How can one fund be so wildly oversubscribed when the industry is in the worst fund-raising doldrums in modern memory?

The fund-raising problems are expected, and I have written about them here and in Kauffman papers. They  have something to do with venture industry performance over the last ten years, with the ten-year numbers having turned negative once the last of the dot-com numbers dropped off. The troubles have even more to do with shrinking portfolios at major LPs, whose newly smaller portfolios are forced into shrunken allocations to venture, even if they hold percentage allocations constant.

But that is only part of the issue, as the Sequoia data point shows. Because this is also a market in which fewer large, branded venture funds exist that can accept the kind of slugs of capital that large institutions want to dole out. While there may be a cadre of new super-seed funds emerging, most are too small for large LPs, and they have no track record or brand, which makes them scary to your average pension fund or endowment. Granted, that also means that in a few years when some of those funds are successful LPs will be scrambling to try and get access, but in the interim they are all trying to elbow their way into the few large and branded venture funds that can & will take capital commitments of $50-million on up per investor.

Is this a healthy situation? No. We have LPs demonstrably making capital commitments, in part, on the basis of a GP's ability to accept sizable commitments, and we have new and smaller funds -- the likely providers of most of this industry's return in the coming years -- struggling to raise money among high net-worth friends and family foundations. In other words, just as the venture industry is diversifying away from a few funds delivering all the returns, the LP community is committing capital as if the industry is more hits-driven and marquee fund-driven than ever.

Why isn't there an economist on the Supreme Court?

What's the most important economic job in America: President of the United States, Head of the Ways and Means Committee, or Chairman of the Federal Reserve Board? Answer: None of the above. The most important job is Supreme Court Justice.

Far and away, the most important economic decisions are the longest-term ones, the ones with the deepest roots that establish the most fundamental institutions. What exactly are property rights so constituted in our society?  Who sets prices? What information can be private, or should be transparent? What obligations do employers have to their employees: free contract, minimum pay, basic safety, paternalism, or more?  Is there a right to eat or a right to be fed?

Indeed, the almost entirely unreported but vital issue regarding the nominee to replace retiring Justice John Paul Stevens is whether he or she is economically literate, or rather, expert. It is not whether that person is left-liberal or left-center, pro-life or pro-choice, etcetera, yawn, etcetera. Face it, most Justices know almost nothing about economics beyond an Econ 101 class they had as a college freshman three, four, five decades ago. And these are the people who decide what the commerce clause means ... the ones who made it illegal for a man to grow his own tomatoes without federal approval?  Today we enjoy a Court that said it was peachy keen for the federal government to take ownership of General Motors on behalf of taxpayers who wouldn't touch GM stock of their own free will. To that, we can all say: "Thanks for less than nothing."

Isn't it about time we see an economist on the Supreme Court?  There are nine jusices, and nowhere in the Constitution does it say that a law degree is a qualification.  Yet, what we have now is a monopoly of lawyers on the Court. A monopoly.  All I'm suggesting is that a mere one of the nine have an economics degree.  And to assuage the fears of the status quo, a nominee with dual degrees would be more than fine. My own colleague, Bob Litan, has a Ph.D. in economics from Yale AND a law degree from Yale.

So why not Bob?  (That's our new rallying cry in Kansas City)

And maybe we're biased towards Litan, but how about Bob Cooter, a professor at Berkeley's law school and a pioneering thinker in the "Law and Economics" movement?  Or maybe skeptics want to stick to a reliable and registered Democratic economist. Fine with me. Why not Christina Romer or Austan Goolsbee, two of the President't top economic advisers?  Instead, I'm afraid we'll get the same short list of sitting judges who are part of the merry-go-round of law school-clerkship-judgeship pontificating.  It's time for a marginal revolution on the Court, Mr. President.

UPDATE: Thank to readers for catching the typo (Stevens, not Stephens).

From a Drunkard's Walk to a Pile of Drunks

This morning Paul wrote a very insightful post about job creation by new companies, trying to put things in a larger economic and mathematical context. (I am one of those (blessed? unfortunate?) people who thinks the game of baseball explains everything in life, including the economy, so it helps me to think of Paul's post in terms of the never-ending debate between sabermetricians and those who prefer a non-statistical view of baseball. In this view, Paul's post is the equivalent of putting a 5-hit game on Opening Day in a larger context of probability, rather than imbuing it with deeper meaning.)

I want to try to round out Paul's point by discussing the accumulating universe of firms over time (or, the accumulating pile of drunks in Paul's illustration). In an economy with a more or less steady influx of new firms and more or less consistent survival rates, we will have an accumulating number of firms as an economy moves through time. And, in any given year, "young" firms (5 years old and younger, including brand new startups) will constitute the largest percentage of the overall number of firms. By sheer arithmetic, then, shouldn't we expect that we will see a large number of new jobs from the largest cohort of firms? Maybe, maybe not.

Here is how it might work. Let's start with an economy with zero firms. In Year 1, we have 700,000 new businesses started (firms plus establishments; my thanks, by the way, to Mike Horrell for research assistance). Using survival rates calculated from the Business Dynamics Statistics database, we know that the average survival line for firms founded each year since 1977 looks like this:

So twenty percent of new firms survive to age one, two-thirds to age two, and so on to age 5. For age 6 and up, Mike used imputed survival lines extrapolated out from age 5. The real-world will be lumpier, but from what research I've seen from the SBA and others, the survival line post-age 5 is mostly a smooth downward slope. At some point, it likely becomes a near-asymptote, although some organizational research does suggest that survival for several decades, say to age 40 and beyond, is quite rare--conceivably, all firms die at some point.

Using these survival rates we can construct a chart showing the birth, death, and survival of firms as an economy moves forward from Year 1. In the first year, there are the 700,000 new firms. In Year 2, the initial batch of startups now consists of 552,440 firms, joined by the second year's round of incoming startups, another 700,000. So there are now 1,252,440 firms in this economy. If we continue this process out to, say, year 25, the process looks something like this:

 By year 10, firms ages 5 and younger account for nearly two-thirds of all firms. By the end of the series, in year 25, firms ages 5 and younger account for one-third of all firms. With assumed constancy of startups and survival rates, the absolute number of firms younger than age 5 remains the same but constitutes a decreasing proportion of the entire universe of firms. It remains true, however, that in any given year, young firms make up the largest cohort of companies. This would be reinforced if we added a constraint that no firm survives past, say, age 20. The point is that if the level of firm formation is steady (which it has been in the United States), and if survival rates for new firms have been consistent (ditto), than this is what an economy's population of firms would look like over 25 years.

What does this mean for job creation? It means we should expect the largest number of new jobs from the largest cohort of firms. I don't think is purely a function of the numbers, however--data from economists at the Census Bureau indicate that young firms add, on average, 3.7 (net) jobs per year. Firms ages 6 to 28, meanwhile, add (net) about one job per year. The oldest firms (age 29 plus) add nearly two and a half (net) jobs per year--still fewer than young firms. So it's true that young firms are adding one to two more (net) jobs per year than older firms, but this might be where Paul's drunkard's walk comes in.

So if young firms add 4 jobs per year, that means they add, in net terms, about eight million per year. In year 25, for the other 5 million firms in the economy, they will add about five million jobs; in year 10, they will add four million. (Note that in year 25 we haven't yet reached a point with any 29-year-old plus companies.) Many of those older firms will of course be larger than young companies, but we're talking about their net incremental contribution to American employment. 

None of this changes the fact that young firms account for most net job creation in the United States over time. What I'm wondering about is the why of this. Is it a subjective or normative comparison: young firms are "better" than all other companies? Or is it (partly) a function of mathematics and probability? What, if anything, does this mean for policy? It's never a bad thing when commentators and policymakers begin to realize the importance of new and young companies and stop seeing the economy solely in terms of our behemoth firms, but it's not clear what policies fall out of this if what we're talking about is a natural accumulation of firms and the ensuing natural distribution of net job creation. There is still plenty of dynamism to be worked in here--job creation, job destruction, the outstanding growth of certain companies--but this is (I think) an important point to make. 

It parallels something else I've been working on with regard to high-growth or top-performing firms. When we say that young firms create X% of jobs, or high-growth firms account for X% of job creation, should we be surprised that reality looks this way? Or, should we be more surprised if the economy did not look like this? In the case of high-growth firms, the question is: are we surprised that we find something resembling a Pareto distribution? Don't get me wrong--this does not belittle the importance of new and young firms and what they contribute in terms of jobs and innovations. Far from it. But it is important to keep things in perspective, mathematical and economic. Kind of like an Opening Day performance.

One-in-Four in China

As the saying goes, “if you’re one-in-a-million, there are 1,300 of you in China.”  Usually this phrase is invoked to either say (1) being “one in a million” doesn’t exactly mean “unique” or (2) there are many, many people in China.  And most of the time, the conversation stops there.  However, as China modernizes and enters the same spaces and industries as the United States, there are interesting implications to the above statement. 

Recently, there has been discussion, in this blog and others, on immigration laws and policies.  To go into the current debate, I posit the following question that runs parallel to the logic above: While we might be unique as individuals (making us 1 in about 7 billion), how unique are we as workers? 

One way to address this question is to think of worker uniqueness as scarcity.  If your marketable skills are more scarce, basic economic theory predicts that you will get paid larger sums.  Flipping this around, we can use salaries to rank worker uniqueness, and from here, we can determine a certain wage’s uniqueness by looking at how many people earn a given wage (these are wage percentiles).  With these data, it’s possible to determine the numbers we are looking for.  Fortunately, the relevant data are compiled by the Current Population Survey (CPS). 

According to the 2008 CPS, an individual earning $50,000 is in the 75^th percentile in the U.S. in terms of annual earnings.  This means that 25% of workers in the U.S. have the job skills necessary to earn $50,000 a year or more.  Or put another way, a worker with the job skills to earn $50,000 a year is one-in-four.  

As much as we might not want to admit it, being one-in-four is a far cry from being one-in-a-million.  Translating this to the phrase above, we find: if someone has the job skills to earn $50,000 a year, there will be 325 million people in China who are equally or more highly skilled.  Note that this is larger than the population of the United States (300 million). 

Of course, these numbers are not completely correct.  For one, China does not currently have the kind of skill distribution that the U.S. has, and getting to a similar distribution could take a long time.  Nonetheless, it is impossible not to acknowledge a very valid issue here.  As China (and the rest of the world) comes online in many different industries and begins to match our distribution of job skills, China (and other countries) will constitute a tremendous—and tremendously competitive—pool of talent.  

If our interests in the U.S. lie in maintaining our economic edge, we need to recognize what the numbers suggest, that highly talented individuals do actually come from outside the U.S.  Further, we need to recognize that the number of these individuals is only going to be increasing.  Any policies that ultimately limit our access to this burgeoning pool of talent cannot be in the country’s best interests.

Startups in an Evolutionary Model

In describing how human knowledge advances, Donald Campbell devised the BVSR model to explain the evolutionary way in which knowledge accumulates. BVSR stands for Blind Variation and Selective Retention and is more or less natural selection applied to creativity and epistemology. Others have explored Campbell's with great insight and how it applies to fields such as organization science.

Evolutionary economics moves in and out of fashion but for the most part remains on the fringes of economic thought. Prompted in part by Paul's post earlier today, I'm wondering today about startup firms in a BVSR model of economic dynamics. It's no surprise (and, I don't think, controversial) that free market competition works through an evolutionary process of selection. Individuals and companies try various things (new products, services, processes) and their fate hinges on whether or not the market "selects" them vis-a-vis competing ideas. These new products and services are the variations in BVSR, whether radically new innovations or incremental improvements on something that already exists. We throw lots of spaghetti against the wall to see what sticks. Economic variation, of course, is not completely random since firms often seek to satisfy a previously identified market need or solve a heretofore unsolved problem. Variation is, however, blind in Campbell's sense, in that we do not know beforehand what will or will not succeed. "Blind" refers to our knowledge (more specifically, our lack of knowledge) about the consequences of any particular variation.

So we continuously introduce new variations into the market. The manner in which they are winnowed and propagated is "selective retention." Selection is clear: a new market variation either succeeds or it doesn't. Or, more precisely, it either survives (is selected) or doesn't survive (is not selected or selected against), with survival not always a proxy for subjective superiority. Here, it seems like the BVSR model advances somewhat beyond the standard view of the free-market-as-natural-selection (in addition to the explicit recognition that variations are blind). Once a variation is selected, what happens to it? It is retained, meaning it somehow propagates through the population. A variation doesn't merely survive--it grows and spreads. 

How would you increase economic growth or increase innovation through the BVSR model? Let's say each element is multiplied by the others, so growth or innovation is the result of V x S x R, all divided by B. Increasing any one element in the numerator should theoretically increase the product. (It's not clear that this should be true, by the way. I haven't convinced myself that multiplication is correct here. I suppose it's conceivable that it could or should be, for example, "+" R. This isn't a research paper and I'm just following an idea here, so please feel free to take issue with this. At this point, it's of de minimis concern.) According to this, then, you could increase growth or innovation by increasing variation (the introduction of new products and services), improving the selection process (so only "good" or "right" variations are selected), and improving retention, to the properly selected variations quickly achieve rapid scale and propagation, disseminating their benefits to everyone.

How would we approach startups here? Obviously, startups are one type of variation (at the population-level of the economy). They are selected for and against: roughly half of new firms (48%) survive to age five, with the survival curve slowly falling after that. (I've seen some data indicating that one-third of new firms survive to either age 7 or age 10.) Survival, of course, tells you little about success or quality, and selection in the case of firms is an ongoing process. Some research suggests that only the tiniest handful of companies survive for more than a few decades (suggesting that groups such as those companies on the Fortune 500 are both an incredibly small minority and, perhaps, a secondary story--maybe failure is the dominant story of economic selection). Retention could be either the organic growth of young companies or, I suppose, acquisition by larger, more established companies. (Revenue or employment growth or both would here serve as a proxy for another way of looking at retention: spread of a company's product through the market.) With the denominator, "Blind," we might want to reduce the blindness of our variations--that is, wouldn't we want to have a better idea of the prospective fate of new firms? Or, should B be another multiple here? Would increasing blindness be better because it would throw more of the burden onto the competitive process? Perhaps B is neutral here? That is, perhaps it cannot be increased or decreased? 

In any case, let's assume, with good reason, that startups are absolutely essential to innovation and economic growth. To increase these, what would we do with startups in the BVSR model? To begin with, could we reduce the blindness of a particular startup's fate, or the fate of all startups together? (It's not clear, moreover, what Blind should refer to here: mere survival to a certain age? Success, however nebulously defined?) Let's say Blind refers to the state of knowledge facing the founders of a new company: they do not know, and can't know, whether or not they will "succeed," however they define that term. (Although, if your objective is to simply work for yourself or the ability to wear flip-flops to work, then merely starting your own company can be considered success.) From a macro perspective, it's not clear that we can either reduce or increase blindness at the startup stage--the figure given above for survival to age five (48%) has been remarkably consistent across time. The survival rate for new firms, that is, doesn't appear to vary much founding year. There is some variance by sector but again, the survival lines within each sector are rather consistent, so it's not clear how we could either raise or lower the survival line. Of course, if survival rates have been consistent for thirty years, then perhaps the Blind element is neutralized: there is a 50-50 chance your firm will still be around five years from now.

Now, to Variation. Here, you would simply want to increase the number of new firms that are founded each year, with the expectation that trying more new variations would lead to more "good" things being selected and retained in the economy. An increase here means an increase there. I am sympathetic to this strategy, but I'm unclear as to how we do it. Firm formation in the United States has been pretty steady for two or three decades and the question of how we increase it is not so simple. Things like awareness and lowering barriers to entry are probably our best bets but these will vary by sector and geography and characteristics of the founder. All of this assumes, of course, that a basic increase in startups (more variation) will result in an increase in innovation and growth. And this assumes that we would see a similar proportion of innovative ideas and potentially successful firms in a larger pool of variations--is that a valid assumption? 

Selection of startups occurs through a variety of mechanisms. One, of course, is the market itself: you start a new firm and quickly find out whether or not it will selected in or out. If we increased the number of startups (increased V), then conceivably our selection mechanisms could remain the same, simply working on a larger population of firms. If, however, V remained constant, we might want to intensify S by looking more carefully (somehow) for promising ideas or "sure-thing" innovations. I suppose this is the role played by venture capital firms and accelerators such as Y Combinator. They have many entrepreneurs approach them and apply to them, but only select a few for funding or developing. Those that they do not select still go on to start new companies, so the claim of these particular selection mechanisms is that they are intensifying S so as to increase R: selecting the "best" of V, those with the most potential for retention and propagation by the market. As an overall strategy to enhance Selection, we would look to increase market competition in general, removing protective barriers around certain industries and firms, for example. A perennial complaint about some European economies (and conclusion of numerous McKinsey reports) is that they are not as competitive as the United States--stultified selection suppresses innovation and economic growth. It's also conceivable that simply increasing V would naturally increase S (they are, after all, multiplied by each other)--more firms overall would mean more firms competing. 

These notions of Selection, however, presume that any selection process, whether in biological evolution or in free market competition, is an optimizing one--that the "best" organism or population or idea or company always beats out inferior competitors. Adaptive fit, after all, implies such optimization. Yet we know that natural selection is only one way in which genes and organisms are winnowed and propagated. The role of accident and randomness in evolution cannot be forgotten: we like to think of dinosaurs as having met their proper evolutionary fate because they were all slow and dim-witted. But many evolutionary theorists have pointed out that, if a meteor or volcanic explosion did the dinosaurs in, then that isn't necessarily "natural selection" in terms of adaptation and competition. It was an exogenous event and the emerging population of smaller mammals happened to be better suited for survival. So, yes, an exogenous event "selected" out dinosaurs, but it wasn't necessarily the "optimizing" path we like to imagine. The same applies to the selection process in terms of firms and ideas: Silicon Valley bested Boston and Dallas because it had a better ecosystem, the selection process was more optimizing. But what if William Shockley's mother lived in Dallas, not Palo Alto? What if Frederick Terman had not contracted tuberculosis and had ended up returning to MIT? I realize these are entirely speculative and that the obvious riposte is, 'Well, that's just how things happened.' My point is simply that we shouldn't assume that Selection always implies optimizing; human behavior and group dynamics are such that the economic process contains plenty of satisficing behavior. (We also shouldn't forget that an entity such as a firm can become over-adapted to certain circumstances and thus too sessile to change; selection could work too well.)

Finally, how would we enhance Retention? What would this mean? It could entail somehow promoting those firms that are selected--say, those that survive to age six--via certain rewards such as a retroactive tax credit or something like that. Or, it could mean favoring those firms that grow rapidly in their first few years and have rapidly passed through V and S and we want to enhance their retention and propagation. It could mean reducing barriers to "scale," whether in the form of regulations, corporate taxes, whatever. (I continue to maintain, however, that the effect of certain taxes on entrepreneurship is not nearly as straightforward as some might like to believe.) Maybe we think of Retention as going public, in which case perhaps changes need to be made to Sarbanes-Oxley. Over the past few years, around 80% of VC exits have been acquisitions, not IPOs, and many of the companies coming out of accelerators are acquired by companies such as Google.

In any case, I don't know if this has added anything to the general discussion of entrepreneurship and economic growth or not. If we think about startups through the BVSR model, there are probably certain areas in which we can make changes to enhance the economic impact of startups, although some of them steer quite close to "picking winners." In general, as I said, I favor increasing V, but I'm as yet unclear as to how we go about doing this. Importantly, increased Variation should apply to firms of all types, not simply in favored sectors or those sectors we think (or would like to think) represent promising areas of innovation. Firm formation and innovation are compounding phenomena, so increasing the overall level of startups should (emphasize, should) raise our rates of innovation and growth, and this should be true whatever sector of the economy we are discussing. Information technology has been hugely important for American productivity, both in its production and its use in sectors like retail. We needed IT, but we also needed all those new retail outlets and supply chain innovations for the IT to become productive. It's possible that a BVSR-type of analysis in, say, 1995 might have concluded: we need more IT startups and fewer new retail stores. The economy might not have performed as well as it did.

Drunks, A Wall, Entrepreneurs and Jobs

That young firms account for most of the job creation in the U.S. – as written about my Kauffman colleagues Dane Stangler, Bob Litan, and others -- has quickly become one of those compelling facts that changes the way you apprehend the entrepreneurial world. Young firms assume their rightful priority of place, and the vexing conflation of young/growth firms with small firms is finally and rightly undone.

I am going to take a different perspective on the relation between young firms and job creation, however. I want to explain its mathematical inevitability, and I’m going to do that using the probabilistic idea of the drunkard’s walk.

It works like this: Imagine an inebriated bar-goer having exited the bar, and now standing outside along the wall. Imagine further that in his or her state every single step is random, a coin flip whether it will be toward or away from the bar wall.

At first, however, the bar-goer is at the wall, so further steps toward the wall can’t happen. The only direction he or she can go with that first step is toward the curb. After that things change, of course, with at least some steps toward the wall possible, after which the drunkard is back at the wall and unable to go further. Given enough time, and with 100% probability, the drunkard will eventually end up in the gutter away from the wall.

Evolutionary theorist Stephen Jay Gould famously used the idea of the drunkard’s walk to explain the rise of complexity over time in humans. It wasn’t progress, he argued, just a blind evolutionary process staggering away from a left wall of minimum biological complexity.

The same holds in job creation. Young companies are the single-celled paramecia of the economic world: at t=0 they stand at the bar wall facing the gutter. They can’t lose jobs because they haven’t created any yet. All they can do initially, other than fail, is stagger away from the zero employment wall. Now, we know that about half of young companies last five years, more than enough time for companies to stagger back and forth such that, even if we assume no managerial skill, the drunkard’s walk model tells us they will grow and add jobs, even if only because that left bar wall prevents them from going below zero jobs.

The same doesn’t hold for older companies. They have been in business long enough that at t=0 they are already some distance from the bar wall, staggering back and forth. They can create jobs, of course, but they can also lose many jobs, the latter being something young companies mathematically cannot do given how they start at the left wall of zero employment.

In short, the central thing about job creation from young companies is its inevitability. It is a species of mathematical certainty (one driven by initial simplicity and a wall) that young companies must create the most jobs (even without assuming particular skill on their part, or taking into account sectoral or economic growth, both crazily conservative assumptions). That the drunkard’s walk applies to the economics of young firms is an mind-altering realization (in a good way), one that helps put the messy data of company and job creation in a more plain and meaningful context.