Growthology

Why Not a Market for Advancing Innovations out of Universities?

Yesterday I had the privilege of delivering testimony on behalf of Bob Litan in front of the Joint Economic Committee. The subject of the hearing was how the United States could maintain its position on the global frontier of innovation, with a specific focus on universities and federal funding of research and development. Most of the Members of the Committee were in general agreement with the panelists: innovation is key to economic growth, universities are important to R&D and innovation, and the United States needs to make some changes if we are to remain an innovative economy.

On one particular point, however, there was a considerable degree of contention. Congresswoman Carolyn Maloney (D-NY) inquired as to the state of technology commercialization in higher education. Can it be improved? Is everything peachy-keen? 

The Kauffman Foundation takes the position that all is not well in the land of technology commercialization. There are success stories, to be sure: Gatorade, Vitamin D, Netscape, MRIs and so on. And there are star performing universities--Stanford, WARF (the Wisconsin system), and the University of California system do a phenomenal job of moving innovations out of campus buildings and into new (and existing) companies. But universities, on the whole, appear to be under-performing relative to what they could be contributing to economic growth. The Bayh-Dole Act of 1980 allowed universities to hold the intellectual property rights to innovations and discoveries that result from federally-funded research. The result was a wave of university innovations as well as a wave of attempts to move university innovations into the marketplace. Most universities receiving federal R&D dollars established technology licensing or transfer offices (TLOs or TTOs) to manage the intellectual property and serve as the liaison for faculty members seeking to commercialize their innovation. As noted, many universities have managed to successfully commercialize new technologies.

As with anything, however, the structure that was set up in response to Bayh-Dole has now run into problems. The productivity of federally-funded research at universities has been declining for a number of years. Technology transfer offices are typically understaffed and unable to manage their university's stream of innovations--innovations, moreover, that often span a wide diversity of disciplines. At the same time, however, bureaucracy has grown up around the process of technology commercialization and dramatically slowed, if not stalled, the process in many places. Anecdotal evidence abounds of faculty members running headlong into bureaucratic drywall at their licensing office. Furthermore, as a result of the outstanding success of a handful of universities with a handful of innovations, many TTOs and TLOs have implicitly or explicitly adopted a home-run mentality, chasing the next big hit at the expense of many smaller innovations. 

Finally, many universities have latched onto the most easily measured outputs of R&D, patents and licenses. But, there is little correlation between federal research funding and the returns (in patents and licenses) on that funding. Maybe we shouldn't expect there to be such a correlation, of course, but the race by universities in the wake of Bayh-Dole to establish commercialization offices and the drift of research spending toward a more political rather than scientific distribution have raised the implicit promise that there is such a correlation. The wonderful historian Roger Geiger has documented such drift: at one time, the distribution of university innovations and federal R&D money to universities both followed a Pareto distribution, with a handful of institutions far outdistancing everyone else in terms of inputs and outputs. Over time, however, while the distribution of innovative outputs remains skewed, the distribution of research dollars has gradually gotten flatter. We expect proportional output in terms of innovations but don't receive it.

There is no magic solution to these bottlenecks, but my colleagues Lesa Mitchell and Bob Litan have come up with a fantastically simple and novel idea: open up technology transfer to market competition. That is, allow a professor from University X with a potentially breakthrough innovation to go outside his or her university's TLO and use that of University Y, if University Y happens to be more skilled at commercialization in this particular discipline. University X would not be required to relinquish IP rights, and of course the professor is not required to do anything. The idea is simply to bring more openness and competition into a process that has become muddled and distorted. Where else in society do we tolerate such artificial monopolies with public research dollars at stake? This idea, in fact, perfectly carries forward and extends one of the primary motivations behind Bayh-Dole--to smooth the commercialization process. Bayh-Dole was enacted in part to construct a platform upon which faculty and professors could more easily interact with companies (new and existing). Allowing universities to hold IP rights was meant to remove one of the legal entanglements in this process.

Who could oppose such openness? Who could oppose competition when competition has been shown repeatedly to be the best avenue toward maximizing innovation and social welfare? Not to sound trite, but follow the money. Most universities and TTOs and TLOs vehemently oppose this idea. In fact, you can scroll through the webcast of yesterday's hearing to the very last question and witness the animation with which Dr. Samuel Stanley opposes the mere mention of this idea. Basically, the opposing arguments boil down to these: (a) there is no evidence that the current licensing process is dysfunctional; (b) allowing such "free agency" would give rise to all the legal problems that predated Bayh-Dole and were put to bed by that legislation; (c) no professor and no university wants to do this; (d) technology commercialization is a delicate art that cannot be commoditized; and (e) the current system is working fine as it is--as proof, look at all the great innovations universities have given us.

Unfortunately, I did not get a chance for a counter-rebuttal, so I offer it here. First, Dr. Stanley (and others) confuses an absence of evidence with evidence of absence. The absence of overt dysfunctionality does not imply the corollary, that things are hunky-dory. In fact, the arguments I've mentioned above regarding research productivity and returns to patents and licenses would seem to indicate something is amiss, as would the growing stock of anecdotes from frustrated professors and companies. It is of course nearly impossible to prove that something like a university is not living up to its perceived potential in terms of commercializing innovations, but the inability to prove that there is room for improvement is not an argument against opening up the process. That, in fact, is the nub of the free agency proposal--just open it up. No one would be forced to operate as a free agent or to contract with a free agent, as Dr. Stanley seems to think we are suggesting. This is entirely optional, as is any competitive market. It could even be optional at the level of the department or school of any particular university, with one department perhaps choosing to work with ABC agent while another chooses XYZ agent.

Dr. Stanley also predicts that such openness would instigate a return to those dark days before Bayh-Dole when legal machinations corrupted every attempt at commercialization--contract disputes, broken agreements, etc. Oddly, however, technology commercialization at universities is still plagued by these problems--Bayh-Dole did not banish legal disputes, and I'm not sure how Dr. Stanley manages to pull off such cognitive dissonance.

By opening up the technology commercialization process, we would likely see the development of completely new organizational forms to facilitate the process. No one can predict what will happen--and that is exactly the point. Maybe free agency will flop; maybe it won't. But there is no (or shouldn't be) single model when it comes to technology commercialization: free agency would encourage experimentation as a way to lower transaction costs, which was precisely the idea behind Bayh-Dole. In fact, many professors are already finding their way around the TLOs and TTOs, doing "end-runs" around the bureaucracy and finding their own commercialization routes. Rather than see this perversion as a defense of the status quo we should encourage free agency as a way to promote the development of more such alternate pathways. In their promotional materials and commencement speeches, university administrators consistently trumpet the glories of diversity and self-actualization and intellectual experimentation--except, it seems, when it comes to their own operations.

That seems to be a running theme of opposition: technology commercialization is special and cannot be subject to the rules of the market that govern the rest of the economy. Dr. Stanley is far from alone in asserting that each particular innovation is unique and must be granted its own customized commercialization process that can only be run through a TLO. Undoubtedly, there is some truth to this. Just as clearly, however, there is plenty of room to lower transaction costs by standardizing some portions of the commercialization process. This is precisely what UNC-Chapel Hill has done with the Carolina Express License Agreement; we will keep you posted as to whether or not the world ends as a result of this dangerous experimentation with technology commercialization.

Finally, we come to the tried and true defense that everything is fine. Universities have, after all, contributed enormously to economic growth and human welfare. Why mess with success? The real message, however, is: don't mess with us! This is the completely predictable and understandable response of any institution when its monopoly is threatened and should, in fact, serve as a reason to promote more experimentation. Just because universities have contributed much in the past does not mean they are performing optimally today (research is only one of many fronts on which we could have this discussion) and does not guarantee that they will continue to do so in the future. If bureaucracy keeps building up around the discovery and innovation process, it is almost guaranteed that they will not.

Kauffman Economic Outlook Q2

Read the Kauffman Economic Outlook Q2 2010: A Quarterly Survey of Leading Economics Bloggers (PDF)  

Here are the first few charts:

 
  

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.

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.

More on Friedman

Here is another, albeit similar, take on one particular response to Thomas Friedman's Easter column celebrating startup companies. By the way, while you visit the PPI website, be sure to read Michael Mandel's policy memo on why the jobs crisis may well be an innovation crisis. 

Defending Thomas Friedman on Job Creation and Startups

In his column yesterday, New York Times columnist Thomas Friedman quoted Kauffman's Bob Litan about the importance of new and young firms to job creation and emphasized the importance of immigrants to firm formation. It was a trademark Friedman column: factoid, examples, quotations from experts, and concise policy lessons. I'm biased because Friedman used Kauffman data, but it was a good column.

Not everyone, however, wants to hear about the economic change that new firms and immigrants visit upon the U.S. economy. At Beat the Press, Dean Baker took issue with Friedman's column and Kauffman's data. With a layer of snark that is by now wearily standard in the blogosphere, Baker writes: "Friedman's conclusion about the special importance of new firms is utter nonsense." His logic:

The claim that most net new jobs came from new firms conceals the fact that existing firms added tens of millions of jobs in this 25-year period. Of course existing firms also lost tens of millions of jobs. We can say that the net job creation for existing firms was zero, but if we did not have an environment that was conducive for the job adders to grow (how many jobs did Microsoft, Apple, and Intel create after their first 5 years of existence?), then existing firms would have lost tens of millions more jobs.

Well, yes, that's true--and that's precisely the point. There are basically two ways to look at job creation in the economy: gross and net. On gross terms, large existing companies hire thousands of people each year, but they also see thousands of people leave, voluntarily or involuntarily. Gross job inflows and outflows in the American economy are enormous, an indicator of the ongoing and dynamic reallocation of resources that drives economic growth.

At the end of the day, however, if we want to keep pace with an expanding labor force (new entrants) and changing economy (the rise and fall of sectors and companies), what matters is net job creation. We have fifteen million people unemployed in the United States right now, and over the next several years net job creation has to proceed at a remarkable pace to not only provide jobs for this population but also create jobs for the millions of new people who will enter the labor force in the coming years. The last two years have seen the two biggest matriculating classes ever in American higher education, which means that in four or five years we will see a large influx of new graduates searching for jobs. How does Baker propose we keep pace with such growth?

From a macro perspective, for keeping pace with this growth, the only thing that matters is net job creation. It would be little consolation if we had 100 people looking for jobs, and large company ABC hired those 100 people but also fired 100 different people. For Baker, this is a good thing. And it is--for the 100 people who were hired. But what does Baker do with the 100 newly unemployed folks? Relate to them the wonders of big companies and their gross hiring?

Big, established companies are indisputably important--the symbiosis between new and old, small and large is a key strength of the U.S. economy. But we only get net job creation--a positive increment of new jobs to keep pace with labor force growth--from new and young companies. True, this population is highly dynamic, equally adept at creating jobs as eliminating them. Whereas this dynamic process works out to a net gain of zero in big companies, the net result among new and young companies is positive. If you subtract startups from the American economy over the past thirty years, there is only a handful of years in which the economy would have created a positive net number of new jobs. This makes sense as a brand new company can only create, not destroy jobs, but from the perspective of adding new jobs--for those 100 people above--this doesn't change the fact that new jobs come from new and young companies.

Baker also neglects to mention that once a company survives to a certain age (at age six a company is no longer classified in the data as "young") it becomes not an organic generator of jobs but an acquirer of new jobs via other companies, which are largely young and small. Baker asks, seemingly rhetorically, how many jobs Microsoft added over the age of five, but companies like Microsoft and Intel and eBay and others can generally only add a positive increment of net new jobs by acquiring young companies. So even the appearance of net job creation in our largest companies reflects the contribution of new and young firms. None of this, moreover, even begins to approach the role of new and young companies in innovation and economic expansion--not monolithic growth but the evolution of sectors and firms into new and unknown territory.

Baker also appears to cast cold water on Friedman's emphasis on the importance of immigrants, but doesn't dwell on it. There is, however, a faintly palpable nativist tinge in the comments to Baker's post. Why bring in "foreigners" to start companies? Don't we trust Americans? Nowhere, however, does Friedman (or Kauffman) claim that Americans are insufficient for entrepreneurship. In fact, immigrants who start companies in the United States create thousands of jobs for Americans--who could argue against that? For a country made great on a history of immigration, the United States risks falling prey to nativist sentiment from both the right and the left, which will inevitably stifle economic dynamism.

In criticizing Friedman (and Kauffman), Baker tries to cover his tracks with snark, wishing someone would revoke Friedman's license to discuss economics. In an altogether brilliant post last week, Michael Pettis observed, "Snarkiness is always a sign of intellectual insecurity or confusion, and never an indication of insight." Rather than snark, Baker should consider how his vision of a big-companies-only economy would lead to stultified job growth, harming the people he claims to want to protect.

Waging Politics Through Graphics

For those of you who haven't seen it, this is a recently released graphic being pushed by the Obama Administration to illustrate the recession it inherited and the impact of the stimulus:

 Source.

Although it doesn't quite embody the "golden age" of data visualization that Paul Kedrosky likes to say we're living in, it is a very clever graphic--a "brilliant image" says Ryan Avent. That said, it's not without problems--Drew Conway provides a nice angle.

Has the Great Recession Ended?

This is the question of the moment for many economists and analysts and policymakers, although the relevance of the answer will vary widely across the country. Will someone who has been unemployed for seven months or longer (which is now the average duration) celebrate when the National Bureau of Economic Research (NBER) officially dates the end of the recession?

In a recent research note, William Hester of Hussman Funds examines the four primary indicators tracked by the NBER Business Cycle Dating Committee: Industrial Production, Real Manufacturing and Trade Sales, Real Personal Income Less Transfer Payments, and Nonfarm Payrolls. Many readers won't be surprised to learn that the first two indicators have bounced back nicely, in line with prior recoveries:

Source: William Hester, Hussman Funds 

The Manufacturing and Trade chart is similar, although with not quite the same "V" shape as Industrial Production. Personal Income has risen in the last several months, but so far is merely flat-lining rather than rising. But as you can guess, it's the employment situation that will continue to weigh on the economy:

Source: William Hester, Hussman Funds 

Yikes. Hester points out that the trend of NonFarm Payrolls thus far tracks quite closely the "jobless recovery" that followed the 2001 recession. That recession was said to be over in November 2001, but employment didn't recover for about two years and the bear market persisted for another year. As Hester notes, "it would go against precedent for [NBER] to declare the end of a recession with the mixed signals that are currently in place."

So what do you think? Is the Great Recession over? If it is, does it matter? Don Peck has a very disheartening piece in the newest Atlantic predicting a "long shadow" that will stretch across the economy for several years to come and will even produce a "slow motion social catastrophe," wrecking marriages, cities, and quality of life for whole swathes of the United States.

It's a perpetual temptation for every generation to declare its time to be historic, for everyone to perceive themselves as living through some sort of inflection point. Such time-centrist sentiment often proves unfounded, but occasionally the signals are so overpowering that you can't help wondering: is this the moment when everything changed?

What I Meant to Say . . .

Some timely humor, courtesy of here:

And I totally wish I'd had this poster in hand for yesterday's post:

Would a Jobs Credit Work? A Response to Pozen

(Bob Litan)

Main Street is impatient with the pace of the recovery. Yes, the stock market has rebounded smartly from its March lows; and yes, government statisticians tell us that total output of goods and services actually increased at an annual rate of 3.5% in the third quarter, most likely marking an official end to the Great Recession. But on Main Street, unemployment has now passed 10%, and many more Americans are discouraged from looking for work, or engaged in part-time jobs unable to upgrade into full-time work.

No wonder then that policy makers in both political parties are frantically searching for ways to reverse the monthly job losses and start putting more Americans back to work. One idea that has attracted a lot of attention is a temporary tax credit or a partial or total suspension of the payroll tax to encourage employers to begin hiring again.

Robert Pozen, a thoughtful and experienced financial expert, recently provided some useful analysis of this idea, and came up with a highly targeted job creation proposal designed to provide the largest bang for the policy bucks (to minimize the impact on the uncomfortably large federal deficit). The notion is to provide a 15% tax credit, up to $100,000 per employee, for employers making net additions to their payrolls, but require that half of the new workers come from the ranks of the previously unemployed.

However, this proposal would limit the credit only for already established employers – those in business prior to some cutoff date (Pozen suggests September 30th of this year). The rationale for excluding all new firms from eligibility is to prevent existing firms from breaking themselves up or forming new subsidiaries or affiliates simply in order to qualify for the credit.

What sounds like a minor detail – the eligibility cutoff – would actually be a big mistake--for it reflects a fundamental misreading of which firms are most likely to hire new workers and sustain the recovery after the stimulus measures wind down and are eventually withdrawn.

A new Kauffman Foundation study documents that over the past three decades, until this recession, new firms (those one to five years old) have been responsible for much or all of the net new jobs created in our economy. Remarkably, even in the teeth of the recession, through 2008, the number of new business starts, as measured by another Kauffman study, has actually increased modestly. What we don’t know is whether the constraints on business credit or other impediments will deter these new firms, as well as those recently created, from continuing the historical pattern by being the prime source of net job creation now and in the years ahead. What do know, though, is that excluding new firms from receiving any job tax credit will certainly break that historical pattern – hardly the outcome anyone wants.

Fortunately, there is much more straightforward way to prevent the kind of gaming that Pozen worries about: in calculating the employment benchmark for determining whether a firm has added to its payrolls, the tax authorities should include all subsidiaries and affiliates in which a firm has an equity interest above a certain threshold (such as 10% of  an entity’s equity).

Meanwhile, policy makers should continue to look for other ways to boost the formation and growth of new companies, which are not only likely to be source of new jobs but of the next wave of new products and services that will restore optimism about our economic future.

Some examples: Establish a “job creator’s” visa for immigrants who launch new companies and hire workers; fix bank capital requirements so that they are less likely to discourage business lending in economic downturns (by making the requirements less pro-cyclical); allow shareholders to determine whether their companies should adhere to all or a portion of the requirements of the Sarbanes Oxley Act that make it more expensive for high growth companies to go public and thus expand on their rather than to sell out; and encouraging the development of a truly free market in the licensing of technologies developed by our universities using federal research funds, which would accelerate the commercialization of innovations that will reshape our future. (The House Financial Services Committee recently voted to extend the exemption of small companies from Sarbanes-Oxley's section 404(b). The measure still needs to pass the full House and Senate and does not affect the requirement that these companies comply with section 404(a).)

Agree or disagree, as you may, with some of these specifics. But the source of America’s remarkable job growth, our new firms, is not in dispute. As we all seek to dig our way out of our current economic hole, we cannot leave our entrepreneurs out of the solution, because they are the solution.

--Bob Litan

Peak Unemployment?

The turnaround in employment numbers that we had hoped for has not materialized. Not even close. With today's fresh BLS numbers, the unemployment rate jumped up sharply by 0.4 points -- the kind of spike normally only seen in the darkest months of a recession. When a number of 0.4 points or higher is reported, the odds of that month being designated as recessionary are 88%, implying it is unlikely the NBER will declare the recession over at this point (whenever they get around to making such a declaration).

To put this in perspective, the net change in the unemployment rate is 5.3 points since the recession began in December 2007, surpassing any other modern recession. The following chart considers all recessions since 1970 (and merges the early 1980 double-dip recession into one observation):

 

As bad as this chart looks, the media seems to be underreporting the damage. Practically every piece of news coverage reports the overall level of unemployement as "a 26-year high." That misses the more important peak in net change, which is at something like a 50 or 80 year high. The baseline is not a zero rate, but the contemporary trough (or natural rate) which varies over time. Hence, the chart above. Moreover, any assessment of the deteriorating employment situation should recognize this is in the face of massive stimulus (monetary especially) which is in sharp contrast to earlier recessions, notably '74 and '80-82. Finally, the weak housing situation which many believe precipitated the current financial chaos is likely to suffer further setbacks if joblessness persists.

Another perspective comes from the simple payroll count (unadjusted for population or real-time) in the next chart:

The jobless recoveries of 1991 and 2001 were abnormal, but look like tea parties compared to this downturn. And this unemployment shock has not even peaked yet.

Implications for policy?

Unfortuantely, the legilslative focus on stimulus has emphasized federal spending which was extremely slow to get up and running, and is of questionable effectiveness. White House economists promised that passage of the stimulus would keep the unemployment rates below 8 percent, and forecast it would be settling down to 7.7 about now. Instead, it is 10.2 and rising. (Below is the infamous stimulus sales chart).

 
Whether this or their fault or not is irrelevant -- spending a trillion dollars in stimulus that has a perceived negative effect is unforgettable. And alternative strategies (payroll tax cuts and holidays) have been neglected. GM was nationalized while smaller firms were left to fend for themselves. My colleague Dane Stangler has done heroic work digging into Census data on firm age and job creation, showing that almost all new employment comes from firms younger than 5 years (link to his new report published yesterday)

The biggest loser in all this? Health care reform. If reform had been legislated during a non-recessionary year, I suspect it would have enjoyed bipartisan support and been passed. Instead, the timing could not be worse. Partisan tensions are inflamed which has driven the legislation far left of center. I find it hard to believe any health reform legislation -- which is desperately needed to control deficits and relieve entrepreneurial firms -- will cross President Obama's desk. That's too bad.

The Israel Model

Lo! What's this? A dispatch from our long lost co-blogger Bob Litan! Bob has evidently read a new book and, um, I can't really tell, but I think he likes it.

With the widespread concern about how the U.S. economy is going to generate new jobs and output on a sustained basis after the huge stimulus is withdrawn, the time could not be better to read a new book that tells one country’s remarkable story how it has done it. The country is Israel, and the book is appropriately titled Start-Up Nation: The Story of Israel’s Economic Miracle by Dan Senor and Saul Singer.

This is such a good book I don’t know where to begin with my raves. It is brilliantly written and chock full of great stories that have long deserved a wider audience, and they’ll now have it. Want to know who saved Intel? Read this book! Want to know how a country with deep socialist roots – the collective farms known as kibbutzes have long been a major symbol of Israeli society (inside and outside the country) – has been fundamentally transformed into one of the hottest entrepreneurial hotbeds in the world? Then read this book! Want to know how this all happened? Read this book!

And after you do that, or actually as you’re reading, questions will inevitably pop into your mind. Most important, at least for me: What can the United States learn from the Israeli experience? Knowing that we don’t or ever will have some of the most important keys to the Israeli success – the external fear of being encircled by hostile countries and thus the need to make-do with whatever resources are available, or compulsory service in a military where privates or lesser officers can tell their superiors they’re wrong – what can we nonetheless do to improve our own entrepreneurial networks and attitudes toward prudent risk-taking that the Israelis seem to have mastered?

Readers surely will not stop there. Many will be tantalized, perhaps upset, by the authors’ comparisons of the Israeli miracle with the struggles that its Arab neighbors have long had attempting to diversify out of oil. Others may wonder, as the authors themselves worry, whether the Israeli entrepreneurial machine will slow down now that the tidal wave of Russian immigrants has receded.

But I'll bet no readers come away from the book without being awed by what Israel has been able to do, and without being impressed by the authors' impressive way of telling this story.

--Bob Litan

Picturing U.S. GDP growth Q3 (data from this morning)

Growth is back, and we can all hope this is the start of the rebound:

The main surprise to me is that imports have started weighing down GDP growth so quickly in the recovery. Exports added roughly 1.5 points while imports took away 2.0. All this happens while the dollar is losing value?  Maybe.  Maybe just rebalancing the wild swings of the last 3 quarters. 

Where Have All the Loans Gone?

Last week the Obama Administration announced the expansion of a few Small Business Administration (SBA) loan programs, raising the cap on 7(a) loans, increasing the size of "microloans," and offering more aid, via TARP, to community banks. Questions will persist about the efficacy of SBA loan programs for new and small companies, as well as the effect of TARP restrictions on community banks, but two things are immediately clear. 

First, business loans have plummeted during this recession (via Econompic):

Worse, they show absolutely no upward trend in recent months:

(Source: John Mauldin.)

Any expansion of capital for businesses, even from the SBA, should theoretically help in some way. Credit is the oxygen line of new firms and they have been courting asphyxiation in this recession. 

Second, new and young businesses are the primary source of net job creation in the United States, yet this fact of economic life has for the most part been lost on policymakers (and media) obsessed with restarting the hiring process at large, established companies. Any recognition, therefore, of the importance of new firms and their access to capital can only be a good thing.

These steps aren't a silver bullet, mind you, and officials in Washington and every state capital continue to cast around for anything that will address (or appear to address) the dire employment situation this country faces. Nonetheless, President Obama's announcement is a step in the right direction and it comes on the heels of the creation within the Department of Commerce of a new Office of Innovation and Entrepreneurship. New firms are the drivers of job creation, and now Washington is finally turning to them.

Entrepreneurs (And Everyone Else Who Has Flown Since 1978) Owe a Debt to Ted Kennedy

Guest post by Charles C. Johnson

At the risk of wading into the political weeds, allow me to suggest that entrepreneurs owe Ted Kennedy a debt of gratitude for his work regarding airline and trucking deregulation. (h/t: Nick Gillespie of Reason Magazine.)

And the benefits of airline deregulation? The US Department of Transportation estimates that passengers save $19.4 billion dollars per year, thanks to lower fares due to deregulation. Today, airline ticket prices are almost 40% today than they were in 1978. 

 

Economics Bloggers Video

Here's a video of the Kauffman Econ Bloggers Forum:

Thanks to Matt Pozel and Matt Long for an awesome production effort.

The Distinct Dystopian Possibility

Tim posted two interesting entries in recent days, both touching on the recurrent question of whether or not we are entering an extended period of Dystopia. Given that it's been just over a year since I happily discounted the possibility of American Dystopia, I thought I might weigh in here. I won't keep you in suspense: I dramatically downgrade my optimism.

There are two related questions here, one pertaining to recent history, the other toward future projections. The first is whether or not the United States economy has really performed as well as we all like to think it has over the past two or three decades. This is a contentious issue among economists and I have nowhere near adequate space to address it, so I'll confine myself to Tim's point:

". . . the existence of the pernicious Dystopian Myth that middle class incomes are stagnant. The Dystopian Myth is social poison, a fiction shouted by the negative nabobs that convinces voters the American economic system is failing them."

Say it ain't so . . . but I will: it's sort of true. In June, Monthly Labor Review published this article, the abstract of which reads:

"OES [Occupational Employment Statistics] data from 2002–2007 reveal that an overall shift in employment towards occupations with lower mean wages hindered growth in the U.S. real average wage and that wage growth was concentrated in higher paying occupations; the data also show a shift in employment from the middle-paying occupations to the highest and lowest paying occupations."

The gist, as you can tell, is that real wage growth in this recent five-year period was basically stagnant overall because of the large growth in jobs paying the lowest wages--which actually appears to have come at the expense of better-paying jobs. The MLR article conveys the image, though not in so many words, of an emerging barbell-shaped wage distribution. Heartening. (I should just point out that Tim's characterization of the myth as a ploy to fool American voters is actually somewhat true--because voting participation follows income. Self-flattery as political vote-buying.)

Onto the larger point: is the United States now entering a Dystopian period of slow or stagnant growth, marred by class conflict, a dysfunctional national legislature (oh, wait, we already have that), and a "new normal" of diminished living standards? Again, this is a subject for a much longer disquisition, but for what it's worth, some recent reading I've been doing--and too many conversations with Paul Kedrosky--has me convinced that we are in for some very trying times ahead. We will see a short-term bounce in GDP growth here in the next quarter or two, but possibly 2010, and more likely 2011 and beyond, will bring discord, precipitated in large part by not only a higher "normal" of oil prices but also the realization that we are about to enter, prepared or not, a serious energy transition. Oh, and China's entire economy might be a bubble and we might be on the brink of having a failed state on our southern doorstep--because of plummeting oil production, not drug lords. (But they don't help; of course, if California legalizes marijuana to deal with its fiscal problems, this would be a boon for Mexico. Wouldn't it be ironic if the United States, irrespective of what party is in power, supported drug legalization because it would forestall the development of a basket case next door?)

OK, so I sound semi-apocalyptic. Don't get me wrong: I don't expect (at least, I don't think I expect) a Joseph Tainter-esque societal collapse. But there is a worrying disconnect between everyone who claims to see "green shoots" around every corner, even those who foresee a longer recession but eventual "normal" recovery, and the reality of long-term energy trends. Look, there is a reason why the Industrial Revolution has been more aptly named the Promethean Revolution (one of the best books on it is Landes' The Unbound Prometheus): humans harnessed inorganic energy. Our entire economic model is based on the premise of cheap coal and cheap oil: techno-utopians consistently ignore the inconvenient fact that much of that computing power they love to tout runs on such energy.

The obverse is that our economic model is not premised on permanently higher oil prices, whatever climate feedback loops we may be instigating, and the nontrivial risk of geopolitical instability. (The U.S. military, by the way, has little room for anything but a realistic appraisal of the future.)

Little of this will be new to readers: we all know we have energy issues to deal with. And, sometimes it's much easier to be pessimistic than optimistic about the future. To be sure, there are a few reasons for optimism. One is that humans are adaptive and we will likely find a way to adapt to the energy challenge. The profit motive will, or should, play a key role in this transition--this doesn't mean there is no role for government. Obviously, there is and should be: federal labs will be critically important going forward, but we need to unlock the innovations in those labs more efficiently. But government's role will be to do what it always does when it acts as facilitator, viz. frame incentives. In this case, it seems that a carbon tax would be an almost no-brainer. Then again, the fact that a carbon tax is treated like a shoot-the-moon option simply reinforces the pessimistic outlook. 

A key piece to moving forward through the next energy transition--and to possibly suppress or at least mitigate whatever geopolitical unpleasantness arises therefrom--is the supply of entrepreneurs. I don't just mean clean tech. We're talking about wholesale economic and social changes here--let's hope in slow motion, rather than abruptly. Don't just take it from me. At the recent World Economic History conference, Robert Ayres presented this wonderful presentation on the relationship between energy and economic growth, concluding that only entrepreneurs can take us forward. How's that for framing a policy debate?

(This pessimistic outlook, of course, will bring some amusement, namely, the perpetual cognitive dissonance of so-called conservatives and liberals as they endlessly bloviate in endless legislative fights. Rightward-leaning folk don't really seem to have dealt with the inherent tension between their Edmund Burke impulse and their defense of free-market capitalism as a ceaseless source of creative destruction. You can't sanction one type of change and seek to prevent the other. And liberals--or in today's parlance, progressives--haven't reconciled the exact opposite dichotomy: their embrace of "social change" as an all-encompassing yet vacuous strategy, but their readiness to preserve nostalgic remnants of the mid-twentieth century economy.)

The most frustrating thing about such a discussion is that it's quite difficult to talk about an alternative future because all we have to structure our imagination of that future is the present state of affairs. When we're trying to imagine what the next economic model will be, and how it will differ from the one that has carried the world forward for the last century and a half, we have little to draw on by way of reference points. But this, oddly, might be the strongest case for optimism: human knowledge always advances in a desultory fashion. We adapt by trial and error and adoption. The potential for future innovation and new knowledge creation shouldn't be in doubt--it's the institutional response, the adoption and absorption, that should be of concern. 

What's important is that we stop discounting the very real possibility that the future could be anything but bright: the fact that the last two hundred years have seen more or less upward progress in terms of human living standards, steadily spreading over the entire globe, is not a reason to believe that the future will simply be a continuation of this. Believing so is the mistake made by Taleb's "turkeys."

Three Cheers for Ignorance

Does our affection for democracy over alternatives require us to believe that citizens are rational and intelligent? The infamous and insightful comedian Bill Maher recently ranted that Americans are "stupid" and joked that legislators shouldn't bother listening to them during the August recess. At marginalrevolution, Alex Tabarrok blogged that Maher was unleashing his inner Bryan Caplan. Clips from the Maher essay first, then my take on why Tabarrok, Maher, and maybe even Caplan are missing the big picture.

I said [on CNN] 'I wouldn't put anything past this stupid country.' It was amazing - in the minute or so between my calling America stupid and the end of the Cialis commercial, CNN was flooded with furious emails and the twits hit the fan. And you could tell that these people were really mad because they wrote entirely in CAPITAL LETTERS!!! It's how they get the blood circulating when the Cialis wears off. ...

And before I go about demonstrating how, sadly, easy it is to prove the dumbness dragging down our country, let me just say that ignorance has life and death consequences. On the eve of the Iraq War, 69% of Americans thought Saddam Hussein was personally involved in 9/11. Four years later, 34% still did. Or take the health care debate we're presently having: members of Congress have recessed now so they can go home and "listen to their constituents." An urge they should resist because their constituents don't know anything. At a recent town-hall meeting in South Carolina, a man stood up and told his Congressman to "keep your government hands off my Medicare," which is kind of like driving cross country to protest highways. ...

And these are the idiots we want to weigh in on the minutia of health care policy? ...

And if you want to call me an elitist for this, I say thank you. Yes, I want decisions made by an elite group of people who know what they're talking about. That means Obama budget director Peter Orszag, not Sarah Palin.

Which is the way our founding fathers wanted it. James Madison wrote that "pure democracy" doesn't work because "there is nothing to check... an obnoxious individual." Then, in the margins, he doodled a picture of Joe the Plumber.

Let's be fair to Maher, who is clearly poking fun and going to extremes for a laugh. He's a comedian, but is he unserious? Maher is sincere in his elitism, but he clearly misunderstands James Madison whose fundamental message is that the danger of pure democracy required limiting central government power. Nevertheless, he is channeling an ancient dialogue.

I would note that Will Rogers was also a comedian who made his living with political humor. It is telling how times have changed that Rogers made his mark by mocking the powerful, whereas Maher and his fellow pundits score most of their points off of the public. 

If we take this hostility towards democracy seriously, we have to squarely address the Caplan critique, and in doing so convince Alex why he should be a small d democrat. So let's get started.

For the record, Bryan Caplan is a friend of mine who wrote a great book a few years ago called "The Myth of the Rational Voter" which challenges a bedrock theory of political science. The median voter theory holds that democracy is unbiased in its policy preferences, and Bryan brilliantly exposes that conclusion as failure. This is not the end of the story. The Caplan critique is of great but limited value. It does not imply better alternatives. It affirms the Madisonian caution against mobocracy, and reaffirms the desirability of federalism and mixed government republicanism, the former as a channel for policy experimentation in a biased (imperfectly wise) world and the latter as a buffer against majoritarian populism. In the end, the Caplan critique confirmed my sense that policy discussions in a democracy can seem frivolous; voters ultimately cannot care about policy because of bounded rationality and instead care about pragmatic outcomes. Good outcomes equal re-election, regardless of policy particulars.

In sum, I think the Caplan critique of democracy write large fails (and he might agree). Here's why:

First, Caplan tells us that voters are irrational, not that they are stupid. This is big difference between the wise professor and the devious comedian.

Irrational voters are in some sense ignorant, but ignorance is no sign of stupidity. Many surgeons are perfectly ignorant about "frivolous" skills like gardening, automotive engineering, and probably even the inner physics of X-ray machines. But they know how to read an X-ray machine, and isn't that what matters?

Who prefers the surgeon to know less about anatomy and more about NAFTA, tax progressivity, and the effects of the minimum wage on teenage minorities? The surgeon is a voter, but an irrational one because she has incomplete information about political policies. Is this dangerous? Inefficient? Unjust in some way? If we prefer a society where more citizens live longer lives due to better surgeries, we must prefer an ignorant electorate, no?

Let's agree that the human mind can know one subject expertly, five or six subjects really well, and an additional thousand facts, all this in a world with an infinite amount of subject matter. We can trivially claim that a non-ignorant citizenry is an impossible standard. A utopia, of sorts. And the only way to realize such a utopia is to limit the scope of common knowledge, which hints darkly at Mao's little red book.

Second, a growing society requires more, not less, ignorance. In their new Modern Principles: Macroeconomics textbook, Tyler Cowen and Alex Tabarrok argue that the division of labor due to trade (i.e. scale) is better understood as a division of knowledge. Great point. In Chapter 18, they write

In a primitive agricultural economy in which each person or household farms for themselves, each person has about the same knowledge as the person next door.  In this case, the combines knowledge of a society of one million people barely exceeds that of a single person. A society run with the knowledge of one brain is a poor and miserable society.

Again, the alternative to rule by all is rule by the few or rule by one. And yet here is evidence that a more complicated society is even less governable by elites than a pre-modern society was. I think a cursory glance at comparative political economies shows that oligarchies are negatively correlated with prosperity (with North Korea, most of sub-Saharan Africa, and Cuba at one extreme and South Korea and SE Asia moving towards the other end of the spectrum towards democracy).

Third, democratic "failure" is resolved by more federalism not more elitism. Look, if we believe that rational ignorance is a function of growth, then they are both poised to accelerate in the years ahead. As the division of labor and knowledge accelerates, the democratic challenge will be how to reconcile increasing levels of political ignorance with democracy.

Logically, more power will be shifted toward experts because increasingly ignorant citizens don't want to manage train schedules. People tend to desire more varieties of ice cream, barbers, and books, so why would we expect them to be satisfied with fewer choices in the political sphere? They will want more experts, not more powerful experts, to supply them with public goods. Also, it is far from clear that a technocracy is the pre-ordained outcome generated by political "ignorance." The efficient apportionment of public goods supply among various service providers is not something people will vote on in a booth. More likely, different nations will try different institutions, and there will be an iterative social learning process. But I suspect political markets may have a better chance of success than a coercive technocracy at finding optimal solutions.

An example that Bryan and I have discussed is the Federal Reserve, which has a kind of technocratic control over the money supply. I think money is a special case, so the Federal Reserve is a necessarily technocratic organization much like the Supreme Court is. Quite different are health care, transportation, welfare, crime, and education. It is not at all clear to me that a centralized organization can effectively manage those issues on a national scale. To the contrary, I trust voter choices among competing products (states, cities) far more than expert knowledge.

Congress is increasingly failing institutionally at selecting weapons systems efficiently, let alone managing public education. Congress' failures have been the luxuries of a rich nation without a basic budget constraint, which will soon change thanks to looming international financiers. When the pressures to balance the budget become critical, fixing of the "broken branch" will inevitably involve a devolution of central power. Congress is simply overcommitted right now, and the limits of taxation will prove unyielding.

So in the end big fiscal decisions about the balance of government services and taxation will play out among 50 state alternatives (with voters making choices via the right of exit -- voting with their feet). Voters may be ever more ignorant of the policies of the 50 states, but they will know where the good schools, low taxes, and growing economies are.

Wow on Jobs

The U.S. unemployment rate dropped by a tenth percentage point to 9.4.  This is great news.

Since this is August recess all around (including my laptop), I'm punting on the usual chart. Back next month. Enjoy the dog days!

The AP analysis of the jobs report is succinct:

It was a better-than-expected showing that offered a strong signal that the recession is finally ending.

The new snapshot, released by the Labor Department on Friday, also offered other encouraging news: workers' hours nudged up after sinking to a record low in June, and paychecks grew after having fallen or flat lined in some cases.

...

The dip in the unemployment rate — from June's 9.5 percent — was the first since April 2008. One of the reasons the rate went down, however, was because hundreds of thousands of people left the labor force. Fewer people, though, did report being unemployed.

All told, there were 14.5 million out of work in July.