BoAML | With an abundance of stories about how things can go wrong for the US economy, we are often asked to lay out a scenario in which the data surprise to the upside. In our view, the burden rests on the labor market. If there is an increase in demand for labor, which is met by a gain in supply, we could settle on a stronger trend in job growth. We have discussed the possibility of a gain in the labor force in prior research , so in this piece, we explore the mechanism for stronger labor demand. One possibility is that a text-book virtuous cycle develops where final demand increases, spurring greate r business investment (and hiring), which feeds back into stronger consumer spending. Another, perhaps more compelling, trigger would be an increase in business formation. As we argue in this piece, there are both structural and cyclical reasons that the rate of business formation has declined, but we see scope for a gain in the medium term. If business formation increases alongside rising labor force participation, the trend in job growth will remain sng, extending and strengthening the business cycle.
Birthing a business
The rate of business formation fell sharply with the Great Recession and has remained stuck at these levels. Using data from the Business Dynamics Statistics (BDS), we calculate the entry rate of firms and establishments, which we define as new units (aged 0) as a share of existing units. A firm is defined as activity under common operational control while establishment is the individual unit — ie a large chain would beclassified as one firm but with many establishments. In both cases, the entry rate was fairly steady from 1990-2007 before witnessing a sharp, and persistent, decline.
The low entry rate can create a downward bias to labor demand. Although new firms only account for 2-3% of total employment, they make up about 15% of gross job creation. Moreover, assuming survival, these young firms are important contributors to job growth. We find firms between 1 to 5 years old will contribute another 13% to total new jobs. Of course, we are measuring gross rather than net jobs therefore not capturing business deaths which tend to have a higher rate for young firms.
It is important to note that it is not necessarily the current year’s entry rate that impacts job creation, but it is the entry rate over the prior several years that influence the pipeline. This relates to the “ missing generation ” theory where firms that would have been created never appear, depressing job creation rates over the years. Based on work from the Chicago Fed, we can calculate the counterfactual for job growth based on different assumptions of the firm entry rate.
We explore two scenarios starting from the recession and ending in 2014 (when the BDS data end) in which the firm entry rate held steady at either 1) the 2008 level of 9.3% or 2) the average between 1990 and 2008 of 10.8%. Assuming the same realized survival rates and average job gains for a firm in its first six years, the first scenario yielded a net cumulative boost of 756,000 to total employment from 2009-2014, while the second scenario showed 1.57mn additional jobs. The risk is these figures are overestimated given that an increase in the number of firms would likely pressure survival rates lower due to more intense competition. Nonetheless, this exercise clearly shows that higher firm entry rates would be a sizeable positive for labor demand.
Business dynamism matters for productivity
In addition to generating demand for labor, start-ups play an important role in supporting productivity growth. There is a great deal of economic literature that links business dynamism – the pace of gross job creation and destruction – to productivity growth. Across a variety of studies, the conclusions are clear that young establishments (which capture the start-ups that survive) have higher productivity levels and higher productivity gains than more mature establishments. A recent paper from the Federal Reserve Board (and referenced by Vice Chair Fischer in his Jackson Hole speech) estimates that there is a persistent increase in both GDP and productivity as a result of changes in the number of start-ups. Specifically, they found that a one-standard deviation shock to the number of start-ups led to an increase of real GDP culminating to 1-1.5% and lasting 10 years or longer. This suggests a notable and lasting impact on the economy from weak rate of business entry over the past decade. But, I want to know why:
Understanding the cause of the slowdown in business creation will inform our views on the potential for a recovery. We identify four possible reasons.
1. Tighter credit conditions : the tightening of credit conditions as a result of the crisis made it more challenging for entrepreneurs to gain financing. New businesses are dependent on bank financing unlike large businesses which have access to the capital markets. Moreover, many new business owners use their home as collateral against loans, which is a mechanism that became more difficult since the crisis.
2. Uncertainty shock : the economy has been hit by a series of shocks (including several out of Washington), which hurts confidence and could discourage new business creation. Adding to the challenges, the near-term outlook for regulatory and tax changes has been unclear — these are two of the biggest problems highlighted consistently in the NFIB Small Business survey.
3. Technology disruptions : there has been a shift away from “ mom- and -pop ” retail stores in preference for large chains and online competitors which can be seen in a sharp drop in entry rates for the retail sector. We also see a structural downshift for manufacturing but fairly stable entry for financial and services
4. Aging economy/population : as both the economy and population ages, there is a natural downward pull on business dynamism. The economy settles on a slower growth rate which means a slower churn of economic activity. The age of the population is particularly important since entrepreneurs tend to be young. The first two factors are mostly cyclical and, in theory, can be addressed over time. However, we have made only little progress thus far. Mortgage lending standards have remained tight with a relatively low presence of home equity lines of credit. There has been an expansion of the “ shadow ” lending market as a result of the search for yield, which should support the financing of start-ups, but this likely only helps on the margin.
We could see support from demographics – although the overall population is aging, which is a negative for business formation, there will be a swelling in the share of the population in “ prime age ” for entrepreneurs. Research from the Kauffman foundation discovered that the average successful entrepreneur in high-growth industries founded their company when they were 40 years old. With the oldest Millennial just turning 36, demographics should turn supportive for new business formation in the medium term.
The ability to start up
We believe that there are both cyclical and structural reasons for the slowing in business formation. Although difficult to forecast, we could see a scenario where the rate of business formation recovers in coming years. Provided we have an appropriate supply of labor, this should underpin the trend rate of job creation and help to extend the recovery. Moreover, an improvement in the rate of business formation will decidedly support productivity growth.
When we are asked if the economy has the ability to realize stronger growth again, our answer is “ yes ”. The burden is on the economy to become more dynamic, which requires a higher birthrate of businesses. While this will not happen overnight, it is certainly possible in the medium term.