Why We Need New Firms and Better Ways to Generate More of Them

In 2011, the U.S. economy barely grew at all during the first six months. In 2012, the economy managed an anemic 2 percent average growth, very much below the post-recovery periods after each recession since the end of World War II. Despite record amounts of stimulus that was supposed to kick-start the private economy, consumers remain hesitant and businesses have stashed away cash. As a consequence, the unemployment rate that peaked at 10 percent –only the second time this has happened in the post-war period—only dropped to just under 8 percent through the fall of 2012.

Companies large and small, including franchise owners, announced a post-election wave of layoffs, price increases and holding actions that are meant to cope with lackluster demand in addition to the looming cost increases of Obamacare. Even assuming that Congress and the president will have resolved the“fiscal cliff,” business leaders continue to exhibit an overall sense of gloom that threatens to continue to linger over the American economy for the next several months and possibly beyond. Caterpillar, for example, has scaled back earnings expectations and doesn’t see an upturn for its business until the middle of 2013. GE’s Jeffrey Immelt sees 2013 as a flat year. As TheWall Street Journal put it recently, “U.S. companies are scaling back investment plans at the fastest pace since the recession, signaling more trouble for the economic recovery.” Half of the nation’s 40 biggest publicly traded corporate spenders, the newspaper said, have announced plans to curtail capital expenditures this year or next.

Something is clearly amiss. When does the economy recover? We desperately need to grow. The U.S. and other developed economies are now confronted with something few thought would happen—an extended period, perhaps a decade or more, of anemic growth and high unemployment. The challenge today is what can we do to change this stagnation? More government stimulus is not the answer. The Fed has shot that round and is left with an empty chamber. Even the president admits that deficits are too high and must be curtailed. The task is up to the private sector.

In their recently published book, Better Capitalism, authors Robert E. Litan and Carl Schramm, both of the Kauffman Foundation argues that the U.S. needs a new understanding of our economy. They believe that an entrepreneurial revolution might provide a firmer formation of growth that mere stimulus spending and tax cuts cannot ensure. The objective should be to focus on the key drivers of economic activity, specifically the role of individual firms. However, it is not just any entrepreneurial firm that is important; what matters are new firms. One frequently hears that small business is central to job creation and—by extension—wealth creation. The former VP of research and the former president of Kauffman, respectively, beg to differ. “In the roughly three decades preceding the Great Recession, firms less than five years old (and perhaps as young as one year old) accounted for virtually all of the net new jobs created each year in the private sector,” contend Litan and Schramm.

Other research confirms that the greatest job growth is associated with new firms, not small firms. John Haltiwanger of the University of Maryland and two colleagues from the U.S. Census Bureau, Ron Jarmin and Javier Miranda, found that between 1992 and 2005, all net increases in jobs were located in start-up firms or those less than five years old. Dane Stangler, director of research and policy with Kauffman, extended this analysis over a longer period and found it to be true for the years 1980 through 2007. Time in business—not size—mattered for job growth.

There are any number of ways that simple policy changes might advance the formation of new firms, starting with expanding the number of H-1B visas to promising and technically gifted foreign students. It was highly skilled immigrants, such as Andy Grove (Intel), Sergey Brin (Google), Pierre Omidyar (eBay), and Jared Karim (You Tube) who have already transformed our economy.

Likewise, we need to look at more creative ways of unleashing and commercializing university-generated innovation. Litan and Schramm contend that the rates of return from licensing and research are abysmally low and that the process is ripe for improvement. In addition, we need to re-examine the effectiveness of venture funds. On average, such funds record their highest returns in the first two years, with returns in subsequent years falling off sharply.

Kauffman detects a new seed capital industry developing out of successful, cashed-out entrepreneurs turned “super-angels.” Such groups are said to be highly competitive to traditional venture capital firms that rely on general partners to manage other people’s money.

Finally, Congress should reconsider any law that materially inhibits the formation of a start-up enterprise—a controversial undertaking but one which, if our solons at least think about, may limit economic damage due to unthinking lawmaking-as-usual.