Churn, Baby, Churn
It's a messy business, this new economy. And despite what our leaders say, all the turmoil is actually good for us
There are people who actually know how the modern economy works. It's just that nobody in government wants to talk to them.
Consider the story of Donald Hicks, a professor of political economy at the University of Texas. Contracted by the state to examine the past and future of Texas's manufacturing base, Hicks pored over 22 years of sales-tax returns--including those of defunct businesses, interred in a mausoleum-like archive--to trace individual companies as they made their way into and out of existence.
His most striking finding: the "half-life" of new businesses had been cut in half since 1970. That is, a group of companies founded in, say, 1985 took only half as long to have its ranks depleted by 50% as a group born in 1970 did. A process of attrition that used to take five years now took less than two.
More surprising still, the Texas city whose businesses had the shortest life expectancy--Austin--had the fastest-growing job base and the highest wages. The counterintuitive lesson: high business-mortality rates are good for economic health.
Actually, that makes sense. In the past two decades, a variety of factors have dramatically increased the velocity of the basic capitalist dynamic. The economies that succeed are those that quickly shift assets to their most productive uses through vigorous economic churning--through business start-ups and the failures that inevitably accompany them. This is what the Austrian economist Joseph Schumpeter famously termed "the perennial gale of creative destruction."
But what the Texas government really wanted to know was this: what would it take to create 3 million new jobs by the year 2020? Hicks's report offered this answer: the state's task was to produce not 3 million new jobs but 15 million new ones, because by 2020, most of today's companies will have disappeared. Rather than considering jobs a fixed sum to be protected and augmented, he argued, the state should focus on encouraging that economic churning--on continually re-creating the state's economy. To promote long-term economic stability, paradoxically, the state would have to promote constant instability.
Presented with those messy and unsettling findings, what did the state of Texas do? It decided not to release the report.
The Entrepreneur as Protagonist
This tale captures perfectly a problem that is warping the debate about America's political economy. As Regina Tracy, executive director of the Research Institute for Small & Emerging Business, in Washington, D.C., explains it: "Legislators get incredibly nervous talking about creative destruction, about the churning process. They don't want to talk about it."
We shouldn't be surprised. First of all, the case for creative destruction can't be neatly wrapped up in a 15-second sound bite. Second, no politician with even a modicum of regard for his or her political future would stand before voters and advocate economic instability and destruction. And though there is plenty of lobbying pressure to prop up "yesterday's economy," Hicks points out, "there is no political constituency for the future, for the firms that aren't yet born."
The sad result is that our politicians frame debates and create public policy using a model of an economy that no longer exists. Or as Tracy puts it, a model that "causes us to ask the wrong questions."
For instance, most communities' idea of economic development is to lure outside companies through tax abatements and other incentives. Yet from the standpoint of national prosperity, that's silly. It is, of course, a zero-sum affair: one community's gain is another's loss. Rather than fostering innovation and new wealth--by, say, establishing local business incubators, which research has shown are more effective on a cost-per-job-generated basis than business-attraction schemes are--communities grapple over existing wealth as if it were a fixed quantity.
The problem is compounded by the fact that the reigning economic orthodoxy--a neoclassical model known as general equilibrium theory--all but denies the existence of creative destruction. Constructed in the late 19th century and since embellished by generations of economists, equilibrium theory concerns itself mainly with how existing resources are optimized: how supply-and-demand curves determine input, output, prices, and so on. As its name suggests, the theory takes equilibrium to be the normal state of an economy, assuming that market disequilibriums are quickly eliminated through price adjustments. Its mathematically elegant universe cannot cope with entrepreneurs, relegating them to the catchall domain of "external forces," along with war and weather.
Early in this century, Joseph Schumpeter broke radically with his profession by suggesting that general equilibrium theory missed the point. It ignored what he considered capitalism's single most important aspect: innovation, which drives economic changes. "The essential point to grasp," he wrote, with a hint of contempt for his peers and their misleading mechanical metaphors, "is that in dealing with capitalism, we are dealing with an evolutionary process."
Disequilibriums were not passing anomalies, Schumpeter asserted, but rather the very crux of the capitalist process: an entrepreneurial business--Microsoft, Nucor, Southwest Airlines--enters a market with a technological or organizational innovation, destroys the oligopolistic equilibrium, and siphons off wealth and jobs from the hegemonic giants. In that model of constant disequilibrium, the entrepreneur is the central economic protagonist, the fount of economic progress and quality-of-life improvements.
Two Models, One Economy
Schumpeter's perspective did not fare well, mostly because it did not lend itself easily to mathematical expression. Strangely, he was remembered more for a fantastically incorrect prediction--that huge corporations would come to dominate the U.S. economy--than for his central thesis of creative destruction. Today a small tribe of maverick economists--particularly Paul Romer of Stanford University--has resuscitated Schumpeter's vision, contending that it offers an altogether more accurate description of how today's economy actually works. Yet, as Richard Nelson of Columbia University remarks, "there is scarcely a crowd of us."
Ongoing resistance to a more dynamic conception of capitalism has unfortunate policy consequences. For example, there's great self-congratulation in America about "our efficient financial markets," says Bruce Kirchhoff of the New Jersey Institute of Technology. But "from the small company's point of view," he says, "they're anything but efficient. The transaction costs are huge. The deal flow is horrible." If there were a more thorough comprehension of the macroeconomics of small enterprises, Kirchhoff argues, the government wouldn't have waited so long to allow a public market for entrepreneurs looking for equity capital, which the Securities and Exchange Commission only recently OK'd.
Or take the government's data-gathering efforts. As Kirchhoff points out, they're designed under the faulty notion that an insignificant number of small companies grow to become large ones. The resulting methodology makes it difficult to determine such basics as how many new jobs entrepreneurial companies contribute to the economy. That, in turn, leaves policymakers in a data vacuum when fashioning economic policy. "What we're trying to do is sell the American political system on a new view of what the economy is, and to sell it we need good data," says Kirchhoff. "But there is no data."
In the absence of firm numbers and understanding, the American mind falls prey to the crooning of narrative economists. These are commentators who, instead of arriving at informed judgments through assiduous empirical analysis, construct story-line interpretations largely out of anecdote and aphorism. Case in point: the New York Times noticed that a lot of people were being downsized from corporations and reacted by running an interminable, near-hysterical series in March 1996 informing us that we're living through an economic cataclysm of millennial proportions.
That story line, the sensible among us recognized, was simply not true. The data told us so: the combined rate of unemployment and inflation--a pretty good indicator of citizens' economic well-being--was at a 30-year low. Job creation was at a historic high. Presented with that stubborn evidence, the narrative economists came up with a new fable that seemed to trump it, the oft-repeated joke that the economy produced record numbers of new jobs last year, "and I've got three of them." In time, however, that myth was punctured, too: the president's Council of Economic Advisers reported that the new jobs being created were relatively high-paying and overwhelmingly full-time.
Why the Times series, then? It was a classic instance of viewing a current phenomenon through an outmoded lens. Through the lens of general equilibrium theory, the mass dislocation of thousands of workers would, indeed, signal that something was dreadfully awry. Through a Schumpeterian lens, on the other hand, it was a sign of something else--something that could best be described as economic speed. In the so-called new economy, companies and even entire industries can swiftly rise and fall as resources are transferred to more fruitful sectors (as, in a healthy economy, they should be). What's confusing is that a phenomenon that has long been solely associated with economic downturns--massive layoffs--has now become a permanent fixture in the economy.
That is not to suggest that layoffs don't inflict a severe personal toll; certainly they are painful, depressing, even shattering to the people at their receiving end. (And depending on your view of government, there may be a role for the state to play in easing these transitions through job retraining and other programs.) But the story of thousands losing their jobs at a no-longer-competitive industry giant cannot rightly be generalized into an allegory for the state of the U.S. economy. Is this new economy more uncertain and perhaps a little crueler than its predecessor? Of course. But is it less prosperous? Does it offer fewer opportunities? Quite the opposite.
When it comes to the two components of creative destruction, though, the destruction part generally makes for the more dramatic, compelling narrative. The creation part can fall a tad short on story value ("Silicon Valley Start-up Hires 50!"). "Both economists and popular writers have once more run away with some fragments of reality they happened to grasp," Schumpeter complained a half century ago. He'd undoubtedly raise the same objection today.
The Fallout from Getting It Wrong
When these spurious interpretations march victorious, we end up with loony legislative prescriptions. In this past election year, they emanated from politicians of all stripes. Republican presidential candidate Pat Buchanan, blaming foreign competition for all America's woes, demanded protection for dying industries--a surefire recipe for stunting domestic entrepreneurship and securing economic mediocrity. Then labor secretary Robert Reich (narrative economist extraordinaire) demanded tax breaks for companies that refrain from layoffs--another wonderful means of distorting the economy by attacking a symptom rather than the root problem.
Popular debate is largely a contest of interpretations, and without an informed explanation of what's actually driving our economy, these muddled, misconceived story lines advance unchecked.
One still might ask, So what? Well, without vibrant domestic entrepreneurship to constantly disrupt and re-create America's markets, the source of such disruption is more likely to be foreign companies. And when those foreign companies destabilize one of America's placid oligopolies, it's the foreigners who benefit from the creation, and America that absorbs the destruction.
We need only look across the Atlantic to observe the perils of suppressing the economic churning. The causes of Western Europe's abiding double-digit rates of unemployment are manifold, but at their root is the European governments' near-complete obliviousness to the wealth-creation process. Public dialogue tends to focus on how to apportion output equitably rather than on finding ways to let enterprises create more of it. France may lower its retirement age to 55, and several European countries are toying with a mandated four-day workweek--all with the notion of getting the "starters," as it were, out of the game to give the young unemployed some playing time. Those admittedly well-intentioned endeavors would require a massive welfare state, whose taxes and regulations would end up dampening entrepreneurial activity and, ironically, worsening unemployment.
Europe's technocrats might well benefit from a conversation with Donald Hicks. "These data tell us that the economy is in continuing motion, like a children's top," says Hicks of his study. "As long as it's in motion, that's when it's healthy. As soon as you try to protect what you have, it will fall over."
Our understanding of the economy urgently needs to catch up to the reality of what it has become. Only then will we start to hear more sensible interpretations from America's politicians, economists, and journalists. Until then, there may be a lot of happy talk--empty incantations about fostering entrepreneurship--but precious little concrete progress.
A year ago Peter Drucker warned in these pages that America's sense of entrepreneurial superiority was "lulling us into a dangerous complacency--not unlike our complacency about management in the early 1970s." If we don't find ways to better comprehend and stoke our entrepreneurial economy, his ominous prophecy may catch up to us faster than we think.
Jerry Useem is an associate editor at Inc.
Any inquiry into evolutionary theories of economics must inevitably begin with the famous chapter 7 of Joseph Schumpeter's Capitalism, Socialism and Democracy, which was first published in the United States in 1942--now available from HarperCollins (800-331-3761, 1962, $16). Also worth reading is Schumpeter's earlier work (1911), Theory of Economic Development: An Inquiry into Profits, Capital, Credit, Interest and the Business Cycle (Transaction Publishers, 908-445-2280, 1983, $19.95), which deals more explicitly with new firms and entrepreneurship.
On a more contemporary note, Schumpeter's modern-day disciple Paul Romer has attracted considerable attention with his controversial new growth theory, which holds that new ideas are the ultimate source of economic growth. (To download Romer's papers, visit his Web site). Then there's Bruce Kirchhoff's Entrepreneurship and Dynamic Capitalism: The Economics of Business Firm Foundation and Growth (Praeger, 800-225-5800, 1994, $59.95), which takes the empirical approach of measuring company formation and growth.
As for works by noneconomists, there's Michael Rothschild's Bionomics: Economy as Ecosystem (College Board, 1995, $17.95). Rothschild gets bogged down in his analogy of economies as rain forests, but his central point is on the mark: that economies develop, test, and select innovations in much the same way that biological evolution selects species. See especially chapter 4, "The Mythical Machine," an attack on Newtonian physics--and mechanical metaphors--as the basis for economics. Or visit Inc. Online to read senior writer Edward Welles's interview with Rothschild.
For those willing to wade through dense academic prose, the most illuminating read of all may be chapters 2 and 3 of The Sources of Economic Growth (Harvard University Press, 800-448-2242, 1996, $39.95), by Richard R. Nelson, the first post-Schumpeterian economist to revive the evolutionary perspective. A self-described quasi inductivist, Nelson advocates the intellectually unfashionable route of taking observable phenomena and trying to explain them. He rails against the tendency of economists to glorify abstract mathematical virtuosity for its own sake.
Nelson notes that the steady march of economic growth can be misleading because it obscures the tremendous turmoil underneath. "Thus the regularity and the order that the analyst sees in economic growth," he hypothesizes, "may be analogous to the 'spontaneous order' highlighted by the new work on dynamic systems...." If this sort of stuff turns you on, pick up Nelson's book.
DONALD A. HICKS, School of Social Sciences, University of Texas at Dallas, Box 830688, Richardson, TX 75083-0688; 972-883-2733; email@example.com 25
BRUCE KIRCHHOFF, New Jersey Institute of Technology, Newark, NJ 07102-1982; 201-596-5658; fax, 201-596-3074; firstname.lastname@example.org 25
RESEARCH INSTITUTE FOR SMALL & EMERGING BUSINESS, Regina Tracy, 722 12th St. NW, Washington, DC 20005; 202-628-8382; fax, 202-628-8392; email@example.com 25