The real reason why the economy is still going strong

Dire predictions followed the stock-market crash of October 1987. The crash would precipitate a huge recession -- perhaps even a depression like the one following the crash of 1929. Employment growth would stop, probably even decline. The unemployment rate would rise sharply. The economy in general, claimed many experts, would be a mess.

What actually happened? The unemployment rate has dropped more or less steadily since the crash. Employment growth has continued, sometimes at record levels. Manufacturing employment growth has been strong, despite the fact that large companies continue to restructure and lay off thousands. The balance-of-payments deficit continues to shrink.

How can all this be going on?

The events of the year or so since October 19, 1987, are testimony to the true strength of what I've called the "hidden economy' -- the economy that consists of literally millions of companies that are privately held, not listed on any stock exchange, and rarely written about in the business press. This hidden economy, since 1980, has created roughly three times more jobs than Japan. Perhaps most important, the companies of the hidden economy have been terrific shock absorbers for the economy as a whole.

The first indication of the role of the hidden economy during adversity is the rate of new incorporations. The two major recessions since 1970 -- 1974 to '75 and 1980 to '82 -- had relatively little effect on the annual increase in new incorporations. In fact, 1981 was an all-time high (relative to previous history) and 1975 was within 3,000 of the previous record.

While many businesses emerge from someone's long-term vision of what might be, it's also true that a large number are started out of frustration. A major source of entrepreneurs is the group of people who become frustrated with their current jobs. The frustration level inside a company increases during a time of restructuring and downsizing, when new initiatives are frequently put on hold. Of course, a more severe kind of desperation can set in when the restructuring affects you directly.

All the forces of frustration accelerate in bad times. It is no wonder that entrepreneurship booms in such periods.

Our current postcrash period is a good example. With the notable exception of November 1987, the monthly total of new incorporations has generally risen since the crash. Employment growth in the hidden economy, measured in half-year blocks, accelerated throughout the period at both small companies and large. And notice that, despite all the problems associated with the companies on the New York Stock Exchange and the Fortune 500 (the latter group laid off 300,000 people net in 1987), the larger companies in the hidden economy steadily narrowed the gap with smaller firms in terms of employment growth throughout the period. In short, the hidden economy behaved as though the crash never occurred -- or, more accurately, it behaved almost as if it thrived on the crash.

This "thriving" is important to explore. It appears that the difficulties of the very large companies sitting at the top of any industry serve to stimulate growth at lower levels of the industry -- exactly the opposite of what you might expect. When the big companies have trouble fighting foreign competition or keeping pace with rapid product innovation, their very difficulties create a vacuum into which a lot of smaller enterprises rush. Conversely, when the large businesses do well, they are an awesome force to compete against, and smaller companies are held at bay.

Thus we have the paradox that stable or declining industries (such as steel, textiles, or paper) tend to engender large concentrations of rapidly growing companies. Successful industries (such as credit cards, hotels, or parcel delivery), dominated by large companies, offer less of a chance for newer, smaller competitors to enter and grow rapidly. Who wants to compete, for example, against American Express or Marriott or Federal Express? Not I.

A crash such as the one last October 19 is the crash of big companies. It is measured by the Dow Jones Industrial Average. It is dominated by the Fortune 500. In today's world, their troubles simply mean opportunity for everyone else. The fewer dollars that flow to them, the fewer people that work for them, the less space they occupy, and the smaller their market share, the more money, people, space, and market share are available to everyone else.

In a closed economy in which smaller companies depend on larger companies as customers, the decline of large businesses could indeed be serious. But we are no longer a closed economy. Smaller companies are now more likely to export than larger ones. They no longer serve large companies in the United States as their only, or even primary, market. They sell to companies of all sizes all over the world. So they are able to benefit, not suffer, from the inability of larger U.S. businesses to compete in world markets.

This behavior is found in its most extreme form in places in which large companies have suffered most. The precipitous decline of the large oil companies in Houston created a vacuum into which thousands of smaller businesses rushed. To everyone's amazement, Houston was one of the fastest-growing cities in Texas in 1987.

The large layoffs by Mack Trucks Inc. and Bethlehem Steel Corp. over the past five years have dropped unemployment in Allentown-Bethlehem, Pa., from 12.4% to 4.7%, largely by opening doors for about 1,000 rapidly growing companies, about 340 of which are in manufacturing.

Frankly, I keep waiting for the economy to slow down -- even fall on its face. The basics of demography say it should -- we are running out of eligible and qualified workers. The large businesses stagger, even during prosperity. During the 1983 to '87 boom, when the United States created 14 million jobs, the Fortune 500 dumped a net of 1.3 million workers. The crash of '87 summed it all up, in a sense, by reflecting a truer value for the companies whose fortunes the DJIA represents. And yet we prosper. We have observed a truly extraordinary event in economic history: a stock-market crash of immense proportions has stimulated the economy.

Even I underestimated the strength of the hidden economy and its capacity to quickly and efficiently prosper in the face of extreme difficulties by the "visible economy." Its strength is particularly striking when compared with the economies of most of our European counterparts. They go as their visible economy goes; they lack, to a considerable degree, a swarm of aggressive smaller companies able to pounce on every opportunity.

David L. Birch is president of Cognetics Inc., in Cambridge, Mass., and director of MIT's Program on Neighborhood and Regional Change.