Job Creation and the Invisible Foot

This week, Atif Mian and Amir Sufi have published a Federal Reserve Bank of San Francisco Economic Letter on the sources of variation in state-level employment. Mian and Sufi, together with Kamalesh Rao, found in an earlier paper that counties with high household debt-to-income ratios before the housing bust experienced the biggest housing spending declines in the wake of the bust. This spending decline contributed to a sluggish employment recovery in the nontradable sector, i.e., retail and restaurant jobs that cater to local consumers rather than consumers in other regions or countries.

In their new paper, Mian and Sufi seek to compare the relative influence of this aggregate demand channel on job creation against the influence of regulation and government-induced uncertainty. They draw on state-level surveys of small businesses conducted by the National Federation of Independent Businesses to conclude that demand is a much bigger factor than regulation in inhibiting job creation. Michael Derby of the Wall Street Journal has a summary of their findings.

That demand is the heart of the story shouldn’t be surprising. But one problem with Mian and Sufi’s Economic Letter is that it focuses exclusively on existing business enterprises. This is perfectly understandable, as you can’t exactly survey counterfactual business enterprises. But consider the findings of John Haltiwanger, Ron Jarmin, and Javier Miranda:

Using data from the Census Bureau Business Dynamics Statistics and Longitudinal Business Database, we explore the many issues regarding the role of firm size and growth that have been at the core of this ongoing debate (such as the role of regression to the mean).  We find that the relationship between firm size and employment growth is sensitive to these issues.  However, our main finding is that once we control for firm age there is no systematic relationship between firm size and growth.  Our findings highlight the important role of business startups and young businesses in U.S. job creation. Business startups contribute substantially to both gross and net job creation.  In addition, we find an “up or out” dynamic of young firms.  These findings imply that it is critical to control for and understand the role of firm age in explaining U.S. job creation. [Emphasis added]

Tim Kane made a striking finding while working for the Kauffman Foundation:

The study reveals that, both on average and for all but seven years between 1977 and 2005, existing firms are net job destroyers, losing 1 million jobs net combined per year. By contrast, in their first year, new firms add an average of 3 million jobs.

One assumes that a higher level of aggregate demand would encourage entrepreneurship as well as job creation at existing firms, yet one wonders if regulation is more likely to inhibit job creation by business startups and young businesses than by existing firms. If this is indeed the case, government regulation and taxation policies could have a more pernicious impact than Mian and Sufi suggest. 

Ashwin Parameswaran offers a broader perspective. In a fragile economic environment, existing business enterprises are more inclined to take a defensive posture, hence cash hoarding and a general reluctance to hire:

Uncertainty can be tackled at the micro-level by maintaining reserves and slack (liquidity, retained profits) but this comes at the price of slack at the macro-level in terms of lost output and employment.Note that this is essentially a Keynesian conclusion, similar to how individually rational saving decisions can lead to collectively sub-optimal outcomes. From a systemic perspective, it is more preferable to substitute the micro-resilience with a diverse set of micro-fragilities. But how do we induce the loss of slack at firm-level? And how do we ensure that this loss of micro-resilience occurs in a sufficiently diverse manner?

We could pass tax laws that punish firms for hoarding cash, though this kind of central planning may well have negative consequences of its own. Ashwin suggests that we approach this problem differently — firms will give up “slack” only if they are forced to give up slack by competitors:

Vivek Wadhwa argues that startups are the main source of net job growth in the US economy and Mark Thomalinks to research that confirms this thesis. Even if one disagrees with this thesis, the “invisible foot” thesis argues that if the old guard is to contribute to employment, they must be forced to give up their “slack” by the strength of dynamic competition and dynamic competition is maintained by preserving conditions that encourage entry of new firms.

This is why Ashwin places such heavy emphasis on the importance of the “invisible foot,” a concept he attributes to Joseph Berliner:

The concept of the “Invisible Foot” was introduced by Joseph Berliner as a counterpoint to Adam Smith’s “Invisible Hand” to explain why innovation was so hard in the centrally planned Soviet economy: “Adam Smith taught us to think of competition as an “invisible hand” that guides production into the socially desirable channels….But if Adam Smith had taken as his point of departure not the coordinating mechanism but the innovation mechanism of capitalism, he may well have designated competition not as an invisible hand but as an invisible foot. For the effect of competition is not only to motivate profit-seeking entrepreneurs to seek yet more profit but to jolt conservative enterprises into the adoption of new technology and the search for improved processes and products. From the point of view of the static efficiency of resource allocation, the evil of monopoly is that it prevents resources from flowing into those lines of production in which their social value would be greatest. But from the point of view of innovation, the evil of monopoly is that it enables producers to enjoy high rates of profit without having to undertake the exacting and risky activities associated with technological change. A world of monopolies, socialist or capitalist, would be a world with very little technological change.” To maintain an evolvable macro-economy, the invisible foot needs to be “applied vigorously to the backsides of enterprises that would otherwise have been quite content to go on producing the same products in the same ways, and at a reasonable profit, if they could only be protected from the intrusion of competition.”

Mian and Sufi are addressing a rather crude argument about the role of regulation — that the cost of complying with regulation is burdensome for existing firms, and that this inhibits job creation. Yet existing business enterprises reflect a survivorship bias — these are the firms that have managed to survive despite the burden of regulation, occupational licensing, and much else. 

But what if regulation and government-induced uncertainty are binding Berliner’s invisible foot by raising the barriers to new firm entry? Existing business enterprises are thus shielded from competition they might have faced had these barriers been somewhat lower. Under this scenario, it seems reasonable to assume that incumbent firms would tend to hoard cash and pursue labor-saving “efficiency” innovations rather than “empowering” innovations, as this would be the surest route to raising profits. And this will generally mean sluggish job creation. Does this sound familiar?

Recently, Matt Yglesias lamented the fact that Apple doesn’t spend its profits on empowering innovations like autonomous cars. I’m sympathetic to this line of thinking. But my working thesis is that Apple won’t spend down its hoard of cash unless it absolutely has to do so in the face of stiff competition, which is why it’s so depressing that Apple bested Samsung in its recent patent lawsuits.

Reihan Salam — Reihan Salam is executive editor of National Review and a National Review Institute policy fellow.

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