Friday, May 21, 2010

Engines of Economies

By Matt
This post is from our sometime contributor Matt C.

Small businesses create jobs, and everyone knows it, right? Mainstream media outlets and wonkish blogs alike have referred to small businesses as the "engine of job creation" for the United States. Talking heads sing their praises as local leaders woo them. Even Presidents extol the virtues of these diminutive economic saviors.

But even as leaders, reporters and conventional wisdom tell us that small businesses create jobs, new research is calling that assumption into question. This oft-repeated snippet of common knowledge may not actually carry the policy-driving implications we assign it. In one way, it's true that small businesses create a lot of jobs. The implied causality, however--that being small is what makes a business better able to create jobs--might be a complete illusion.

By analogy, consider this statistic: A lot of drownings occur on days during which a lot of ice cream is sold. It's 100% true. Drownings and ice cream sales are highly correlated. But while ice cream sales is a good predictor for drownings, there's a better one: temperature. When it's hot outside, people buy ice cream and go swimming (dramatically increasing drowning chances). Not every day with a lot of ice cream consumption leads to high drownings, but it's close enough to be useful if you don't have any weather information.

Likewise, economists and policy makers have been using the size of a business as a proxy for a much more important variable in predicting job creation potential: recency of entry to a labor market. To state the driving causal relationship, we shouldn't say that small businesses create jobs, but rather, that NEW businesses create jobs. And it just so happens that most new businesses are fairly small (just as most days with a lot of ice cream sold are reasonably warm).

Many small businesses are extremely weak engines of job creation, and most of them have been around for a while. Most sole proprietorships will never employ anyone for very long, and small, stable local businesses and stores don't expand their payrolls with much effectiveness. The small businesses which are best at creating jobs are the ones on their way to become large businesses; they don't stay small for decades. It's time to admit that the fifty year old corner store is not the engine of job creation for the country. It's Sergey and Larry, not Mom and Pop.

The age of the business is a better metric than size, but an even better indicator of hiring potential is the time a business has been in a particular labor market. A multinational conglomerate entering a new market can be an extremely powerful force for job creation. It's not discussed as widely and the impact of small businesses, but a one hundred year old company opening up a new plant or a new market is likely to create more jobs than entire towns full of small businesses.

Fine-tuning the metrics we use as predictors of job creation potential can help fine tune the "engine of job creation" so lauded in the press. Policy makers focusing incentives on new businesses instead of small businesses will be able to spend more wisely. Targeting small businesses in a major city can give hundreds of millions of dollars in tax breaks to some of the organizations least likely to create new jobs. But targeting new businesses only would be a more precise scalpel.

When Philadelphia looks to encourage economic growth, leaders should pay attention to all the research available on job creation. By eliminating business size as a criterion, we avoid repeating mistakes which have taken money out of public coffers in favor of independent consultants and small law firms whose personnel tend to be well off and stable in number. Alternative strategies haven't worked either; efforts to give job creation incentives by targeting new real estate developments usually accomplishes more job movement than creation (while leaving a lot of empty office space). New entrants to the job market are much more likely to respond to incentives, and policy makers should target them accordingly.

It's time to rethink our approach to economic incentives, and restructure our notions of the engine behind American job creation. We have to disassociate our yearning for the idyllic quiet American main street lined with shops and businesses from our economic policy. Recovery isn't going to found in small town storefronts, but rather in garages, basements, and yes, the board rooms of expanding multinational conglomerates. It's time to reform the refrain. Let's get used to saying, "New businesses are the engine of job creation in the United States."

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