With the UK economy showing further signs of weakness – although, as regular readers will know, I put relatively little weight on the Purchasing Managers’ Indices (PMIs) that often get so much attention – the need for the private sector to step up and deliver growth has never been more pressing. The problem is that, with the Government strapped for cash, the various initiatives that have been announced to stimulate and support enterprise tend to be ridiculously small-scale (or just plain laughable). The ‘silicon roundabout’ in Shoreditch is a great example: the Americans get a cluster around a large valley with around 20mn people, and we get a road traffic control with a dodgy set of pipes over an old tube station. But while the various government attempts to stimulate enterprise often leave me shaking my head, what is perhaps more surprising is the general ignorance about how entrepreneurs and SMEs actually affect growth empirically. People often rally behind a call for more start-ups and small businesses: but why? What is it they actually do?
The best way to think about this is to decompose growth over a long time period, to abstract from the cycle. Typically, economists identify a couple of important supply-side factors that generate growth: labour and capital (lazy economists lump everything into labour productivity). We can measure the number of people that are in work reasonably well, and we can come up with estimate of the number of offices, factories and computers that businesses use, and use these data to get an idea of their importance for growth.
However, labour and capital – or people and machines – typically can’t account for all of the growth that an economy sees over the long term. There’s often a bit left over, which is typically called something like total factor productivity (TFP), multifactor productivity (MFP) or the Solow residual. This ‘left over’ growth mops up the cycle, the impact of R&D, entrepreneurship, efficiency, innovation and in fact everything else going on in an economy. And it’s this bit of growth that attracts the attentions of most serious supply-side economists – unpacking TFP has been the name of the game for several decades now.
So, viewed in this manner, what impact to start-ups and entrepreneurs have on these three components of growth? In terms of capital, the answer is not much. Small businesses, measured using turnover or employment, are typically not very capital intensive – although companies with less than 50 employees account for around 35% of total turnover, they only account for about 10% of investment. The growth contribution from start-ups via the capital/investment channel is pretty small.
The story on labour is more interesting. The claim is often made that new businesses create jobs, with small businesses accounting for a little under 50% of total employment. In one client meeting last year, I was definitively told by one very rich individual that only small firms created jobs. (Note to readers: this is not true.) So are entrepreneurs the cure for an 8% unemployment rate? Sadly, probably not.
Clearly, if a new business starts then that creates at least one job (in the case of self-employment) and probably more. But the problem is that those jobs may not last. New businesses are notoriously prone to failure – of all those started in 2004, less than half were trading five years later. Admittedly the recession didn’t help here, but generally small businesses fail a lot of the time. Various studies have found that, while some small firms genuinely do generate jobs, there is an offsetting pool of small firms on the other side of the distribution where jobs are lost. Small firms generate churn in the labour market – but there is little evidence that they have more of a lasting impact on employment levels than medium or large businesses. The share of employment at SMEs has not been rising over time despite lots of start-ups in the past decade – rather, it has been broadly flat.
Instead, the really nifty thing about new businesses may well be related to TFP. A number of recent studies have started trying to unpick this catch-all lump of productivity by using various measures of things like entrepreneurship. And the evidence is pretty good – there are genuine signs that entrepreneurs boost national income via this channel, either by doing something new and different themselves or by challenging existing practices (and everyone copying them). The real gain, perhaps, is that entrepreneurs are more innovative than existing businesses, which benefits everyone. Of course, innovation can also bring great rewards for the companies that foster it, regardless of size: neither Amazon nor Apple were new or small businesses when they launched the Kindle or iPhone, but both have seen the impact on their bottom line. More entrepreneurs would definitely be a good thing – but just don’t expect it to lead to a huge fall in joblessness any time soon.