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A Nation of Startups

By / 4.8.2010

A distinct sense of unease permeates the traditional spirit of American optimism. The unemployment rate appears stuck at 9.7 percent, and many project that it will fall to around only eight percent by 2012 and to perhaps five percent by the middle of the decade. Disquiet over jobs is joined by a vague fear that the U.S. has lost its edge in innovation: our companies are losing ground to emerging market competitors and our students are falling behind their peers in other countries. In a recent post, Michael Mandel put these two concerns together, saying our jobs crisis is simultaneously an innovation crisis.

In response, a common impulse in Washington has been to call on the federal government to somehow solve both problems together, whether by creating “green” jobs, directing more money into research and development, or, most distressingly, provoking a trade war with China. Yet the real solution to both crises — the way to create more jobs and innovation — is right in front of us: startups. As New York Times columnist Thomas Friedman wrote recently: “Good-paying jobs don’t come from bailouts. They come from startups.”

Americans start new companies at one of the highest rates in the world, a pace that has been consistent for nearly 30 years. This steady stream of new companies was responsible for nearly all net job creation over that period of time, and many of those startups introduced new innovations into the economy, whether personal computers (Apple), productivity-enhancing software (Microsoft), 24-hour news (CNN), biotechnology (Genentech) or web browsers (Netscape).

The empirical evidence on the importance of startups is compelling, but not everyone is buying it. Responding to Friedman, for example, Dean Baker wrote:

Friedman’s conclusion about the special importance of new firms is utter nonsense. The claim that most net new jobs came from new firms conceals the fact that existing firms added tens of millions of jobs in this 25-year-period. Of course existing firms also lost tens of millions of jobs. We can say that the net job creation for existing firms was zero, but if we did not have an environment that was conducive for the job adders to grow (how many jobs did Microsoft, Apple, and Intel create after their first 5 years of existence?), then existing firms would have lost tens of millions more jobs.

There are basically two ways to look at job creation in the economy: gross and net. Large existing companies hire thousands of people each year, but they also see thousands of people leave. Gross job inflows and outflows in the American economy are enormous, an indicator of the ongoing reallocation of resources that drives economic growth. At the end of the day, however, if we want to keep pace with an expanding labor force (new entrants) and a changing economy (the rise and fall of sectors and companies), what matters is net job creation. It would be little consolation if we had 100 people looking for jobs, and large company ABC hired those 100 people but also fired 100 different people.

Many people prefer the (ostensible) comfort of big, established companies to the unpredictability of startups. Sure enough, while new companies create thousands of jobs each year, they also destroy thousands of jobs, whether through their effect on existing firms or through failure. (Roughly a third of new firms close in their first two years.) But these firms are important, too, in that they provide one of the few sources for big companies to draw on in adding jobs: in many cases a big company can only add net jobs by acquiring a new firm.

In addition to jobs, startups are an important source of innovation for the economy, responsible for a disproportionate share of breakthroughs. Big companies inevitably become locked into a cycle of quarterly earnings and long-term investments, leaving little room to pursue fringe ideas. Startups have the freedom to explore ideas at the frontier and succeed (or fail) in commercializing them.

This is not to say that large, established companies are unimportant. Far from it — the U.S. economy derives important strength from the symbiosis between startups and big firms. But if policy drifts too far in protecting big companies (whether through bailouts or certain types of regulation), it could suppress the number of startups. Just as importantly, should policymakers choose to focus on promoting entrepreneurship, it’s not clear that we can pick and choose certain sectors. The high-technology companies mentioned above garner much of the attention, but we see plenty of new firms emerge from seemingly mundane sectors such as retail and restaurants. We should reserve judgment on the types of startups we wish to see: every new company represents a source of renewal for the economy.

None of this means that startups represent the saving grace of the American economy; there is no silver bullet solution, to be sure. But, just as plainly, economic recovery will not happen without them. To begin creating our economic future, we need to start more new companies.

Photo credit: http://www.flickr.com/photos/philgyford/ / CC BY-NC-ND 2.0