The Slowdown in Reallocation in the U.S.

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One of the components of productivity growth is reallocation. From one perspective, we can think about the reallocation of homogenous factors (labor, capital) from low-productivity firms to high-productivity firms, which includes low-productivity firms going out of business, and new firms getting started. A different perspective is to look more closely at the shuffling of heterogenous workers between (relatively) homogenous firms, with the idea being that workers may be more productive in one particular environment than in another (i.e. we want people good at doctoring to be doctors, not lawyers). Regardless of how exactly we think about reallocation, the more rapidly that we can shuffle factors into more productive uses, the better for aggregate productivity, and the higher will be GDP. However, evidence suggests that both types of reallocation have slowed down recently.

Foster, Grim, and Haltiwanger have a recent NBER working paper on the “cleansing effect of recessions”. This is the idea that in recessions, businesses fail. But it’s the really crappy, low-productivity businesses that fail, so we come out of the recession with higher productivity. The authors document that in recessions prior to the Great Recession, downturns tend to be “cleansing”. Job destruction rates rise appreciably, but job creation rates remain about the same. Unemployment occurs because it takes some time for those people whose jobs were destroyed to find newly created jobs. But the reallocation implied by this churn enhances productivity – workers are leaving low productivity jobs (generally) and then getting high productivity jobs (generally).

But the Great Recession was different. In the GR, job destruction rose by a little, but much less than in prior recessions. Job creation in the GR fell demonstrably, much more than in prior recessions. So again, we have unemployment as the people who have jobs destroyed are not able to pick up newly created jobs. But because of the pattern to job creation and destruction, there is little of the positive reallocation going on. People are not losing low productivity jobs, becoming unemployed, and then getting high productivity jobs. People are staying in low productivity jobs, and new high productivity jobs are not being created. So the GR is not “cleansing”. It is, in some ways, “sullying”. The GR is pinning people into *low* productivity jobs.

This holds for firm-level reallocation well. In recessions prior to the GR, low productivity firms tended to exit, and high productivity firms tended to grow in size. So again, we had productivity-enhancing recessions. But again, the GR is different. In the GR, the rate of firm exit for low productivity firms did not go up, and the growth rate of high-productivity firms did not rise. The GR is not “cleansing” on this metric either.

Why is the GR so different? The authors don’t offer an explanation, as their paper is just about documenting these changes. Perhaps the key is that a financial crash has distinctly different effects than a normal recession. A lack of financing means that new firms cannot start, and job creation falls, leading to lower reallocation effects. A “normal” recession doesn’t involve as sharp a contraction in financing, so new firms can take advantage of others going out of business to get themselves going. Just an idea, I have no evidence to back that up.

[An aside: For the record, there is no reason that we need to have a recession for this kind of reallocation to occur. Why don’t these crappy, low-productivity firms go out of business when unemployment is low? Why doesn’t the market identify these crappy firms and compete them out of business? So don’t take Foster, Grim, and Haltiwanger’s work as some kind of evidence that we “need” recessions. What we “need” is an efficient way to reallocate factors to high productivity firms without having to make those factors idle (i.e. unemployed) for extended periods of time in between.]

In a related piece of work Davis and Haltiwanger have a new NBER working paper that discusses changes in workers reallocations over the last few decades. They look at the rate at which workers turn over between jobs, and find that in general this rate has declined since 1980 to today. Some of this may be structural, in the sense that as the age structure and education breakdown of the workforce changes, there will be changes in reallocation rates. In general, reallocation rates go down as people age. 19-24 year olds cycle between jobs way faster than 55-65 year olds. Reallocation rates are also higher among high-school graduates than among college graduates. So as the workforce has aged and gotten more educated from 1980 to today, we’d expect some decline in job reallocation rates.

But what Davis and Haltiwanger find is that even after you account for these forces, reallocation rates for workers are declining. No matter which sub-group you look at (e.g. 25-40 year old women with college degrees) you find that reallocation rates are falling over time. So workers are flipping between jobs *less* today than they did in the early 1980s. Which is probably somewhat surprising, as my guess is that most people feel like jobs are more fleeting in duration these days, due to declines in unionization, etc.. etc..

The worry that Davis and Haltiwanger raise is that lower rates of reallocation lower productivity growth, as mentioned at the beginning of this post. So what has caused this decline in reallocation rates across jobs (or across firms as the first paper described)? From a pure accounting perspective, Davis and Haltiwanger gives us several explanations. First, reallocation rates within the Retail sector have declined, and since Retail started out with one of the highest rates of reallocation, this drags down the average for the economy. Second, more workers tend to be with older firms, which have less turnover than young firms. Last, the above-mentioned shift towards an older workforce that tends to shift jobs less than younger workers.

Fine, but what is the underlying explanation? Davis and Haltiwanger offer several possibilities. One is increased occupational licensing. In the 1950s, only about 5 % of workers needed a government (state or federal) license to do their job. In 2008, that is now 29%. So it can be incredibly hard to reallocate to a new job or sector of work if you have to fulfill some kind of licensing requirement (which could involve up to 2000 hours of training along with fees). Second is a decreased ability of firms to fire-at-will. Starting in the 1980s there were a series of court decisions that made it harder for firms to just fire someone, which makes it both less likely for people to leave jobs, and less likely for firms to hire new people. Both act to lower reallocation between jobs. Third is employer-provided health insurance, which generates some kind of “job lock” where people are unwilling to move jobs because they don’t want to lose, or create a gap in, coverage.

Last is the information revolution which may have had perverse effects on reallocation. We might expect that IT allows more efficient reallocation as people can look for jobs more easily (e.g., LinkedIn) and firms can cast a wider net for applicants. But IT also allows firms to screen much more effectively, as they have access to credit reports, criminal records, and the like, that would have been prohibitive to acquire in the past.

So we appear to have, on two fronts, declining dynamic reallocation in the U.S. This certainly contributes to a slowdown in productivity growth, and may perhaps be a better explanation than “running out of ideas from the IT revolution” that Gordon and Fernald talk about. The big worry is that, if it is regulation-creep, as Davis and Haltiwanger suspect, we don’t know if or when the slowdown in reallocation would end.

In summary, reading John Haltiwanger papers can make you have a bad day.

Economic Dynamism and Productivity Growth

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There’s a paper out in the latest Journal of Economic Perspectives by Decker, Haltiwanger, Jarmin, and Miranda (DHJM) on “The Role of Entrepreneurship in US Job Creation and Economic Dynamism“. They document, in more detail than an earlier Brookings report I talked about recently, that the proportion of firms that are “young” has declined over the last 30 years.

DHJM use the number of young firms – those less than 5 years old – as a proxy for entrepreneurship. And therefore the conclusion is that entrepreneurship has declined over the last 30 years. You can see this in their figure 4, below. In 1982, for example, roughly 50 percent of all firms were less than 5 years old, while by 2011 only about 35 percent of firms were under 5 years old. Similarly, the share of total employment in young firms fell from about 18 percent in 1982 to about 13 percent in 2011.

DHJM 2014 Figure 4

Perhaps most important, the share of job creation from young firms has declined over the same period. In the early 1980’s, young firms were responsible for about 40 percent of all new jobs, while by 2011 this was down to about 33 percent. In sum, there are fewer young firms, they employ fewer people, and they create fewer jobs today than they did 30 years ago.

Where is this decline coming from? DHJM show in their figure 5 that for manufacturing, the share of employment in young firms has declined very slightly over the same period, and was never very large to begin with. In contrast, in the service sector the proportion of jobs in young firms was over 25 percent in 1982, and now is around 15 percent. The shift of economic activity from manufacturing to service firms both raised the share of employment in young firms (because of the higher rate in services) and lowered the share of employment in young firms (because of the downward trend within services). On net, the downward trent in services won out, and overall the proportion of jobs in young firms has dropped.

DHJM 2014 Figure 5

There’s nothing to dispute in these numbers, and I don’t think DHJM have done anything to misrepresent what is going on. But the big question is: did this decline in the proportion of young firms lower productivity growth? The short answer is, I don’t see any evidence that it did. [Update 8/1/14: Just to be clear, DHJM are not claiming that it does lower productivity growth. This is a question I have given their data.]

Consider the figure from Fernald’s (2014) recent paper on productivity. It shows the trend of labor productivity from the late 70’s until today. There is no secular slowdown in productivity growth between 1982 and 2011. Productivity growth from 2003-2011 is just as fast as it was in the pre-1995 period. As Fernald points out, 1995-2003 is an outlier, probably associated with the IT revolution. Therefore, if the decline in the number of young firms is bad for productivity, it hasn’t been so bad that it shows up in any aggregate numbers over the last 30 years.

Fernald 2014 Figure 3

So what does the decline in young firms mean? One plausible explanation is mentioned by DHJM, which is the advance of “big box” or national stores relative to mom-and-pop operations. In 1982, if you saw a niche for a coffee shop in your town, you would open up a coffee shop. Now, a Starbucks was there three years ago. National retailers have gotten very good at identifying lucrative retail locations, and are able to move more quickly than individuals.

Note that this doesn’t imply that national retailers are any more productive than mom-and-pop stores (although they do pay higher wages than small retail establishments). If they were, then we should have seen some kind of long-run boost to productivity from 1982-2011. We don’t. My guess is that it just means national retailers have a distinct advantage in identifying and opening lucrative retail locations compared to individuals.

Of course, it could be that the loss of productivity from the drop in young firms is offset almost perfectly by the increase in productivity from having national firms more readily identify and take advantage of new retail opportunities. If so, okay. From a productivity standpoint, though, it’s a wash, and does not necessarily have any implications for future productivity growth.

DHJM 2014 Figure 3

Does it imply anything about employment? Well, as DHJM document in their figure 3, there has been a decline in the job creation and job destruction rates from 1980-2011 (don’t get too worked up about the big dip in the trend line for job creation – HP filters are sensitive to the end points you use). Both rates are declining, meaning that there is less worker churn in the economy, which is consistent with less churn in firms, which is what fewer young firms implies. Again, note that the trend of decline in job creation and destruction occurs over the 80’s, 90’s, and 2000’s consistently, which covers periods in which the employment to population ratio rose pretty consistently before leveling off in the last decade.

The fact that the proportion of young firms in the U.S. is declining doesn’t seem to be anything to get worked up about, and it doesn’t imply that U.S. productivity or employment are doomed to stagnate in the future. If there is some “optimal” amount of young firms to have, we have no idea what it is, and we could as easily be over that amount as under it. For now, I’m mentally filing the decline in young firms alongside the secular shift away from manufacturing and towards services. It’s one of those structural changes that occur as economies grow. But evidence from either (a) longer time periods in the U.S., or (b) across countries, could easily change my mind.

Declining U.S. Dynamism?

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There’s a research report from Brookings that’s making it’s way around the inter-tubes. The title is “Declining Business Dynamism in the Untied States“, by Ian Hathaway and Robert Litan. The upshot is that business dynamism is declining. The firm entry rate (i.e. the number of firms less than one year old as a proportion of all firms) was about 15% in 1978, was about 11% in 2006, and is currently less than 8%. This trend is taken as a troubling sign of reduced dynamism. What dynamism exactly is supposed to mean isn’t clear, but on the assumption that it is synonymous with firm entry, then it is declining. There is some hand-waving about how this portends lower growth in the future.

But it isn’t immediately obvious that the declining rate of entry is a problem. I’m suspect that this is a measure that seems like it would be better if it went up, but that isn’t necessarily true. Imagine if the entry rate went to 100%; would it be good that literally every firm in the U.S. was less than 1 year old?

Their appendix figure A1 shows the actual number of firm entries per year. This held at roughly 500,000 new firms per year from 1978 to 2007, and then there is a deep plunge to 400,000 by 2010 before recovering slightly in 2011. So it is not that the U.S. is coming up with fewer new companies. Even in the midst of the worst economic downturn since the Great Depression (or 1981 depending on what rows your boat) the U.S. added 400,000 new companies. At the same time, the absolute number of exits has increased from about 300,000 a year in the early 1980’s to about 450,000 over the last few years. Because we have more firms now (remember all those entries?), this means the exit rate has held steady at about 9% of firms exiting each year.

So, does this imply some kind of loss of dynamism in the U.S. economy? As I said, it’s not obvious. One of the things I think is a pretty robust empirical fact is that productivity (labor productivity or total factor productivity) varies by a lot across firms in the U.S. and other countries (see Syverson, 2011). The stylized fact I have in my head is that the 90th percentile manufacturing firm in the U.S. is roughly 2 times more productive than the 10th percentile firm. A large portion of productivity growth comes from reallocation of inputs from low-productivity firms to high-productivity firms. Some of this reallocation takes place by having low-productivity firms exit and having high-productivity firms enter. But I don’t know that the research is conclusive that entry is the primary source of this reallocation – shifting inputs to existing high-productivity firms is a big part of productivity gains.

Foster, Haltiwanger, and Syverson (2008) is one of the best studies I know of these reallocation effects because they are able to distinguish physical productivity (number of widgets produced) from revenue productivity (number of dollars produced). What they find is that entry alone accounts for 14% of revenue productivity growth from 1977 to 1997. Entry accounts for 24% of physical productivity growth in the same period. A sizeable portion, but reallocation between existing firms and productivity growth within existing firms account for the remaining productivity growth observed.

However, FHS are looking only at very specific industries: coffee, boxes, bread, gasoline, sugar, plywood, and a few others. Basically, industries with very homogenous outputs that can be measured easily (e.g. gallons of gasoline). Their results may under- or over-state the true effect of entry on overall productivity growth in the U.S.. As they note, though, their study actually shows much higher effects of entry on productivity than prior work because of their separate data on revenue physical productivity. Their firms also have entry and exit rates (22% and 19%, respectively) well above the average for the U.S. as a whole, and if entry is very important for dynamism, then shouldn’t these industries show the strongest possible role of entry?

Even if entry does account for a sizeable portion of productivity growth, the Brookings report isn’t saying that entry has fallen to zero. If the entry and exit rate flatten out at, say, 9% each, then this means that every year 9% of all firms go out of business, and that number is exactly replaced by a entirely new group of firms. The total number of firms will remain constant, but each firm would have an average lifespan of about 11-12 years. Do we care if the total number of firms stays constant, so long as there is turnover?

There isn’t any reason to believe that a growing number of firms is necessarily good, especially as we move more and more to producing goods and services that scale easily. To be more clear, it makes sense to believe that the number of cement firms or bakeries increases proportionately with population, as these goods don’t transport well and so meeting demand requires new locations (and possibly new firms). But just because we have more people doesn’t mean we need another Microsoft (you could argue we don’t need the one we have already). So the fact that the growth rate of the number of firms is slowing down doesn’t necessarily bother me. It may just indicate a change in the nature of products we produce, or represent better screening by lenders/backers/VC firms.

I could of course be horribly wrong, and we’ll all be living in the woods in three years. I, at this point, am not planning on buying extra canned goods.