Saturday, March 31, 2012

Austerity, growth and responsability in Europe

Andre Velasco, Chile finance minister from 2006 to 2010 and now at Harvard University, has written one of most elegant and well written texts I have read about the present economic crisis, posted by Project Syndicated. Only the title is not so clear: "Austerity according to St. Augustine".
He begins with the usual narrative from the "guardians of austerity", that sounds good, but it is not true:
  • When some economists spoke of panic and confidence crises, they meant their own. Bailout funds and Eurobonds were an invitation to moral hazard. Throwing money at the problem turned out to be unnecessary. Europe’s problem was an old-fashioned one: too much spending. Now that technocrats have replaced populists in the eurozone’s Mediterranean members, sustained fiscal austerity will get us out of trouble.
Velasco puts it right, how it happened:
  • A country with a large public debt (say, more than 50% of GDP) is safe if everyone thinks the debt will be serviced; the interest rate charged on the debt remains low, and the country can indeed pay it, following a path of virtuous self-fulfilling expectations. But everything changes if markets come to doubt that the debt will be repaid; then the interest rate demanded by investors can rise so high that the country cannot pay. Default follows, owing to a vicious self-fulfilling panic.
Disaster stroke with the combination of Greece problems and Germany hard attitude in the beginning of Greece crisis: make privates pay (the "haircut") because we (the German people) will not pay the bills for Europe cohesion. That was the moment when markets understood that euro was faulty designed and that euro rating, based on German solid financial position, was prone to attacks - which of course has followed. The short sighted view of european leadership nearly have created the collapse of the euro system, with consequences everywhere:
  • If European leaders had deployed a rescue fund endowed with overwhelming financial force in early 2010, Europe and the world would have been spared two years of agony. In the end, it was the ECB that stepped into the breach, drowning eurozone banks with liquidity to make sure that they purchased every government bond that moved – and then some. 
This seems now to have stopped the speculative attacks. But anyway excessive debt must be removed:
  • So the speculative attacks were stopped, at least temporarily (though interest-rate spreads in Spain and elsewhere have begun to creep up again). That was the first task. But there remains a second one, and here the guardians of austerity are getting it wrong again. ... To prevent a repeat of the last two years, they must reduce their public debt dramatically. ... The question is how. In Greece, debt forgiveness was the only answer. Some has been accomplished; more will be necessary down the road. For the rest of Europe, massive upfront austerity of the kind advocated by German Chancellor Angela Merkel – and supported by the prevailing German orthodoxy – will not do the trick.
The solution:
  • Up-front gradualism must be the name of the game. And adjustment must be wedded to a growth strategy. Revenue will grow consistently only if the tax base – that is, the economy – grows. And that growth requires higher public investment in infrastructure and human capital. The guardians of orthodoxy are not about to put forward such a growth strategy. Will anyone else? 
I am afraid one day responsabiities for the insane management of Europe may be asked. A weak leadership at the Comission and wrong policies by leading countires are mining the european foundations. Barroso is very far from being Delors, and Delors has been very clear and vocal about what he thinks about the this. Remember Barroso suggestions about Eurobonds or similar financial instruments? Nein.

Brad DeLong and Lawrence Summers have made recently a communication to Brookings Institute that gives a strong theoretical support to growth policies in depressed situations. In their draft paper ("Fiscal policy in a depressed economy", available here) they conclude that
  • policies of deficit reduction in the presence of substantial output shortfalls will have adverse impacts in both the short and long run, and may even exacerbate creditworthiness problems.
  • We argue that, while the conventional wisdom rejecting discretionary fiscal policy is appropriate in normal times, discretionary fiscal policy where there is room to pursue it has a major role to play in the context of severe downturns that take place in the aftermath of financial crises.
The major message of their paper:
  • A combination of low real U.S. Treasury borrowing rates, positive fiscal multiplier effects, and modest hysteresis effects is sufficient to render fiscal expansion self-financing. 
(Italics our responsability).

(Update: see Martin Wolf post in his FT blog, about DeLong and Summers paper, 20 april 2012:
  • This is an important paper. It challenges complacent “do-nothingism” of policymakers, let alone the “austerians” who dominate policy almost everywhere. Policy-makers have allowed a huge financial crisis to impose a permanent blight on economies, with devastating social effects.)

Thursday, March 29, 2012

Manufacturing of wood products: R&D in Sweden and Portugal

OECD C19 industry code includes manufacturing of wood and cork products. Furniture manufacturing is basically included there. But this code does not include wood pulp, paper and paper products (code C21). Under OECD classification, this is a very low tech industry - although one of the most innovative and successful companies selling wood products with high design content (IKEA) strongly depends on wood industries suppliers (C20). And IKEA group, headquartered in Sweden, itself includes highly competitive and innovative industrial operations manufacturing wood products (Swedwood, for instance).
Wood and furniture industries are classical case of “traditional” industries, considered low tech manufactures by OECD and Eurostat / EU, where policies suggest that countries should not give incentives to these “traditional and low tech industries” - although most of the economic value added and employment is generated by these industries.
Let´s have a look at some numbers about total R&D intensity statistics in five countries: Germany and Sweden, Portugal and Spain, and United States (
(source: OECD.StatExtracts, STAN indicators).
First, let’s consider all manufacturing industries (first figure). R&D intensity of manufacturing in Sweden (around 12%) in higher that USA  (around 10%) and Germany ones (8%). Portugal and Spain are at lower level: 3% for Spain and 1% for Portugal. We will not discuss here the reasons for such large gaps between the iberian countries and the other three. But different structure of manufacturing explain an important part of the variation (see this post).

Second figure isolates the case of Sweden and shows how important is the gap between the curves of all manufacturing and wood products manufacturers. R&D intensity in one of the most advanced countries in manufacturing of wood products, home of the most innovative wood furniture and related products company in the world, is much smaller than the aggregated intensity of all manufacturing sectors in the same country.

Next, consider the R&D intensity of wood /furniture industries (C20 code, third figure). The interesting point here is that variation across countries is very small. Overlapping is the main message. Yes, R&D intensity in Sweden used to be larger than in Spain, but Spain intensity during last years improved and it is now larger than Germany - and Sweden. Portugal is the middle. 

Anyway, the order of magnitude of the differences between R&D intensity between wood industries across countries is much, much smaller than between manufacturing across the same countries. With some ups and downs, R&D intensity in wood products manufacturing is less than 1% for all the five countries. If Portugal intensity in overall manufacturing was clearly lower than Sweden, Germany and USA, its intensity in manufacturing of wood products is clearly at the same level of the other four countries.
The conclusion: when we consider a sector like manufacturing of wood products, portuguese companies have the same level of R&D intensity that the equivalent companies in the most advanced industrial countries - including Sweden. Of course this tells a lot about the usual popular idea that “portuguese companies do not invest in R&D”, and how biased it may be.

The ratio between R&D intensity of wood products manufacturing and all manufacturers is around 0.1 for most of the cases (now around 0.2 for Sweden). R&D intensity for aggregated manufacturing is between 5 to 10 times larger. But not for Portugal: see last figure. Even ignoring the years 1998, 99 and 2000, the ratio is around 0.5 for Portugal. This looks strange and to be more than statistical noise.

Sunday, March 25, 2012

Competition and change (innovation): the inverted U relationship

We have been arguing that innovation ("profitable change") is the economic result of competition in the market. Innovation is a consequence, not a driver. The drivers are competition, survival and profiting. And the "innovation machine" that drives the capitalist model is based on the concepts of free market, including rule of law.
There are relationships between competition and innovation - but they are non linear and not straightforward.
Too little competition and incentives for innovation are low, stiffing economic change and growth. Monopolies may like it, but society does not. "Anti trust" laws in USA find here their origin and justification. Competition avoidance or exclusion have a negative social value and competition policy should help society to avoid them. Soviet Union collapse is usually related with lack of innovation, consequence of lack of competition and too much protected (non competitive) state enterprises under central planning.
But too much competition may be also harmful. An inverted U relationship between competition and innovation has been recognized. Too much competition can have adverse effects in innovation: if substitution of existing products (process)  by new products (process) is too fast, economic depreciation may be insufficient, and it is impossible to restore the initial investment capital. Too much competition can be a negative incentive for innovators because opportunities to profit (at the individual and social level) mat be too weak to justify a sufficient incentive to the risk of innovation . An highly competitive market also tends to be too much fragmented and volatile: small companies have less resources to invest in innovation risks, and a small companies economy (like Portugal) can not afford the full needs of high intensity innovation activities.

We may argue that China case during last thirty years may suggest that "jungle" competition (intense competition within a market without a strong safety net based on rule of law) seems to have had a dramatic impact in economic growth, under the existing conditions: China may be a unique case in the history of development economics - decades of continuous high growth rate (often in the two digits range - see figure fir annual growth rate of China and USA from 1970). Until one day - nobody knows when and how. Soft or hard landing?. This is one question I have been following for last ten or fifteen years. (See here for a good update by Harvard professor Jeffrey Frankel). Advanced, or mature, economies have a common policy: to control and to limit "jungle" competition through legal regulation of the markets (rule of law, at the institutional and property levels.
The balance between  "too little" versus "too much" competition policies seems to be a very tricky one. It seems to be path dependent and also dependent on the stage of development of each case.
William Baumol made a strong case for innovation as a engine of capitalism economic growth. But the social value of innovation may be difficult to evaluate against the individual value of innovation (for the innovator). The social value of competition, through change of process and products (innovation),  may create difficult problems in competition policy.

Friday, March 16, 2012

Why are Portuguese firms shrinking?

Serguey Braguinsky and Lee Branstetter are from Carnegie Mellon University. Andre Regateiro is portuguese, from IST, working with both of them in the School of Public Policy and Management, under the Carnegie Mellon Portugal Program. Together they have published last year an elegant paper with a strong title: “The incredible shrinking portuguese firm” (2011), in the prestigious NBER working paper series. It is an outcome of the CMU Portugal program, involving both international scholars in the analysis of portuguese problems, and portuguese PhD students in top research teams. And the paper has been cited in The Economist (3 March 2012). Definitely this is good.
The authors claim that Portugal firm size distribution shows a pronounced shift for the left, at least during last two decades. They claim this shift not to exist in other advanced industrial countries, and that it cannot be fully ascribed to expanding data coverage or other “natural causes” (like the shift from industry to services along the same period of time). They believe this is a Portugal unusual and distinctive shift, and they claim to be the first paper to document “this surprising change”. And they also claim that it reflects the unusual and distinctive labor market regime in Portugal, that shrinks firms and lowers aggregate productivity of the economy.
Well - we may have some problems.
First, the so called “unique” (and “incredible”) portuguese shrinking firm does not seem to be so unique (and not so incredible). See, for instance, our previous post about Choi and Spletzer (2010). Braguinsky et al (2011) do not cite this paper - although Chou and Spletzer do cite them (in a subtle footnote). So the shrinking firm does not seem to be so specific to Portugal: during last decade, it happened both in Portugal and US - and may be also in other countries. In next figure we plot data from both papers during last decade: size of firms index, rebased to 2001=100. 
Portugal declive is more pronounced than US one.

But Braguinsky et al do not control for age of the firms. No age cohorts have been extracted from the data (although that may be feasible). We have seen before (here and here) how important this is and how misleading it can be to ignore them. Are the companies smaller and smaller because they start smaller and / or they grow less and less?
Second, Braguinsky et al paper argues that the reason for smaller firms is due to restrictive regulations of labor market, a negative incentive to growth of portuguese firms. They show that a “shift to the left” in size distribution is compatible with the impact of legal thresholds of firm size on their analytical models. So their hypothesis has not been refuted - what, of course, does not means it is true (remember Karl Popper).

The authors present a list of laws supporting small firms (and, consequently, assumed to be disincentives for large firms). But it seems the list (annex B of their paper) only includes entries in the regulation, from 1983 to 2005, not exits. Some of the laws cited have meanwhile been revoked along the period, or they have been superseded.
The minimum we can say is that the authors have ignored, or discarded, other possible reasons for the shift, without any justification. For instance, the technology hypothesis previously advanced by Chou and Spletzer (2010) for the US economy.
We have our own "grounded" ideas about the impact of labor restrictions on growth of firms in Portugal. I have around twenty five years of “field experience” in top management of companies in Portugal, from small to medium and to very large manufacturing firms listed in stock market, exactly during the period of time of this analysis. I agree that labor laws do indeed condition the operational flexibility of firms in Portugal, but in practice they are more onerous and difficult for small companies than to large companies. Labor regulations probably make an important contribution to early mortality of small companies. But I do not feel, based on my personal experience of management in different types of firms, that labor regulations have been the main obstacle to growth of firms in Portugal during that period of time. Problems of financing, yes, very probably. Geography, far from large consumer markets, it may also be (in some cases). What my experience tells me is that easy access to financing and lack of non banking sources of financing (venture capital, business angels, large capital markets), or difficult access to them, may be a much more more important reason “not to grow” (and probably to die earlier).
The “up or out” model of Haltiwanger et al (1910) can be useful if applied here. The technology reasons for the shrinking firm could be very credible indeed. We can easily construct a narrative, parallel to the legal one suggested by Braguinsky et al in their annex B, about the “incredible” update of technologies used by portugueses business firms during last decades, after Portugal joined the European Union (1986). Several generations of programs of european funds (from PEDIP to QREN) helped an huge renew and update of technologies and business infrastructures, especially in manufacturing firms. Sure, this did not go without consequences.
Labor restrictions hypothesis can be very attractive inn the actual political climate. And the authors explicitly recognize this when they say that “given the difficult choices facing Portugal’s new government, the message of this paper may prove to be a timely one”. This statement is a surprising one in an academic paper. Of course, ultra liberal politicians will be very happy to claim that it is now “scientifically proved” that labor laws are the reason for portuguese lower productivity. But Braguinsky et al have not proved it - they have claimed it and suggested theoretical considerations to support a similar shrinking effect due to labor regulations.

By the way, is it reasonable to apply Braguinsky et al claim to USA, and to claim restrictive labor regulations during last decade, dominated by Bush rightist policies, to explain the shrinking american firm? I do not think so.
Without controlling for age cohorts and considering alternative sources to explain the variation in the data, their paper may be elegant, but it is far from convincing.

To be fair, full data plot (see next figure) shows different medium term trends in Portugal and USA, suggesting different mechanisms may be involved in the variation of the size of firms in different periods of time.

Thursday, March 15, 2012

From young to mature: up or out.

Age cohorts are fundamental to understand dynamic behaviour in business demography, we discussed in previous post. A paper by Haltiwanger, Jarmin and Miranda (2010), published as a NBER working paper ("Who creates jobs? Small vs. large vs. young"), deals with the old controversy of job creation by small versus old firms. Their main finding is that once we control for firm age (through age cohorts), there is no systematic relationship between firm size and growth. Controlling for age had a dramatic impact on the analysis.
The high importance of small firms in job creation is a very popular and “politically correct idea” between policy makers. But once again it is misleading.
Haltiwanger and colleagues used a large set of data, from 1976 to 2005 (equivalent to 70 million firm-year observations) and they show that small companies are not the job creators. However start-ups, new entries, make important contributions to job creation - and indeed also to job destruction during their (usually) short life. But net job creation by start ups makes a significant contribution to net employment.
Typically a new entry (start up) begins small and grows. This paper gives evidence for a “up and out” dynamic of young firms: new firms begin small, and they grow or they disappear (exit).  They either grow fast or they disappear. But in manufacturing sectors the exit pattern during early stages is much stronger.
From young to mature, along time (age), usually firms go from small to larger - may be medium size and, in some (rare) cases, they become very large corporations.
In early stages, firms are small and they have small, incremental, effects on job creation and destruction. But lots of them can create a sizable effect. While they are small, even small absolute changes in size can give high relative rates of change. Usually they are financially weak and dependent of external sources of funds (venture capital, equity). They often have an high R&D intensity, but their share of total R&D activities is marginal.
Later, in the mature phase, if they survive, firms are larger, their relative rates of change are smaller, but their share of total employment is larger, their contribution for job destruction is also larger when they collapse, and they make substantial contributions to R&D activities (even if their R&D intensity is smaller).
It is easy to chart these important changes in business behavior as firms go from young / small to mature / large. But starting point also influences firm behavior (path dependency): technologies used and related operational / organizational aspects are different for a start up today and for a start up, in a similar business and environment, twenty years ago (for instance).
Mortality is high for small firms, including start ups in early stages: a robust finding from the authors is that small firms are more likely to exit than large firms, even controlling for age.
Business start ups have a small contribution for total employment in any given year: roughly 3%. But these new jobs become significant in the overall net changes in employment, from job creation and destruction. They account for almost 20% of gross job creation.

Young firms exhibit high rates of job creation and destruction. They have very high job destruction rates from exit (closing of firms). After five years, around 40% of the jobs initially created by start ups have been eliminated by exit of the firms. But if the firm survives this initial and testing period, young (then small) firms will grow more rapidly than their more mature counterparts. Anyway - large, mature firms account for a large fraction of the jobs.
The authors make some relevant conclusions:

  • We think our findings help interpret the popular perception of the role of small businesses as job creators in a manner that is consistent with theories that highlight the role of business formation, experimentation, selection and learning as important features of the U.S. economy. Viewed from this perspective, the role of business startups and young firms is part of an ongoing dynamic of U.S. businesses that needs to be accurately tracked and measured on an ongoing basis.
  • Our findings suggest that policies targeting firms based on size without taking account of the role firm age are unlikely to have the desired impact on overall job creation.
  • It may be, for example, that the volatility and apparent experimentation of young businesses that we have identified is critical for the development of new products and processes that are in turn used by (and perhaps acquired by) the large and mature businesses that account for most economic activity.
Our own conclusions:
- Analyzing dynamic data about firms by isolation of age cohorts gives new insights. Overlapping of different dynamic behaviours (firms of different ages) can create a misleading “confounding” effect (well known in statistics) that can easily induce wrong conclusions from time series data about firms.
- Young companies role is very important in economy change (innovation), so is entrepreneurship. But young companies do not mean young people. Young companies by mature people are specially important (see previous post).

- Small and large firms have different roles in the innovation ecosystem (as predicted by William Baumol, and also recognized by Joseph Schumpeter in his later phase).

Is US firm size now diminishing?

Choi and Spletzer (2011) ("The declining average size of establishments: evidence and explanations") have shown a declining trend in the average size of US firms and establishments during last decade, after a reverse of trend during 2000/2001 (from 1993 to 2001 the trend was crescent, and also long term trend from 1977).
The declining trend occurs in almost all industries and can be explained by the age of the firms and establishments. They found that new establishments and start ups are smaller: they start small and they stay smaller hen they mature.
Although not driven by a particular industry, the decline in manufacturing size of firms had a substantially larger effect than in other industries.
They advance the hypothesis that new entries (births) adopt new modes of production, more based on technology and less based on labor. Industries more technology intensive really show a more declining trend.
An important point of their paper is the critical role of age cohorts in order to understand the evolution of size of firms along time.

Their figure 6B shows two important things:
- establishments growth along time: initial size was around 7 for entries during 2001, but ten years later their average size was around 14 (a compounded annual rate of growth around 8%)
- establishments start smaller and smaller: average initial size was around 4.7 in 2010, versus around 7 ten years earlier, in 2000.

It is interesting to compare with their figure 6A, size by age, not age cohorts: it shows a declining trend for units of the same age, along time. This means that three years old units were around 12 people in mid 90’s, but less than 8 in 2011. Figure 6A is a consequence of overlapping of different curves from figure 6B.

Thursday, March 1, 2012

Young entrepreneurs - or not.

Media, as well as a lot of politically correct people, seem to believe that
- entrepreneurship is specially appropriate for young people to enter business life
- young people are the drivers of entrepreneuship,
so public policies should target young people as entrepreneurs. Previous cases like Microsoft, Apple, Google and now Facebook are usual mandatory cases presented as "proof".

But we know both ideas are plainly wrong, considering the strong empirical evidence available. Aged professionals have much better chances of success than inexperienced young people. Young age may be the worst time do it: no experience, no network, no financial resources and no credit or credibility, often no mentoring at all. Yes, young people can have a lot of energy and drive, and to work long hard hours, may be no family and children to worry with. But often it can be a disastrous or less successful experience - although also a good opportunity for hard learning about business life.
A recent post in Schumpeter blog in The Economist (25 february 2012) makes good reading about these points:
  • The rise of the infant entrepreneur is producing a rash of ageism, particularly among venture capitalists. Why finance a 40-year-old (with a family and mortgage) when you can back a 20-year-old who will work around the clock for peanuts and might be the next Mr Zuckerberg?
  • Research suggests that age may in fact be an advantage for entrepreneurs There were twice as many successful founders over 50 as under 25, and twice as many over 60 as under 20. ...
  • the highest rate of entrepreneurial activity (is) among people aged between 55 and 64—and the lowest rate (is) among the Google generation of 20- to 34-year-olds.
  • Experience continues to count for a great deal, in business as in other walks of life
  • It is one thing to invent a clever new product but quite another to hire employees or build a sales machine. 
  • Experience may be nothing if it is not linked to mould-breaking creativity. But there are plenty of older people who are capable of breaking moulds.
My personal advise for young people considering to become entrepreneur:
- first of all, make sure you understand the financial risks: not making a salary is not a big problem, but loosing the money lend by your family, friends or by banks can easily destroy your next decades of personal and business life (as well as destroy a lot of friendships). Remember: knowledge and hard work are important, but do not guarantee business success. Venture capital is much safer - but also much difficult to find in Portugal and Europe.
- second, try to learn business with others (mentoring, coaching,...), while maturing and improving your business ideas, before you adventure yourself alone.
Should public policies for entrepreneurship target young people first of all? I do not think so.
Aged gray people (yes, even after the 60's) may well be the next wave in entrepreneurship.

(Italics my responsability. Sources of research in the original post)