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 Braguinsky et al (2011) do not cite this paper - although Chou and Spletzer do cite them (in a subtle footnote).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.