Friday, September 25, 2020

How the US Start-Up Industry is Faltering

One of the long-term strengths of the US economy has been that it fostered the growth of new businesses. Some provided employment for only a few, while others grew into giants. But that dynamic process of new businesses ultimately benefited not just those who worked in them, but also innovation, productivity, and consumers. But as I have pointed out in the past, there are a variety of signs that this business dynamism has been declining. Here are some additional pieces of evidence: 

Thomas Astebro, Serguey Braguinsky, and Yuheng Ding discuss "Declining Business Dynamism Among Our Best Opportunities: The Role of the Burden of Knowledge" (September 2020, NBER Wroking paper 27787). They write: 
We employ the nationally representative Survey of Doctorate Recipients to show a decline over the past 20 years in both the rate of startups founded and the share of employment at startups by the highest-educated science and engineering portion of the U.S. workforce. The declines are wide-ranging and not driven by any particular founder demographic category or geographic region or scientific discipline. 
Here's a figure focused just on those with PhDs in science and engineering fields. As the authors note: "The figure reports the share of PhDs in science and engineering who are employed full-time with non-zero salaries in new (five years old or less) private for-profit companies (startups) compared with PhDs in science and engineering who are employed full-time with non-zero salaries in all private for-profit businesses." The dashed line shows the share of this group who are employees in startups, while the solid line shows the share who are founders of start-ups. 

They argue that when dealing with new technology, the benefits of working established firm may be rising. They point out that PhDs in science and engineering who are starting firms now do tend to hae more business experience, suggesting that the task of running a new technology-based business might be becoming more complex, even as the potential rewards for doing so may be diminishing. 

First, entrepreneurial outcomes are immensely skewed. Only a very small subset of entrepreneurial ventures make a meaningful contribution to growth, job creation or productivity improvements. The average entrepreneurial venture typically ends up as economically marginal, under-sized and poorly performing enterprise, or a ‘Muppet’. The second finding is that the skewed distribution of outcomes seems to be decreasing over time. Positive outcomes are becoming less common. While the share of firms with growth intentions seems to be increasing, the quality of entrepreneurial ventures seems to be falling, with high-growth outcomes becoming more unlikely. The rare ‘gazelles’ and ‘unicorns’ that disproportionately propel the economy, are becoming rarer. Economically trivial ventures, are becoming more common.
The suggest that a possible answer is the rise of the "Entrepreneurship Industry," which has the goal of selling to people who want to see themselves as entrepreneurs. They write: 
The Entrepreneurship Industry leverages the Ideology of Entrepreneurialism to create products and services that can be marketed to entrepreneurs. The industry grows its own market by encouraging greater entry into entrepreneurship and persistence in entrepreneurial ventures, irrespective of their likelihood of success. In doing so, it has transformed entrepreneurship from a generally gainful economic activity into a largely wasteful form of conspicuous consumption motivated by aspirations to the socially attractive identity of ‘being an entrepreneur’. This form of wasteful entrepreneurship is what we refer to as Veblenian Entrepreneurship. That is entrepreneurship that masquerades as being innovation-driven and growth-oriented but is substantively oriented towards supporting the entrepreneur’s conspicuous identity work.
Josh Lerner and Ramana Nanda offer a different set of concerns in "Venture Capital's Role in Financing Innovation: What We Know and How Much We Still Need to Learn" (Journal of Economic Perspectives, Summer 2020, pp. 237-61). They argue that while the venture capital industry has had some great successes in the past, "venture capital financing also has real limitations in its ability to advance substantial technological change." In particular, 
Three issues are particularly concerning to us: 1) the very narrow band of technological innovations that fit the requirements of institutional venture capital investors; 2) the relatively small number of venture capital investors who hold and shape the direction of a substantial fraction of capital that is deployed into financing radical technological change; and 3) the relaxation in recent years of the intense emphasis on corporate governance by venture capital firms. We believe these phenomena, rather than being short-run anomalies associated with the ebullient equities market from the decade or so up through early 2020, may have ongoing and detrimental effects on the rate and direction of innovation in the broader economy.
They argue that venture capital firms have become narrower in their focus, looking for firms where the uncertainty about whether the business will succeed is likely to be resolved fairly quickly, and thus less willing to take on a wider variety of start-up ideas where the uncertainty will remain for a substantial time--and where the direct involvement of the venture capital firm in corporate governance over an extended time might make the difference between success and failure. As one example, here's how the focus of Charles River Associates has evolved over time:  
Charles River Ventures was founded by three seasoned executives from the operating and investment worlds in 1970. Within its first four years, it had almost completely invested its nearly $6 million first fund into 18 firms. These included classes of technologies that would be comfortably at home in a typical venture capitalist’s portfolio today: a startup designing computer systems for hospitals (Health Data Corporation), a software company developing automated credit scoring systems (American Management Systems), and a firm seeking to develop an electric car (Electromotion, which, alas, proved to be a few decades before its time). Other companies, however, were much more unusual by today’s venture standards: for instance, startups seeking to provide birth control for dogs (Agrophysics), highstrength fabrics for balloons and other demanding applications (N.F. Doweave), and turnkey systems for pig farming (International Farm Systems). Only eight of the 18 initial portfolio companies—less than half—were related to communications, information technology, or human health care.

The portfolio of Charles River Ventures looks very different in December 2019. Of the firms listed as investments, about 90 percent are classified as being related to information technology comprising social networks, applications for consumers, and software and services related to enhancing business productivity. Approximately 5 percent of investments are classified as being related to health care, materials, and energy. This shift in Charles River’s portfolio reflects the patterns of the industry at large ...

I don't feel as if I have a good handle on all the reasons for the decline in US startup firms. But it does seem to me that a lot of the private sector has become highly focused on start-up firms that involve web-based networking in one way or another. Fortunes can be made in such firms with a relatively small number of employees. In contrast, as Lerner and Nanda point out, start-ups in areas like clean energy or new materials may not have as clear a path to follow, and those thinking about starting such firms may not find it easy to get support from venture capital or with other parts of the finance system for start-ups. 

Thursday, September 24, 2020

Interview with Joshua Gans on Pandemic Economics

Like many of us, Joshua Gans found himself stuck at home in March. Unlike many of us, he decided to write a book about the pandemic. In fact, MIT Press put the first draft of the book up online for comments. David A. Price interviews Gans about lessons he learned in the process of writing the book, as well as about some of his other work on artificial intelligence and how an economist thinks about parenting (Econ Focus: Federal Reserve Bank of Richmond, "On managing pandemics, allocating vaccines, and low-cost prediction with AI," Second/Third Quarter 2020, pp. 18-22). Here are some thoughts from Gans on the policy response to the pandemic: 
What's reflected in the book that's coming out is that I now see these pandemics as manageable things. Policymakers have to react right away and stay the course, but pandemics can be managed. If I had to guess how history is going to judge this period, the judgment is going to be that this shouldn't have been a two- to three-year calamity, it should have been a three-month calamity.

The need for testing aggressively at the beginning had to be appreciated. You aggressively isolate people you find who are infected, you trace who they had contact with, and you aim for quick, complete suppression. The countries that had had experience with pandemics — Hong Kong, South Korea, Taiwan, most of Africa — got it right away. They knew what the problems would be if they didn't do anything about it. So experience with viruses was definitely a factor. But Canada had that and didn't quite get its act together quickly enough. ...

But once the virus breaks out, then you've got a problem. Then you've got to do the complete lockdown. And we're seeing places that did a complete lockdown — like they did in Italy, France, and Spain — squash it all the way down. Locking down is terribly painful; that's why you don't want to go through it in the first place. But you may have to. ... 

Early in the crisis, people in the United States and Canada were not talking about the virus as something we needed to suppress completely. The discussion was mainly, "We're going to push down the curve, and then we'll wait for a vaccine." But the evidence both historically and now with this virus is that, as I said, you can achieve suppression in months if you act quickly. You have to keep working at it because if you don't have a vaccine, the disease can crop up again, but it's manageable. ...

The issue of treatments is a little bit easier because you don't need enough for everybody. You just need enough to treat the sick. And fortunately, at any given time, there aren't that many people sick. Unless, of course, the virus goes out of control and there are a lot of people sick, with intensive care units filling up — that's going to create scarcity on the treatment side. That was the whole discussion back in March: Let's not let that happen. Let's keep the infection rate low so we can treat everybody. As it turned out, overrunning of hospitals was avoided by the skin of our teeth. If we had waited another week, it would've happened.
The interview also offers an insight from Gans about one way that technology has made it easier for to get children to clean their rooms--at least in the Gans household:
[Y]ou care about the mess in the room and the children do not. It is much easier to negotiate an outcome where you can find things that people care about equally: You care about X as much as I care about Y. So to negotiate with a child to clean up a messy room, you have to be able to find in that negotiation bundle something that the child cares as much about. ...

 I've found the most useful thing that I have that the child cares a lot about is the access to the Wi-Fi. I have a button that I can press to cut my children off from the internet. Suffice it to say, that's all I need. I may encounter resistance; I might encounter a child saying, "Fine! Shut off the internet, I don't need it!" But a few hours later, I'm getting a clean room. So there's new technology that has changed the balance. The iPad and other such devices are a parent's dream. They are reducing the cost of punishment.

The interview also explores some of Gans's insights about economic implications of artificial intelligence. He also wrote about that issue, with a couple of co-authors in the Spring 2019 issue of the Journal of Economic Perspectives in "Artificial Intelligence: The Ambiguous Labor Market Impact of Automating Prediction." 

Finally, as a mignardise. I'll point out that back in the Winter 1994 issue of the Journal of Economic Perspectives, when Josh was still a graduate student, he and George Shepherd had the idea of contacting leading economists around the world and asking for their most painful experience in having a paper rejected. They received responses from 60 economists, including 15 Nobel laureates. For anyone interested in back-story economics profession gossip and/or struggling with the vagaries of academic publishing, it may be either refreshing or disheartening to hear that the best-known and most successful have had their tribulations, too. The article is Joshua S., Gans and George B. Shepherd. 1994. "How Are the Mighty Fallen: Rejected Classic Articles by Leading Economists." Journal of Economic Perspectives, 8 (1): 165-179.

Tuesday, September 22, 2020

Where Federal Debt is Headed and Staying Off the Interest Payments Treadmill

By now, it's old news to anyone paying attention that the federal debt, based on current law, is on a trajectory to rise in an unsustainable way over the next few decades. What is less well-known, I think, is the extent to which these forecasts for rising federal debt rely on interest payments soaring out of control. The message comes through clearly in the Congressional Budget Office report "The 2020 Long-Term Budget Outlook" (September 2020). 

Here's the CBO projection for where federal debt is headed, based on current law. The federal debt/GDP ratio is now on the verge of surpassing its previous high, which was the debt incurred to fight World War II. These debt projections are typically viewed as conservative, because Congress often passes laws that suggest taxes will be raised or spending will be cut several years off in the future; for example, that the tax cuts in the 2017 Tax and Jobs Act will end in 2025. The CBO projections faithfully assume that these future tax increases and spending cuts will be enacted, but often when the date gets near, they are postponed until further into the future. 

This "baseline" prediction, as it is called, suggests that higher spending will be a main driver of the future deficits. This figure shows projections for future spending and tax revenues. The burst of pandemic-related spending is clearly visible. Looking at 2025, you can see a bump upward in tax revenues when certain tax cuts from the 2107 legislation are projected to expire. But outlays just keep rising. Why? 


One underappreciated factor is that at some point, a vicious circle emerges in which the interest payments on past borrowing get so big that they make annual budget deficits notably larger, which in turn drives interest payments higher, too. Here's a breakdown of the projected rise in federal spending by main categories. As you can see, spending on Social Security rises, as does spending on major health care programs. But it's net interest payments that really; indeed, the current projections are that interest payments will be larger than the Social Security program by the early 2040s.  

The obvious lesson here, as anyone with a credit card has learned, is that it's important to stay away from that treadmill where debt and interest payments on the debt keep driving each other to new heights. How might that be done? 

Part of the issue here is that we have been making a slow-motion decision over time to shift the role of the federal government away from investment and away from national defense, and toward social insurance. It has been obvious for decades now since that surge of birthrates after World War II that we call the "baby boom generation" that spending programs for the elderly like Social Security and Medicare would be expanding in the 2020s. We seem to have a fairly broad social consensus in support of the spending for these programs, but we haven't been able to agree on taxes to finance them. This figures shows the projected rise in these programs over time, how much of it can be attributed to the aging of the population, and for health care programs, how much can be attribute to what seems to be an inexorable rise in health care costs. 


There are a number of possible ways to stay off that interest payments treadmill via higher taxes or lower spending in other areas of the budget. But it's now 10 years since the passage of the Patient Protection and Affordable Care Act of 2010, and based on current campaign advertising by Democrats, it seems clear that it did not succeed either in holding down costs or providing an assurance of health insurance coverage. If a way could be found to hold down that excess growth in health care costs, it would be a big step in reducing the growth of federal debt and staying off the interest rate treademill.

Monday, September 21, 2020

An Overview of Emergency COVID-19 Lending from the Fed

 The Federal Reserve, like central banks everywhere, view providing financial liquidity during a crisis (being the "lender of last resort") as one of their core functions. What has the Fed done so far in the COVID-19 recession?. Tim Sablik offers a crisp overview in "The Fed's Emergency Lending Evolves" (Econ Focus: Federal Reserve Bank of Richmond, Second/Third Quarter 2020, pp. 14-17).  

Here's a list of the nine main lending programs the Fed has used, and to whom the credit was extended: 

And here's a graph showing how much was loaned under these programs as of August 12. The Main Street Lending Program doesn't appear on this graph because it had loaned $226 million--not enough to show up on a graph measured in tens of billions of dollars. 


As you can see, total Fed lending spiked very quickly in late March, then eased a little higher in late June and a little lower in early August. A short description of the various lending programs from the Federal Reserve is here; an update on lending through the end of August is here.  

In practical terms, the key test of emergency lending is whether it is repaid fairly soon, and thus fades away. When that happens--say, look at the blue Primary Dealer Credit Facility at the bottom of the figure--it suggests that the real problem was a short-term credit crunch, which soon resolved itself when the Fed made emergency loans available. The Money Market Mutual Fund Lending Facility seems on a similar trajectory. 

Based on the current data, the real challenge for current lending will be the Paycheck Protection Program Liquidity Facility--the program where the Fed helps banks to make loans to small-ish or at least non-huge companies so that they can meet payroll and not need to lay off workers. The Small Business Administration has the power to forgive these loans; in other words, any losses that arise from loan forgiveness in this program will be attributed to the SBA, not to the Fed.  

In broader terms, the key distinction is that it is acceptable for a central bank to be a lender of last resort in a short-term financial market panic, as arguably occurred in March, with the expectations that such loans will be repaid when the market stabilizes. The infamous section 13(3) of the Federal Reserve Act is the break-glass-in-case-of-emergency part of the law, which gives the Fed the authority to do "broad-based" lending under ""unusual and exigent circumstances." Section 13(3) got a workout during the Great Recession, and it is the legal justification for all nine of the lending programs above.  But as the Fed takes a few halting steps into assuring credit for corporate bond markets and for payroll protection, there is some danger that it is sticking a toe or two over the line of the lender of last resort role, and instead becoming a tool for extending credit in a few favored markets. 

Sunday, September 20, 2020

Advice on Writing from Ruth Bader Ginsberg

David Post offers some personal reminiscences about Ruth Bader Ginsberg at the Reason website ("RGB, R.I.P," September 18, 2020). As someone who has worked as an editor for a long time, several  pieces of her advice to him about writing resonated with me.  Here's a paragraph from Post (who got to know Ginsberg while clerking for her): 
Most of what I know about writing I learned from her. The rules are actually pretty simple: Every word matters. Don't make the simple complicated, make the complicated as simple as it can be (but not simpler!). You're not finished when you can't think of anything more to add to your document; you're finished when you can't think of anything more that you can remove from it. She enforced these principles with a combination of a ferocious—almost a terrifying—editorial pen, and enough judicious praise sprinkled about to let you know that she was appreciating your efforts, if not always your end-product. And one more rule: While you're at it, make it sing. At least a little; legal prose is not epic poetry or the stuff of operatic librettos, but a well-crafted paragraph can help carry the reader along, and is always a thing of real beauty.

Friday, September 18, 2020

Every Day is a Bad Day, Say a Rising Share of Americans

The Behavioral Risk Factor Surveillance System (BRFSS) is a standardized phone survey about health-related behaviors, carried out by the Centers for Disease Control and Prevention (CDC). One question asks: “Now thinking about your mental health, whicjh includes stress, depression, and problems with emotions, for how many days during the past 30 days was your mental health not good?” 

David G. Blanchflower and Andrew J. Oswald focus on this question in "Trends in Extreme Distress in the United States, 1993–2019" (American Journal of Public Health, October 2020, pp. 1538-1544).  I particular, they focus on the share of people who answer that their mental health was not good for all 30 of the previous 30 days, who they categorize as in a condition of "extreme distress." Here are some patterns: 

This graph shows the overall and steady rise for men and women from 1993-2019. 

Here's a breakdown for a specific age group of those 35-54 years of age, with a simple breakdown by education and by ethnicity. 
This kind of survey evidence doesn't let a researcher test for causality, but it's possible to look at some correlations. The authors write: "Regression analysis revealed that (1) at the personal level, the strongest statistical predictor of extreme distress was `I am unable to work,' and (2) at the state level, a decline in the share of manufacturing jobs was a predictor of greater distress."

Of course, one doesn't want to overinterpret graphs like this. The measures on the left-hand axis are single-digit percentages, after all. But remember, these people are reporting that their mental health hasn't been good for a single day in the last month. The share has been steadily rising over time, through different economic and political conditions. In those pre-COVID days of 2019, 11% of the white, non-college population--call it one out of every nine in this group--reported this form of extreme distress. The implications for both public health and politics seem worth considering. 

Thursday, September 17, 2020

Stock Buybacks: Leverage vs. Managerial Self-Dealing

Consider a company that has been earning profits, and wants to pay or all of those earnings to its shareholders. There are two practical mechanisms for doing so. Traditionally, the best-known approach was for the firm to pay a dividend to shareholders. But in the last few decades, many US firms instead have used stock buybacks. How substantial has this shift been, and what concerns does it raise? 

Here, I'll draw upon a couple of recent discussions of stock buybacks. Siro Aramonte writes about "Mind the buybacks, beware of the leverage," in the BIS Quarterly Review (September 2020, pp. 49-59). Kathleen Kahle and RenĂ© M. Stulz tackle the topic from a different angle in "Why are Corporate Payouts So High in the 2000s? (NBER Working Paper 26958, April 2020, subscription required). 

Kahle and Stulz present the evidence both that overall corporate payouts to shareholders are up in the 21st century, and that stock buybacks are the primary vehicle by which this has happened. They calculate that total payouts from corporations to shareholders from 2000-2017 (both dividends and share buybacks) were about $10 trillion. They find that corporate payouts to shareholders have risen substantially post-2000, and that stock buybacks are the main vehicle through which this has happened. They write: 
In the 2000s, annual aggregate real payouts average roughly three times their pre-2000 level. ... Specifically, in the aggregate, higher earnings explain 38% of the increase in real constant dollar payouts and higher payout rates account for 62% of the increase. ...

In our data, the growth in payout rates, defined as the ratio of net payouts to operating income, comes entirely from repurchases. This finding is consistent with the evidence in Skinner (2008) on the growing importance of repurchases. Dividends average 14.4% of operating income from 1971 to 1999 and 14% from 2000 to 2017. In contrast, net repurchases, defined as stock purchases minus stocks issuance, average 4.8% of operating income before 2000 and 18.3% from 2000 to 2017.
The tax code offers obvious reasons for share buybacks, rather than dividends, as economists were already discussing back in the 1980s.  Dividends are subject to the personal income tax, and thus taxed at the progressive rates of the income tax. However, the gains of an investor who sells stock back to the company are taxed at the lower rate for capital gains. In addition, when a company pays a dividend, all shareholders receive it, but when a company announced a share buyback, not all shareholders need to participate, if they do not wish to do so. Thus, share buybacks offer investors more flexibility about when and in what form they wish to receive a payout from the firm. 

In addition, economists have also recognized for some decades that corporations will sometimes find themselves in a position of "free cash flow," where the company has enough money that it can make choices about whether it can find productive internal investments for the funds, or whether it will fiud a way to pay out the money to shareholders, or whether it will use the money to pay bonuses and perquisites to managers. If we agree that lavishing additional benefits on managers is not a socially attractive choice, and if the firm honestly doesn't see  how to use the money productively for internal investments, then paying the funds out to shareholders seems the best choice. 

The public response to firms that pay dividends is often rather different than when a firm does a share buyback--even when the same payout is flowing from the firm to its shareholders. The concern sometimes expressed is that corporate managers have an unspoken additional agenda with stock buybacks, which is to pump up the price of the company's stock--and in that way to increase the stock-based performance bonus for the managers.

Sirio Aramonte also documents the substantial rise in stock buybacks in recent decades. He points out that a primary cause for stock buybacks is for firms to increase their leverage--that is, to increase the proportion of their financing that happens through debt. He writes: "Corporate stock buybacks have roughly tripled in the last decade, often to attain desired leverage, or debt as a share of assets." This pattern especially holds true if the firm finances the stock buyback with borrowed money, rather than out of previously earned profits. He writes: 
In 2019, US firms repurchased own shares worth $800 billion (Graph 1, first panel; all figures are in 2019 US dollars). Net of equity issuance, the 2019 tally reached $600 billion. Net buybacks can turn negative, and they did during the GFC [global financial crisis of 2007-9], as firms issued equity to shore up their balance sheets. ... Underscoring the structural differences between dividends and buybacks, the former were remarkably smooth, while the latter proved procyclical and co-moved with equity valuations ...
Aramonte crisply summarizes the case for share buybacks: 
In a number of cases, repurchases improve a firm’s market value. For instance, if managers perceive equity as undervalued, they can credibly signal their assessment to investors through buybacks. In addition, using repurchases to disburse funds when capital gains are taxed less than dividends increases net distributions, all else equal. Furthermore, by substituting equity with debt, firms can lower funding costs when debt risk premia are relatively low, especially in the presence of search for yield. And, by reducing funds that managers can invest at their discretion, repurchases lessen the risk of wasteful expenditures.
What about the concern that corporate managers are using share buybacks to pump up their stock-based bonuses? Aramonte's discussion suggests that this may have been an issue in the past--say, pre-2005--but that the rules have changed. Companies have been shifting away from bonuses based on short-term stock prices, and toward bonuses based on long-term stock value for executives who stay with the firm. There are increased regulations and disclosure rules to limit this practice. Also, if CEOs were using stock buybacks in a short-term pump-and-dump strategy, then the stock price should first jump after a buyback and then fall back to its earlier level--and we don't see this pattern in the data. Thus, this concern that managers are abusing stock buybacks seems overblown. 

What about the linkages from stock buybacks to rising corporate debt? Aramonte provides some evidence, and also refers to the Kayle/Stulz study: 
[B]uybacks were not the main cause of the post-GFC rise in corporate debt. After 2000, internally generated funds became more important in financing buybacks. For one, economic growth resulted in rising profitability. In addition, firms exhibited a higher propensity to distribute available income. Kahle and Stulz (2020) find that cumulative corporate payouts from 2000 to 2018 were higher than those from 1971 to 1999 and that two thirds of the increase was due to this higher propensity.

In short, the overall level of rising corporate debt in recent years is a legitimate cause for concern (as I've noted here, here, and here). Share buybacks are one of the tools that US firms have used to increase their leverage, but the real issue here is whether the higher levels of debt have made US firms shakier, not the use of share buybacks as part of that strategy. The pandemic recession is likely to provide a harsh test of whether firms with more debt are also more vulnerable. As Aramonte writes: 

There is, however, clear evidence that companies make extensive use of share repurchases to meet leverage targets. The initial phase of the pandemic fallout in March 2020 put the spotlight on leverage: irrespective of past buyback activity, firms with high leverage saw considerably lower returns than their low-leverage peers. Thus, investors and policymakers should be mindful of buybacks as a leverage management tool, but they should particularly beware of leverage, as it ultimately matters for economic activity and financial stability.