Creative Entry

Are business cycles and the creative destruction they bring about healthy for the economy? Do we need business cycles to clear out the inefficient firms to make room for more creative and more efficient firms to take their place?

The research described below finds that "recessions do not appear to be times of massive cleansing of less-efficient incumbents." The creative destruction of existing firms is about the same in both booms and recessions, there is nothing special about the firms that are driven from the marketplace when things are bad, so bad times are no more effective at cleaning out the inefficient than good times. It is on the entry side where there are differences over the business cycle, and making it easier for firms to enter in recessions rather than accelerating their departure may be a means of encouraging innovation and "an effective method for stabilizing the economy":

Are there cleansing effects of recessions? Entry and exit of manufacturing plants over the business cycle, by Yoonsoo Lee and Toshihiko Mukoyama, Vox EU: Creative destruction is a major driving force of modern market economies.[1] Firms enter and exit the marketplace, plants are built and destroyed, and workers change jobs and occupations. In recent decades, economists have started to learn that the amount of reallocation that occurs in market economies is massive.[2] It is the rule rather than the exception, and it is essential in a well-functioning market economy. The microeconomic ups and downs of reallocation allow new products to be introduced, new technologies to be put to use, and resources to be moved to productive places.

Modern market economies also experience ups and downs at the aggregate level. Booms and recessions—sometimes mild, sometimes severe—occur all the time, and stabilizing the business cycle is one of the major policy goals of many governments. But before conducting a stabilization policy, a natural question to ask is: how are macroeconomic fluctuations (business cycles) and microeconomic fluctuations (creative destruction) related? If macroeconomic fluctuations reflect the resource reallocations of a well-functioning market economy, the business cycle may not be such a problem after all.

One popular view among economists is that business cycles do in fact represent waves of creative destruction. Booms are times of heavy creation, and recessions are times of heavy destruction. If so, attempts to stabilize the business cycle could actually hamper the healthy process of resource reallocation. Recessions would not be a bad thing either, especially from a long-run perspective, because they would serve to cleanse the economy of inefficient production units.[3] Not all economists agree. Some hold the opposite view and see recessions as times of slow reallocation,[4] where creation and destruction decelerate. In their view, a recession is indeed a bad thing.

For policymakers then, it is important to know what actually happens to the reallocation process during the business cycle. We examine this issue for the US manufacturing sector in a recent paper (Lee and Mukoyama, 2007), using plant-level data from the US Census Bureau.[5] In particular, we look closely at the entry (birth) and the exit (death) of plants over the business cycle. Overall we find that entry rates (the percentage of plants opening in a given year) are much higher in booms than in recessions. However, exit rates (the percentage of plants closing in a given year) are comparable in booms and in recessions. What is interesting is that plants entering during recessions are very different in terms of employment and productivity from those that enter during booms, whereas exiting plants are rather similar in both phases of the business cycle. On average, plants that enter during recessions are larger (they hire more workers) and are more productive than plants that enter during booms. Such differences are relatively small for plants exiting in booms or recessions.

These results cause us to rethink the relationship between business cycles and micro-level reallocations. In the literature that argues for a cleansing effect of recessions, a lot of emphasis is placed on the belief that cleansing occurs at the destruction (or exit) margin. That belief rests on earlier research, which found that job destructions at continuing plants are strongly countercyclical. In contrast, our research finds nothing special going on at the exit margin. Because closing plants are similar in booms and recessions, it suggests that recessions do not necessarily cause productive plants—those that could have survived in good times—to shut down in large numbers. During recessions, when it is hard for businesses to survive, businesses tend to reduce their workforces by firing existing workers. But recessions do not appear to be times of massive cleansing of less-efficient incumbents. Less productive plants are indeed driven out of the market, but not only in recessions. Rather, cleansing at the exit margin occurs all the time, in a similar manner, regardless of business cycle phase.

Of course, this does not mean that the business cycle and reallocation process are not related at all. Quite the contrary—entry behavior is very cyclical. The fact that entrants are very different in booms and recessions suggests that there is some very important selection going on at the entry margin over the business cycle. In booms, a small and relatively unproductive plant can enter—because times are good, an unproductive plant can still be profitable. But in recessions, only productive (and large) plants can profitably enter. Recessions might have a positive effect on average productivity by selecting only more productive plants. However, such selection does not necessarily mean that the cleansing of inefficient, existing plants is taking place. Selecting only highly productive entrants can be more important. In short, when we study the effects of business cycles, we should shift our focus from exit behavior to entry behavior: “Creation” is a more important margin than “destruction.”

We believe our findings matter for policy makers in the following respects. First, the fact that the plants that enter in booms are different from those that enter in recessions indicates that there is a much larger barrier to entry during recessions. Such a barrier may hurt the long-run growth of the economy. New plants often embody innovations, and researchers find that entry is an important source of aggregate productivity growth. For this reason, an important question is what makes entry more difficult during recessions. Perhaps the costs of the initial investment for startup are higher or financing is more difficult to obtain.

Second, our research indicates that the outcome of various stabilization policies will depend on their effect on entry and exit rates. In our paper, we build a model that is able to quantitatively replicate the features of the data, and we run several experiments with it. Imposing firing taxes could have a stabilizing effect if the policy did not affect entry and exit behavior, because the tax would induce plants to reduce the frequency of their firing and hiring.[6] But we find that entry rates fluctuate more with the firing tax, which could translate into more volatile aggregate output. Entry rates fluctuate more because the firing tax discourages entry more during recessions than during booms. Because the firing tax is more likely to affect larger plants that tend to reduce their workforces in the near future, entering plants during recessions are more likely to be affected.

Our finding points to the importance of policies that are targeted to the incentive to enter. For example, an effective method for stabilizing the economy is to encourage entry during recessions. In particular, if a market inefficiency (such as financial constraints) is creating barriers to entry, then encouraging entry during recessions is indeed a good thing.

Finally, we would like to emphasize that our empirical results are based on US manufacturing data. An intriguing question for future research is to see how these results can be compared across sectors and across countries.

References

Barlevy, G. (2002). “The Sullying Effect of Recessions,” Review of Economic Studies 69, 41-64.
Caballero, R. J. and M. L. Hammour (1994). “The Cleansing Effect of Recessions,” American Economic Review 84, 1350-1368.
Caballero, R. J. and M. L. Hammour (2005). “The Cost of Recessions Revisited: A Reverse-Liquidationist View," Review of Economic Studies 72, 313-341.
Davis, S. J., J. C. Haltiwanger, and S. Schuh (1996). Job Creation and Destruction, Cambridge, MIT Press.
Dunne, T., M. J. Roberts, and L. Samuelson (1988). “Patterns of Firm Entry and Exit in US Manufacturing Industries,” RAND Journal of Economics 19, 495-515.
Lee, Y. and T. Mukoyama (2007). “Entry, Exit, and Plant-level Dynamics over the Business Cycle,” Federal Reserve Bank of Cleveland Working Paper 07-18.
Samaniego, R. M. (2006). “Entry, Exit and Business Cycles in a General Equilibrium Model,” mimeo. George Washington University.
Veracierto, M. L. (2004). “Firing Costs and Business Cycle Fluctuations,” mimeo. Federal Reserve Bank of Chicago.

Footnotes

1 The research in this article was conducted while the authors were Special Sworn Status researchers of the U.S. Census Bureau at the Michigan Census Research Data Center. Research results in this article have been screened to insure that no confidential data are revealed. The views expressed in this article are those of the authors and do not necessarily reflect the position of the Census Bureau, the Federal Reserve Bank of Cleveland or the Federal Reserve System.
2 See the pioneering work by Dunne, Roberts, and Samuelson (1989) and Davis, Haltiwanger, and Schuh (1996).
3 See, for example, Caballero and Hammour (1994) for a theoretical examination of this view.
4 See, for example, Barlevy (2002) and Caballero and Hammour (2005).
5 We use the Annual Survey of Manufactures from 1972 to 1997.
6 See Veracierto (2004) and Samaniego (2006). In Samaniego’s (2006) model, entry is endogenous but it fluctuates very little over the business cycle.

Comments

[James Killus]

I've suggested before (based on anecdotal evidence) that it is actually health firms that are most at risk during credit crunches (which are not necessarily tied to recessions, of course), as the financial sector tends to go "where the money is" in Willie Sutton's colorful phrase, and unhealthy firms don't have as much cash on hand.

But my observations are more slanted toward non-manufacturing firms, and the authors' caveats apply even more strongly.

[barry payne - economist]

Why is it "cleansing" that is occurring, as if all the "competition" via creative destruction is always a purging of inefficient demons for more efficient angels.

Were parallel actions of merger and divestiture incorporated? Does "entry" mean fresh start-up from scratch or extension via a division or subsidiary of an existing company? Was venture capital involved?

Why is concentration always associated with efficiency? What about companies that have survived over many cycles, whether intra-industry or the general economy? What's the relative size of companies that survive, enter and exit?

For example, study details would be interesting for pharmaceuticals, telecommunciations, electricity and the military industrial complex in terms of entry, exit, combinations and diversifications - all compared to corresponding measures of market power and the ability to impose costs on competitors.

Likewise, are the study results important enough to challenge traditional theories of industrial organization and market structure or instead complement them? What about the "baseload" part of the cycles that never change and how far is it from the peak?

Interesting study that raises many questions.

[save_the_rustbelt]

Chapter 11 and Chapter 7 filings have surged up and down since the 2000 recession.

The mad rush to globalization has changed the old patterns, in which recessions were times for bankruptcy spikes (as I remember '81-'82 caused a significant spike).

The mad rush to cheap labor has changed the viability of many businesses, so the old rules no longer apply, IMHO.

[ken melvin]

Recessions take out the new. The old, established can hang in there.

[Winslow R.]

"New plants often embody innovations, and researchers find that entry is an important source of aggregate productivity growth. For this reason, an important question is what makes entry more difficult during recessions. Perhaps the costs of the initial investment for startup are higher or financing is more difficult to obtain."

Recessions take out the highly leveraged.

Highly leveraged financial firm entry and exit are most closely tied to the business cycle. Remember the large number of new hedge funds over the last few years? Who is going bankrupt now?

The financial sector is an integral part of the Fed transmission mechanism.

A pretty crude mechanism designed by big bankers. TAFs were a necesssary refinement. Imagine if we reduced corporate leverage further ...... to zero.

[save_the_rustbelt]

"Recessions take out the new. The old, established can hang in there."

In my experience, it is some of both the new and old. The old timers that die tend to be badly managed or have a weak business plan.

The number of manufacturers will be going down because most of the old timer manufacturers are being offshored before they get a chance to go bankrupt (or go offshore as a result of the bankruptcy, a la Delphi).

[barry payne - economist]

WR
If corporate leverage was reduced to zero, would macro business cycles disappear altogether, subsiding into something like a steady state of positive real growth with zero inflation ... leaving only micro-cycles driven by creative destruction?

Or would there still be self-generated macro cycles even absent "Fed transmission"? Would banks be decentralized and based on 100% reserved requirements? Would this prevent voluntary leveraged lending?

How would this affect the entry-exit phenomena observed in the study? For example, would hedge funds still be there, just not leveraged?

[Marginal Productivity---Marginal Pay?]

Of course, the marginally productive businesses that start up during boom times may not pay as well, but that is a topic for some future study...

[Winslow R.]

bp wrote:"If corporate leverage was reduced to zero, would macro business cycles disappear altogether, subsiding into something like a steady state of positive real growth with zero inflation ... leaving only micro-cycles driven by creative destruction?

I think so as it would improve the transmission mechanism.

bp wrote:"How would this affect the entry-exit phenomena observed in the study? For example, would hedge funds still be there, just not leveraged?"

I see hedge funds as offsheet extensions of banks or rather unregulated banks and therefore unneeded.

I guess your kind of new here, so thanks for showing interest.

My 'agenda' is to reduce the need for highly leveraged corporate banking. I find public citizens to be much more credit worthy than corporate bodies or at least easily trackable if they aren't.

Leverage is the 'lazy' path to wealth, and find it disconcerting that the only asset market the U.S. citizen is able to easily leverage is their principal residence which is not really an investment.

The barriers to access citizen leverage are set too high for little reason, in my opinion, giving almost all the rewards to a small select group (bankers) while the ultimate risk is assumed by the larger population.

I have regularly posted at Mark's site presenting similar themes (making me pretty one-dimensional) hoping our host or fellow readers poke some holes in my framework. A few friendly readers have obliged over the last two years.

By reducing/distributing leverage the gains/losses would be distributed more evenly across society. One of my first proposals is to allow U.S. citizens to leverage Tsy debt at the Fed. Yes, rates are inverted right now but by a very small amount. 95% of the time rates have a positive slope making leverage profitable. Next steps would be student loans, small business loans, and finally corporate bonds. Each of these debt markets would be set up similar to the NYSE. The current problem with the debt market is that there are so few participants. Each citizen would have a cap based on a credit score. If there are failures they would be distributed rather than concentrated.

I think we would still have economic cycles but the goals of the government and population would become more tightly entwined as the Fed would be more interested in making sure U.S. citizens succeed and vice versa.

Why let the financial sector have all the fun?

[Lafayette]

MT: Are business cycles and the creative destruction they bring about healthy for the economy

The Next Big Thing

Why associate the two necessarily?

Schumpeter posited the theory of creative destruction, and wrote about them in his 1939 book Business Cycles. He thought that innovation produced such cycles. He may be right, but not entirely. I suspect that Consumer Demand can be cyclic for reasons quite extraneous to innovation.

I lived through one such creative destruction and it was massive. It happened in the Information Technology industry. And, it happened in three phases of Creative Destruction.

The three successive waves of computing technology each atomized the technology further and further, from massive central computing to the PC. (The next phase will obviate the PC and one will need only an Internet Interface Device. Maybe, because it is not yet obvious.)

Each of these waves had its survivors and its losers. Who remembers Univac, one of the first central computing systems to have been sold in the 1950s. Who remembers Remington-Rand, the company that sold Univac machines and spawned generalized computing (from its earliest roots in the Eniac computer)? Who remembers "IBM and the Seven Dwarfs" (RCA, GE, etc.) that comprised the nucleus of generalized computing through 1960s and 1970s. The Seven Dwarfs are all gone. (Whereas GM and Chrysler are still here, barely, despite the Japanese manufacturers.)

When the mini-computer arrived it spawned an entire new set of IT purveyors and the nascence of inter-connected computing. This predominated from the mid 1970s to the mid 1990s -- but who remembers (then the world's second-largest computer manufacturer) DEC -- which manufactured mainly mini-computers. (I do, because I worked there.)

Then the next wave, brought about by the King of Komputing, Billy-boy Gates, arrived - more like a tsunami. It was the last purpose-built machine expressly for personalized computing, that arrived also in the late 1980s.

The PC has now become a commodity product that is being made progressively obsolete by the Internet, upon which we shall see (in a near future) all the programs currently managed by the PC (Word Processing and Document Archival, Computer Aided Design, Internet Access, etc.) IBM, the orginator of the PC, got rid of its PC-business to the Chinese -- because it became a low-cost commodity product, from which the only real value-added was software (which IBM did not produce, but Billy-boy did).

These successive creations brought about the destruction of hi-tech companies that had made billions of dollars in profits. And, when we talk presently of IT's progress, are the Star Companies those of hardware or software? The latter, I suggest, not the former. A great deal of hardware has become commodity-like in nature, particularly when based upon open-standard software run on it.

Business cycle downturns certainly can spark the destruction of market participants that can only maintain themselves above water in periods of "normal economic activity". But, a recession does not necessarily see wholesale destruction -- so I wouldn't even look for it there. (It depends upon the industry. Computers are capital goods that are strategic to businesses, so one does not do away with or replace them blithely even during a recession.)

Destruction comes with a new idea that replaces and old idea -- and that process can happen at any time in the business cycle. It can even span business cycles.

In fact, the elements of the Internet, which has had the most profound effect on computing technology, took more than a decade and a half to evolve and become viable -- and that period spanned more than a few downturns in the business climate.

And so, what's the Next Big Thing? I wouldn't look for it in technology, but in lifestyle. The Internet will take a gradually more important role in our lives, since it is basically an information access and retrieval tool.

But, the transition from the Industrial to the Information Age will bring about not only more personal productivity, but more leisure time. (Europe is prepared for that change. I am not sure America is.)

The challenge is to make sure that the Luxury of Leisure is more accessible to all strata of society -- and not just the upper and middle-upper levels. Therein lies, methinks, the economic challenge of this century.

[reason]

It is on the entry side where there are differences over the business cycle...

And I would have thought it obvious that the recovery phase was the most creative, when lots of cheap resources are lying about. This is what makes the destruction creative (otherwise it is just a contradiction in terms).

Corrollary: So eliminating the business cycle may diminish creativity? As economics doesn't really come to grips to creativity very well I wonder how this could be modelled and tested?

[Meh]

Lafayette poses a very interesting question, are the waves of "creative destruction" anything to do with "cyclical waves of economic output and/or consumer spending (recessions)."

I think it's a mark of the strength of the orthodox economic discourse that we all fall into associating the two things together because the orthodox discourse uses Schumpeter to justify a moralistic, purgative view of recessions and their resulting downward pressure on wages.

[ken melvin]

Innovation, recession aren't perforce separate; they can and do occur simultaneously. I started up in the seventies. Then, just as I would get together a crew and some operating cash the economy would turn, same for any start-up; though we were usually better at doing whatever it was. For recessions; the old companies were better situated to ride it out, and it was either innovation or offshoring that took them out.

[save_the_rustbelt]

There are weak, badly managed businesses and one brutal result of recessions is to euthanize those businesses.

In my bankruptcy accounting experience there were some common trends for dying businesses:

1. resting on laurels - resistance to change
2. the alcohol consumption of the senior management
3. family businesses with inadequate succession plans, or stupid children, or dad was an arrogant SOB
4. resistance to technology
5. hitched to a troubled business line (e.g., auto parts)

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