San Francisco Fed: Workforce development may help boost business formation

This article originally appeared on SSTI.org

From Main Street businesses to technology startups, research has shown the rate of new business formation in the United States has plummeted since the 1970s. In the past year, the Digest has frequently cited research from the Economic Innovation Group (EIG), the Kauffman Foundation, and the Federal Reserve on the impacts of declining dynamism on America’s economic outlook. A recent letter by economists at the Federal Reserve Bank of San Francisco suggests that an often-overlooked aspect of business formation is the availability of labor, and that policies that seek to improve and deepen the labor pool may help increase new business growth.

In What’s Holding Back Business Formation?, a recent economic letter from the Federal Reserve Bank of San Francisco, authors Patrick Kiernan and Huiyu Li present evidence underscoring the importance of labor supply in explaining the number of new business starts. To make this case, the authors develop a theoretical model where business formation is largely determined by two long-run factors: population size and labor productivity. While the authors find mixed evidence on the impact of growing productivity on business formation, the case for growing the labor supply is clearer. The authors suggest that policies aimed at boosting business formation may be more effective if they address labor availability. This is because a larger population leads to a larger supply of potential customers, which in turn increases demand and encourages the formation of more businesses.

This relationship may help partially explain why states seen as being more “dynamic” generally have more population growth. In the Economic Innovation Group’s Index of State Dynamism, top performing states like Nevada, Utah, Florida, Colorado, and Texas all have fast growing populations. In these states, because the rate of business formation and availability of labor is seemingly higher, the dual-effect of more customers and more potential entrepreneurs could be playing a role.

Kiernan and Li’s letter prompts two main questions. First, if labor availability is holding back business formation, what is holding back labor availability? Second, what types of policies can help address labor availability?

Perhaps the most notable drag on labor availability is that for many places – including the country as a whole – population growth has sputtered. For the nation, population growth happens in two ways: natural increases and through immigration. U.S. population growth is at its lowest levels since the Great Depression, according to Brookings demographer William Frey, and a major cause is that birth rates have declined while death rates have risen.  In other words, the rate of natural increases has declined. Immigration is expected to drive growth in the working-age population through at least 2035, according to the Pew Research Center.

Writing for the BBC, Frey notes that the United States is on the cusp of great change, with a rapidly aging white population that still holds considerable economic power and a workforce that is increasingly younger and more diverse. As the U.S. becomes more reliant on minorities for economic prosperity, however, Frey suggests that significant challenges remain. For example, considerable portions of minority children attend under-resourced schools, educational attainment for Hispanics and blacks lags, and access to capital for minority communities is scarce. Increasing the skills and outcomes for America’s young workers could be essential to the nation’s future economic competitiveness, Frey writes.

Kiernan and Li also recommend enhancing the labor pool through education. Additionally, they suggest that strategies to boost labor supply could include encouraging more immigration, later retirement, or increasing the labor participation rates among women and minorities. The authors cite a recent speech from Janet Yellen, Chair of the Board of Governors of the Federal Reserve System, who observes that promoting entrepreneurship could play a meaningful role in workforce development. “Relevant and effective training can reduce the failure rate of businesses by helping owners make better decisions and avoid costly mistakes,” Yellen notes in the March 2017 speech. “These programs are especially critical in low-income and rural communities where other resources to support small business development may be scarce.”

Another approach to boosting labor availability could be to help address some of the many other policies that research suggests could potentially stifle economic dynamism. A recent New York Times analysis examines the economic toll that the opiate crisis has had on labor availability. Harvard economist Ed Glaeser notes that more can be done to support entrepreneurship through training and the removal of barriers and roadblocks to starting a business. Non-compete agreements, occupational licensing, and land-use laws are three of the many policies worthy of additional investigation.

In a response to Kiernan and Li’s findings, Jon Talton, a columnist with the Seattle Times, points to two additional important contributors: “The intense consolidation of industries through mergers and the rise of cartels and giant companies with commanding market power and ability to undersell competitors.” Indeed, the evidence of concentrated power in industry is a critical part to the debate on business dynamism. The U.S. economy’s “market power” problem threatens economic growth and increases inequality, according to a recent report by the Washington Center for Equitable Growth.

Ultimately, as has been argued elsewhere, there is no silver bullet policy that can address declining dynamism, and in particular, business formation. Paying attention to the availability of labor, however, is an important consideration in understanding why some places have seen their economies become more dynamic, while others have struggled.