Sources of growth: large and small, new and old

Everyone is pro-growth and pro-employment. So, when an economy stagnates and unemployment rises, there is always concern. In Europe, real GDP remains below where it was at the end of 2007. That is, the economies in the euro area and the broader European Union (EU) have not collectively returned to the level of economic activity they enjoyed more than six years ago!  Unsurprisingly, as the real economy has languished, unemployment across the EU has risen, going from a low of below 7% to its current level of 10.6%.

Needless to say, the patience of policymakers has worn very thin. After trying to promote recovery through a mix of policies – mainly monetary accommodation – they have turned to credit. Now, it is a risky business to encourage highly-indebted people to borrow. And in many European countries, private debt levels remain at historic highs. The hope has to be that new debt will spur sufficient growth to make this worthwhile.

This desire has pushed policymakers to look to the credit needs of small- and medium-sized enterprises (SMEs). In much of the advanced world, SMEs account for a large fraction of employment. That is, most people work for firms that are modest in size. And, SMEs account for a large fraction of employment growth. This recognition has led to proposals for the pooling and securitization of loans to SMEs. It’s worth noting that U.S. financial innovators have tried to do this for some time. They failed because of the difficulty in making the loans sufficiently similar to allow for pooling that would yield predictable results.

Okay, so what about SME lending?   Well, it turns out that not all SMEs support job growth. In particular, SMEs can be new or old. That is, they can either be like the family-run bakery that has been on the corner for generations, or they can be like Steve Jobs in his parents’ garage!

The point is that all new firms are small, but not all small firms are new. And, as recent research highlights, it is the new firms that are the source of new jobs.

The lesson for policymakers is clear:  don’t subsidize lending to SMEs indiscriminately; promote firm formation. It is entrepreneurs and startups that are the sources of growth and new employment. That’s the creative part of “creative destruction.”