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Godzilla footThe mainstream’s view about small business is nicely encapsulated in the 1960s cult classic, “Bambi Meets Godzilla.”   In 90 mesmerizing seconds Tokyo’s all-star quickly dispatches the cute Disney character with a single, pulverizing stomp. Similarly, the conventional wisdom suggests that small businesses, while cute and pleasing for communities, don’t stand a chance against rigors of global competition. That’s the message of James Surowiecki’s piece, “Big is Beautiful,” in The New Yorker, 31 October 2011. “These days….” he complains, “the fetishization of small business continues apace.”
 
Wanting to appear fair, Surowiecki begins by admitting that “some of the support derives from real virtues that small companies offer—diversity of choice, connection to local communities.” He seems to be unaware of the growing academic literature that local small businesses also help communities grow incomes, improve equality, attract tourists, create walkable communities, enhance environmental protection, and encourage voting participation.
 
“But the truth,” insists Surowiecki, “is that, from the perspective of the economy as a whole, small companies are not the real drivers of growth.” He can only arrive at this stunning conclusion by ignoring the evidence from recent studies by the Kauffmann Foundation on the critical job-creating roles of small, start-up businesses.  So instead he turns to international data.
 
“One can see this by looking at the track record of the world’s economies,” he writes. “The developed countries with the highest percentage of workers employed by small businesses include Greece, Portugal, Spain, and Italy—that is, the four countries whose economic woes are wreaking such havoc on financial markets. Meanwhile, the countries with the lowest percentage of workers employed by small businesses are Germany, Sweden, Denmark, and the U.S.—some of the strongest economies in the world.”
 
A critical reader of Surowiecki’s column is then stuck, because he gives no reference for these data. Those who do study industry structure around the world track SMEs – small and medium enterprises. (What’s a medium-scale enterprise in most countries is regarded as small in the United States.) A nice summary of the percentage of the workforce involved in SMEs was prepared by Marta Kozak of the IFC in 2005. Among the things her data show:
 
-          The smallest percentage of the workforce in SMEs actually can be found in the former communist countries like Armenia (26%), Latvia (21%), Slovenia (20%), Georgia (7%), and Ukraine (5%). None of these countries are paragons of economic stability or growth. Nor are other big-business countries like Malawi (38%), Guatemala (32%), Tanzania (25%), or Thailand (18%).
 
-          Surowiecki is correct that the four currently unstable countries of Europe have a high (>70%) SME presence. But an equally strong SME presence can be found in economic powerhouses like Korea, Switzerland, New Zealand, China, and Japan. Where’s the causality?
 
-          Surowiecki is completely wrong about Denmark (which is at 78% SME) and Germany (70%). And mostly wrong about France (63%).
 
-          Indeed, among the OECD countries, the highly wobbly U.S. economy stands as having one of the lowest representations of SMEs (about 51%). 
 
“This correlation is not a coincidence,” concludes Surowiecki. “It reflects a simple reality: small businesses are, on the whole, less productive than big businesses.” In fact, the absence of a correlation and Surowiecki’s mispresentation of the actual data is not a coincidence either. It reflects the unreliability of his scholarship.
 
Next, Surowiecki turns to a World Bank study of 99 developing countries, written by Megahana Ayyagari et al. (“Small vs. Young Firms Across the World,” April 2011, Policy Research Working Paper 5631). He neglects to mention the principal finding of that paper: “Overall, we find that small firms and mature firms have the largest shares of job creation but large and mature firms have the largest share of job losses. Even in countries which had a net job loss we find small firms creating jobs.”
 
Indeed, the World Bank study offers more evidence for the power of small businesses in churning out new net jobs—annual created jobs minus lost jobs—than the Kauffmann Foundation research does for the United States: “The U.S. evidence suggests that small mature firms have net job losses whereas in developing countries we find that small mature firms have the largest share of job creation. Moreover, in countries that have had net job losses in the economy as a whole, it is only the small firms, especially small mature firms, that have net job gains.”
 
Surowiecki focuses on another, tiny part of the study, however, to make a debating point about productivity: “that large firms had significantly higher productivity growth.”
 
Again, the World Bank study is more nuanced that Surowiecki is: “SMEs with 5-100 employees irrespective of age have significantly lower productivity growth than the larger firms. While the mid-sized firms (101-250 employees) that are <2 years old or 3-5 years have as good or slightly higher productivity growth than the largest mature firms, the mature mid-sized firms (101-250 employees and 6+ years) have significantly lower productivity growth than the largest mature firms.”
 
So it turns out that the best contributors to productivity growth are not large-scale companies, but medium scale and young. Small companies don’t do as well in the developing country context, compared to those in the OECD countries, because their proprietors are less well-educated and their access to capital is more limited. One can think of other special problems that small businesses in the global south face that their northern counterparts do not. Southern small businesses often lack access to the internet and basic technology. Their labor pools are disorganized. Limited transportation and communication infrastructure limits their ability to export.
 
After his around-the-world-tour with fictitious data, Surowiecki returns to the United States. “And in the U.S. the connection between size and productivity is, as a 2009 study showed, especially close. Big businesses are also better able to make investments in productivity-enhancing technologies and systems; in the U.S., for instance, big companies account for the vast majority of R&D spending.” He doesn’t give any clues about what 2009 study he’s referring to, but there’s enough literature out there to accept his facts but refute his conclusion.
           
Yes, larger businesses generally have higher labor productivity. Another way to think of it is that they apply more capital relative to labor. But if higher labor productivity means less employment, it doesn’t necessarily improve national well being. Higher labor productivity once meant higher wages, but that’s no longer the case. One of the key phenomenons of recent years is the dramatic growth in the productivity of U.S. firms, and the stagnation or decline of wages. When managers extract greater compensation packages and shareholders extract greater profits, the productivity gains do not translate into better pay. 
 
In the long run, higher labor productivity may be necessary but insufficient for higher incomes. By subjecting themselves to greater accountability from stakeholders like employees, customers, and shareholders, smaller firms, particularly those that are locally owned, actually can ensure that productivity gains result in higher incomes. This may help explain why several regression analyses of the United States show that communities with higher densities of small business experience higher income growth.
 
A year ago, for example, in the Harvard Business Review, a graph appeared with the headline “More Small Firms Means More Jobs.” The authors, Edward L. Glaeser and William R. Kerr of Harvard, wrote, “Our research shows that regional economic growth is highly correlated with the presence of many small, entrepreneurial employers—not a few big ones.”
 
Here’s another piece of evidence: The workforce associated with small businesses, when one accounts for the skyrocketing of home-based businesses, actually has been growing over the past decade. That’s hardly the mark of diminishing competitiveness.
 
Finally, big companies may account for most U.S. R&D spending, but small businesses spend proportionately more of their budgets – and generate 15 times more patents per unit business than do larger businesses!
 
Surowiecki’s bias against small business comes from a Mad Men view about economies of scale. What he overlooks – and which I document extensively in The Small-Mart Revolution – are a dozen global trends that are shrinking economies of scale. Global distribution systems have become unwieldy and inefficient. Rising energy prices will make global transportation unacceptably expensive for heavy nondurable goods like food, wood, and building materials. The internet is giving small businesses the ability to do anything from anywhere. Homeland security concerns are placing a premium on local self-reliance. Alliances of local businesses are learning how to compete through collaboration (Tucson Originals, for example, is a group of local food businesses that lower costs through collective purchasing of local foodstuffs and cooking equipment). And so on.
 
Ignoring the ways in which monopolies wreck free markets and gouge consumers, Surowiecki praises the innovations of monopolists like A&P last century and Wal-Mart in this one: “Because A & P invested in its own warehouse-and-delivery system, it was able to improve inventory management, which is essential for any retailer. While its competitors were taking four months to turn over their inventory, A & P was doing it in five weeks. Walmart, similarly, invested heavily in making its supply chain more efficient, and it was directly responsible for a sizable portion of the productivity boom of the nineties.”
 
There’s no question that big companies can drive some innovations. But many others – like the deployment of low-tech energy efficiency measures – require small firms operating at the community level. Even in the area of supermarkets, the innovations pioneered by A&P and Walmart could be adopted, even improved, by small competitors. Independent IGA markets, for example, blend advantages of local grocery stores with inventories provided by highly efficient global purchasers like SuperValu Inc.
 
Perhaps the only observation Surowiecki makes that is remotely true is that “it’s harder for small businesses to innovate in these ways…when credit is tight, as it is now.” And it underscores why reforms in local investment, as Amy Cortese documents in her great book Locavesting (and as I’ll elaborate in my forthcoming Local Dollars, Local Sense) are key to improving the competitiveness of local small business.
 
Does does this also mean, as Surowiecki suggests, that small businesses are not interested in expanding or innovating? “A recent study by the economists Erik Hurst and Benjamin Pugsley,” he writes, “shows that only a tiny fraction of small-business owners have any interest in becoming big-business owners, or even in bringing a new idea to market. Most are people who simply want to run a small company, do work they enjoy, and have some control over their own financial lives.”
 
The Hurst-Pugsley study is filled with fascinating data about the inclinations of small-business entrepreneurs, but the results are easy to overinterpret. Small business owners may not want to become big business owners, but does that necessarily mean they do not want to modestly grow their companies, their products, or their bottom lines? As the Association for Enterprise Opportunity has shown, even a slight expansion of every small business in the country would solve the nation’s unemployment problem. 
 
Moreover, might small businesses be relatively unambitious because they are keenly aware of the myriad ways public policy opposes their expansion? Might they be frustratred that the anti-trust division of the Department of Justice, like Suroweicki himself, has given a free pass to monopolists like Wal-Mart? Or that securities law favors big-dollar investors? Or that tax laws favor interstate sellers? Might this unequal playing field drawn certain kinds of entrepreneurs, and push away others? And might more fair rules draw more ambitious entrepreneurs into local businesses?
 
“It’s hardly a coincidence,” Suroweicki concludes, “that in the decades after the Second World War, when ordinary American workers became part of the middle class, very big companies employed a huge percentage of the workforce: in the early seventies, one in five non-farm workers worked for a Fortune 500 company.” In fact, this history is a reflection of the fact that U.S. companies dominated the global economy between World War II and the 1970s. Large economies of scale were the norm. Today, that era is ending. 
 
Despite the rhetorical “fetishization” of small business, U.S. policymakers continue to neglect them. Economic development programs overwhelmingly favor the attraction of nonlocal big business, and President Obama’s stimulus program prioritized big business benefits and tax cuts. The catastrophic results of these priorities are plain for everyone to see. Small may not be beautiful to James Surowiecki, but at least we know it works.
 
Michael Shuman is director of research for Cutting Edge Capital, director of research and economic development at the Business Alliance for Local Living Economies, and a Fellow of the Post Carbon Institute. He is the author of Local Dollars, Local Sense: How to Shift Your Money from Wall Street to Main Street and Achieve Real Prosperity, forthcoming in 2012 from Chelsea Green and Post Carbon Institute.
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