Perspectives from Around the World

Scale Startups: Meeting the growth challenge in developed economies after the recession

Robert E. LITAN
Vice President for Research and Policy at the Ewing Marion Kauffman Foundation

The 2008 economic crisis began in and struck developed economies most heavily, and virtually all of them (Australia and Canada being notable exceptions) are finding it very difficult to recover. Compounding the challenge is the wave of retirees, and the accompanying social security and medical obligations that governments have promised to pay them. As these "entitlement programs" are cut back, or taxes increased to finance them, in order to keep structural government deficits from exploding out of control, these measures will add a "fiscal drag" that will slow consumer spending and thus growth in all of the affected countries.

Unless it is reversed, slow growth could bring with it all sorts of maladies. Most important, slower output growth will mean slower growth in hiring, which will keep unemployment rates abnormally high for years, if not decades. If workers in rich economies can't find jobs, some will migrate, if they can, to medium-income countries, while others will retire early or not even work at all, if they can sustain themselves on shrinking welfare state payments. The downsizing of expectations will be bitter pills to swallow for many, and could easily contribute to rising social frictions and political tensions.

There is only one way, in principle, to avoid these bleak outcomes, and that is for rich countries to host or take advantage of new and continuous waves of innovation that make their citizens more productive and earn them greater incomes. Rising incomes, in turn, can fuel the growth in consumption and investment that are required to turn a potential vicious cycle of despair into a virtuous cycle of hope.

Policy makers are too often immediately tempted to meet any innovation challenge by increasing government expenditures on basic research and development, in the hope that the discovery of new ideas eventually will be translated into new products, services, or methods of production or service delivery. Even if it were the right answer, which it is not clear that it is, this apparently easy fix is no longer available to rich country economies mired in debt and seeking ways to cut rather than to add to government spending. A far more cost effective strategy is to keep open, and ideally remove, remaining barriers to trade and direct investment. Technological advances move most quickly from one country to another if they are carried by the movement of goods and services, and perhaps even more important, of patient capital across borders.

Yet even open borders do not guarantee that innovations developed elsewhere will be absorbed most effectively into the commercial activity of a given country. Some progress in this direction will be made, of course, simply by accepting and ideally giving national treatment, to foreign-owned firms that want to make investments in other countries. But the best way to make use of and even improve upon technological advances, developed at home or abroad, is to make it easy--and ideally to encourage--the formation of new companies that can grow or scale quickly.

That is certainly the U.S. experience. The truly disruptive technologies that have made modern life what it is today in the U.S. and elsewhere--the car, the airplane, air conditioning, virtually all aspects of computing, and many Internet businesses, including eBay, Google, and Facebook--were introduced to the market and successfully commercialized by entrepreneurs starting new firms rather than by established businesses. There are exceptions to this rule, mainly from Japanese companies, notably Toyota and Honda, which both introduced the hybrid car.

Nonetheless, there is a reason that the exceptions prove the rule. Established companies have a vested interest in the status quo, especially if they helped create it and are profiting handsomely from it. Moreover, because of their bureaucratic structures with layers of managers in the decision chain, large firms typically cannot move nimbly to take advantage of new opportunities in the marketplace. In contrast, entrepreneurs don't care about the status quo and indeed exist precisely to disrupt it. And they don't have layers of management and can change directions quickly if their initial ideas are not accepted by consumers. For all these reasons, we tend to see disruptive innovations emerging from newer firms while large firms, with their large R&D staffs and big budgets, concentrate on incremental innovations.

Also in the U.S., until the Great Recession, various papers published or funded by the Kauffman Foundation have established that new firms have been the engines of job creation, accounting for virtually all net new jobs created in the U.S. economy since 1980. Recent research published by the RIETI has found new firms to be important sources of jobs in the Japanese economy as well (i). I have not seen similar analyses for other developed economies, but I know that in some of them (Israel and Taiwan, for example), entrepreneurship has been and continues to an important source of economy-wide growth.

If new, scale firms are vital to both innovation and job creation in developed economies--as I believe they are--then the key to a sustained recovery from the recession, as well as to faster growth thereafter must be the creation and growth of new, innovative firms. Truly innovative firms create not only wealth for their founder-owners, but for society as a whole. By one account, inventor-entrepreneurs only reap 1/25 of the social value of their innovations for themselves, the rest leaking out to benefit others who use their technologies to create other companies (ii). Think, for example, of the economic ecosystems built around the automobile, or all of the application software tools built to work with the platform technologies of Microsoft's Windows or Apple's iPhone, and you get the idea.

Armed with this analysis, I recently conducted a hypothetical calculation for the U.S., asking how many "scale firms," which I arbitrarily defined to be firms whose annual sales would eventually grow to $1 billion or more, would the U.S. economy need to create each year to permanently raise the growth rate by one full percentage point? The answer is about 30-60, depending on certain assumptions that went into the calculation. This is a small number compared to the roughly 500,000 new firms that are created in the U.S. economy each year, but it is a large number compared to U.S. historical experience since the 1850s, which has seen only about 10-15 such "billion dollar firms" launched on average per year (iii).

Fortunately, the task of incubating true "home run" firms is less daunting once one assumes that future growth also will be driven by smaller, but still successful firms. You don't need as many home runs to run up a high growth score if the economy can produce plenty of singles, doubles and triples.

Recent U.S. economic performance has been disappointing, however. Data reported by the Kauffman Foundation show that while the numbers of new firms being created each year has increased somewhat since the recession, the numbers of new firms with employees has dropped, and has been dropping for some time. I hope soon to document more about this disturbing trend in new research with my Kauffman colleague, E.J. Reedy. I have not seen data on employer-based new firms in Japan or Europe, but I would not be surprised if these countries follow the U.S. pattern.

How, then, can policymakers, who tend to be most comfortable dealing with the challenges of larger businesses, best foster the creation of new scale firms, or those most likely to hire other employees? I believe the quickest and least costly answer to this question--for all economies, including Japan--is to permit and ideally encourage the entry of all of the skilled immigrants who want to come, not just for temporary work (which is essentially the case in the U.S. now), but permanently.

In the U.S., an obvious place to start would be to give all of the roughly 65,000 foreign graduates of U.S. universities with degrees in science, technology, engineering or math ("STEM") a green card with their diplomas. The U.S. workforce not only would benefit from this human capital, but over time we would get the formation and growth of a lot more scale businesses, given the greater propensity of immigrants to establish such companies.

A fallback solution is to permit entry of just those who immigrants who actually start businesses, with low thresholds for outside capital or initial revenue in the U.S., as legislation proposed by Senators John Kerry and Richard Lugar would do (although I do not believe we should keep the current cap on the total number of entrepreneur- immigrants). Giving new visas to immigrant entrepreneurs avoids the greatest political impediment to more immigration--the threat that immigrants will "take" jobs away from Americans--because, by definition, the visa only would be made permanent if the immigrants actually hired other (non-family) workers. Despite this, the politics of immigration in the U.S. is so complicated and divisive that even this sensible idea so far has gotten nowhere.

Not in Chile. That country has seen the light by just launching a program that pays the 300 most enterprising entrepreneurs who apply each year the equivalent of $40,000 to come to its country. Other developed economies, like the U.S. and even Japan might not even have to pay, if only they were more welcoming to such individuals.

Japan historically has not welcomed immigrants, despite its aging and shrinking work force. I can understand the hesitancy to change course given the close cultural and ethnic ties among Japanese people. But just as all countries have found that opening their borders to trade and capital improved their economies, they eventually will discover that in a global economy where companies increasingly are doing business globally and attracting and needing workers from many countries, it is good business to accept and ideally recruit individuals from other nations. Since immigrants to any country tend naturally to be risk-takers--it takes immense fortitude to pick up and leave your home country and move to another, after all--why not eagerly accept and seek out especially those individuals who want to start businesses?

It may be said that foreigners will find it difficult without already spending a lot of time in Japan to launch scale companies. While this is surely true, this too can change if Japan sought out more foreign students to attend their universities. There remains a fascination with Japan in the U.S. among students that Japan could tap into, especially if it made clear that university students who came to the country could stay if they launched businesses within a certain period of time. Such a policy would help make attractive Japan a more attractive destination for younger people, and specifically would help it compete with China, one of the world's favorite destinations right now for people with entrepreneurial ambition, which still does not have the political freedoms found in developed country democracies.

Of course, there are more steps that Japan will need to consider if it wants to put itself back on a higher growth path, which this essay has argued will require a much larger rate of formation of scale companies. In particular, another significant barrier to entrepreneurship in Japan is that many larger companies provide housing or housing subsidies to their employees. While this fringe benefit is important and highly valued by Japanese workers in light of the high housing costs in the country, especially in or close to major cities, it also discourages those Japanese workers who are most likely to build new successful companies--individuals whose work experience has given them the insights into new markets and opportunities that all entrepreneurs require--to leave the comfort of their large companies to strike out on their own. I am hesitant as an outsider to know how best to change Japanese practices in this regard, but perhaps one place to start is with tax incentives or penalties for Japanese companies to abandon this practice and pay workers higher wages to compensate for the loss or cutback in employee housing benefits.

Another important impediment to entrepreneurship in Japan, as it is elsewhere, is the stigma or shame that individuals suffer if their businesses fail. The ability to fail without shame, and indeed even with honor, has contributed importantly to the success of entrepreneurs in California's famed Silicon Valley. Indeed, many venture capitalists and angel investors in the U.S. will not invest in a new company unless its founder already has failed before and thus learned what mistakes not to make in his or her next ventures.

Here, too, I am reluctant to offer concrete suggestions how to change Japanese attitudes toward business failure, which are clearly cultural and not easily altered through one or more policy changes. Perhaps one place to begin is in schools, even as early as elementary school, but certainly in universities, to teach students that some of the best learning comes through failure. Even the most successful Japanese companies (let alone many companies elsewhere) have had to learn, through a process of trial and error, before coming out with a solution that is widely accepted by consumers. This process of failing as a predicate for later success is something that should be acknowledged and welcomed by Japanese business and thought leaders.

Finally, while I earlier expressed some skepticism about the need, and certainly the affordability, of more government spending to promote innovation, there is more that governments in all countries can do to ensure that the R&D monies they do spend are diffused more efficiently and quickly in usable form through successful commercialization. The U.S. government has channeled much of its R&D spending into universities, which have had some success in translating their discoveries into commercial products and services. But I believe the U.S. can do better. One place to start would be for the U.S. government to require that university recipients of government R&D funding give their faculty inventors the right at least to license their technologies without being forced to use the licensing services of their own universities. Introducing competition into the licensing of faculty innovations would only speed more of them to commercial success.

My understanding is that in Japan, much government R&D money is channeled to government labs and to industry directly, and compared to the U.S., much less to universities. I do not have sufficient knowledge of how this system might be reformed to generate more commercially successful products at a faster pace, but perhaps the government could experiment with ways of either giving the individual inventors some property rights in their inventions or some other monetary awards once those inventions are commercialized.

In summary, the developed world faces extraordinary challenges in the years ahead, not only mounting a recovery from the deepest recession of the post-war era but in finding ways to boost growth on a sustained basis without spending money that governments do not have. The futures of their citizens and of much of the world hang in the balance.

June 2011
  1. See Fukao Kyoji and Kwon Hyeog Ug, "Sources of Future Economic Growth in Japan: An empirical analysis based on micro-data," Research Institute of Economy, Trade and Industry (RIETI) Discussion Paper Series, 11-J-045, English abstract available at:
  2. William D. Nordhaus, "Schumpeterian Profits and the Alchemist Fallacy," Yale Working Papers on Economic Applications and Policy, Discussion Paper No, 6, 2005, available at:
  3. Robert E. Litan, "Inventive Billion Dollar Firms: A Faster Way To Grow," Kauffman Foundation, December, 2010, available at

June 1, 2011

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