Employment and Competitiveness of Small Businesses

During the presidential campaign there was a lot of talk about the role of small business in employment.  One of Romney's central theses was that the small business community is the largest creator of new jobs in the country and so we should give small businesses breaks to allow them to hire.

In actuality, small businesses may create new jobs but they aren't the largest employer in the country.  Large companies with more than 500 employees employ slightly more than half of all working Americans, while firms with fewer than 100 employees collectively employ about ~30% of the workforce.  Still, smaller firms are more labor intensive than large firms in that they spend a higher share of revenue on labor.   Mid sized firms employing between 10-100 workers spend over 20% of revenues on their workforce.  By contrast, large firms only spend 15%.  (I'd guess the reason 1-4 employee firms looks relatively low is that the majority of income is proprietor's income rather than payroll).

Source: Census Bureau

Even though they employ fewer people, there are many more small businesses in terms of number of firms.  However, since 1988 the average number of employees per firm has risen steadily (see below).  This implies that there's been consolidation in the economy and the average size of US businesses is increasing.  Today there are 5.7 million firms in the US, which is down 5% from the start of the recession.  By category, the number of businesses with 20-99 employees shrank the most over this time frame, falling by 11% since 2007.

One might wonder if the business landscape has trended towards consolidation because of the labor intensity of smaller firms. Larger firms have the resources to spend on technology and globalization of supply chain, which improves efficiency and allows bigger companies to take share from smaller ones.  One could probably argue in different directions as to the effect this has on the aggregate labor force, but the fact that large firms spend a smaller proportion of revenue on labor raises some underlying questions about the extent to which today's elevated unemployment is structural (vs. cyclical)--caused by the elimination of jobs through increased implementation of technology and business consolidation.

Source: Census Bureau

Are we Heading For a Recession?

Every time the equity markets go through a correction the recession chatter seems to pick up.  In the last few days, the chart below has started to pop up around the internet in support of the idea that we might be heading for one again.  It's a recession probability index (which isn't widely followed to my knowledge) but has a good track record of predicting previous recessions and is past the threshold that has signaled false alarms before.

The indicator was developed by two professors, Marcelle Chauvet and Jeremy Piger.  The inputs are: "a dynamic-factor markov-switching model applied to four monthly coincident variables: non-farm payroll employment, the index of industrial production, real personal income excluding transfer payments, and real manufacturing and trade sales."

I'm not particularly familiar with this indicator so it's tough to know what the biases could be, but I generally tend to be somewhat skeptical of models like this one.

A more time tested recession indicator is the slope of the yield curve--when the spread between 2 year and 10 year treasuries is inverted recession normally follows.  In a zero interest rate environment the yield curve may have lost some of its informational content, but it's been a great cyclical indicator for a long time and it's grounded in sound economic logic, so it shouldn't be totally ignored.  Today, even though the curve has flattened since '09 it is still not at or near the zero threshold.  As of right now I'm still on the lookout for the yield curve to go completely flat or invert when recession is imminent, even in this environment.

To clarify, I did write yesterday in my investor letter that I think recession will happen sometime in the next presidential term, but that doesn't necessarily mean it's imminent.  My base case is that it could start sometime late next year absent a totally botched fiscal cliff.  The forecast is mostly reliant on the average duration of economic expansions.  As I've written before, this expansion would be short even compared to the 1933 expansion if it ended today.

How Many Hours of Work Does it Take to Buy...

The reason that economists adjust nominal data to "real" numbers is that they are trying to create a better picture of general welfare after adjusting for inflation.  If an economy produces $100 worth of widgets one year and $150 worth of widgets the next, the dollar increase doesn't tell you much if the price of a widget also rose from $100 to $150.  In that case the economy has still produced one widget in the year, so welfare has not changed and theoretically real GDP should be flat.

At a fundamental level, "real" economic numbers are an attempt to measure output against time.  In the previous example, the data was adjusted to have a more clear picture of the number of widgets produced per year.  For humanity, time is really the only scarce resource there is.  Therefore, the number of hours worked that it takes a person to buy an item is the true measure of welfare.

Today's employment report showed that average hourly earnings fell slightly to $23.58.  Below are charts of the number of hours that it has taken to purchase a home, a barrel of oil, an ounce of gold and "an S&P 500," at the prevailing hourly wage of the era.  In general a downward slope would mean that societal welfare is increasing because it would take fewer hours to buy the same good.

What's so Great About GDP Growth if We're Not Building Wealth?

I'm going to be traveling for a bit until after labor day, so this will be my last post until then.  Sorry to leave everyone with a rant, but I think this is an important concept worth pondering.

One of the main reasons that our economy feels so stagnant is that our economic policies are focused on maximizing the wrong economic indicator.  We fixate on GDP growth, when in actuality this is the second derivative of what really matters for economic well being: wealth.

Wealth is most important because wealth is the key determinant of how much one can consume.  Wealth is distinctly different from income.  A person with a high net worth and no income is generally better off than a person with a high income and no net worth.  Income is important because it controls the pace at which wealth growths, but our ultimate economic goal as individuals is maximization of wealth and by extension, consumption.

In an economic sense, GDP is an income measure (even more accurately a revenue measure).  As an income measure, GDP itself (i.e. $15T) is the growth measure.  If all of GDP were saved in a year, wealth would grow by $15T per year.

As a society we follow GDP, but we are even more concerned with GDP growth (for example 3%).  This is mostly misguided because it is the second derivative of what we actually should care about.  GDP growth measures the pace at which the growth of your wealth is growing.  It is an acceleration measure.

In physical terms, wealth, GDP and GDP growth are akin to position, velocity and acceleration.  If you are trying to reach a destination, who cares if you are going fast and headed faster in the wrong direction?

If our intended economic destination is the maximization of wealth, we as a society have been failing miserably.  The charts below measure the aggregate net worth of US households: Assets-Liabilities.  Two major factors are left off of the headline number which are added back into these charts:  1) Federal Government Debt, which Ricardian equivalence argues is a direct liability on the household balance sheet 2) Inflation adjustment.

When one adds government debt and the declining value of the dollar back into the picture, the outcome is bleak.  There has been no increase in real household net worth since 1999.  If one adjusts the chart further for a per capita number it takes real household net worth back to 1997 levels.  Worst of all if we include the very real but unfunded liabilities of Social Security and Medicare (someone has to pay for these programs if not the government), household net worth all but vanishes.  

We have been failing to increase wealth because our economic policies have been designed deliberately to destroy it in order to pursue GDP growth.  Low interest rates and large deficits are policies that force more debt and inflation in order to generate GDP growth.  These policies can stoke economic activity, but do so in a way that directly restricts the accumulation of wealth by actively combating what has already been saved.  Negative real interest rates are by definition wealth decaying.  Debt wasted on an unproductive asset is similarly harmful to net worth.  The above chart implies that over the last 12 years these wealth destructive policies have wiped out all of the GDP produced during the period.  Thus our aggregate net worth has remained flat.

Our current policies are the equivalent of declaring economic war on one's self--like tearing down a perfectly good home in order to rebuild it.  The rebuilding of the home contributes to GDP for the period, but did it make the dweller any better off?  Destroying and rebuilding valuable assets doesn't increase wealth it destroys it.

Why do we as a society continue to push our foot to the gas pedal trying to go as fast as we can in the wrong direction?  What is the value of producing one more widget per year if we destroy two saved widgets in order to do so?  When will these destructive and misguided economic policies end? Sadly, it probably wont be with any official running for office today.

What Percentage of the US Population Works?

Below is a chart of the employment/population ratio for the US.  It measures the percent of the population in the US that is working.  Even though the unemployment rate is 8.2%, that only measures those looking for work who can't find jobs.  The number below takes into account the whole population.  At 58% of the population employed, the number is the lowest it's been since 1984.  The employment ratio for men is near an all time low set in 2010.

Still, compared to some other developed countries the percentage of the US population that is working is relatively high.  In Italy, less than half the population is employed.

Alan Greenspan on Forecasting in Businessweek

This week's issue of Businessweek has an interview with Alan Greenspan, in which there was an interesting exchange on his ability to forecast future events.

You also told the commission that you were right 70 percent of the time and wrong 30 percent of the time. What were you wrong on?   

Forecasting the next week’s stock market change. I’ve been in the forecasting business for more than half a century. If I get it right 70 percent of the time, I consider that very successful. People don’t realize that we cannot forecast the future. What we can do is have probabilities of what causes what, but that’s as far as we go. And I’ve had a very successful career as a forecaster, starting in 1948 forward. The number of mistakes I have made are just awesome. There is no number large enough to account for that. But I’m right more than half the time.  

Some people said you were giving yourself a C-minus, but maybe in the business of predictions, a C-minus is better than it sounds? 

Forecasting our futures is built into our psyches because we will soon have to manage that future. We have no choice. No matter how often we fail, we can never stop trying. The ancient Greeks had the Oracle of Delphi, who allegedly had the capability of seeing into the future, and military leaders used to go to her. And then there’s Nostradamus, two millennia later, who had very much the same aura. Fortunetellers and stockpickers today make a reasonably good living. Physical scientists can forecast with some precession. But in economics, we are extraordinarily fortunate that we succeed a majority of the time. (I think there's room for debate on this one)