Is Regulation to Blame for the Decline in American Dynamism?

by on February 18, 2015 at 7:36 am in Economics, Law | Permalink

The US economy has been one of the most dynamic economies in the world but recent research suggests that US dynamism is in decline. The startup, job creation, and job destruction rates have all declined over the past three decades with a possible increase in the rate of decline in the past decade. The dynamism decline is robust, appearing in a variety of data. Moreover because startups and the movement of resources from low to high productivity firms are closely associated with improvements in productivity, the decline of dynamism may reduce real wages and the standard of living.

Could regulation be increasing barriers to entry, raising the costs of reallocation, and slowing the diffusion of productivity innovations? To test the hypothesis that regulation is reducing dynamism Nathan Goldschlag and I combined data on dynamism with an industry level measure of regulation. Our measure of regulation is produced by an innovative technique that combs the Code of Federal Regulations (CFR) for restrictive terms or phrases such as “shall,” “must,” “may not,” “prohibited,” and “required”. The count of restrictive words in each section is then associated to industries via a machine learning algorithm that recognizes similarities between the language in that CFR section and industry language (e.g. a section of the text with words such as “pipeline” would be associated with the oil and gas industry). In this way, we can associate each industry with an index of regulation derived from the entire CFR.

The following figure shows the startup rate against the regulatory stringency index (both averaged by industry over the period 1999-2011). Contrary to expectation, there is a slight positive relationship; industries with greater regulatory stringency have higher startup rates. We find a similar relationship with job creation rates.

Startup Rate Against Regulation Stringency by Industry (1)

Of course, it could be the case that more dynamic industries attract greater regulation so the apparent positive relationship in our graph would not reflect a causal connection and could even be masking a negative causal connection. Thus, to further test the relationship, we statistically test whether increased regulatory stringency is associated with reduced dynamism within an industry over time (we give each industry a “fixed effect”). After subjecting the data to a number of different tests we find no statistically significant relationships between dynamism and regulatory stringency (see the paper for details).

One simple test divides manufacturing industries into those that experienced a large increase in regulation (+50% or more) during our time period and those where regulation hardly changed at all (+10%-to -10%). If regulation were the cause of changes in dynamism we would expect to see big differences between these groups. The figure below, however, shows that startup rates, for example, track similarly across the two types of groups suggesting that regulation is not a primary cause of declining startup rates (the same is true for job creation and destruction rates).

Manufacturing Startup Rates

It’s important to note that regulation could have large negative (or positive) effects without having a big effect on dynamism. A tax, for example, could reduce the size of the industry without have a big effect on the startup rate or how well the industry responds to shocks by reallocating labor from low to high productivity firms. In short, regulation can have significant effects on levels without necessarily having large effects on growth rates.

If regulation is not responsible for the decline in dynamism then what is? We offer some suggestive hypotheses in another paper. First, it could be the case that we are mis-measuring entrepreneurship. If entrepreneurship is measured as new firm creation, for example, we miss the entrepreneurship inherent in rebuilding and revitalizing larger and older firms. Since most workers work for larger and older firms, revitalizing these firms may be a more important use of entrepreneurship than starting new firms. In an increasingly global economy we may also miss some of the outsourcing of dynamism that has occurred in recent decades. Apple, for example, is measured in US data as a relatively stable firm but the Apple ecosystem from which Apple sources its product is a maelstrom of entry and exit as Apple hires and fires new firms with each new iteration of the iPhone.

Even if dynamism has declined is this necessarily a bad thing? We should not let word associations influence our evaluations of underlying realities. Dynamism as measured by, for example, job reallocation rates might equally well be called churn. Declining churn doesn’t sound as bad as declining dynamism. Moreover, combining the last two points, perhaps the reason for some of the declining dynamism as measured in the US statistics is that we have outsourced some of our churn. A very different way of describing the same data.

More generally, information technology may allow us to reduce churn while still allowing adaption and innovation. Creative destruction is necessary for a growing economy but if we can boost the ratio of creation to destruction that counts as an improvement in welfare.

Reallocation of labor and capital is an important force driving the American economy forward. We don’t fully understand, however, what the causes of declining dynamism are or exactly how our measures of dynamism relate to entrepreneurship, growth and improvements in the standard of living.

Addendum: Cross-posted at the Columbia Law School Blue Sky Blog.

1 rayward February 18, 2015 at 7:51 am

Is what’s taking place in Silicon Valley not dynamism? Is it dynamism if the ideas hatched in Silicon Valley are implemented in, for example, India or China? Is it dynamism if the ideas hatched in Silicon Valley are for bits and not atoms (to use Thiels’ terminology)? Or if the ideas are for what are essentially toys or entertainment? Is it evidence of dynamism if the best and brightest students pursue high paying careers in finance? Taborrok to his credit alludes to a few of the questions I raise. But his focus, on regulation, I would argue is misplaced. Sure, I don’t doubt that a few good ideas are deterred by barriers to entry, but regulation is not the most significant, not by a long shot. Business is sitting on piles of cash not due to barriers to entry but because the projected rate of return on investments is not enough to justify the risk.

2 Andao February 18, 2015 at 8:55 am

Agree. If there was some awesome opportunity, Apple would spend some of its enormous cash pile in a less regulated country, building new research centers or factories.

The simplest explanation is that in the past we innovated because local labor was expensive. Low cost manufacturing in Asia removes that incentive. Assuming China labor becomes expensive over the next decade, innovation as Alex is measuring it should return.

3 Chip February 18, 2015 at 8:51 pm

SV is SV because of its people. The talent gravitates there because other talent builds wealth there.

It will take a great rupture to break this, though California is doing its best to produce one.

4 SomeGuy February 18, 2015 at 2:41 pm

I’d wager that a substantial majority of newly formed firms are not Silicon Valley tech firms, but instead the more mundane single-site restaurants, McDonalds and Subway franchises, car mechanics, martial arts studios, dry cleaners, accountants and local law firms, financial advisors, and all the other little companies that fill up the strip malls across the country.

5 Brenton February 18, 2015 at 10:10 pm

The ‘strip malls’ of Silicon Valley have been filled for decades.

6 Michael February 18, 2015 at 7:58 am

When a blogger titles a post with a question, the answer is usually “no”.

7 Brandon February 18, 2015 at 9:17 am

Betteridge’s law of headlines:

“This story is a great demonstration of my maxim that any headline which ends in a question mark can be answered by the word “no.” The reason why journalists use that style of headline is that they know the story is probably bullshit, and don’t actually have the sources and facts to back it up, but still want to run it.”

http://en.wikipedia.org/wiki/Betteridge%27s_law_of_headlines

8 J February 18, 2015 at 9:27 am

I’ve also noticed a new version of this law that goes, “Study: unsupported claim.” By throwing in “Study:” the writer distances himself from the likely untrue claim.

A good example recently from Vox is: “Study: We’ve wiped out half the world’s wildlife since 1970.”

Translation: no it hasn’t but this is click gold, Jerry, gold!!

9 Benny Lava February 18, 2015 at 8:28 am

Interesting stuff. My first assumption is that regulations reduce dynamism because they increase the opportunity cost. I will have to spend more time reading this post deeply rather than skimming.

10 Delmar February 18, 2015 at 11:11 am

Extremely speculative and fuzzy, but not interesting. One would suppose that our legions of professional economists would have many decades ago determined whether regulation generally slows innovation and productivity. What do these professionals do all day and what do they all firmly agree upon ?

A semantic analysis of the Code of Federal Regulations (CFR) is a long way from serious economics.

11 Gabe February 18, 2015 at 8:47 am

Admittedly over-simplified reading of this post:
We want to test whether A (a “bad” thing) reduces B (a “good” thing). However, the data says that A actually increases B! Dang.
Response 1: Perhaps A does reduce B – the data must be incomplete.
Response 2: Perhaps B is actually a “bad” thing – which explains why A and B are correlated.
Logical conclusion {not found}: Under these circumstances, More of A = More of B

Question drawn from the first graph: Why is the start-up rate for funds and trusts so much higher than all other industries? If I wanted to cast blame for a perceived loss of dynamism in the American economy, the first place I would look is at the enormous and growing amount of capital being profitably recycled entirely within the financial services industry. Where a great deal of regulation one might find written in the CFR is, shall we say, loosely enforced.

12 SPENCER February 18, 2015 at 9:49 am

One reason that start-up rate for funds and trusts is higher is that the barriers to entry are much lower.

If you establish a good track record as a portfolio manager it is very easy to go independent and set up your own shop.

But if you are a good manager in other industries it is much more difficult to go independent and start another firm.

13 dearieme February 18, 2015 at 8:52 am

“an important force driving the American economy forward”: are you veering towards a teleological fallacy here? Or just indulging in mild huckstering?

14 Eric H February 18, 2015 at 9:06 am

Yet another way to approach this might be to look at the size of firms already in that industry and the number of regulations they already face. If an industry is already dominated by a few large firms, and you add a steady 1% increase in regulation year after year, that might not have as large an effect because they already have the infrastructure to manage the new regulations. GM and Ford could incorporate airbags with little extra effort. At the opposite extreme, if an industry is nearly atomistic and you suddenly drop a 20% increase in regulations on them, you might see a larger shift in that industry since the smallest firms may not have the staffing or skills to manage the new requirements. I know of one company that tripled their compliance staffing at the expense of product development after an unexpected and dramatic increase in regulations in their industry.

You may also have firms who move across industries and run into new regulations. Google and Apple are trying to become automobile manufacturers: it’s all fun and games until they have to start doing offset frontal collision testing. And try making the shift from being a roofer, then a solar panel installer, then an electric utility provider; from an infrastructure standpoint, you just need land for the third step because you already have the skillset. From a regulatory standpoint, you simply wouldn’t do it because your skillset would change radically.

15 Thomas Sewell February 18, 2015 at 9:18 am

Alex,

Maybe you already explored this and just didn’t mention it, but the flipside statistic to startups is failures.

An industry with high number of failures and high numbers of startups might be classified differently than one with a high number of startups, but few failures. It’d be interesting to see if there is a difference in failure rates.

Another interesting and relatively simple measurement might be an industries change in growth rate over time measured against their regulatory burden.

Also, I’d be interested in seeing specific data points related to the internet and/or computer technology. Comparing those to the field might provide interesting reference information towards validity of your measurements since some of us have a pretty good grasp on what they’ve gone through over the years.

It sure is an interesting study, though.

16 tom February 18, 2015 at 11:07 am

I was in the comments to make this point as well. One possibility is that a highly regulated market will have lots of inefficiencies that appear to be good investment opportunities, leading to many start ups, and many failures as the realities of regulation come crashing down.

17 SPENCER February 18, 2015 at 9:53 am

How does the study treat the growth of big box retailers like Wal-Mart and Home Depot?

Traditionally many start-ups are mom and pop retail establishments. But the massive expansion of big box retailers into almost every hamlet in the US almost certainly caused a major decline in retail start-ups.

18 JCW February 18, 2015 at 9:58 am

One possible hypothesis for this data is that we often overestimate the impact of regulation generally on industries. Obviously, we can all come up with examples of regulation that imposed a noticeable burden on an industry, but I would argue that in a quiet majority of cases, regulation is a lagging response–regulations are imposed well after an industry has already identified the problem to be regulated and begun to respond. A noncompliant start-up, in such cases, would be either an incompetent or a bad-faith actor. By contrast, I would expect innovation not to run afoul of regulation precisely because it engages in a new kind of activity or does the old activity in a new way. That’s not to say that regulation might not chase the innovator. But that still makes innovation a lagging cost, rather than an upfront barrier.

The “sharing industry” might be a good example of what I am thinking about (Uber, AirBnB, etc.). A key “innovation” for these companies was to use technology to open an old business (taxis, guest accommodations) in a new, and therefore unregulated, space. In both cases, you now see the old industry players trying to chase the new ones with additional regulation. But that makes the regulation a lagging factor, rather than an upfront barrier. Indeed, you could make a strong argument that the costs imposed by regulation, in this instance, actually created an impetus for innovation, by creating an exploitable niche that makes the new business more competitive. The food trucks narrative might also fit this hypothesis.

19 Hazel Meade February 18, 2015 at 1:41 pm

The sharing economy is a key example of what I’m talking about below.
According to one way of analyzing it, Uber counts as one startup, according to another way of thinking about it, every single one of Uber’s drivers is a startup. If you count every person renting a room out on AirBnb as a “business” then I think you would find that dynamism is not decreasing, in fact it is likely accelerating. And if you just looked at pure barriers to entry (as opposed to general regulation) – then you would probably find a negative correlation between startups and barriers to entry. Especially if you counted all of the people who have been enabled to start something up by “sharing” websites.

20 K.R. McKenzie February 18, 2015 at 10:15 am
21 Damn Kids February 18, 2015 at 10:29 am

Old people ain’t so dynamic

22 derek February 18, 2015 at 10:38 am

What is the cost of each of those musts, shall or required?

How many of them are blue laws, not enforced? Either de facto in the industry, or ignored even by the regulators?

23 Jeff February 18, 2015 at 10:49 am

Why is dynamism associated with more jobs rather than higher output or productivity? I can certainly imagine a scenario in which a more regulated industry needs more lawyers, accountants, etc., tht do not increase output.

24 cassander February 18, 2015 at 11:07 am

“You shall not do X” vs. “You shall not do X, except in cases of Y”

Which of these represents a more regulated environment? the second is more words, but the first is theoretically stricter. and the problem gets harder as the code of regulations expands to thousands of clauses and sheer length starts to become a limiting factor on the ability of people to understand them. Replacing a “don’t do X” with a 1000 pages of rules governing when you can and can’t do X is not de-regulation in any meaningful sense of the term.

25 Bjartur February 18, 2015 at 11:09 am

1) startups probably underestimate the regulatory impact: the upstarts may be less experienced at dealing with regulators, less knowledgeable about regulators, more naïve about regulation (thinking it has something to do with justice)
2) startups might be rightly aware that the regulators will not be gunning for them to the same extent that they are gunning for the big players: going after the big players gets you more bang for your buck/resume; no point in wasting resources on firms that may not be around for long; small players haven’t been around long enough to get on the regulators’ shit lists

26 Clover February 18, 2015 at 11:21 am

Technological advancement has slowed.

27 George Pareja February 18, 2015 at 11:37 am

You should look at the differences in productivity amongst industries. Then parse out when they occurred and if the barriers to entry was from innovation vs. legislation. There is a good article from the cato group on this theory of regulation hindering growth in an economy … http://object.cato.org/sites/cato.org/files/serials/files/regulation/2014/12/regulation-v37n4-3.pdf

28 I'm Sorry I had To Ask This, But February 18, 2015 at 11:44 am

Did Koch/AEI draft this, or did they merely provide the inspiration? I feel like a tool for asking it, but it has to be asked for obvious reasons.

The reason I bring it up is because so often these Free Market Knights in Shining Armor will call for the reduction of regulation in their own sector (Coal, etc) while keeping in place regulations which keep down the competition (Auto dealers vs Tesla).

29 dan1111 February 18, 2015 at 12:18 pm

Are you suggesting that Koch/AEI wrote this paper showing a negative finding that doesn’t demonstrate any harm from regulation?

30 Alex Fan February 18, 2015 at 7:28 pm

LOL Unreal.

31 Marcos February 18, 2015 at 12:22 pm

Way to compare a metric with the rate of change of the other. Regulation can’t be measured by the amount of laws published, but by the amount of laws in action. That’s enough to claim the paper is useless and meaningless.

Besides, one can certainly just as well measure those laws by number of pages or words. It’s probably just as good as “shall”s, and certainly much easier.

32 Brett February 18, 2015 at 12:46 pm

State-level regulation probably has a much bigger impact on start-ups than Federal-level stuff, especially when you consider how much basic business rules (contracts, time and cost of starting a business, occupational licensing, etc) are handled at the state level. It’d be worth doing a broader analysis including state-level data.

33 libert February 18, 2015 at 1:29 pm

There is a strong case to be made that regulation can actually encourage start-ups and dynamism in general. Small businesses are usually exempt from many regulations, with their main target being the big players.

Regulating the big guys can make the industry much more dynamic by giving small firms an advantage.

34 Jason Sorens February 18, 2015 at 1:31 pm

I question the index of regulatory stringency. Big random measurement error in the independent variable -> attenuation bias. In my own research at the state level, I have combed the statutes for phrases like “shall not practice,” “must not practice,” “must be licensed,” etc. and have found that they correlate only modestly with other indicators of regulation (~0.2 is typical). I see 3 problems: “shalls” and so on can apply to *regulators* and the procedures they must follow before issuing new regs; different regulations may use different types of language to describe the same thing, a problem I have run into with the states and attempted to solve, but probably imperfectly (some use “shall” a lot, others use “must,” others “may not”); a count of prohibitive words doesn’t capture well the economic significance of individual regulations.

35 Hazel Meade February 18, 2015 at 1:31 pm

I’m not sure I believe the data that startups are declining. It seems to me as if there are tons of people freelancing or working consulting gigs or self-employed as independent contractors. Technically, all of those are small businesses. It may just not be counted in the official statistics, because that’s hard to track. Or it may be that it is grey-market activity, and thus not reported. Or it may be that there are many people in informal working arrangements that just don’t feel the need to register as a business.

36 stan February 18, 2015 at 2:25 pm

So the job killing regulatory burden of Obamacare, the EPA, and Dodd-Frank across all aspects of the economy are not measured because they don’t strangle only a single industry?

May want to re-think the study.

37 Eric February 18, 2015 at 3:30 pm

Stata graph pro tip:
To remove the blue background and legend box on those graphs, include the following in the “options” (at the end of the comand, after the comma) portion of your twoway command:
graphregion(fcolor(white) lcolor(white) color(white)) legend(region(lcolor(white)))

38 Bill February 18, 2015 at 4:28 pm

Ponder these defects with the methodology:

1. Time series. Regulations often arise YEARS after the enactment of legislation.

2. Presumption that Regulation Restrains: Often regulations create exceptions, qualifications to the application, etc. Look at how many regulatory loopholes are in Dodd Frank

3. Presumption that laws effect only arises from regulation. Some laws take effect upon enactment, without regulation.

4. Use of “must” or other words may in fact imply less regulation: A regulation that does not prescribe the manner of doing something, but instead says that the overall result “must” achieve a result may not be a barrier to entry at all. There are many ways to do something, so long as you achieve a result.

5. Take an economics course and look up the word barrier to entry. The Chicago School would say that something is not a barrier to entry if both incumbents and prospective competitors have to comply with the regulation. Moreover, if the minimum efficient scale is not significantly changed such that the same number of would be potential entrants are the same before and after the regulation the argument fails to show the regulation as a barrier to entry either. Finally, some firms you want to erect a barrier to entry…such as pharmaceutical companies selling products which kill people or don’t work. Or firms which pollute the downstream water drinkers.

39 Steve Sailer February 19, 2015 at 2:03 am

A lot of innovation these days, like AirBnB and Uber, is to get around regulatory burdens on old innovations. For example, if you call yourself a hotel you have to spend a certain amount of money meeting fire safety regulations, such as posting fire exit maps on doors. If you call yourself a taxicab company you aren’t allowed to discriminate against people in wheelchairs who want to go to South-Central.

But if you call yourself instead an App, well, screw all that stuff. You’re disruptive!

40 John February 19, 2015 at 7:13 am

While not specifically about regulation CNBC had a related story about a law suit by A123 Systems claiming Apple is “poaching” batter engineers from them. A123 is apparently a pinonering (dynamic, innovating company in the LI battery space).

41 John February 19, 2015 at 7:16 am

Related to the subject, this morning CNBC’s ewbsite reported a suit by A123 Systems claiming Apple is stealing “poaching” engineers from them.

42 Bill February 19, 2015 at 11:07 am

Raise their wages.

43 jm February 20, 2015 at 4:25 am

The patent system is a major inhibitor. Patent offices have been incentivized to grant patents rather than refuse them, due to being funded by fees rather than from general government revenues. The result has been a harmful decrease in patent quality. Moreover, the US Patent Office is staffed mainly by young people who have no prior industry experience and therefore are poor judges of what should be “obvious to someone of ordinary skill in the art”. Many patents have been granted in the software area on ideas that are utterly obvious. So if you are not a firm already established in a field with a patent portfolio that poses a threat to competitors such that they are compelled to cross-license with you, you are taking a great risk in starting a new firm or branching into a new line of business.

http://www.wti.org/fileadmin/user_upload/nccr-trade.ch/wp3/3.2/The_Structure_of_Patent_Costs_and_Patent_Offices_Financing_The__Missing__Link_to_Patent_Quality.pdf

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