13 Jul 2012 The Importance of Small Business

It was a light week for economic news, but one of the most significant announcements came from the National Federation of Independent Business. It described the latest reading from its small business optimism index as a “significant” decline. Major contributors were poor job creation and consumer confidence, as well as declining capital investment plans and earnings trends. Only 1 in 10 components improved last month, according to Econoday.

Why is small business so important? The usual answer is that small businesses create more jobs than big business. Historically small businesses created more than 60% of new jobs in this country. However, recent new data from the Bureau of Labor Statistics shows that trend may be changing. From April 1990 (a high point in employment for that cycle) through March 2011, a year after employment bottomed after the 2007-9 recession, large companies (> 500 employees) increased jobs by 29% while small companies (< 49 employees) increased jobs by 10.5%. The report did show that employment was far more stable at small companies than at large ones. In other words, large companies hire bigger when times are good and they fire bigger when times are hard.

Statistics aside, there is a far more important consideration all too often ignored, understandably by the bean counters, but unforgivably by policy makers and leaders. Small business represents the heart and soul of the American economy. The last sentence of the previous paragraph summed it up from the perspective of employer loyalty. By their very nature, small businesses are family like and relational, while big businesses are impersonal and policy driven.

Small businesses are great innovators. According to the Small Business Administration, small companies “produce 13 times more patents per employee than large patenting firms.” And small firm patents tend to be more technically important; “these patents are twice as likely as large firm patents to be among the one percent most cited.” The first airplane, the FM radio, the personal computer all came from small businesses. General Electric, Apple, Google, Facebook, Dell, Mattel Starbucks, Amazon, Whole Foods to name but a very few, all started as one- two- three-person businesses and struggled mightily for survival before making it big. But just as in job creation, small businesses are seeing declines in innovation. As measured by patents granted, small businesses have fallen from 30% of patents granted in 1995 to 20% in 2009.

Small businesses make it possible for large businesses to run effectively and efficiently. For every General Motors or General Electric, there are thousands of vendors, suppliers, specialists, and consultants. It is not an over-exaggeration to say that large businesses could not exist without small businesses.

The US economy is mired in a sluggish growth cycle that is well below its potential. Most economists believe the economy needs to grow by at least by 3% (measured by gross domestic product GDP) to approach its  potential and to produce jobs. Between the years 1962-2000 the US economy experienced GDP growth above 3% 31 out of 38 years or 82% of the time. Since 2001 the US economy has seen GDP rise above 3% only one full year.

We have blamed excessive government reach in the form of regulations and debt as primary causes for the long-term economic doldrums. Regulations increase the cost of doing business,  while increased government borrowing unfairly crowds out the ability for businesses to borrow. Anyone in business will tell you these are two powerful disincentives for risk-taking, i.e. doing business.

But are we overlooking perhaps the biggest cause of them all? What if the declining roles of small business innovation and job creation are actually causal for the economy’s malaise rather than the result of it? What if the policy direction of our country toward more centralized government was actually causing similar results in business, through increased uncertainty, regulation, and capital burden? Or is it perhaps even by design?

The America Invents Act of 2011, signed by Obama, “takes away key legal provisions that small businesses and start ups have used for decades, adds risk and promises to increase the cost of obtaining, maintaining and enforcing patents” according to Todd McCracken, National Small Business Association. Eventually the small business will not be able to afford patent protection. How can that benefit a major engine of innovation? Future Steve Jobs and Steve Wozniaks will go to work for IBM and Apple and their ideas may or may not make it through the corporate thicket.

The increase in taxes on individuals and Sub-Chapter S Corporations (many of which are small businesses) making more than $250,000, is interminably touted by Obama as good policy. Its good if the intention is to further centralize business. Take away the small business profit incentive (that’s what taxes do) and you take away a powerful incentive to innovate or to grow, or to hire. You eventually kill the incentive to start small businesses.

Adam Smith in The Wealth of Nations said “To found a great empire for the sole purpose of raising up a people of customers may at first sight appear a project fit only for a nation of shopkeepers. It is, however, a project altogether unfit for a nation of shopkeepers; but extremely fit for a nation whose government is influenced by shopkeepers.” Napoleon used the theme disparagingly to describe England as unfit for war against France when he chided “England is a nation of shopkeepers.”

According to Wikipedia “Napoleon’s assertion proved itself wrong. Although Britain had half the population of France during the Napoleonic Wars, the country’s manufacturing capacity was greater, so that there was a higher per capita income and, consequently, a greater tax base, necessary to conduct a prolonged war of attrition.” And According to historian Paul Kennedy, “The enormous sustained demand which Admiralty contracts in particular created for iron, wood, cloth, and other wares produced a “feedback loop”, which assisted British production and stimulated a series of technological breakthroughs that gave the country yet another advantage over the French.” And a stable currency persisted througout the war period.

Centralization concentrates power, capital, and intelligence. It rarely benefits from innovation, creative thinking, or risk-taking. And it exposes the viability of the enterprise to the mistakes of a few. We were a nation of shopkeepers, of widely distributed wealth, innovation and risk takers, but we are losing what makes us great on virtually every front in favor of mega corporations, banks, and governments that have no hearts or fire of innovation. This November we have an opportunity to reboot or to continue down the path we’ve allowed our political system to take us: Will we choose the course of shopkeepers or of France?