Deadwood and Downturns

It’s often said that recessions clear the deadwood out of an economy.

We’re not exactly in recession in the UK (as Germany, unfortunately, is, and as around 20 EU economies were last winter). But things are pretty bad, with high interest rates, a severe monetary squeeze and business being (to put it mildly) less than great all round. So what does that bode for the clear-the-deadwood metaphor? Are all those deadwood companies, still upright thanks only to years of ultra-low interest rates, finally going to perish and give their ground to thrusting green-shoot enterprises?

Unfortunately, I think the opposite may be true.

What really makes unemployment peak in economic downturns is not so much the result of established firms sacking workers. Firms never like laying people off. It looks bad, and in countries like the UK and those of the EU, tightly regulated labour markets make it hard and expensive to sack employees. A much more important factor is that downturns make firms of all sorts more cautious, and more reluctant to take on new workers (especially, again, when employment regulation makes it hard to lay them off again if that proves necessary).

The result of that is that people who do lose their jobs spend longer looking for new ones, and those entering the labour market for the first find themselves competing for fewer openings, so they too join the ranks of the unemployed.

But it is younger, more entrepreneurial firms which are likely to contribute most to the unemployment, because they have not yet built up the confidence, the capital and the other resources needed for them to be sure they can survive a downturn, far less expand while one is in progress. In fact, precisely because they do lack that firm foundation, a greater number of new ventures fail during downturns than do established ones.

Unfortunately, therefore, the mature, deep-rooted deadwood companies are more likely to be standing at the end of a downturn than are the new, green-shoot thrusting ones. It’s the very opposite of what the ‘forest fire’ analogy predicts.

What are the policy implications of that?

First, if we want to speed recovery, we have to encourage newer, smaller entrepreneurial companies and start-ups. That means keeping entry barriers (like regulations) low, but most importantly, keeping taxes on businesses and on capital low. People who are starting or trying to grow businesses always cite taxation as their biggest obstacle: they are taking big risks, probably borrowing money from friends or mortgaging their homes to invest in their new venture, and the government’s tax collectors cutting themselves in for a large slice of any possible future product raises that risk even more. There is even a case for having lower taxes and regulations on small firms and start-ups, just to even up the risks when economic times are hard.

Second, we need a flexible labour market, free of employment regulation that makes firms reluctant to take on workers in the first place. A large part of that is making it easier and less costly for firms to scale back employment when market conditions dictate.

Only such an enterprise-friendly approach, especially a new and growing enterprise-friendly approach, is likely to keep unemployment down, strengthen government and private-sector revenues, capture the innovative capacities of entrepreneurs, and create the new, sometimes revolutionary, businesses that will pull us out of a downturn.