Economy

Failing at Innovation? Bank on It


At the turn of the 20th century, the board of directors of the Cleveland Trust Co. met weekly to go over the bank’s loans. The minutes show the directors carefully scrutinizing loan applications, especially from local entrepreneurs. Yet toward the end of the 1920s, the minutes start reflecting a board less interested in local business lending and more absorbed with sending money to New York to play the stock market. “There was none of the careful oversight of before,” says Margaret Levenstein, executive director of the Michigan Census Research Data Center at the University of Michigan, who examined the minutes as part of an ongoing research project. “They wanted to speculate.”

The bank’s finances took a hit when the stock market boom went bust in 1929. Cleveland Trust survived the Great Depression, including a 1933 bank run that ended after its president, Harris Creech, clambered on a desk and calmed down nervous customers. But its speculative splurge evokes the banking industry’s race to a fast buck 75 years later. And the rise and fall of Cleveland’s economy from the 1870s into the 1930s may help explain why entrepreneurship—a key engine of new job creation—is falling short in America today.

For all the buzz in business publications about bold start-ups and TV ads extolling the joy of striking out on your own, there’s less entrepreneurship in the U.S. than there used to be. The U.S. created fewer start-ups that employed at least one worker in 2007 than in 1990, after adjusting for population growth, says Scott Shane, professor of entrepreneurial studies at Case Western University. The new companies that do get formed employ fewer people, too, according to economists Robert Litan and E.J. Reedy. They found in a recent Kauffman Foundation study that in the 1990s, new establishments opened for business with about 7.5 jobs on average, compared with 4.9 jobs in the 2000s.

“The trend has been a downward-sloping line on start-up firms and new firm job creation,” says Shane. “There was a big acceleration of the underlying trend during the recession.”

Networked Economy

Here’s where Cleveland comes in. From the 1870s to the Great Depression, Cleveland was a hotbed of technological innovation, with networks of entrepreneurs, start-up companies, and financiers. The innovators built enterprises in key Second Industrial Revolution businesses like iron and steel, machine tools, automobiles, electrical machinery, and chemicals products. Cleveland’s networked economy was reminiscent of contemporary Silicon Valley, according to a series of scholarly papers by economic historian Naomi Lamoreaux of Yale University and Levenstein of Michigan.

Granted, Cleveland was geographically blessed. The region was rich in resources, including oil. It became a major transportation hub with access to the Erie Canal and Lake Erie, as well as three main railroad lines. But by the standards of its times, Ohio had a well-regulated banking sector, a relatively equal distribution of income, and an educated workforce, Levenstein says. Community elites, eager to make money, drove large investments in infrastructure. For instance, the Case School of Applied Science was founded in 1880 (now Case Western University) and the Cleveland Stock Exchange opened for business in 1900. The CSE in its early years had more industrial companies listed than the larger New York Stock Exchange.

“Lots of people were participating in the economy and they were not impoverished,” says Levenstein. “And the economic interests of local boosters were tied to local infrastructure.”

America has faltered at making the kind of productivity-enhancing investments that powered entrepreneurship in Cleveland back then. In inflation-adjusted dollars, American infrastructure spending is about the same level as in 1968. Little wonder freight bottlenecks and congestion cost the much larger economy of today about $200 billion a year, or 1.6 percent of GDP, according to the Transportation Infrastructure Report 2011. State funding of higher education has declined since the mid-1970s and the cuts have become severe during the downturn. The federal share of spending on research and development hasn’t breached 1 percent of GDP since 1992, and in 2008 it was only 0.73 percent.

Workers’ Shrinking Income

Workers are taking home a smaller piece of the economic pie. The shrunken wallets and household budgets of the average employee can be captured with a number of different metrics, but the most intriguing is their shrinking share of national income. Labor’s share averaged 64.3 percent from 1947 to 2000, according to Susan Fleck, John Glaser, and Shawn Sprague in the January 2011 Monthly Labor Review. That share fell over the past decade to its lowest level on record, 57.8 percent in the third quarter of 2010. The financial-services industry went on a record-setting spree of financial speculation during the 2000s.

Of course, there are remarkable hot spots of entrepreneurial innovation in America. (See: Apple (AAPL), Facebook, Google (GOOG).) Silicon Valley is the global epicenter for leading-edge information technologies such as the mobile Internet and social media. But from an economywide perspective, it’s hard not to believe that the failure of business, government, and finance elites to come together and fund the kind of investments that nurture networks of innovation isn’t a barrier to start-ups today.

Cleveland’s innovation network didn’t survive the trauma of the Great Depression. Many of the small businesses that existed in the 1920s didn’t make it through the long downturn, according to Lamoreaux and Levenstein. What did survive? Larger companies with their stronger balance sheets and greater resources. History may be repeating itself during the current great contraction. America’s largest companies have boosted their cash holdings for the past 10 quarters in a row, to a record $963 billion. That’s 58 percent over the comparable figure in December 2007. Even as those big businesses bulk up, the number of new companies that create jobs for more than just the owner has fallen 27 percent since 2006, according to Litan and Reedy. Coincidence?

There isn’t any simple, single answer to America’s declining entrepreneurship. The question is, without greater efforts to reverse the trend, will the U.S. economy go the way of Cleveland, from a center of innovation starting in the 1870s to a symbol of the Rust Belt in the 1970s? It’s a chilling thought.

Chris_farrell
Farrell is contributing economics editor for Bloomberg Businessweek. You can also hear him on American Public Media's nationally syndicated finance program, Marketplace Money, as well as on public radio's business program Marketplace.

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