Tuesday, August 5, 2014

The Sobering Truth about Business Failure Rates

A statistic on business failure in the United States: only 50% of new businesses will survive after 5 years, only 38% will last 10 years, and only 31% will last 15 years (from Birch 1987 cited in Lane and Schary 1991: 97).

Although the data here are from the years before 1991, subsequent empirical studies of both the US and other nations result in much the same findings: e.g., in Canada, 68% of businesses with fewer than 5 employees fail within 5 years, and 48% of business with 5 to 99 employees fail within five years too (Monk 2000: 12).

And matters are no better when you look at business failures in different, more laissez faire systems like the gold standard era: what good data from 19th century that does exist suggests that business failure rates were very high back then as well (Lerner et al. 1975: p. 913, “Series V 20-30. Business Formation and Business Failures: 1875 to 1970”).

If anything, the data in the Historical Statistics of the United States, Colonial Times to 1970. Part 2 (pp. 912–913) shows that business failure rates – though high – actually fell after 1945 under modern, interventionist monetary and fiscal regimes, so that the post-1945 record is better than the pre-1939 or pre-1914 one.

If one looks at these failure rates, one can only conclude that decentralised, private decision-making on production and investment mostly turns out to be wrong and a failure; it is not some incredibly efficient system at all, for a 50% failure rate after 5 years for new businesses means massive wasted resources and lost opportunity costs.

This is curious given how frequently we hear paeans to the alleged extraordinary success of private enterprise over government production, and the power of the private sector to efficiently decide what and how much to produce as demanded by consumers in businesses that are viable.

All in all, the claims made for the private sector seem grossly overrated when one looks at the sobering facts on how high business failures rates actually are.

Governments can fail too of course and sometimes fail badly, but I see no evidence that their failures are any worse than the stunning and abysmal failure rates that plague the private sector.

I hasten to add that none of this is meant to be an argument for a command economy over private production of most goods and services; it is merely a sobering look at why the private sector is not necessarily better than government.

The main reason for high business failure rates throughout modern history is most probably this: fundamental uncertainty.

You cannot predict many aspects of the future with objective probability scores, and decision-making on private investment is made under subjective expectations. Of course, some businesses can reduce their degree of uncertainty and risk, and we have institutions – both public and private – that reduce uncertainty and stabilise the system.

But a great deal of private investment is simply a type of gambling, where some few get lucky and many others lose.

And once we realise that investment itself is unstable given that business confidence can fluctuate between waves of pessimism and optimism, we can understand the essence of Keynes’ revolution in economics as summarised by George L. S. Shackle:
“[sc. Keynes’s] ... theory of involuntary unemployment is perfectly simple and can be expressed in a paragraph, or in a sentence. If you express it in a sentence, you simply say that enterprise is the launching of resources upon a project whose outcome you do not, and cannot, know. The business of enterprise involves investment, the investing of large amounts of resources--huge sums of money--in things whose outcome you cannot be certain of, which could perfectly well turn into a disaster or a brilliant success.

The people who do this kind of investing are essentially gamblers and they can lose their nerve. And if they decide to withdraw from trade, they sweep their chips up from the table. If they decide it’s too risky, if their nerve gives out and they can’t bring themselves to go on investing, they cease to give employment and that is the explanation.”

“An Interview with G.L.S. Shackle,” The Austrian Economics Newsletter, Spring 1983.
BIBLIOGRAPHY
Birch, David L. 1987. Job Creation in America. Free Press, New York.

Lane, Sarah J. and Martha Schary. 1991. “Understanding the Business Failure Rate,” Contemporary Policy Issues 9.4: 93–105.

Lerner, W. et al. 1975. Historical Statistics of the United States, Colonial Times to 1970. Part 2 (bicentennial edn.). U.S. Dept. of Commerce, Bureau of the Census, Washington, D.C.

Monk, Richard. 2000. “Why Small Businesses Fail,” CMA Management 74.6: 12–13.

5 comments:

  1. "none of this is meant to be an argument for a command economy"

    Some people often mistake arguments against command economies as proofs in themselves that 'laissez-faire' is the best of all possible worlds. This sort of confusion is rampant among austro-ancap cultists.

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  2. As you say: resources are wasted. Thus, if production was at full capacity -- as is typically assumed by marginalists -- goods would be used up with no forthcoming consumption. This would create inflationary pressure. I've never had a marginalist economist -- Austrian or non-Austrian -- explain to me why, with high failure rates, the private sector is not inherently inflationary. In their own model it should be. It doesn't matter if that model is DSGE of Mises' or Hayek's, in all of them failed companies should generate inflationary pressure. It's bizarre that no one has pointed this out.

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  3. "If one looks at these failure rates, one can only conclude that decentralised, private decision-making on production and investment mostly turns out to be wrong and a failure; it is not some incredibly efficient system at all, for a 50% failure rate after 5 years for new businesses means massive wasted resources and lost opportunity costs."

    I think the rejoinder would be that the high level of business failure is an essential feature keeping the competitive system efficient. I think I've heard right-wingers use rhetoric along the lines of, "Would [choose a hated government agency] stay in business two weeks if they had to compete?!?" Indeed, proponents of school "reform" in the US think that introducing this dynamic among teachers will improve school performance.

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    1. (1) "I think the rejoinder would be that the high level of business failure is an essential feature keeping the competitive system efficient. "

      Yes, but it still comes with tremendous waste of resources.

      (2) "I think I've heard right-wingers use rhetoric along the lines of, "Would [choose a hated government agency] stay in business two weeks if they had to compete?!?"

      And yet many government owned services or enterprises do make a profit and do succeed even by this criterion.

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