Where are the European Entrepreneurs?

By Simon Johnson

This post is based on class #2 in my MIT Sloan course, Entrepreneurship Without BordersAn edited version appeared this morning on the NYT.com’s Economix blog.

Europe today is relatively rich on average, and there is undeniable potential for further convergence towards Northern levels in use of technology, organization of firms, and productivity levels.  We witnessed some impressive economic improvements over the past 20 years as Eastern Europe left behind its communist system – in part due to the creation of dynamic new firms (e.g., in Poland) and in part as a result of investments by foreign companies (e.g., in Hungary).  But the extent of North-South productivity convergence within Europe has proved disappointing since the formation of the euro area in the late 1990s.

Southern peripheral Europe is now in the midst of a serious economic crisis – precipitated by the realization that sovereign debt may actually be quite risky.  The immediate financial market pressure receded last year when the European Central Bank indicated that it will intervene to keep yields (i.e., interest rates on government debt) at manageable levels, but there is still the critical question of when growth will turn – and what rate of growth is sustainable in the medium term.

Does economic crisis of this type lead to more entrepreneurship – in a form that will put these economies onto a stronger growth path?  Or does the contraction of credit and pressure on consumers and firms mean that it is much harder for a new business to get started?

Portugal is a good place to look for some specific answers – and perhaps for clues to what may happen more broadly in Europe.

By some measures, Portugal is making good progress in terms of stabilizing its economy and getting public debt under control.  A presentation in April by Vitor Gaspar, then finance minister, made a strong case that Portugal is on the mend – and should be seen more like Ireland than like Greece.  Certainly the budget picture has improved and growth in the second quarter was better than expected.

But any macroeconomic recovery requires either existing firms to grow or new firms to form – this is what creates jobs.  In terms of individual stories there are definitely some positive signs – including from this recent New York Times coverage of firms that are increasing exports, in part because domestic market prospects are not strong.

And there are broader indications that corporate performance is gradually recovering across the board.  Large investment projects are unlikely to face political obstacles – although the overall level of political uncertainty remains an issue (and Mr. Gaspar resigned in July).

For smaller firms, there are numerous discouraging barriers to entry and growth, and the Portuguese government has not made it a priority to address these.

The World Bank’s Doing Business indicators provide a useful window into some of the concrete issues.  Obtaining construction permits is a big problem (measured relative to other countries in this extensive database).  And access to credit in Portugal is dismal, according to these measures — credit access worsened from 2012 to 2103 (Portugal’s rank fell from 97th in the world to 104th).  This is not just the crisis; the available indications are that it was also hard to obtain credit before the government’s finances were viewed as problematic.

To be fair, the basic enforcement of contracts in Portugal is good (ranking 22nd in the world, according to the World Bank) – collecting on a bad debt or enforcing a noncompete clause in an employment contract is not much harder than in London or New York.  And while there may be some corruption involved in real estate transactions, it does not seem to endemic in all areas of economic activity.

Still, something more should be done – and not just in Portugal.  The prospects for a rapid recovery in Italy also do not look good, if you focus on the potential for new business growth.

The broader picture is that the euro has not depreciated, so the incentive to export is more muted and the ability to compete against imports on the basis of price is less than in some crises (e.g., what happened in Asia after the 1997-98 crisis there or in Argentina after the currency board collapsed in early 2002.)

Economists like to talk about restoring price competitiveness – but this is code for cutting wages, which is never popular politically.  Portugal is no exception, although there has been an impressive decline in annual compensation that on average is probably around 10 percent (in part through not paying the so-called 13th month bonus).

The best hope in peripheral Europe is the creation of new firms and the expansion of firms that are currently small.  Cutting regulation and red tape would be enormously helpful.  Making it easier for firms to go out of business would also make sense – start-ups need to be able to fail in a clean and relatively painless way when things do not go well.  Simplifying the tax system would also help.

I’m not in favor of the government trying to pick winners – or even, once fiscal order is restored, putting money into any kind of venture fund or providing tax breaks or subsidies for particular sectors.  This kind of policy has gone wrong in Portugal (and many other places) in the past.

But there must be broader ways for the government to make it easier to commercialize technology developed in universities.  And matching big international firms with pockets of technology, for example around biotech development related to agricultural inputs, could make sense.  Facilitating these activities does not necessarily require a significant capital outlay.

In January 2012, Peter Boone and I were pessimistic about the macroeconomic outlook – and I’m glad that our worst-case scenarios have not materialized.  In part, the European Central Bank has been able to signal support for troubled governments without actually having to commit a great deal of additional credit.

We do not know how long it will be possible to sustain this policy – and eventually countries like Portugal must find their way back to growth.  But in the decade before the crisis, Portuguese growth was anemic – around 1 percent per year (see Mr. Gaspar’s presentation, above).

Portugal has lots of talented, energetic people – as well as some strong engineering schools and outstanding physical infrastructure.  The weather and the food are excellent.  This is a friendly place where contracts can be enforced.

What would it take to move Portugal to a higher medium-term growth rate?

4 responses to “Where are the European Entrepreneurs?

  1. The U.S. recession and the reported austerity measures of Europe are also reshaping the traditional methods of earning and investing in capital. Taking a course in entrepreneurship would certainly be helpful, if not timely. The latest business model since 2007? Monetizing your web site – you too can follow in the steps of Twitter’s IPO and beyond (“In what will likely be the largest initial public offering since Facebook’s botched debut on NASDAQ in 2012, Twitter announced in a tweet late Thursday that it has filed its paperwork with the Securities and Exchange Commission to become a publicly traded company.”). Though your financial success not impossible, “Who’s Your Daddy” would probably have a lot more sway than presenting your business plan to your local banker: http://tr.im/4djjj . Best regards.
    P.S. Couldn’t resist this: Fran Gillespie@FranGillespie – “Shouldn’t we all be Putin Assad our differences? I’m Syria-s.”

  2. I’m sorry, but this is horrible. The biggest problem facing portugal isn’t wage-costs necessarily, it’s wage-costs because they cannot devalue, and because they’re locked into the same currency with countries such as nl/de, which entered the euro at an exchange-rate that was deliberately too low. That way they ‘put into stone’ a further competitive advantage over the advantages they already had (by way of industries being much more efficiently run already, and having access to superior machinery).. Mercantilism at its finest/worst, so to speak.

    The other thing I would dispute is that it was ‘suddenly realized that lending to Southern European (local) govts was risky’: the reason why it was seen as advantageous to allow this was a. to allow western banks to lend lots of money in order to jack up their revenues, and to subsidize dutch/german/finnish/etc exports, which would never have grown so much had it not been for all that lending to governments and consumers. Before the Euro was called into being western banks were ‘languishing’, and complaining a lot about that, because the markets they were in were already credit-saturated; the euro made lending (seem) riskless because there was no more risk of devaluation, while they could charge much higher interest rates to southern (and middle) Europeans than they could to western Europeans. This was seen as a fantastic thing in Western Europe, as the profits all went there, while the social upheaval (and inflation) was localized in the South, and invisible. And now that the bubble has been punctured, they get to moralize a lot about the imprudence of ‘garlic-eaters’, when the whole thing was just a despicable mercantilist experiment of giant proportions, which functioned largely to prop up stagnant western-european economies.

  3. Interesting to see how the economy can affect entrepreneurs. Hopefully the economy stays well enough to bring growth to small business. Thank you for sharing.

  4. Nicholas Martin

    I’m disappointed by the bland claim that “cutting regulation and red tape would be enormously helpful”, followed by vague references to easing bankruptcy and simplifying taxation. I’m happy to believe that this is necessary or desirable, but without any kind of data to show (or at least suggest) that “regulation” (which, exactly?) is unduly onerous in Portugal or bankruptcy and the tax code unreasonably complex, this sounds rather like something a blogger from the Economist would write, which is no longer an accolade. Because you are Simon Johnson and not an Economist blogger, I’m willing to believe that you are thinking of some specific and important regulatory matters here, but if so, please elaborate.