Financialization and its Entrepreneurial Consequences

8/7/2019 Financialization and its Entrepreneurial Consequences

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Paul Kedrosky and Dane StanglerEwing Marion Kauffman Foundation

Kauffman Foundation Research Series:Firm Formation and Economic Growth

Financialization and ItsEntrepreneurial Consequences

March 2011


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2011 by the Ewing Marion Kauffman Foundation. All rights reserved.

Authors:

Paul KedroskyEwing Marion Kauffman Foundation

Dane StanglerEwing Marion Kauffman Foundation

The authors would like to thankHarold Bradley and Lacey Graverson for their

help and support.


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F i n a n c i a l i z a t i o n a n d I t s E n t re p re n e u r i a l C o n se q u e n c e s

Kauffman Foundation Research Series:Firm Formation and Economic Growth

Financialization and ItsEntrepreneurial Consequences

March 2011

Paul Kedrosky and Dane StanglerEwing Marion Kauffman Foundation


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K a u f fm a n F o u n d a t i o n R e se a rc h S e r i e s : F i rm F o rm a t i o n a n d E c o n o m i c G ro w th2

A H i s t o r i c a l O v e r v i e w

OverviewThe U.S. financial sector expanded dramatically

over the last hundred years in both relative and

absolute terms. This expansion has had a number

of causes and consequences, most of which can

be lumped broadly under the heading of increased

financialization of the economy. This led, in

part, to the financial crisis of 2008/2009. In this

paper, however, we consider the implications

of financialization for the structure of the U.S.

economy, in particular for entrepreneurship.

A Historical OverviewA financial industry plays an important role in

any modern economy. It provides widely varying

principal and intermediation services to households

and corporationsservices that sometimes are

simple, but often complex. The services range from

lending, to stock brokerage, to complex securities,

to real estate and insurance, among many others.

The industry has changed considerably in itsimportance over the last 160 years.1 As Figure 1

shows, the U.S. industrys share of domestic

GDP was at its lowest during the mid-nineteenth

century, when it hovered between 1 percent and

2.5 percent. From 1900 to 1930, however, it rose

steadily, before peaking at approximately 6 percent

of GDP at the beginning of the Great Depression. It

then fell sharply in importance over the next fifteen

years. The industry resumed its rise in 1945 and has

yet to peak, having touched 8.4 percent of U.S. GDP

in the last two years.

Why the industry has changed in relativeimportance over time is a crucial question. After all,

unlike other sectors, in a true Arrow-Dubreu economy,

the financial services industry would not exist in

Figure 1: Financial Sector as Percentage of U.S. GDP: 18502009

Kauffman Foundation

1850 1860 1870 1880 1890 1900 1910 1920 1930 1940 1950 1960 1970 1980 1990 2000 2010

Source: The Evolution of the US Financial Industry from 1860 to 2007: Theory and Evidence. NBER.

1. In this paper, we use financial services in reference to the Finance and Insurance sector, NAICS sectoral code 52. Many commentators often discuss FIRE:Finance, Insurance, and Real Estate, adding NAICS sectoral code 53. While there is clearly an intimate (and lately damaging) relationship between finance and realestate, for our purposes here we exclude real estatethus sadly depriving ourselves of clever wordplay on the FIRE economy.


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anything like its present form.2 Its intermediatingfunctions would be simple and, thus, readily providedby a much smaller and less-profitable sector. Such isdemonstrably not the case, however, so it is worthconsidering why the industry has grown to be as largeand systemically important as it has become.

Across its history, the financial services industrysperiods of more-rapid growth have generally beentied to periods during economic history when theneed for financial intermediation was growingsharply. For example, the financial services industrysrise in the late nineteenth and early twentiethcenturies corresponded to the appearance ofrailroads and early, large-scale manufacturing.Its next sharp rise, in the 1930s, corresponded tothe build-out of the U.S. electrical grid, as well asrapid growth in the automobile and pharmaceuticalindustries.3 We subsequently can see a sharpincrease in financial services as a percentage ofGDP from 1980 to the late 1990s, with a proximatecause this time being the financing of wavesof information technology, culminating in theInternet boom.4

Not all periods of more-rapid U.S. economicgrowth have, however, coincided with a significantincrease in financial services relative role in theeconomy. For example, as the above figure shows,the 1960s were a period of substantial economicgrowth, but were accompanied by only a tiny

increase in financial services growth as a percentageof GDP.

In general, however, and most importantlyfor this paper, there should be no question thatthe financial services sector plays a key role forentrepreneurs. It helps reduce moral hazard, whilemitigating adverse selection problems that otherwisemight exist for young companies that lack longtrack records or significant collateral. To pretendotherwiseto pretend that we can have widespread

entrepreneurial capitalism in the absence of asignificant and active financial services sectoris tobe fanciful.5 At the same time, however, financialservices and entrepreneurial ventures compete in theeconomy for many of the same employees. Giventhat the social returns from entrepreneurial effortsgenerally are higher than the private ones, this canbe a source of allocative inefficiency in the economy,one with potentially material consequences.6

Having said the preceding, all observers of theU.S. economy should be concerned when thefinancial sectors activities increasingly feed backon the sector, rather than on the real economy.We have recently seen a consequence of the2008 financial crisis. There are more and otherconsequences, and we focus on some of them in

this paperin particular, the effect of financialservices growth and capital misallocation on young,growth companies. As John Maynard Keynesmemorably said, When the capital development ofa country becomes the byproduct of the activities ofa casino, the job is not likely to be well done. 7

Financialization andthe Economy

The U.S. financial sectors rise to relative economicimportance is historically unprecedented. Even

during the peak years leading up to the GreatDepression, the U.S. financial services industrynever rose above 6 percent of GDP, a figure thattook until 1990 for it to regain. Since then, theindustry has continued to carve out an ever-largerposition for itself in the economy, to the point thatit now employs 6.5 million people and accountsfor 8.3 percent of GDP. This share of the economyquadrupled since the end of World War II, and grossoutput of finance and insurance rose by 97 percent

2. Philippon, T. 2008. The Evolution of the US Financial Industry from 1860 to 2007: Theory and Evidence. NBER.

3. Ibid.

4. On the relationship between technological breakthroughs and their cause-and-effect correspondence with finance, see generally Carlota Perez, TechnologicalRevolutions andFinancial Capital: The Dynamics of Bubbles and Golden Ages (Edward Elgar, 2002).

5. This has been recognized by economists for at least a century. See Joseph A. Schumpeter, The Theory of Economic Development (first published in Germanin 1911).

6. Philippon, T. (2007). Financiers vs. Engineers: Should the Financial Sector be Taxed or Subsidized? NBER Working Paper. 2007:(October):127.Available at http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1024974.

7. Keynes, J.M. The General Theory of Employment, Interest and Money. Atlantic Publishers & Distributors. 2006:400:140.


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from 1997 to 2007, outpacing the 70 percent rise ingross output across all American sectors.8

Some recent changes have been a function of

the information technology industrys appearanceand growth. This industry has required immenseinvestment, from new companies receiving venturecapital to larger companies requiring banking servicesfor public offerings, mergers, and other transactions.

It is not clear, however, that the increasing shareof U.S. GDP accounted for by financial services isentirely a function of the growth of new, capital-intensive sectors like information technology. Thatindustry is maturing rapidly, while newer variants,like Web 2.0, are less capital intensive; at thesame time, funding is flat or even declining inother sectors, like life sciences. With fewer initial

public offerings being conducted, and with rapidconsolidation in financial services (especially sincethe 2008 crisis), instead it seems that the financeeconomys rise largely has been a function ofthe financial economy detaching from the realeconomy. Thinking of it in flow terms, consumersand businesses increasingly have used debt to fuelasset purchases that, in turn, became collateralfor additional debt and asset purchases. This wasnot a productive capital allocation in the broadereconomy, but it did generate higher returns in theshort run.

Innovation has driven some of the increased size

of the financial sector. Developments in technologyhave greatly increased the nature, flow, and scopeof financial products, thus increasing the size ofthe sector in both relative and absolute terms. Inparticular, the rapid expansion of financial servicesover the past few decades has been directly tiedto continued advances in information technology.As a result, there are new and growing pressuresto increase the size of the sector and increase thefinancial-centricity of modern economies.

We investigate the effects of this misallocation inthe following section.

FinancializationsConsequences

Capital increasingly flows toward financial assetsand in service of the further financialization ofthe economy, which has many consequences. Themain characteristics of this change are summarizedusefully by Dore (2008) 9 as follows:

1. An increase in the proportion of the incomegenerated by the industrial/post-industrialeconomies, which accrues to those engaged inthe finance industry, as a consequence ofthree things:

a. The growth in and increasing complexityof intermediating activities, very largely ofa speculative kind, between savers and theusers of capital in the real economy.

b. The increasingly strident assertion ofowners property rights as transcendingall other forms of social accountability forbusiness corporations.

c. Increasing efforts on the governments partto promote an equity culture in the beliefthat it will enhance the ability of its ownnationals to compete internationally.

We are focused on the first of thesefinancialization characteristics. In particular, we

want to understand their consequences for thenon-financial economy. Given the larger incomeshare accounted for by the financial sector, andgiven the increasingly speculative activities takenon by the financial sector, what have been theeffects in the real economy? How, for example, hasfinancialization increased (decreased) the numberof entrepreneurs in the economy? How has it beenmade easier (harder) for companies to be created,or to raise money? Given that one function offinance in a capitalist economy is to help fund newbusiness ventures, what effect has financializationhad on entrepreneurship in the United States?While we have no base case, so we cannot know

precisely how the economy would look in theabsence of financialization, we can characterize

8. Bureau of Economic Analysis.

9. Dore, R. Financialization of the global economy. Industrial and Corporate Change. 2008:17(6):10971112. Available athttp://icc.oxfordjournals.org/cgi/doi/10.1093/icc/dtn041.


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13. Lowell, B. Lindsay, et al., Steady as She Goes? Three Generations of Students through the Science and Engineering Pipeline. Paper presented at the Association forPublic Policy Analysis and Management, November 2009, at http://policy.rutgers.edu/faculty/salzman/SteadyAsSheGoes.pdf.

performing students fell steeply in the 1990s and

early 2000s:

[T]op STEM majors may be responding to

market forces and incentives Highly qualified

students may be choosing a non-STEM job

because these other occupations are higher

paying, offering better career prospects, such

as advancement, employment stability, and/

or prestige, as well as less-susceptible to

offshoring. There are numerous accounts of

financial firms hiring top-performing STEM

graduates at much higher salaries than those

offered by STEM employers.13

This shift is borne out, at least partially, by dataon where in the economy scientists and engineerscan be found. Indeed, by 2006, the Securities andCommodities Exchanges sub-sector accountedfor the twelfth-highest share of science andengineering employment by sub-sector, ahead ofsemiconductor manufacturing, pharmaceuticals,and telecommunications (Figure 4). This sub-sectorsshare was more than four times the average.

This distribution of human capital and,accordingly, wages falls into a long historicalpattern: The relative skill intensity and relativewages of the financial sector exhibit a U-shapedpattern from 1909 to 2006. Prior to the 1930s,

Figure 4: Science and Engineering Employment by Sector, 2006(average across all sectors: 4.6 percent)

Computer Systems Design & Related ServiceSoftware Publishers

Scientific R&D Services

Computer & Peripheral Equipment Mfg

Internet Service Providers & Web Search Portals

Data Processing, Hosting, & Related Services

Internet Publishing and Broadcasting

Architectural, Engineering, & Related Services

Communications Equipment Mfg

Navigational, Measuring, Electromedical, & Control Instruments Mfg

Aerospace Product and Parts Mfg

Securities & Commodity Exchanges

Semiconductor & Other Electronic Component Mfg

Pharmaceutical and Medicine Mfg

Other Telecommunications

Management, Scientific, & Technical Consulting ServicesAudio and Video Equipment Mfg

Oil & Gas Extraction

Manufacturing & Reproducing Magnetic & Optical Media

Telecommunications Resellers

Wired Telecommunications CarriersKauffman Foundation

Source: National Science Foundation

0% 10% 20% 30% 40% 50% 60%

48.6%

48.4%

42.2%

49.6%

38.6%

31.6%

29.5%

29.2%

27.2%

27.1%

24.6%

21.8%

20.8%

19.3%

18.5%

18.2%

17.7%

17.2%

17.0%

16.9%

16.2%


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T h e I n c r e a s i n g S i z e o f t h e F i n a n c i a l S e c t o r

the American financial sector was a high-skill,high-wage industry. A variety of factors, includingtechnology and regulation, dampened the humancapital and wage premiums for the subsequenthalf-century. Around 1980, however, the situationreversed and finance once again became a high-skill and high-wage sector, thus attracting peoplefrom a wide range of financial and non-financialbackgrounds.14

Capital, including human capital, flows to theopportunities with the highest risk-adjusted returns,but those opportunities perceived merits are subjectto distortions. Regulations can change capitalallocations, as can feed processes. In the lattercase, capital can begin to feed on itself, with higherasset prices inducing more investments, and thusgenerating still higher prices, a misallocating processthat continually feeds on itselfuntil it stops, oftenunhappily and expensively.15 The subject of capitalmisallocation is much broader than this paper, butsuffice it to say that capital misallocation happens,and has consequences.

What are the consequences of capitalmisallocation? Fundamentally, it means thatcapitalboth human and financialis beinginefficiently allocated in the economy, with theresult being that some sectors and opportunitiesare being starved, relatively speaking, while othersectors see a flood of capital, potentially producing

a positive feedback cycle that exacerbates one orboth of the preceding effects. In particular, capitalmisallocation can lead to inflated (deflated) assetprices, lower productivity, less innovation, lessentrepreneurship, and, thereby, lowered job creationand overall economic growth. The mechanismthat creates each of these effects is, of course, theflow of capital in the economy as exacerbated anddistorted by financialization.

Entrepreneurship withoutFinancialization

Having recognized the consequences offinancialization and capital misallocation, it isnow time to consider the direct effects of thesedistortions on entrepreneurship in the United States.If we consider financial services firms percentageof U.S. GDP and, then, as a counterfactual, modela return to historical norms, we can begin totentatively assess financializations consequences.

Financial services peaked at almost 9 percentof U.S. GDP in its most recent upswing. In thepreceding decades, its share had been volatile, but ithad averaged roughly four percentage points lower,or approximately 5 percent of GDP. Were that to be

the case again, what might the consequences be toentrepreneurship? To answer this question, we firstmust look at potential consequences the financialsectors explosive growth had on entrepreneurshipover the past several decades. In terms of anaggregate picture, Figure 5 compares the economicvalue that finance and insurance have added since1947 to varying measurements of new businessformation. Financial services have been on a steadyupward march since the end of World War II. Since1980, firm formation rates in the United Stateshave fallen slightly and then hit a plateau, with onlyminor fluctuations from year to year (Figure 5).

The financial services sectors increasing growthis not the sole or necessarily the largest causeof falling and flattening new business formationrates, but it does appear to have a role. As thechart illustrates, per-capita rates of new businessformation in the 1980s and 1990s were not muchdifferent from those in the 1940s and 1950s and,in fact, recent rates are lower than they were inthe early 1980s. The reasons behind this stagnationin entrepreneurship (or, more positively, its steadymaintenance and non-decline) are a persistentpuzzle.16 The discussion in this paper so far suggestsone potential culprit: the metastasizing financial

14. Philippon, T., and Ariell Reshef, Wages and Human Capital in the U.S. Financial Industry: 19092006, December 2008. The authors also showed the risingdisparity between the wages of financiers and engineers working in non-financial sectors, particularly after 1980.

15. See, e.g., Hyman Minsky, Stabilizing an Unstable Economy (McGraw-Hill, 1986).

16. See, e.g., Dane Stangler and Paul Kedrosky, Exploring Firm Formation: Why is the Number of New Firms Constant? Kauffman Foundation Research Series onFirm Formation and Economic Growth, Paper No. 2, January 2010, at http://www.kauffman.org/uploadedFiles/exploring_firm_formation_1-13-10.pdf.


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E n t r e p r e n e u r s h i p w i t h o u t F i n a n c i a l i z a t i o n

FinanceandInsuranceValueAdded

asPercentageofGDP

Per-CapitaBusinessCreation

Figure 5: Finance and Entrepreneurship

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1944

1946

1948

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Sources: BEA, BDS, BLS, Census Bureau, SBA

sector, which potentially could have affected theflow of entrepreneurial talent.

As the data on MIT graduates and the sectoralshare of science and engineering employmentsuggest, it is conceivable that some degree oftalent allocation between entrepreneurship andemployment was affected by the rise of finance.Recall Figure 3: If we presuppose that some fractionof those scientists and engineers working in thefinancial sector would otherwise have startedcompanies, we can imagine perhaps a slight effect

of financialization on potential entrepreneurship.This also points to a question of the quality ofcompanies being started, which we discuss below.It is difficult, again, to make firm statementsas to causation, but the historical data seem tosuggest that a two-way feedback effect exists.Financialization could have a suppressive effect on

potential entrepreneurship by draining away humancapital. Conversely, an underlying decrease (or, atleast, not an increase) in entrepreneurship createsa shortage of new financing opportunities for thefinancial sector, meaning the sector must find otheroutlets in which to be innovative and make moneyfrom moneycausing the sector to expand.

Entrepreneurship volume, of course, provides anincomplete picture of the effect of new companieson the economy. And, as weve seen, the level offirm formation in the United States apparently has

not changed much over the past thirty, and perhapssixty, years, even as the economy as a whole hasundergone various frissons and comedowns. Justbecause the aggregate velocity of firm formationhas not changed even as finance has exploded insize does not mean that finance has suppressedentrepreneurship or had no effect on the types


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a boom in computer-related companies, togetherwith financial developments in the 1970s, principally

junk bonds and other higher-risk financing activities,precipitated rising IPO intensity that helped to callforth a growing financial sector in terms of size,relative wages, and human capital levels. The annual

number of newly listed firms more than tripled,rising from 156 per year in the 1970s to 549 peryear from 1980 to 2001.20

Thus, multiple potential mechanisms are at workin terms of capital allocation and the consequencesfor entrepreneurship. We have seen that, contrary tothe standard model of finance, the financial sectors

sizepresumably a proxy for its activity levelis notdriving firm formation in the American economy.Yet, there may be two additional mechanisms at

work, which together comprise what we mightthink of as a cannibalization effect. These are thedistortions introduced by financializations pull onhuman capital, particularly entrepreneurial talent,and the resulting effect in the types of companies

that are formed and their performance. It seems

certain that financialization, an effect and cause ofentrepreneurial capitalism, subsequently cannibalizedentrepreneurship in the U.S. economy.

The growing wage and skill premiums in financeattracted individuals who might otherwise havestarted companies. Why, then, wouldnt the overalllevel of entrepreneurship have fallen? Well, whileit had mostly stayed flat for the past thirty years,closer examination reveals a decline through the1980s and then a plateau since 1990. From 1978to 1987, the average annual startup rate was 10.4,while the average annual establishment entry ratewas 13.8. Over the subsequent two decades, thesetwo rates averaged, respectively, 8.4 and 12.2.Importantly, too, the rate has fallen across numerousentrepreneurship indicators, even as the absolutenumber of new businesses has remained fairlysteady, as Figure 7 indicates.

More worrisome is the drop in entrepreneurialintention among certain cohorts of high-skilledworkers in the United States: middle managers andexecutives.

Figure 7: New Businesses Formed Quarterly, 19932009

Source: Bureau of Labor Statistics

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20. Fama, Eugene F., and Kenneth R. French, New Lists: Fundamentals and Survival Rates, Journal of Financial Economics. 2004:73(2):229.


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Thus, we have experienced a falling rate of newbusiness creation and falling intention amongcohorts of workers with presumable entrepreneurialtalent, as Figure 8 shows. Why, then, has the overallvolume of entrepreneurship in terms of absolutenumbers remained steady? One answer could bethat the quality mix of new companies shifted overthe past ten to fifteen years. Here we return tofinance as a potential cause of this shift.

If democratized finance made it easier for weaker(or prospectively weaker) firms to obtain financing,then a growing finance sector would have helpedboth to maintain a steady rate of entrepreneurshipand contributed to the declining quality of newcompanies started. This is difficult to prove,especially since survival rates of new firms have not

changed much since 1977. One indicator we canexamine is the employment performance of youngfirmshave they performed better, worse, or thesame over time?

As shown in Figure 9, the net job-creation ratesof one-year-old companies closely track the overallhealth of the economy: The recessionary years

of 1980, 1981, 1982, and 1992 saw negative

net job creation among companies started one

year prior, as did 1983, when this would havecaptured firms started in the rough year of 1982.

The only other string of consecutive negative years

was 2002 to 2009; this period includes both the

jobless recovery following the 2001 recessionand the most recent recession of 2008 and 2009.

Companies founded in 2002 through 2006

performed just as poorly as those founded during

recessions. This period also happened to coincidewith poor performance in terms of initial public

offerings.

This could have nothing to do with finance, of

course, but it is difficult to resist making some

connection, particularly since these were precisely

the years during which the financial services industryreached its peak in terms of economic share. The

effect of democratized financing, too, has been

found to have other consequences. While volatilityamong privately held firms has fallen dramatically

in the past three decades, the volatility among

publicly traded firms has risen just as dramatically.

Figure 8: Entrepreneurship Participation Rates, 19862009

Source: Challenger, Gray & Christmas, Inc.

Kauffman Foundation

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Figure 9: Net Job-Creation Rate of One-Year-Old Firms

Source: BDS

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One reason appears to be easier access to financeand, thus, a higher number of IPOs, but withouta corresponding increase in the quality of thosecompanies. Thus, the universe of public firmsexperienced an influx of more volatile firms thanin years past.21 Financialization boosted volatilityamong publicly traded firmswithout raising eitherthe number or quality of new companies.

We might then imagine a cannibalization effectat work: Shifts in underlying entrepreneurial activity,whether measured by a burst of companies at thetechnological frontier or IPO intensity, precipitatean increase in financial services. Subsequentfinancialization makes it easier to start companies,but, by drawing potential entrepreneurial talent intofinance while continuing to fund new companies,it could suppress both the potential rate of newbusiness creation and the quality of businessesstarted.22

We now can turn to the question of whatthe American economy might look like once thefinancial sector shrinks as a share of GDP, as itseems likely to do. This probably will not entail adramatic decline to 1960s levels, but perhaps adecline to the levels we saw in the 1980s. We thinkthere would be several effects. First, we should notexpect a smaller financial sector to cause a rise orfall in new business creation, although we mightanticipate higher social value from new companies.We have seen that rising financialization borelittle apparent relationship to the volume of firmformation in the United States. So, while no one canpredict the trend, we should not expect an impacteither way from a smaller financial services sector.There are, in fact, other reasons to expect a possibleincrease in new business creation and, should we

enter such an era with a smaller financial sector, wemight experience a happy concordance between a

21. Davis, Steven J., et al., Volatility and Dispersion in Business Growth Rates: Publicly Traded versus Privately Held Firms, NBER Macroeconomics Annual 2006(National Bureau of Economic Research, 2007).

22. The quality issue might be related particularly to branch-banking deregulation in the 1970s and 1980s. See, e.g., William R. Kerr and Ramana Nanda,Democratizing Entry: Banking Deregulations, Financing Constraints, and Entrepreneurship, Harvard Business School, Working Paper 07033, December 2008.


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financial sector focused on real wealth creationand a steady supply of companies seeking financialservices. Such a state of affairs would produce moreeconomic and social value than would a situationwith an explosively growing finance sector butdiminished entrepreneurship. A smaller financialservices sector will be smaller relative to recenthistoryit most likely still will be larger than in priordecades and, so, financial intermediaries will notlose the ability to provide services important to newand young companies.

Given the distortions on talent allocationacross sectors and occupations, we should expectimprovements in allocative efficiency amongtechnical graduates. This does not mean that therise of finance is the primary culprit behind theperceived crisis in science and engineering talentin the United States. As with entrepreneurship,numerous factors lurk beneath human capitalproblems in those areas, and a smaller finance sectoractually might have a small negative impact in termsof reducing one dimension of requisite demand forscience and engineering talent.23 In particular, fallingdemand in the labor market has contributed torising unemployment (prior to the Great Recession)among scientists and engineers. More people inscience and engineering programs should considerentrepreneurship as a career option: New sources oftalent demand evidently need to be created, and thebest way to do so is to send entrepreneurs off to the

frontier to open new paths of economic exploration.

Conclusions andDiscussion

In this paper, we tried to re-imagine the U.S.economy in the absence of a financial servicessector larger than its historical role. We considerthe effects, both positive and negative, of a smallersector, with a particular focus on young and fast-growing companies, and on the entrepreneurs whocreate those companies.

The conclusions we reach bear directly on thefuture of the economy. First, a smaller financialservices sector might not create many morecompanies, but the companies it creates mighthave higher social value. Second, a smaller financialservices sector still could provide the financial

intermediation services that are most importantto young companies. Third, a U.S. economy witha smaller financial sector would cause fewerdistortions in capital allocation.

What might we expect in terms of a boost tobusiness creation? Were the finance sector to shrinkin terms of its GDP share back to the levels of the1980s, say, we might expect an increase of two orthree percentage points in the entrepreneurshiprateback to where it stood through the 1980s, aswell. This obviously is not as precise as we wouldlike it to be, but, given the allocation and financingissues discussed here, it seems likely that we could

see several thousand new businesses formedeach year, to say nothing of the quality of thosecompanies.

The financial sector shrinkage in the comingyears also will coincide with other trends that,independent of the retreat of financialization, shouldprovide a boost to American entrepreneurship.Together with a contracting financial sector,however, these emerging trends should be amplifiedand contribute to a substantial increase in firmformation. Such trends include the falling costof starting a company, largely as the result oftechnological change. This decline does not apply

exclusively to the information technology sector,

23. Lowell, B. Lindsay, and Harold Salzman, Into the Eye of the Storm: Assessing the Evidence on Science and Engineering Education, Quality, and WorkforceDemand, Urban Institute, October 2007, at http://www.urban.org/publications/411562.html.


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C o n c l u s i o n s a n d D i s c u s s o n

as many might say. Indeed, the emergence oforganizations and phenomena such as TechShopand Maker Faire have lowered the barriers to entryeven in sectors such as advanced manufacturing.The continuing integration, too, betweencyberspace and the real economy means thatit has become easier to start physically basedcompanies with greater reach.24 Additionally, U.S.demographic trends, while often presented inuniversally negative fashion, have the potential toboost entrepreneurship.25 In short, the reversal offinancialization and the flowering of parallel trendscould work to substantially increase firm formation.

What will beor what could bethe impactof these companies? Every generation claims,tiresomely, that in its particular era the countryfaces serious challenges on a different order fromany prior age. Some of todays challengessuchas energy, infrastructure, and health carewerefamiliar to foregoing generations. What sets themapart in the contemporary context is their sheereconomic, and political, and social complexity.Saying that the United States, indeed the globe,faces an energy challenge implies a host of issues:climate change, regulatory barriers, infrastructureshortcomings, national security issues, developingalternative sources to fossil fuels, and so on. Thesame could be said of other areas. But it is theirvery complexity that, perhaps ironically, makes themperfect areas for entrepreneurship, new ideas, and

new entrants. Startup firms specializein a waythat larger and more-established companies canbarely contemplatein attacking complex problemsin cheaper and more efficient ways. For the leadingareas in need of entrepreneurship today, scientistsand engineers are essential to start firms or join newcompanies.

A reversal of financialization might act as onemechanism in pushing this along. Without beingPanglossian about the contraction in the financialservices sector, we think there are importantconsequences in the industrys restructuring towarda smaller size. There will be job losses in financial

services, some of which will be counterbalanced byjob creation by young companies that otherwisemight not have existed. Given our need forentrepreneurs to bring products and services tomarket that help us with some of the most difficultand complex societal problems we have ever faced,there could not be a more auspicious time forthe change.

24. For additional discussion of these trends, see Dane Stangler and Paul Kedrosky, Neutralism and Entrepreneurship: The Structural Dynamics of Startups, YoungFirms, and Job Creation, Kauffman Foundation Research Series on Firm Formation and Economic Growth, Paper No. 6, September 2010, at http://www.kauffman.org/research-and-policy/neutralism-and-entrepreneurship.aspx.

25. See, e.g., Dane Stangler, The Coming Entrepreneurship Boom, Kauffman Foundation, June 2009.


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Financialization and its Entrepreneurial Consequences

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