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September 4, 2015

Major innovations come from new firms that disrupt the established order.

By Peter Howitt

With the Canadian economy shrinking for the past two quarters, the news has looked grim. But people leaving jobs and companies going out of business can also be signs of a dynamic economy – one in which new companies are successfully challenging old ones.

Economic growth is an uneven process that does not immediately benefit everyone. The technological innovations that drive growth arise sporadically. Economist Arnold Harberger taught us that an economy doesn’t grow uniformly as if it were bread rising in the oven. Instead, economic growth is like mushrooms springing up in the forest bed. Some industries grow rapidly, while others languish. Some people thrive, while others face obsolescence. This unevenness has important implications for Canadian economic policy.

Major innovations come from new firms that disrupt the established order. Microsoft shook the foundations of once-dominant IBM. Instagram turned a few dozen employees into billionaires at the expense of giants such as Kodak. Shale-oil producers are menacing large-scale oil sands producers.

These are examples of how economies grow through a process of creative destruction.

People need to leave jobs in dying or less productive industries to take jobs in new industries. New firms may succeed, in which case they use new technology to drive out incumbents. Or they fail, in which case they drop out.

Either way, a high rate of both job creation and destruction is a key ingredient of a growing economy.

We need to allow upstart firms to compete freely. That may mean concentrated or even widespread losses at established firms. These established firms with political connections can seek protection that biases the economy against disruptive upstarts. Sustaining growth requires explicit policies to counterbalance that bias.

What would such policies look like?

Federal and provincial political parties of all stripes offer tax breaks for small businesses. But new firms, not necessarily small firms, are the agents of creative destruction. We would have higher economic growth if governments gave preferences to new firms instead of supporting firms only because they are small.

Even without new firms entering, the threat of their competition can be enough to spur established firms to innovate. Take the Canadian telecommunications industry, for example. Eliminating foreign ownership restrictions in the industry would create an effective threat of competition. The result for consumers would likely be better quality, lower costs or both.

The same ideas can apply across the economy. Lower barriers to trade have the same effect of adding new competitors to spur incumbents to raise productivity. Freer trade has the added benefit of giving domestic firms access to a bigger market, encouraging them to use and improve on the latest technologies.

But many are left behind by change. And governments must deal with this. That is not only because of fairness to the victims of change. A democratic society will not support economic growth if the benefits are restricted to the lucky few with jobs in the right part of our mushroom patch of an economy.

Published in the Globe and Mail on September 3, 2015

Peter Howitt is the Lyn Crost Professor of Social Sciences Emeritus at Brown University, international fellow at the C.D. Howe Institute and author of the C.D. Howe Institute study Mushrooms And Yeast: The Implications Of Technological Progress For Canada’s Economic Growth.