Hindering growth from within: Start-up costs

I'm sure you've all heard of it. It's been around the news for so long we do not even pay attention to it any more. It has become the favourite catchphrase of politicians and policymakers when they want to show they are sympathetic towards the perils of the populace. But it is often vague, it appears rather cold and insensitive and it lacks application. The word we are looking for here is growth.

It's all we've been hearing for the past couple of years. First came Ireland during the sub-prime lending crisis, then Greece, with each subsequent Prime Minister promising policies to rejuvenate growth, then Spain, then Italy, then Cyprus and even Germany. But most promises were nothing but thin air. The more we talk about growth, the more "emphasis" placed on the problem of youth unemployment, the more youngsters stayed out of the job market and the more GDP contracted. The latest (seasonally adjusted) data show that the trend is still on the rise:

Who's to blame for this? Some point at the ECB who has done very little  in order for the euro to survive (as they claim). I beg to differ. As already said the ECB's "whatever it takes" declaration was interpreted as a positive sign by the markets (although we usually forget this, markets are nothing but the collective wisdom of many humans). Then who might the reader ask? The EU? It's policies? No, not really. The simple answer is the Member-States themselves.

What follows is graph of the start-up costs per country, as obtained by the EU website, adjusted by the effective exchange rate. Note that the official EU "encourages" countries to allow for a set-up of under 3 days, at a cost of less than 100 euros. 

Of the 5 countries who required assistance or were in trouble during the crisis, Italy has the highest cost at €2046, followed by Greece at €1007, Portugal at €360, Cyprus at €265 and Spain at €120. Ireland is the only country which abides by the EU standards at €56. Things don't fare better when it comes to days of required to set-up a new business: 5 for Greece and Cyprus, 2-5 for Ireland, a surprising 1 for Portugal and Italy and a whooping 17.5 for Spain. Multiply the cost with the days required to set up a business and a rather different setting occurs:

While the multiplication may appear to be rather arbitrarily chosen (although the idea resembles the Misery Index) it shows the relative cost per country better than just the cost of setting up a business. For example, even though it just costs €120 to set up a business in Spain, the 17-day delay will mean that the cost rises; and note that the official amount of days is most likely the best case scenario where the application is perfectly completed with no mistakes at all, from either side. In this new setting, Greece dominates. It takes more than 1000 euros and 5 days  to set-up business there, in the best case scenario, at a total "cost" of €5036. Not that Northern countries would fare better: Germany would get 1445 in the above index, with Sweden at an even worse 2933. From what it appears, most Member-States need more than "encouragement" to do things like they should.

This unwillingness, nevertheless makes things tougher for their citizens. Think about it for second: what do start-ups have in abundance and what do they mostly lack? The answers are willingness and money respectively. Why should one bother with high costs and a mountain of bureaucratic obstacles (such as most periphery countries) and not set up a business elsewhere? That is why there has been a flight of the periphery's brightest to the North. As the Wall Street Journal notes, Ireland is ranked the most entrepreneurial country in the EU (the cost in the above index is a very low €196) followed by Sweden, the UK, Finland and Denmark. Not surprisingly, there were no periphery countries in the top 10 list. In fact, Europe actually lacks start-ups as The Verge points out. 

In order for unemployment to fall, we need new job openings. In order to get more job openings we need more investment. (Don't take my word that start-up costs hinder growth. Nobel laureate Christopher Pissarides and his colleagues showed evidence about this argument more than 10 years ago.) For investment we need two things: sufficient current demand or high potential demand and institutional support. Even if the periphery has the former it certainly lacks the latter. Why does this occur though? In a discussion with an MEP, she noted that there is a built-in resistance to changing these issues; perceived voter pressure is what holds them back. 

The magic word here is perceived. I doubt that any citizen would object to doing things faster than at the moment and I can really find no sane argument against that. If we all want more jobs and more investment in our countries then why should we object to this from within (and blame the EU about it) when we can do something to overcome these issues? It's rather odd to act like a victim when you are the culprit. So please, next time a politician speaks of growth and policies, just point the start-up costs and time needed to form a business.

P.S. There are more than one ways to build a better structure for start-up support. One of these ways has been online by fellow bloggers Horatiu Ferchiu, Alex Ghita and yours truly since 2012. Here are the links:

1. A skeleton-scheme for funding innovation

2. A Detailed Scheme for Funding Innovation in the EU

3. Funding Innovation in the EU – A governance perspective

4. Detailed Scheme for Funding Innovation: Part II

Detailed Scheme for Funding Innovation: Part II

From what it appears, a start-up scheme covering the whole of the European Union, seems to be a topic where many people have been considering, and hopefully many more will in the future. After the previous post where a detailed scheme for funding innovation was presented, and especially after Horatiu Ferchiu's excellent comments and Alex Ghita's significant contribution to this discussion, the time is here for a little more detail into what should constitute a Scheme that would be both beneficial and sustainable.

To quote Alex:
"Firstly, building the fund allocation system on national banking systems would mean that each member state would have different rules regarding allocation and especially regarding taxation (not of funds especially, but of the direct output). This could make some member states hot-spots for start-up building and innovation, while leaving others in the shadows. This would lead to further increase in disparities, not making the overall situation any different that it is now. Also, it would neglect start-ups and innovation based on international cooperation. Secondly, not all national bureaucratic/economic systems work the same, and with the same efficiency. Insuring an efficient system, for fund management that works in similar ways (national laws make it impossible to make it work in the same way) is key. The contrary would lead to the same polarization effect described above."

For better or for worse, Alex is right. Nevertheless, it was an omission from my side not to mention that when defining what the Sovereign Fund would do, I failed to mention that the particular Fund would only accept applications from that Member-State's nationals and the company would have to be based and registered in that Member State. This would essentially mean that the scheme would eliminate the tendency of having some countries benefit the most as start-up hotspots. Thus, by forcing the nationals to stay in their home nations, it would mean that we are trying to actually decrease disparities in the EU. Obviously we can never know whether an idea in Greece would be more or less successful than an idea in Netherlands, nevertheless this is a "risk" that we have to take.

An issue which will arise from the above explanation is what should happen when a national of e.g. Germany and a national of Malta decide to form a new company. Or what should happen when 3 or more people from different countries decide to apply for funding. In the case of 3 or more people the answer would be easy: apply and form the company in the Member-State where the most of the founders are from. In the case where all founders are from different nations then the answer would be that they would be free to select any country they see fit to apply to. This is not an easy selection, however. In our example of Germany and Malta, the former has more access to industrial goods and may provide a larger network of partners, nevertheless, Malta has a very lower tax rate for businesses, it makes it easier for a company to be set up and if the company is purely technological, access to industrial goods is not needed. If industrial goods are indeed needed though, then Germany would be a better choice.

Phenomena like just selecting a partner from another EU country, just to apply for funding there may arise (this already happens for many EU programs), but in the start-up context, very few people would be willing to share an idea with a stranger and give him/her access to potential millions just for an opportunity to register in a foreign nation. And besides, let us not forget that the funds would be distributed proportionately to the EU countries, which would make competition even harsher in either a small or a large county.

Bureaucracy is unfortunately not the same across the EU and Alex is right about that as well. Nevertheless, this is the reason why both the Sovereign Fund and the Investment Fund should not be considered as institutions of the particular country they are based, but as EU institutions. This would allow them to function irrespective of the bureaucratic system of each nation and reach decisions faster and more efficiently. When, however, they would be forced to work with the local authorities, country-specific bureaucracy might pose significant problems.

This is where an amendment to the previous article is needed: the Sovereign Fund should have priority to all other participants in any procedure that would require co-operation with local authorities. For example, when applicants are trying to register their new company, they should have priority over every other person applying for company registration. This is one of the reasons that I have not been very supportive of employing local banks as a way to promote innovation: the banking institutions would usually take longer than if an independent organization is used. Thus, in order to reduce bureaucracy, an independent institution should be created for this issue.

Again, Alex is right when stating that "Any fund, project, policy, or programme is useless if the targeted actors do not actively participate. This is why the governance model would also have to provide the necessary tools for the independent formation of supporting participatory structures, which could ensure the reaching of targeted of actors." It is my belief, or at least my hope, that with the introduction of such a project, many would choose to participate. On the wider circle, a surge in consultants and advisers is surely to emerge as many would seek assistance before or after obtaining the grants. I trust that although this wider circle may not emerge in the first year of the Scheme's application, it would arise after due time. For better or for worse, this is an issue we cannot rush and force.

What Horatiu was mostly worried about during our discussions (you can have a look at them here and here) was that the technocrats controlling the Sovereign and Investment Fund would have tremendous power over what the businesses and that embezzlement or misuse of funds might arise. After considering this issue, Horatiu proposed that a simultaneous audit on both the Fund and funded company would be of more use than just on the former. In addition, I would also comment that the audit should occur bi-annually, at random intervals and on all funded companies simultaneously, so that the possibility for fraud is reduced. Severe penalties should also be imposed, to both the people responsible in the Fund as well as the funded company, when irregularities are discovered.

As for the technocrat power, this is unfortunately unavoidable. What the Scheme should account for though, is for aligning their interests with the Fund's interests. By this I mean that the participants in both the Investment and Sovereign Fund should receive remuneration at about the average salary of the country they are being employed and additional bonuses when funded companies do well. This would create an incentive for them to fund the companies which would appear to have the most growth potential, something which would help themselves, the funded companies, the Member-State and the Union as a whole.

I would like to end this article with another quote from Alex's contribution to this subject:
"The opportunity given by this type of fund is, I believe, a currently non existent way of sponsoring a type of work-economy that is specific to this day of age. Sponsoring location independent businesses and creating the infrastructure for them to function from anywhere, is one of the ways in which the EU can step ahead of its competitors."

We should not forget that although companies need a specific space and place to function, its people do not.

Let us know if you have any contributions, suggestions or comments on the subject.

3 Ways to Fight Unemployment in Europe

Although as stated yesterday, the light at the end of the tunnel is not so far, it is nevertheless a light concerning only macroeconomic variables for the time being. And as is well known, no man can eat on GDP only. (If anyone has proof of the opposite please inform me immediately!). The following graph is copied from a Eurostat press release dated July 31st:

As you may remember and confirm from the above graph both the EU27 and the EA17 unemployment rates have been rising over the past few months. The same holds for youth unemployment which reached 22.6% in the EU27 and 22.4% in the EA17, also rising over the last months. The situation appears to be even worse when one considers that many youths are not on the list because they have not applied for unemployment benefits or have not communicated with their state unemployment agency (recent graduates for example). Even if all macroeconomic indicators move to positive ground the biggest issue European countries (especially in the South) have to face is unemployment. There are however three ways (or policies) which can assist in creating more jobs.

(i) Promote start-ups and spin-offs by youths

The reason I believe that start-ups are important is because they provide the foundation for future growth in an economy. True, they usually need very few people when they begin, however, their growth may be spectacular. (Google, a Stanford University spin-off now employs more than 50,000 employees worldwide) Obviously not every start-up or spin-off can be Google. This is, however, irrelevant to the policy. Even if they end having about 10-20 employees it is more than great. Small and medium businesses (SME's) account for 99% (!) of all EU businesses. EU policies are stating to be in favor of SME's and yet little is being done in order to promote entrepreneurship. I have personal experience of EU funds being targeted to existing businesses in amounts of about 100,000 euros. The EU could have funded 3-4 business start-ups with these and I am not even allocating them correctly (usually, seed money for start-ups or spin-offs are in the realm of 15-20,000 euros). Universities should also be encouraged to spin-off their researchers' discoveries as this may create several successful businesses and employ many graduates (let alone the stream of money the university will gain from the spin-off). Not to be misunderstood, when I say youth, I include all people under 35 not just the under-25's the statisticians consider when they create their tables.

(ii) Promote research in Universities

 With the notable exception of the UK, most universities in Europe are funded by their home nations (maybe some benefactors as well). EU-wide, research-promoting policies would essentially mean that the Universities would have to hire graduates in order to assist to that research. A clause should force them to do so, in the rare case that some Universities will choose not to create a research position for their grant. The current is that many EU Universities earn EU grants, many of which however are targeted to the professor(s) applying. These policies should be expanded in order for job positions to be created, alongside with (i) so that Universities can themselves gain even more from this. An additional advantage for the potential researchers is that jobs of this kind usually pay a lot more than average salary.

(iii) Force distressed large firms (e.g. banking institutions) to spin-off operations

Consider the following scenario: a company which employs 100 people decides to cut its operations in half and create two separate companies. How many people do you think that the two companies will need in order to function properly? If you guessed 50 then you got it wrong. A new company will need new management, and a reallocation of job positions which will almost certainly create more jobs than if it continued to be a single one. The idea that one large company needs less people than two separate ones is called economies of scale in economics. However, I do not mean that companies should be forced to spin-off operational parts. This should only occur with insolvent (or sometimes solvent as well) banks or other companies which face bankruptcy: spinning-off a part would make them focus more on what they do best instead of having to allocate sources all over the place. Even if they end up collapsing, the damage will be less for the economy if less people lose their occupation and the companies are smaller after the spin-off.

The three propositions above are ranked by their ease of implementation. For example, I believe that (i) is the easiest to implement and is also the one which will prove to be the most lucrative for economies. Something that is targeted in that direction is the announcement of the Italian government that people under 35 will be able to start a company with as little as 1 euro for capital. However, the need for more targeted policies, especially at the EU level remains and is now more important than ever.

Start-ups, Democracy and Growth

While the economic climate is deteriorating rapidly in South Europe what seems to raise our expectations about the future is the fact that in Spain, with unemployment reaching 25% and youth unemployment more than 50%, young people have began creating start-up businesses as a response to the economic crisis in the country. (for more information concerning start-ups in Spain read this).

Europe, especially in the South, does not have the same mentality or maybe not even the same resources when it comes to start-ups and establishing new businesses, as countries like the US or Israel do. The only nation in the EU that comes near this mentality is the technology-oriented Estonia which in 2005 it became the first country to offer Internet voting nationally in local elections. The feature itself is very impressive and something I would love to see in all countries. This will bring a new era in democracy, allowing citizens to have a direct opinion on many aspects of national affairs through courses of action like referendums. For those who love numbers 1.9% of the Estonians (approximately 9,300 people) voted online in 2005 whilst the percentage rose to an impressive 15.4% (150,800 persons) in the 2011 parliamentary elections.

Returning on the start-up discussion, with a simple visit to the EU grants website the reader may observe how many grants are targeted in  start-ups. Exactly none. Entrepreneurship is left to be promoted by individual countries and not at the EU level. Nevertheless, whilst in the UK (and to a much lesser degree in Germany), entrepreneurship attracts a rather significant amount of young talent, the South European mentality states that a job at a large corporation or in the government sector is a much more prestigious one. This is rooted in genes of all South European people, maybe a fact which derives from the instability in governments over the last century and has resulted in a need for a stable job, salary and life. (remember that Italy, Spain, Portugal and Greece suffered through dictatorship regimes over the last century, with all of them experiencing terrorist attacks over time and Cyprus had been prone to rough civil disputes and a Turkish invasion in 1974). These experiences lead to a risk-averse society, with the specific mentality passing on to the next generations.

However, when talking to today's youth, this mentality seems to be changing. This might be the result of the economic catastrophe the aforementioned countries are facing, where the most stable of organizations of the past, the banking institutions, are proposing layoffs and shrinking of business activities to survive. It seems that the most prestigious employers have lost their reputations.

My hope for the future is that EU governments understand the importance of start-ups in the economy and provide financial assistance, in the form of subsidies or state-owned Venture Capital (VC) firms to aid individuals get the funding needed to start their business. This need only be done for a short period of time, since after the initial phase, more and more privately held VC firms and angel investors will emerge. The cost of funding a start-up is also very low as most of them require less than 100,000 euros to function. Given the amounts each country spends on foolish expenses each year sparing 10 million a year for start-up funding is infinitesimal. On the contrary, the outcome of such policies will be extremely beneficial as the now deteriorating economies will be able to bounce back, create thousands of jobs and restore confidence in the nation as a whole.