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A month ago, when I debated Deutsche Bank’s chief economist on Larry Kudlow’s CNBC show, the consensus held that a rapid recovery in employment would ensue during 2010. This expectation crashed and burned with last Friday’s employment report for December, showing that more than 600,000 “discouraged workers” had left the labor force. Today we have an unexpected rise in initial claims for December on top of an unexpected drop in December retail sales.

It has dawned on the financial press that the jobs that were lost in the Great Recession never will come back, and the US economy’s previous source of employment recovery—small business—is as crushed as were the kulaks under Stalin.

A website called Shadow Government Statistics does a public service by un-adjusting the govermnent’s data, for example, to include “discouraged” as well as “long-term discouraged” workers in the unemployment rolls. By that measure US unemployment is at 22 percent, an astonishing number.

Alternate Unemployment Chart

Here is what I wrote over at the “Inner Workings” blog Dec. 18:

My disagreement with Deutsche Bank chief economist Joe Lavorgna over future job creation–which we debated last week on Larry Kudlow’s CNBC show–lies in the crucial role of small business in job creation. The process of job destruction (from big companies) and job creation (from small companies) are two sides of entrepreneurial “creative destruction.” The problem today is that we have the destruction without the creation.

Companies with less than 50 employees predominated in job creation during the great economic expansion that ended in 2007.

In the chart below drawn from a recent study by the Census Bureau and the University of Maryland, the really tall bars (reflecting net creation of new jobs) come from new and small companies.

What’s happening to small business today?

As I noted, the Discover Small Business Watch collapsed in November to an index level of 76 from 88, with 52% of respondents reporting cash flow constraints. Every other available measure of small business performance looks utterly miserable. The National Federation of Independent Business Optimism Index is crawling along the bottom, as reported last week in the Atlantic’s business blog:

NFIB small bus rpt 2009-12.PNG

Small business sales show no recovery at all, according to the NFIB:

NFIB small bus rpt 2009-12 - 2.PNG

Joe’s argument in favor of a snapback in hiring stems from the historical relationship between inventory change and employment. As I calculate this (using GDP inventory data), the long-term regression coefficient is 57%, not bad for quarterly changes. But there’s a trick: it is very, very big in downturns, but not in recoveries. That is, layoffs correlate heavily with inventory liquidation. But job creation DOES NOT correlate with inventory rebuilding. That is because most of the jobs (I presume) are created by start-ups rather than big companies who hire and fire on the basis of inventories.

Structurally, a very large percentage of job losses during recessions reflect creative destruction: big companies who lay off workers in recessions downsize permanently. The jobs are not replaced at the same companies; the old jobs go away forever, and new jobs are created at the grass roots of the economy.

That’s why we have to look to small business for continued job growth, and why the prospects are grimmer than the market seems to believe.

Visually, the relationship between changes in payrolls and changes in inventories appears quite strong:

Quarter-on-Quarter Change in Inventories (GDP Basis) Vs. Payrolls (Establishment Survey)

But closer examination shows that the relationship is quite one-sided: the correlation is very high in recessions, but practically nil in recoveries.

Correlation (over 12 quarters) Between Inventory and Payroll Change vs. Payroll Change

The one-sidedness of the correlation is consistent with the fact that the vast majority of new jobs during recoveries are created by new, small businesses. The inventory cycle is largely a function of big firms. They shrink in recessions and their job losses often are permanent. The old jobs are replaced by new entrepreneurs.

Given the miserable situation of entrepreneurs, there is little reason to expect that future job growth wil be correlated with any recovery of inventories.



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