Albert Harlingue/Roger-Viollet/The Image Works

Three years have passed since the financial crisis of 2008, and unemployment rates remain painfully high. As of August 2011, America employed 6.6 million fewer workers than it did four years earlier. To try to fix the problem, the Obama administration has pursued a variety of Keynesian measures—above all, the huge stimulus package of 2009, which included not only direct government spending but also such features as tax credits for home buyers and temporary tax cuts for most Americans.

Such policies ignore a simple but vital truth: job growth comes from entrepreneurs—and public spending projects are as likely to crowd out entrepreneurship as to encourage it. By putting a bit more cash in consumers’ pockets, the tax cuts in the stimulus package may have induced a bit more car- and home-buying, but the next Steve Jobs is not being held back by too little domestic consumer spending. Tax credits for home buyers and the infamous program Cash for Clunkers encourage spending on old industries, not the development of the new products that are likelier to bring America jobs and prosperity.

Unemployment represents a crisis of imagination, a failure to figure out how to make potential workers productive in the modern economy. The people who make creative leaps to solve that problem are entrepreneurs. If we want to bring America’s jobs back, our governments—federal, state, and local—need to tear down barriers to entrepreneurship, create a fertile field for start-up businesses, and unleash the risk-taking innovators who have always been at the heart of our economic growth.

The U.S. Census’s Business Dynamics Statistics program shows definitively that entrepreneurs’ fledgling companies are the country’s jobs engine. Consider a good year, 2005, when American firms added 2.15 million new jobs to the economy. Most kinds of companies didn’t contribute to that growth; firms between six and ten years old, for example, added about 1.7 million new jobs but destroyed more than 2 million through contractions or closings, for a net job loss of more than 350,000. In almost every age group, job destruction exceeded job creation. The exceptions were two types of firms: the very old and the very young. Firms over 26 years old added slightly fewer than 100,000 jobs, on net, while brand-new firms added more than 3 million.

Or look at the period from 1996 to 2008. Every year, the new firms added more than 2.9 million jobs, on net; every year except 2000 and 2006, the other firms, considered as a whole, destroyed jobs, on net. Similarly, the boom of the 1980s was led by job creation from new firms. Even in 2009, at the bottom of the recession, new firms managed to add more than 2.3 million new jobs—though those job gains were overwhelmed by the 7 million jobs lost by older firms. The lesson here: older firms generally shrink, while new firms erupt, hire new workers, and make up for the older firms’ job losses.

Further evidence of the economic power of entrepreneurs is the strong connection between entrepreneurial activity and urban success. One way of estimating entrepreneurial activity is average firm size; the idea is that a city with lots of smaller firms must have a lot of entrepreneurs running them. Another commonly used measure is the percentage of a city’s employees who work in new firms. Over the last 30 years, cities that are entrepreneurial, according to either of these measures, have added jobs more vigorously than those that aren’t. Even within cities, researchers have found, more entrepreneurial neighborhoods add jobs more quickly.

These findings support the ideas of the economist Benjamin Chinitz, who argued 50 years ago that New York City was resilient—it could remake itself as economic conditions changed—while Pittsburgh was not, because New York had a remarkable history of entrepreneurship. New York’s garment industry, the largest industrial cluster in postwar America, was a hive of small companies where anyone could get started with a good idea and a few sewing machines. Pittsburgh, by contrast, was the home of U.S. Steel—practically the definition of corporate America—whose company men were exceedingly unlikely to become entrepreneurs when the steel industry faltered.

Even more than Pittsburgh, Detroit emblematizes un-entrepreneurial America. But before it was dominated by three gigantic auto companies, Detroit was filled with clusters of private, interconnected innovators. Indeed, without the economic energy that those innovators generated, Detroit would never have become the Motor City. So Detroit’s history testifies to two important phenomena: first, the link between American entrepreneurship and employment; and second, the ability of a successful, big-firm industry to destroy a local culture of small-firm start-ups.

Long before it made its first car, Detroit was one of the many economic hubs that grew up around water. The Erie Canal connected the Great Lakes to the markets of the East, and cities sprouted at convenient spots—such as the straits that gave Detroit its name—along the great inland waterway. Naturally, shipping companies emerged, like Detroit Dry Dock, where the young Henry Ford learned about engines. Ford soon found himself attracted to one of the great economic challenges of the 1890s: making affordable cars. The basic technology, including the four-stroke internal combustion engine, had been invented in German cities; it clearly had the potential to produce vast profits, but only if someone could use it to create a functional and affordable automobile. America’s tinkerers—bicycle producers, carriage makers, and engine experts like Ford—flocked to the challenge.

Charles B. King made Detroit’s first car in 1896. King had trained as an engineer at Cornell and gained practical experience working at the Michigan Car Company (which made railcars) and the Russel Wheel and Foundry Company. It may be just a legend that Ford followed King’s car down the streets of Detroit on a bicycle, trying to figure out how the machine worked. But it’s certainly true that for his own car, Ford started “borrowing freely from King for the transmission as well as from existing engines,” as the economic geographer Peter Hall writes. Ford also took advantage of Detroit’s stock of mechanics, parts suppliers, and lumber barons for financing.

Ford was only one of Detroit’s many automotive innovators. The Dodge brothers, the Fisher brothers, David Dunbar Buick, Ransom Olds, and Billy Durant, the founder of General Motors in nearby Flint—all were part of the creative cluster around Detroit that solved the problem of producing an inexpensive, effective car. The collective genius of this cluster helps explain why New York City, which had dominated the market at first, quickly ceded its primacy to Detroit, which boasted more than 40 car companies by 1905. Through the early 1920s, Detroit remained a model of innovation through competition, with more than 50 auto manufacturers supplying one another with parts, ideas, and financing even as they fought for market dominance.

One of those ideas was Ford’s method, quickly imitated by his competitors, of building big factories with mechanized assembly lines, which created massive economies of scale and enabled him to cut prices repeatedly. The Ford approach created tens of thousands of jobs, and initially, at least, they were pretty much all in the Detroit area. One of Ford’s Detroit factories, the River Rouge plant, was the world’s largest factory during the 1930s, employing more than 100,000 workers. The great majority of them had little formal education, but starting in 1914, they were earning $5 a day—far more than they could bring home doing almost anything else. Ford’s innovation had made them productive and well paid.

So far, so good. But when change happened, Detroit was unprepared for it. Seeking to reduce costs and fleeing the powerful Michigan unions, auto companies started building factories in lower-cost areas soon after World War II. (Comparing the industrial growth of adjacent counties in states with differing union rules, economist Thomas Holmes has found that between 1947 and 1992, manufacturing grew 23 percent faster on the antiunion side of the state line.) By the late 1970s, the car companies were also struggling to compete with a new set of foreign firms offering attractive prices, quality, and fuel efficiency.

So Ford’s legacy to Detroit has been mixed. On the one hand, he surely brought many jobs there. But the scale of his success transformed a city of small, smart entrepreneurs into a city of vast factories filled with less educated workers. Decades of dominance by big companies in a single industry left Detroit with an ample supply of company men but a dire shortage of the kind of entrepreneurs who can reinvent a city when the economic climate changes. Even today, only 12 percent of Detroit adults have college degrees, and firms remain big. Meanwhile, urban success over the past 40 years has been tightly tied to having an abundance of educated workers and lots of little firms. The scale of Detroit’s decline is breathtaking: a city of 1.85 million residents in 1950 has fewer than 720,000 today.

Detroit also has much to teach us about how wrongheaded public policy can discourage entrepreneurship. The federal government, to begin with, has repeatedly acted to save the auto industry. In 1979, President Jimmy Carter signed the Chrysler Corporation Loan Guarantee Act, which guaranteed $1.2 billion of Chrysler debt. In 1981, the U.S. government pressured the Japanese into accepting “voluntary export restraints” that limited the number of Japanese cars imported into America to 1.7 million per year. (A side effect of the restraints was pushing Japanese manufacturers to open production plants within the United States; needless to say, they typically chose spots far from union-dominated Detroit.) Most recently and spectacularly, the feds bailed out General Motors with $50 billion and Chrysler with $10 billion.

It’s easy to understand why the government wanted to keep two large companies from collapsing in the middle of a recession. But the Big Three were synonymous with industrial stagnation; for all we know, a dissolution of General Motors would have led to a cluster of smaller, more nimble companies. Some might have failed, but others might have been innovative enough to start adding employment. What we do know is that we haven’t produced a world-beating car industry that will be a future jobs machine. These companies will probably keep sputtering along, making money in good years and requiring more bailouts in bad.

On the local level, Detroit is an object lesson in the failure of policies that emphasize physical capital rather than human capital and entrepreneurship. In the 1950s, Mayor Louis Miriani guided a sizable urban-renewal program, spending tens of millions of federal dollars on subsidized housing and overseeing the completion of the $70 million Cobo Convention Center. Miriani’s successor, Jerome Cavanagh, similarly used the federal largesse that showered Detroit in the 1960s to build new housing. And four years after Cavanagh left office, Detroit elected its first African-American mayor, Coleman Young, who spent millions supporting projects like the Joe Louis Arena and General Motors’ Poletown plant. He also invested in a monorail system, using the federal funding for urban transit made available by the National Transportation Act of 1973.

Detroit’s People Mover now glides over underused, often empty, streets, a reminder of the mistaken notion held by all three mayors and by the urban-renewal movement generally: that shiny new buildings can make a shiny new city (see “Urban-Development Legends”). Subsidizing new housing never makes sense in a declining city, since the hallmark of declining cities is that they have an abundance of structures relative to the level of population and demand. At the moment, more than 90 percent of Detroit’s houses are priced below construction cost, so it hardly makes sense to bribe people to build more of them. As for infrastructure, it can be valuable, especially when it radically reduces the costs of doing business, as the Erie Canal did. But today, America and its cities are already well connected, and new infrastructure investments are likely to have fairly modest effects. They are especially unlikely to bring back declining cities.

What would help is knocking down the barriers that block entrepreneurs from thriving. Here, alas, Detroit is a leader in erecting barriers. Take Pink FlaminGO!, a food truck operated by entrepreneur Kristyn Koth, who sold “Latino-influenced locally-sourced fresh food,” as the blog Eat It Detroit put it, out of a Gulf Airstream. Rather than cheering her on, the city gave her so many tickets that she had to close. What Crain’s Detroit Business calls “Detroit’s archaic ordinances governing all types of vending in the city” block food trucks from locating near existing restaurants or “in the most populated areas of Detroit”; they also tightly limit which foods street vendors may sell, partly to limit competition with restaurants.

Just as it isn’t the federal government’s job to prop up failing companies, it isn’t a city’s job to defend the status quo against innovative entrepreneurs. Detroit’s heavy regulations are a big reason why there aren’t enough new firms rising to offer alternatives to the Big Three.

Declining industrial cities don’t have to follow Detroit’s path—thanks to entrepreneurs. Forty years ago, as Boeing chopped down its local workforce, two jokers put up a billboard on a Seattle highway that read: WILL THE LAST PERSON LEAVING SEATTLE TURN OUT THE LIGHTS? Today, of course, Seattle looks nothing like Detroit. A stream of innovative companies—Microsoft, Amazon, Starbucks, Costco—has completely transformed the city. Between May 2010 and May 2011, it added more jobs than any metropolitan area except Dallas and Houston.

Like so many examples of American entrepreneurship, Costco has its origins in New York City’s garment industry, which employed the parents of one Sol Price. Price left the Bronx, moved to Southern California, and worked as a business lawyer for years. When he turned 38, some entrepreneurial gene awoke in him and he began to open discount warehouse retail chains—first FedMart, which catered to government employees, and then Price Club. In 1983, one of Price’s top managers at both companies, James Sinegal, borrowed Price’s idea—Sam Walton did, too—and took it to Seattle, where he founded Costco. Today, Costco has more than 400 stores and is the third-largest retailer in the United States, with $60 billion in domestic sales and nearly $20 billion abroad. Costco employs almost 150,000 people; many of them lack significant formal education, but smart management has made them far more productive.

Starbucks employs only 10,000 fewer people than Costco does, and its origins were far more modest. Two teachers and a writer decided to get into the coffee-roasting business. One of them learned the trade by working in the Berkeley store of legendary Swiss émigré Alfred Peet. When Starbucks opened in 1971—mere days before the jokers’ highway sign went up, as it happened—the company just roasted and sold beans, initially avoiding the sale of brewed coffee.

The transformation of Starbucks was led by Howard Schultz, a kid from Brooklyn who also once worked in the Garment District. Schultz was working for a housewares company when Starbucks piqued his interest by buying so many plastic cone filters, unusual in the coffee industry at the time. He quickly saw the potential in specialty coffee—how an increasingly affluent world would want to brew better joe. Schultz joined the company as head of operations and marketing in 1982. But on a trip to Milan, Schultz became convinced that Starbucks should sell lattes as well as beans. Breaking with the company’s founders, he left and started his own coffee shop, Il Giornale, which was inspired by the cafés that he had seen in Italy. It specialized not only in higher-end coffee but also in trained baristas who were supposed to provide a better retail experience. The success of Il Giornale enabled Schultz to buy Starbucks and create the chain as it is known today.

The company is another brilliant example of how entrepreneurs can create employment for the less skilled. Both Schultz and the original founders saw the demand for better coffee. Schultz’s vision, though, required thousands of workers who didn’t need much formal education but did need the right kind of training. His model became an employment machine. Remember, unemployment represents a crisis of entrepreneurial imagination—and people like Schultz and Sinegal had the imagination to see how they could make thousands of lightly skilled workers amazingly productive.

Seattle also owes its success to its formidable skills base, a major boon to high-tech giants Amazon and Microsoft, which both employ large, highly skilled local workforces. More than half of the city’s adults have a college degree, which makes it one of the more educated places in America. We know that the share of a city’s population with a college degree in 1970 is a strong predictor of its subsequent employment growth. Another predictor is the presence of a land-grant college in an area prior to 1940, which supports Senator Daniel Patrick Moynihan’s old claim that the best way to create a successful city is to found two world-class universities and wait 50 years. One reason an educated population leads to jobs is that it helps entrepreneurs find—and create—opportunity in today’s complicated, technologically intense world. After all, the occupation and skills of prospective workers shape the choices of entrepreneurs; no one would start an engineering company in a city without engineers.

Brainy Minneapolis’s success—per-capita incomes are higher there than in nearly any other metropolitan area between the East Coast and Colorado—shows that having a skilled population can enable a city and its entrepreneurs to overcome even freezing temperatures, which often chill urban vitality. Take Earl Bakken, who studied engineering at the University of Minnesota and later connected with C. Walton Lillehei, a pioneer of open-heart surgery who worked at the university’s hospital. The flow of knowledge between the two led to the invention of the first battery-powered artificial pacemaker, a device that would make Bakken’s company, Medtronic, a major firm. Medtronic remains on the cutting edge of medical technology and now employs 38,000 people, many of them in the Minneapolis area.

Unfortunately, today’s America seems to have too many Detroits and not enough Seattles and Minneapolises. How can more cities become centers of skilled invention and entrepreneurship?

Entrepreneurship doesn’t happen overnight, and it’s rarely the direct creation of government. Bureaucrats aren’t experts in finding unexpected market niches, so politicians are prone to throwing money at the fad of the moment, like “green jobs.” Also unhelpful are policies that privilege older, big-firm industries. My research with William Kerr has found that places blessed—or cursed—with natural resources, such as coal or iron mines, 100 years ago still have larger firms today, across all their industries, and that the employment picture there is correspondingly bleaker than in cities with fewer natural resources. So we should worry about policies like auto bailouts, which are the artificial equivalent of coal mines, encouraging big, stagnant companies at the expense of job-creating start-ups.

Still, certain policies can help entrepreneurs and boost American employment. Since an educated workforce is so important to urban success, America needs better schools, especially in its dense urban areas. Perhaps the most hopeful development on this front is the emergence of charter schools. Since entry to the most successful of these schools is typically by lottery, social scientists can compare the test scores of those who won and got in with the test scores of those who didn’t. A significant number of papers now show the remarkable long-run effects that getting in can have on children’s academic outcomes.

That’s particularly satisfying because charter schools themselves channel American entrepreneurship, replacing poorly performing public monopolies with something closer to the free market. Not every charter school is a success, obviously—not every big-box store is, either—but the good ones attract students and the bad ones eventually fail. That’s how entrepreneurship works.

Another badly needed reform that would help unleash entrepreneurs: every level of government needs to rethink and reduce its regulations, which have grown excessive and stifle innovation (see “The Regulatory Thicket”). The federal government could lead the way by establishing a federally funded independent body, perhaps attached to the Congressional Budget Office, to analyze state and local regulations. Localities that instituted entrepreneurship-killing regulations would lose their power to issue federal-tax-exempt bonds.

Cities play an outsize role in supporting entrepreneurship, especially the kinds of entrepreneurship that employ the less skilled. Our three largest metropolitan areas—New York, Los Angeles, and Chicago—produce 18 percent of America’s output while housing only 13 percent of America’s population. Yet many of our policies, like subsidized highways in low-density areas, pull Americans away from the urban centers that are the country’s true economic heartland. We need to eliminate those policies.

In general, we should never use public dollars to bribe people to remain in dead-end jobs. We should place far less emphasis on the industries of the past and more on those of the future. Federal policies that bail out auto companies and subsidize agriculture aren’t merely expensive; they also encourage people to stay in declining industries rather than strike out on their own.

And we should work diligently to support free markets, whose most important function may be to allow human genius to create new ideas that give jobs to thousands. As America looks to the future, it must renew its commitment to economic freedom, a climate in which entrepreneurs—and America’s workers—can thrive.