IN DECEMBER 2004 Microsoft paid a massive $33 billion dividend to its shareholders. The largest payment of its kind, it made up 6% of the increase in Americans’ personal income that year. Examples of how big firms can have a big impact do not come much starker. These kinds of firm-specific shocks are typically excluded from economists’ models, which assume that individual businesses’ ups and downs tend to cancel each other out. Yet to understand how things like trade and GDP evolve, tracking the biggest companies is essential.

At first sight, the numbers seem to justify taking a top-down view. The business world is huge: America has around 27m firms, Britain 4.8m. Each country trades with hundreds of other countries across hundreds of industries, producing thousands of country-industry trade links. The global network runs to the millions. Because economies are built of millions of firms and trading relationships, each seems like a speck of dust: individual companies and export channels should not matter. This suggests that only common shocks can explain aggregate fluctuations: a workers’ strike at one firm is not enough, but a general strike is.

Yet aggregate shocks do not explain volatility very well. A 2007 Bank of Spain paper* studies OECD countries’ trade balances. Common shocks (to whole countries or global industries) explain only 45% of the variations. Hunting for the cause of the other 55% of trade fluctuations, the authors used finer data on 8,260 country-industry “flows” (59 industries and 140 trading partners) for each OECD member. The data show that the picture of trade as millions of links is inaccurate; in fact, flows are extremely concentrated. Most links are unimportant. For America 99% of trade flows accounted for just 25% of trade. But a few are vital: for the average OECD country the 25 main country-industry flows explain two-thirds of trade, and the 100 largest 85%.

Even such detailed data mix lots of firms. The flow of cars between America and Japan includes GM, Ford and Chrysler with Toyota, Nissan and Honda. So the researchers dug down another level to study individual companies. In a case study for Japan they found yet more concentration: the top five Japanese firms accounted for 20% of exports. That suggests that trade volatility, an aggregate statistic, could stem from just one firm’s behaviour.

Some companies are certainly big enough to have that sort of effect. In America the 2008 census showed that 981 firms with 10,000 or more staff account for a quarter of all jobs. Of Italy’s 4.5m firms, 96% are “micro” SMEs with fewer than ten people; a giant like Fiat, a carmaker, sits at the other end of the scale. Samsung alone notched up 17% of South Korea’s exports in 2011. Finland is perhaps the most extreme example, with Nokia, a telecoms titan, contributing 20% of exports and 25% of GDP growth on its own between 1998 and 2007.

This is a problem for the top-down view of the economy. A 2011 paper by Xavier Gabaix of New York University explains how diversification works when firms are independent and their sizes follow a regular “bell-shaped” distribution. Imagine an economy where one firm produces everything: its volatility of earnings determines volatility in GDP. But as the number of firms grows GDP volatility shrinks, because firms’ shocks cancel out. With 100 firms, volatility falls to a tenth of the level in a one-firm economy; with 1m firms, it falls to a thousandth. Since there are more firms than this, company-specific shocks disappear.

That’s the theory, at any rate. When the distribution of firms has “fat tails” (ie, there are more very small firms and very big ones) the theoretical relationship breaks down. An economy now needs 22,000 firms for volatility to fall to a tenth of the level in a one-firm economy (there would never be enough firms for it to fall to a thousandth). The logic of diversification fails when companies are sufficiently large. Firm-specific shocks do matter.

Mr Gabaix tests this new “granular” theory against data for the largest 100 American firms between 1951 and 2008. Stylised facts support his hypothesis. There is a fat tail of very big firms: the 100 largest had sales equivalent to 35% of GDP in 2009, up from 30% in the mid-1980s. Their performance is volatile: sales fluctuate by an average of 12% a year. And the correlations between firms are low, suggesting shocks are firm-specific rather than economywide. Next Mr Gabaix examines how well shocks involving these big firms explain changes in GDP. Very well, it turns out. Up to 48% of the volatility of American GDP can be traced to the performance of individual big firms.

On the rocks

The importance of the goliaths extends to trade. A widely held view is that trade lowers volatility: exporting to more markets means greater diversification. But in a 2012 paper Julian di Giovanni of the IMF and Andrei Levchenko of the University of Michigan find that more foreign trade exposes economies more to the fortunes of large firms, since they trade disproportionately.

Central bankers should take note. Mr Gabaix shows that taking account of firm-specific shocks can help improve economic forecasts. The models that determine economywide decisions—like those run by the Federal Reserve before its meeting this week—might be improved by looking at how big firms are doing. There is also something to chew on for governments. The granular approach shows that what is good for GM really is good for America. But the converse also applies: when big firms do badly, everyone suffers. Ford, GM and Chrysler employ close to 0.5m people. When markets tanked in late 2008, they successfully tapped the taxpayer for billions in bail-out money. The problems of being “too big to fail” stretch far beyond banking.

Sources

“Trade Patterns, Trade Balances and Idiosyncratic shocks”, by Claudia Canals, Xavier Gabaix, Josep M. Vilarrubia and David Weinstein, 2007, Banco de España, Documentos de Trabajo

“Country Size, International Trade, and Aggregate Fluctuations in Granular Economies”, by Julian di Giovanni and Andrei Levchenko, 2012, Journal of Political Economy

“The Granular Origins of Aggregate Fluctuations”, by Xavier Gabaix, Econometrica, May 2011

“Nokia and Finland in a Sea of Change”, ETLA—Research Institute of the Finnish Economy

Economist.com/blogs/freeexchange