Noncompete Clauses Make Your Economy Sick

Handcuffing employees stifles the innovation that powers growth.

Don't hold them back.

Photographer: Mark Ralston/AFP/Getty Images

Lots of people are worried about noncompete clauses in employment contracts. And after taking a look at the issue, I’m worried too.

A noncompete requires that, as a condition of getting hired, an employee agrees not to work for competing employers for a certain period of time.  In other words, a worker gives up a valuable option, because she has to pass up other job opportunities. This allows the company to stop the employee from transferring knowledge of its business practices to a competitor.

From an economics standpoint, there are other problems with noncompetes -- they introduce an externality. A noncompete with one company affects the economic prospects of all the other companies that are covered by the contract, reducing the pool of labor from which they can hire. A situation like that, where an agreement between Person A and Person B also affects Person C who isn’t party to the agreement, messes up the magic of the free market.

Noncompetes are especially disturbing because they seem to be on the rise at the worst possible time. Whereas in the past, noncompetes were rare, nowadays they’re being used by companies like Jimmy John’s, a sandwich chain, to restrict the movement of low-wage workers. Nor is this an isolated case. The U.S. Treasury Department recently issued a report showing that about 18 percent of all American workers are covered by these agreements.

That’s very bad, because the U.S. is in a period of falling economic dynamism. New companies just aren’t being started at the rate they once were -- entrepreneurship, long considered the engine of American economic strength, is sputtering. And workers are switching jobs less as well. John Haltiwanger, an economist who studies dynamism, used the following chart in a presentation last year (it shows the rate of job creation plus job destruction on the y-axis):

job creation graph

Declining business formation rates and sluggish movement of labor are exactly the kinds of problems that noncompetes tend to cause. There is research to back this up. Business professors Matt Marx and Lee Fleming have surveyed the academic literature on noncompetes, and they found the following:

We observe that non-competes are generally favorable for established firms though less so for firms that are young, small, or not yet established. These benefits to firms appear to be offset by costs to individual workers, who are often unaware of noncompetes when they accept an employment offer and end up with reduced opportunities for employment or entrepreneurship going forward. At the regional level, evidence is thinner but points again to the tension between the interests of established firms and those that do not yet exist.

In other words, noncompetes hurt startups and workers, and help big, established companies -- exactly the opposite of the direction the U.S. needs to be going right now.

There’s another big problem with noncompetes, which is that they can block the spread of technology. When employees move from company to company, they take their ideas and know-how with them. Noncompetes keep ideas bottled up within the walls of a single company. Though some argue that this gives companies a greater incentive to investment and innovate -- since they’re less afraid that their research will be cheaply copied by competitors -- this positive effect could easily get swamped by the negative impact of trapped technology. That would tend to hold back productivity growth, making everyone poorer in the long run.

This may already be happening. A 2015 report by the Organization for Economic Co-operation and Development showed that in many industries, the economy’s most productive "frontier" companies are still experiencing fast growth in their productivity, but that their competitors are falling behind. Here are a pair of graphs from that report:

frontier companies

This is another problem that noncompetes make worse.

Perhaps for this reason, lots of people speculate that noncompetes explain much of the difference between the Silicon Valley and Massachusetts technology clusters. California, which bans noncompetes, has seen its tech industry grow and dominate the country and the globe, while Massachusetts, which enforces noncompetes strictly, has struggled.

So noncompetes are probably exacerbating two of the U.S.'s most biggest economic challenges -- declining dynamism and stagnant productivity. They are a bad economic equilibrium -- a breakdown of the free market -- and the federal government probably needs to step in. In a promising move, some Democratic senators are pushing a bill to ban noncompetes for employees making less than $15 an hour, and many states are cracking down as well. Let's hope there is more of this, at both the national and state level. In this sluggish economy, American workers, entrepreneurs and researchers need all the help they can get.

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.