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Why the Recovery Eludes Small Business


The Federal Reserve Bank of New York recently released a study to explain why employment at small businesses dropped so much more than employment at large companies during the Great Recession. The upshot of the Fed’s analysis: Small employers cut staff so severely because of a drop in consumer demand. I disagree that was the only reason. I think two factors—reduced access to credit and the concentration of small businesses in the worst hit sectors of the economy—play a bigger role than the Fed researchers acknowledge.

Let’s start with where we all agree. Small businesses lost proportionately more jobs than big companies during the economic downturn. As the Fed report explains, businesses with fewer than 50 workers lost 10.4 percent of their jobs during the recession, compared with only 7.5 percent at businesses with more than 49 workers.

This, of course, is a huge problem. Businesses with fewer than 50 employees accounted for 28 percent of the 121 million Americans employed in the private sector in 2008, the latest Small Business Administration figures show. That’s too much employment in small businesses for policymakers to find a way to fix the job problem without getting the smallest companies to boost hiring. Getting Americans back to work requires a good understanding of why small businesses eliminated so many jobs during the downturn.

The New York Fed report says that “weak consumer demand for the firms’ products and services” was the primary cause of small business job loss during the downturn. Sure, but it’s also the reason why big companies laid off so many people. The real question is why the job loss was proportionately greater at small companies.

ABSORBING THE BRUNT

The Fed researchers said the concentration of small businesses in certain sectors of the economy isn’t the explanation, because small companies had greater job losses than large businesses in all economic sectors. I disagree. Small businesses are underrepresented in two sectors that have weathered the downturn relatively well: exporters and those in research-and-development-intensive industries. And small businesses account for much more of the employment in the sectors hardest hit by the downturn.

Take construction. SBA data show that, in 2007, 85 percent of employment in construction was in businesses with fewer than 500 employees, the agency’s definition of a small business. In contrast, only half of all employment was found in companies of that size. While total employment fell only 4.4 percent from 2007 to 2009, employment in construction dropped a 19.4 percent. With so many small businesses in construction, this has meant heavy job loss.

The Fed researchers also play down the importance of tightened credit markets in accounting for the losses, arguing that most of the decline in borrowing by small businesses during the recession came from a decrease in demand for loans—not a reduction in supply. But the National Federation of Independent Business’s monthly survey of its members suggests otherwise. In March 2009, at the depth of the recession, only 29 percent of small business owners reported that their borrowing needs were being met, down from 40 percent back in February 2007.

RELYING ON HOME EQUITY LOANS

Moreover, small business credit was badly affected by the decline in home prices. A 2007 survey by Barlow Research Associates shows that one-quarter of small business owners use the equity in their homes to fund their businesses. And research by Kean University professor Samuel Bornstein shows that many of the loans used to tap that equity were the Alt-A, adjustable-rate and interest-only mortgages at the toxic heart of the crisis.

The decline in housing prices sucked a large amount of small business credit out of the system. In a Federal Reserve Bank of Cleveland commentary I wrote with Mark Schweitzer, the Cleveland Fed’s vice-president for research, I estimated that small business borrowing via home equity loans alone is $25 billion below where it would have been had the trend in home equity lending during the housing boom continued.

In short, all businesses lost jobs during the Great Recession because demand for products slackened, causing companies to cut back on employment. But the two factors I’ve detailed above made the situation worse for small businesses. If policymakers want to counteract the job losses in small business, they need to do more than say that the cause is decreased demand. Rather, they need to stimulate the small business heavy industries that were badly damaged by the recession and keep credit flowing. That, of course, will require new approaches that offset the decline in small business credit that has come from the fall in home prices

Scott_shane
Scott Shane is the A. Malachi Mixon III Professor of Entrepreneurial Studies at Case Western Reserve University.

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