Pethokoukis, Economics, U.S. Economy

Here’s one explanation for the decline in US startups — and the weak economic recovery

Credit: Kauffman Foundation

Credit: Kauffman Foundation

One big reason the US economic recovery has been so anemic: weakness in the small and young firms which typically have high job creation rates. (The sector also generate lots of innovation.) These businesses were were hit especially hard by the Great Recession and Financial Crisis and continue to suffer.

As a new paper points out, businesses less than five years old and with fewer than 20 employees saw a decline in net employment growth from 26.6% to 8.6% from 2006 to 2009. At the same time, businesses more than five years old with more than 500 workers saw a decline in net employment growth from 2.8% to -3.9%. The net growth rate differential between such young/small businesses and older/large businesses fell from 23.7% to 12.5%.

But why were startups and new firms so vulnerable? In “How Firms Respond to Business Cycles: The Role of Firm Age and Firm Size,” researchers point to the role of the collapsed housing sector as the continuing culprit:

Since young firms disproportionally contribute to job creation in any given year, our results further indicate that the disproportionally large decline of young and small businesses is important for understanding not only the depth of the recession, but also the slow recovery. …

Why was the impact on young and small businesses especially large in this period? The evidence in this paper points to the collapse in housing prices as a potential critical factor. In states where housing prices declined the most (and after controlling for the endogenous impact of local business conditions on those prices), we find that there has been an especially large decline in the net employment growth for young and small businesses.

We think there are a number of channels possibly at work that make young and small businesses more vulnerable in general to cyclical shocks and to housing prices in particular. One possible channel of interest is a home equity financing of startups and young businesses. Research has shown that startups and young businesses are much more likely to use home equity for financing.

I don’t think this research means we should a) reinflate the housing bubble or b) continue  to massively subsidizing housing through tax policy as an indirect way of subsidizing entrepreneurship. Better to push policies, such as some form of universal savings accounts — that both expand and diversify savings to provide savings that could be used for startups — or for retirement or education.

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