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Why Small Businesses Aren’t Hiring

Tuesday, August 24, 2010

In the recoveries from the previous two recessions, small businesses led job creation. This time, however, small businesses aren’t hiring. Here’s why.

In the recoveries from the previous two recessions, small businesses led job creation. This time, however, small businesses aren’t hiring. That about-face has left a lot of economic prognosticators scratching their heads. I think the reason is clear. The collapse in home prices is holding back small-business hiring. And unless we fix the residential real estate mess, we won’t see small business hiring anytime soon.

The weak residential real estate market is keeping small businesses from hiring in five ways:

1. Declining house prices have softened demand for small businesses’ products and services. The 29.5 percent drop in home values from the first quarter of 2006 until the end of the first quarter of 2010 has led to a huge drop in household wealth, which has led to reduced consumer spending.

Studies show that consumption falls by about 8 cents for every dollar of decline in wealth. Thus, housing price declines have taken a bite out of consumer demand. Also, because small businesses generate half of non-farm gross domestic product, they are the recipients of a big part of the housing-price-driven decline in consumption.

Just over half (51 percent) of small business owners indicate that their number one problem is weak sales, according to a 2009 National Federation of Independent Businesses (NFIB) survey. As long as consumer demand remains weakened by slumping house prices, small business owners will face slack demand that will dampen hiring.

2. Small businesses are overrepresented in the real estate-related industries that have been decimated by the residential housing market collapse. Falling home prices have devastated employment in construction and real estate businesses, virtually all of which are small companies. According to the Small Business Administration’s annual publication, “Small Business Economy,” 99.9 percent of all employer businesses in the construction sector and 99.6 percent of all employer businesses in the real estate sector have fewer than 500 employees, the cutoff for small businesses.

Business borrowing of more than one in five small business owners is tied to the value of their homes.

From the start of 2008 through the third quarter of 2009, Bureau of Labor Statistics data show a net loss of 1.8 million jobs in construction alone. While a decline in the value of residential real estate only accounts for some of these job losses, they are nevertheless at least partially responsible.

Small business employment was relatively high in these sectors. In 2006, the latest year data are available, 10.4 percent of all people employed in small businesses worked in construction. That’s more small business construction workers than small business manufacturing workers. Add another 2.5 percent who work in real estate and rental and leasing businesses, and we had more than one in eight U.S. small business workers in construction and real estate.

3. Small business owners use their homes to obtain business credit. According to the 2009 Gallup/NFIB survey, 16 percent of small business owners finance a business with a home mortgage, and an additional 6 percent pledge that real estate as collateral. As a result, business borrowing of more than one in five small business owners is tied to the value of their homes.

As home prices have fallen, small-business-owning households have seen their personal balance sheets weaken. And the NFIB survey shows that 9 percent of owners owe more than their homes are worth.

The more fragile financial position of small business owners has made expansion difficult. In addition, as home values have fallen, the 22 percent of small business owners whose business debt is linked to residential real estate have faced demand for more collateral by lenders. The weakened balance sheets and demand for additional collateral has meant that fewer small business owners have been able to expand.

4. Banks have tightened lending standards in response to a rising share of non-performing real estate loans. The banks with real-estate problems are among the biggest small business lenders. A February 2010 congressional report explains that, “smaller banks with the highest exposure—commercial real estate loans in excess of three times Tier 1 capital—provide around 40 percent of all small business loans.” These banks have tightened up their lending standards. The Federal Reserve’s survey of bank loan officers shows that from the first quarter on 2008 through the first quarter of 2010, in every single quarter more banks tightened their lending standards for small businesses than loosened them. Tighter loan standards mean fewer small businesses can get capital for expansion that leads to hiring.

5. Small business owners were major customers of residential real estate loans during the boom, making them among the consumers hardest hit from the collapse in home prices. Small business expansion depends a lot on small business owners’optimism. And that optimism is influenced by the owners’ personal financial position. Small business owners took on a lot of mortgage debt during the real estate bubble and are now suffering from the fall in residential real estate prices. Data from the Fed’s consumer finance survey indicates that from 1989 to 2007, the portion of people with their own businesses who had home equity loans went up 82 percent, nearly four times the rate among people who work for others. This heavy borrowing increased by 48.4 percent the home equity debt held by the typical self-employed head of household. (It shrank 28.9 percent among those worked for others.) As a result, in 2007, the average debt load for a self-employed household was $123,000, roughly 50 percent more than the average debt load for wage-employed households.

Tighter loan standards mean fewer small businesses can get capital for expansion that leads to hiring.

Waiting for small business owners to begin hiring in this economic recovery has become like waiting for Godot. Rather than continuing to wait (while chanting the mantra that “small businesses are the major job creators in economic recoveries”), we should acknowledge why small businesses aren’t leading job creation this time around and come up with solutions to the residential real estate problems that are holding them back.

Doing this is imperative. Slightly more than half (50.2 percent) the private sector works in small companies. If the residential real estate mess keeps the small business sector from hiring, it will be awfully difficult to reduce our unemployment rate to a reasonable level.

Scott Shane is the A. Malachi Mixon III Professor of Entrepreneurial Studies at Case Western Reserve University. The author recently released a book from Oxford University Press: Born Entrepreneurs, Born Leaders: How Your Genes Affect Your Work Life.

FURTHER READING: Shane has also written on credit proposals that offer “No Way to Help Small Businesses,” “When Less Is More for Investors” with the new financial regulation reforms, and on immigrants and entrepreneurship in “Give Me Your Tired, Your Poor, Your Entrepreneurs.” Lawrence Lindsay answers “Did the Stimulus Stimulate?” Henry Olsen discusses “Unemployment: What Would Reagan Do?” and Alex Pollock discusses the housing market in “What Should the New System Be Able to Do?”

Image by Rob Green/Bergman Group.

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