By Robert Fairlie
Today, we’re fortunate to have Rob Fairlie, UC Santa Cruz Professor of Economics as a guest blogger. Some of his work was discussed in this earlier post.
On Monday, President Obama announced a plan to unfreeze capital for small businesses (see here). With the potential of creating new jobs and helping the country move out of the recession, the White House offered several actions to help small businesses obtain the capital that they need. The financial crisis has taken a devastating toll on entrepreneurs as capital has become increasingly scarce. This year’s projections for loans guaranteed by the Small Business Administration are down to $10 billion, which is half the amount of loans guaranteed last year.
To get capital flowing again for small businesses, the President’s plan calls for purchasing securities backed by SBA loans, reducing lending fees, increasing loan guarantees, and easing the tax burden. To increase confidence among banks to lend to entrepreneurs in current economic conditions, the White House will temporarily raise guarantees on loans to 90 percent in SBA 7(a) Loan Program. Currently, the government guarantees on small business loans made by private lenders are either 85 percent for loans under $150,000 or 75 percent for larger loans. The temporary reduction will provide some needed confidence to a shaky banking sector. Although the findings from research on SBA’s loan programs are mixed, with critics noting that making credit too easily available sets up many small businesses for failure and wastes money, a temporary increase may be what we need right now to regain reasonable levels of access to credit. Many entrepreneurs who own otherwise successful and efficiently-run businesses may go under because they cannot pay the rent or meet payroll in this historically deep downturn. In an extensive research project of mine using confidential Census data, I find that access to capital is the most important factor predicting whether small businesses will survive or fail.
President Obama also plans to substantially reduce and ultimately eliminate capital gain taxes on investments made in small businesses. The current plan is to exclude 75 percent of capital gains for investors in small businesses who hold their investments for at least five years. The reduction or elimination of these taxes will increase the effective return from investing in small businesses. Although many investors, understandably, will continue to be wary of putting their money into small businesses in these economic conditions, reducing capital gains taxes could inject some much-needed capital into the small business sector because of the current lack of attractive alternatives.
In my research I have found that the most common source of capital among small business owners is their own or family savings. But, with incomes falling, the stock market down, and housing equity drying up, entrepreneurs will increasingly need to seek out alternative sources of capital, such as banks, credit unions and angel investors.
These are desperate times and they call for quick and bold actions by the federal government to help what many consider to be the life-blood of the U.S. economy — small businesses. Maintaining adequate access to financial capital for the nation’s nearly 13 million business owners should be viewed as one of the most important goals of the economic stimulus plan.
For more on entrepreneurship, see “Race and Entrepreneurial Success” (MIT, 2008) and “The Kauffman Index of Entrepreneurial Activity”
by Robert Fairlie
Technorati Tags: small business, SBA,
financial capital, entrepreneurs, and loan guarantees.
“Many entrepreneurs who own otherwise successful and efficiently-run businesses may go under because they cannot pay the rent or meet payroll in this historically deep downturn.”
Please successful companies actually produce positive cash flow that covers expenses. The idea that the taxpayers are going to cover small business losses is another idea only an academic economist can grasp. We have enough zombie corporations surviving on bond refi and various stock ponzi schemes.
Obama looks more like another bad actor opening the flood gates to default artist,snake oil salesman and the rest of the garden variety SBA loan folks opening another nail saloon all at taxpayers expense.
“In an extensive research project of mine using confidential Census data, I find that access to capital is the most important factor predicting whether small businesses will survive or fail.”
Do better ideas receive more capital? (Is the access to capital really the key determinant of small business success or is it a consequence of the business plan?)
You also don’t distinguish between equity and debt capital in the chart.
Please again…if your business can not pay it’s expenses then perhaps it’s just not a viable business? I understand a ‘line of credit’ to finance materials and labor for a legitimate purchase order, but to pay the bills with a loan is a bad idea. How do I know this? because, I ended up doing it with my SBA loan. Stupid idea. As far as using a loan to *start* a business just what exactly kind of business are you going to start in this economy?
There is way to much capacity in every sector. An economy founded on building and selling facsimile crap that nobody REALLY needs. And a service economy filled with experts that can’t even predict if the sun will shine in the next moment.
Deflation…get used to it.
As a volunteer counselor at the SBA’s SCORE organization, I can tell you first hand that the small business credit situation is quite dire.
It’s a given that pie-in-the-sky startup ideas don’t and shouldn’t get SBA backed loans. That’s not the issue. As of last fall, we saw major lenders like CIT and others halting all underwriting. Things are easing a bit now, but banks are being very tight-fisted. Make no mistake, sound businesses are getting caught up in this whirlpool. Credit lines that finance seasonal variations are being pulled unexpectedly, even for paid up customers.
Things are bad, and these measures sure seem like they could help. In the end though, the real solution is to get a handle on the solvency of the banks. Even with only 10% of their cash on the line, if bank balance sheets are a mess, they just won’t lend.
It took Obama exactly 60 days to become the worst President ever. My god, it really is much easier to destroy than to create.
If Comrade Obama understands that tax burdens have a direct impact on investment decisions, then what possible justification can he fall back on for raising the general capital gains tax during a stock market collapse? Of course major investors have continued to flee the market as they have seen their after tax returns decreased. All the while, Americans of all classes watche their retirement funds dwindle away and Nero laughs with the late night jester as the nation burns.
“As of last fall, we saw major lenders like CIT and others halting all underwriting.”
Actually that is what the market is desperate for, a drying up of excess borrowing by companies that have poor business plans,excessive competition,low margins,bad management the list is long. Let me give a couple examples based on real life experience.
financing for new equipment: Company wants a new high speed equipment for say 4 million bucks spread over 10 years. The bank throws in another one to two million dollars to assist in marketing, installation and help get this up and running.
The company goes out and hires away producing sales people from competitors by offering employment bonus and high commissions same for equipment operators.
It also lowers prices for the product in the market place to generate new sales.
The competitors who once had good solid business are suddenly scrambling for business and sales people. The result is that only the worst run business survives, the one with the dumb money loans, and they finally get bought out by a consolidator down the line who has borrowed huge sums by various bond and stock offerings.
Example two: SBA loan for large digital format printer: small business wants to enter large format printing using SBA loan for equipment,payroll etc. Now he enters the local market and competes with other current supplies thereby lowering margins,creating excess competition and eventually making everybody in the business worse and using taxpayer money guarantee as the basis for the loan rather then his/her good sound prior business experience and funding.
As I read this I was reminded of what I heard about the reason there are Catholic schools. If you get them while they are young you can instill your ideals in them.
So the government is going to get the small businesses while they are young and take a controlling position in them. Then the government can become the parasite sucking the life out of the business.
I am not exaggerating. Two days before the government took a controlling equity position in AIG Bernanke said the government would never nationalize private business. Just this past week we heard speaker after speaker say that as owners of AIG the congress had the right to take back money paid as bonuses. Those who have problems with definitions, the word defined as an economy where a government takes ownership of a business but leaves management in the hands of the private sector is “Fascism.”
Man, you guys are a tough crowd!
Certainly one can make a good conservative argument that the SBA should be eliminated and the free market should rule. That’s fine, and usually, I’m a pretty staunch libertarian on stuff like this.
OTOH, it’s tough to ignore good results when you repeatedly see them first hand. Volunteering at SCORE has given me a chance to see a lot of good come from this government “meddling” in the free market. It’s actually left me rather conflicted.
What Obama has done to date is proven he and those whom he has hired have NO flipping clue what they are doing.
Even Communist China is telling Obama to cut his spending and Obama answers back with printing money.
Maybe if 20 million people were to send Obama coupons to the Local Jr. College Econ. 101 class he might get a clue.
JFK,Reagan,Bush,Clinton and Bush have the Blue Prints to fix this economy. Obama has made the choice to go with Vladimir Ilyich Lenin to remove prosperity for the many in order to gain even more power for the few (DNC Contributor Base like Soro’s).
In closing I leave you with this.
We will not have to travel half way around
the world anymore to fight Socialism and Communism.
Obama voters have brought it here.
Lincoln Saved the Union & Freed the Slaves. Obama Put in Office By The Unions and Enslaved The Free.
Dave Johnson.
Sacramento CA.
It looks like the Kiwis will join the Chinese in ruling the world after the Great Inflationary Depression ends.
Kiwis focus on supply-side
Whilst governments in countries such as Australia and the USA are spending like drunken sailors in the hope that it will stimulate the economy, New Zealand appears to be taking what is at the moment a unique alternate approach. Rather than fiddling with the demand side of the equation they seem to be focused on the supply side.
An extract from a recent Wall Street Journal article:-
We dont tell New Zealanders we can stop the global recession, because we cant, says Prime Minister John Key, leaning forward in his armchair at his office in the Beehive, the executive wing of New Zealands parliament. What we do tell them is we can use this time to transform the economy to make us stronger so that when the world starts growing again we can be running faster than other countries we compete with.
That idea growing a nation out of recession by improving productivity puts Mr. Key and his conservative National Party at odds with Washington, Tokyo and Canberra. Those capitals are rolling out billions of dollars in stimulus packages with taxpayers money to try to prop up growth. Thats risky, Mr. Key says. Youve saddled future generations with an enormous amount of debt that then they have to repay, he explains. There is actually a limit to what governments can do.
And whilst Australia experiments with ever higher amounts of public spending the New Zealand government includes a coalition partner, The ACT Party, that is pushing for Colorado style legislation that would put a cap on growth in government expenditure. An approach sometimes refered to as a Taxpayer Bill of Rights or TABOR. According to the ACT / National agreement this looks set to be drafted as a legislative bill some time around May this year.
Current political and economic trends in New Zealand continue to be well worth watching.
“Many entrepreneurs who own otherwise successful and efficiently-run businesses may go under because they cannot pay the rent or meet payroll in this historically deep downturn.”
This is not true in the real world. Many people made the wrong bets and assumed a market for their goods and services that would not exist unless the government and Fed could keep bubbles inflating forever. When bubbles pop the best ting to do is to let such people go under and let others who have better ideas put the liquidated resources to a better use.
The fact that I make a bad bet and invest in a copper mine development play that cannot find financing without excessive dilution of shareholders is my problem, not the government’s or the taxpayers. If my company goes under the resources will still remain and will be developed later, when the markets have a need for the copper or when other investors come to the table and decide that they have the capital required to develop the mine. Actually, the best thing that can be done to help me is to have the government fire useless federal employees that prevent the development of viable mines by forcing more time to be used up in filling out forms than out in the field looking to add to reserves.
Instead of trying to manage the economy government needs to get out of the way and let the market weed out the weaker, less efficient players. In case you have forgotten, that is what made the country great in the first place, not federal financing of private ventures.
This is hysterical!
In all seriousness, I think the idea is to identify the market failure – which is the credit freeze from the recession, and ask if the program is big enough or of the right type to do anything about it. As a Keynesian, I would be very weary of increasing investment funds, since investment is mainly a function of aggregate demand and not the interest rate. Although this program is small, and will likely to have some effect on the margins, I doubt this program will have much success.
As SBA policy in general, however, as a person who would generally trade a bit of market efficiency for more jobs, I think sustaining and increasing the amount spent on the SBA to be an excellent idea.
Robert,
Thanks for your contribution. You state: “In my research I have found that the most common source of capital among small business owners is their own or family savings. ”
What is the second and third most common source? Is the SBA up there?
Also, has the demand for SBA loans changed, or is it more of a supply issued from risk averse banks increasing fees and rates?
Thanks
I own two small businesses (eg, a glutton for punishment) and have taken several trips through the SBA process. One of my businesses deals with capital expenditures for other small and medium businesses, so I see quite a bit of what goes on. Here’s my take on SBA loans:
SBA loans have made banks lazy and incompetent. Because their exposure is minimized, they take a brief look at existing financials and projections and focus the rest of what little time and energy they put into the process on deciding if they can cover their 15% (or whatever) exposure and if they can cram the loan through the SBA process. I’ve seen excellent business plans get kicked to the curb, and I’ve seen crap business plans get funded multiple times over (and then implode). By minimizing the risks to banks, the government has removed the incentive for them to really know what they’re doing. This is similar to what happened with the mortgage industry – when it’s not the broker’s money in play, they care more about the loan meeting the government’s criteria than they care about whether or not it’s actually a good loan.
I’m not sure what the best solution is. I suspect that banks would be more competitive and flexible in their offerings if the SBA’s one-size-fits-all approach wasn’t dominating out the small-to-medium business loan business. That being said, I’m pretty confident that whatever the best approach is involves the buck stopping as close as possible to the people making the loan decisions. Bankers need to get smarter, and leaning on the government doesn’t help this to happen.
This is one of those assertions by economists that 1) deeply confuses correlation with causation, and 2) is so asinine as to be hysterically funny to people who have actually seen businesses start up and grow. Yes, you need some money to start a business. That being said, having too much money is often more damaging to a business than not having enough. Businesses that start “fat” tend to stay “fat” – when the going gets tough, they don’t know how to run lean. Having difficulty getting capital to start my second business was the best thing that happened to us. We’re growing nicely – even right now – because we’ve had to have excellent financial discipline. We can be profitable even if the recession gets worse.
My $.02 on the most important predictor of success for a new business: how many times the people involved have started new businesses in the past. You make a lot of mistakes the first time (or two), as I can personally attest. Recovering from the repercussions of these mistakes teaches some incredibly powerful lessons that serve you well the next time(s) around.
I agree that small business is the lifeblood of the economy and I am glad that President Obama recognizes that fact. However, some of the stuff that’s supposed to make things easier for small businesses to finance actually makes it harder in the long run. This was a well thought out and written guest post.
Those increased loans and improved rates don’t mean much if small businesses can’t put together the loan proposals that bank’s need to make the loans.
PBO seems to have ignored increasing the number of SCORE and SBDC counselors available to assist small businesses in accessing the improved capital. SBA was stripped of personnel years ago to reduce budget deficits and lacks the manpower to build all the loan proposals themselves.
The announced programs are akin to giving the homeless building materials, but no carpenters or plumbers to guide them, and just as ineffectual.