When I was a boy, I spent two weeks every summer on a farm. My parents had befriended a family in Wisconsin and thought that exposing me to rural life would build character. My brother and I were put to work feeding the livestock when we were small and then working in the fields or the barn as we got older. I still think that shoveling out the milking stalls after the cows had left was great training for certain professional situations.
Even though a significant percentage of the worlds population lives in cities, all cultures have romance with the land and those who work it. In the same vein, all cultures have a big affection for small businesses, even though many of us work for larger companies. The image of an entrepreneur building something from nothing with ingenuity and elbow grease is held out internationally as a paragon to pursue.
The standing of these small- and medium-sized enterprises (SMEs) has received a lot of attention lately. Across the world, smaller firms generate substantial amounts of output and employment. As large corporations continue to retrench, some policy-makers have pinned hopes for economic recovery on SMEs. Yet getting a sense of what drives small business is not easy, given the wide range of firms that might fit the definition. And finding the right formula to support their prosperity is a complicated proposition.
As shown in the charts below, small businesses (generally defined as those with fewer than 250 workers) employ a very significant share of the population. But the rate of small business formation has flagged ever since the global financial crisis.
A certain correction in entrepreneurship was to be expected. With business prospects dimmer than they had been prior to 2008, prospective profits from new ventures have diminished. The worlds appetite for risk has also been slow to recover. Monetary and fiscal policies aimed at improving the economic outlook should certainly help SMEs. But there may be structural impediments that could limit the magnitude of any benefit.
Limited access to credit is one potential barrier. Smaller firms with shorter financial histories rely heavily on the banking system for capital. U.S. underwriting standards for loans to small enterprises tightened considerably after the crisis but have since eased. The National Federation of Independent Business survey of small businesses does not suggest that banks are hindering respondents; in a list of top 10 problems, financial conditions now rank last.
The U.S. Small Business Administration (SBA), which is celebrating its 60th anniversary this year, has helped. The SBA offers both direct financing and loan guarantees to newer companies and currently has more than $100 billion in principal outstanding. While some might wish to leave all of this to the private sector, the SBAs proponents suggest that the agency fills a gap that private financial institutions cannot.
As we discussed last week, however, the gap left by financial institutions in Europe is significantly larger. The challenges faced by European banks have caused overall lending to decline, reducing the funding available for nascent firms. This issue ranks second on the list of small business concerns in the Eurozone. And the gap in SME financing conditions between Germany and peripheral Europe is extremely wide.
Some had proposed that the European Central Bank (ECB) try something similar to Britains Funding for Lending Scheme, but the idea has been tabled for the moment. With bank repair looking like a long-term process in Europe, it is critical that policy- makers find alternative channels to get capital to SMEs.
Access to capital is only one factor in the calculus of entrepreneurship. Taxes, regulation, legal conditions, infrastructure and labor force quality also enter the equation. These elements are often collated under the heading of competitiveness.
The World Bank compiles an annual review entitled Doing Business. In it, countries are ranked on the basis of frictions faced by new companies. For all the concern about over-regulation and tax burdens, the United Kingdom and the United States are in the top 10 of the most recent roster. But places like Spain (44), Italy (73) and Greece (78) are well down the list.
What this suggests is that policy-makers need to focus on more than just stimulating growth and shoring up banks. Where structural impediments to business formation are especially high, financial liberalization will be far less effective.
Cleaning up the messy small-business climate in some countries will make my adolescent chores in the barn seem tame by comparison. Tidying the Augean stables may be a more appropriate analogy, but there is no Hercules on the horizon to help.
China: Strained Markets, Straining Patience
In a piece we wrote in early April, we discussed the underlying issues behind Chinese real estate market prices and how imbalances increasingly drove speculation. As the situation evolved, we wondered about the calm approach of the Peoples Bank of China (PBoC), which seemed reluctant to acknowledge the asset bubble, much less take action to deflate it. The government took steps to curb speculation and property hoarding, but the central bank has described its own policy measures as fine-tuning a rather passive approach to a multi-trillion-dollar problem.
With the markets apparently turning against the banks, the PBoC finally took an active role, though its justifications are not well understood. Last week, the central bank held back from injecting liquidity into the interbank market, which let the Shanghai Interbank Overnight Lending Rate (SHIBOR) briefly soar to 13.4% Thursday before coming back to a still-elevated 8.5% by the end of the week.
This roiled Chinese equity markets. From its end-May peak, the Shenzhen index fell 17.8% over the following three weeks before reclaiming its footing in the wake of conciliatory central bank comments. But confidence has been shaken, and the investment community has been made keenly aware of Chinas lending situation and just how difficult it will be to manage.
In response to panic in the markets, the PBoC explained that this was its way of punishing banks that made risky or hazardous lending decisions and instilling discipline in the financial sector. It then issued several briefings about how end-quarter financing placed unusual pressures on the SHIBOR markets, which would resolve of their own accord in a couple of weeks with no negative repercussions. Now the Bank is centering its statements around the concept that it will remain the lender of last resort for all banks, but the days of cheap credit are over. The PBoCs shifting messages have not provided the markets with the clarity necessary to confidently step forward.
The PBoC has not addressed this situation with the finesse witnessed in other countries, but it does have a number of weapons at its disposal if a crisis emerges. Reserve requirement ratios are high, so a flood of liquidity can be released into the markets if necessary, and policy-makers have stated that significant resources can be utilized for individual institutions to prevent exceptional events from triggering contagion. This is a heavy arsenal for combatting any problem.
From our perspective, a few critical points can be extracted from the past few weeks, and they do not suggest optimism going forward. First, monetary conditions are tightening. The benchmark policy rates remain firmly anchored, but the cost of financing credit has risen and is not expected to ease any time soon. Second, confidence has taken a severe blow that will not easily be reversed. Chinas precarious lending situation has returned to the front page, and the headlines are not too reassuring, suggesting further credit growth will be weak. The third, and possibly most important, factor is that economic growth is slowing. This will be further aggravated by the first two points, and all these issues will place pressure on bank balance sheets that are already strained.
Every asset bubble has a long and storied history, and while they have different causes and symptoms, common factors bring about their end: a tightening in market liquidity either from policy adjustments or shifts in sentiment, a loss of confidence and economic growth no longer supportive of expected returns. This is what we are seeing now and what we believe international markets are sensing as well.
One more thing asset bubbles have in common they never end well.
The Unemployment Rate and Termination of Fed Asset Purchases
The outcome of the June 2013 Federal Open Market Committee meeting will go down as one of the turning points in Fed policy after the Great Recession. If the Feds optimism is vindicated, a 7% unemployment rate will be reached by mid-2014 and allow a gradual termination of asset purchases by the central bank.
The route to a 7% jobless rate is not a unique path. The participation rate is a critical element in the progression of unemployment in the coming months. The Atlanta Fed Jobs Calculator is a handy tool to create scenarios with assumptions about the participation rate, population gains and the job creation that may satisfy the Feds 7% jobless rate threshold.
Assuming a flat participation rate of 63.4% (the May 2013 standing), an average of 177,000 new jobs per month in the next 12 months would be needed to meet the 7% unemployment rate threshold. If the participation rate declines to 63.2%, creation of roughly 139,000 jobs will be adequate. An increase in the participation rate to 63.6%, holding other things constant, would imply a gain of 216,000 jobs per month.
Studies indicate that half of the drop in the participation rate over the past four years is structural, and half is cyclical. Applying this result would imply a participation rate of 64.8%; hiring would have to advance by around 446,000 jobs per month to reach the 7% jobless rate in 12 months under this scenario. (All job computations are based on the Atlanta Fed Jobs Calculator.)
According to the household survey, which drives the unemployment rate, employment has grown at a monthly average pace of 104,000 and 133,000 jobs in the last six and 12 months, respectively. In light of these trends, attaining the 7% unemployment rate in the next 12 months assumes much better job creation than weve witnessed recently and virtually no change in the labor force participation rate.
This suggests that there remains downside risk to the Feds forecast and that asset purchases may continue just a little longer than some are assuming.