Start-Up Business Activity and the Health of the U.S. Economy

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President Obama meets with small business owners in the Roosevelt Room, recognizing that start-up businesses are an important barometer of the overall economy. Image by Pete Souza

As a commercial lender, I’ve seen a substantial number of start-up businesses come and go over the past 25 years. Start-ups are created in all shapes, sizes and colors, from restaurants to manufacturing companies to (increasingly) Internet-based businesses, along with countless other types.

As diverse as the new businesses can be, the general outlook for start-ups follows predictable trends. During strong economies, the number of start-up businesses launched slows dramatically. Conversely, in weaker economies, start-up businesses surge.

How do these numbers correlate, and are start-ups predictive of future economic growth?

Start-Up Businesses: By the Numbers

In the wake of the Great Recession, start-up businesses spiked, then slowly trended downward. According to annual reports compiled by the Kauffman Index of Entrepreneurial Activity, .34% of American adults launched businesses in 2010, .32% in 2011, .30% in 2012 and .28% in 2013. The last figure translates into about 476,000 new businesses each month, a number consistent with pre-recession levels.

Declining male entrepreneurship appears to be the primary reason for the decrease. According to the Kauffman report, male entrepreneurs declined from .42% in 2011 to .34% just two years later. Female business start-ups, on the other hand, remained relatively stable: .23% in 2011 and .22% in 2013. With respect to ethnicity, the number of start-ups have trended downward across the board, but Latinos saw the biggest gains in recent years as their percentage of the U.S. population continues to climb.

Why Do the Numbers Rise and Fall?

As evidenced by the numbers, business start-ups tend to surge during weak economies and fall during stronger economic times, lagging somewhat behind the general economic indicators of the time period. Although seemingly counter-intuitive, the primary driver is not entrepreneurs’ belief in better economic times ahead but the health of the job market itself.

During declining or poor economic times, businesses tend to lay off employees or institute hiring freezes. Displaced workers often have difficulty finding jobs and elect to start their own businesses instead. Certainly, other factors are involved in the decision to start a new business, including the notion of being one’s own boss, perceived flexibility, the potential upside of selling the business down the line for significant returns, and other factors.

No matter what the reason, there is a clear correlation between the overall job market and the incentive to start-up a new business.

The Current Economic Climate

As the U.S. economy continues to repair itself from the damages wrought by the Great Recession, few would call it ‘strong’ today. In fact, according to a year-end CNN/ORC poll, 68% of those surveyed believe the economy is in poor shape. This characterization flies in the face of gains in the stock market, the strongly rebounding housing market, and an economy that has created approximately 181,000 new jobs per month over the past 41 months.

Despite the poll, consumer confidence is edging upward. The Confidence Board released data that showed the index currently stands at 82.3 (1985 = 100), up four points from February and nearly 30 points higher than the 2007-09 monthly averages. The index is roughly 20 points higher than one year ago. With improving confidence and an economy that has shown gains, why do so many people believe the economy is doing poorly?

The Partisan, Gridlocked Political Climate May Be Impacting the Results

The disconnect between surveyed individuals and the current state of the economy may have as much to do with the topic of income inequality and discontent over the current state of politics as it does traditional economic data. According to Pew Research, 60% of the public trusted the government in October, 2011, whereas only 19% did as of October, 2013.

Unease over the growing national debt, battles between the two parties as to budget, debt and deficits and the growing belief that government cannot solve the long-term threats to the overall economy may well explain the differences in the numbers.

That being said, the number of start-ups generated by the current economy, by percentage, is roughly at the average seen over the past 17 years. Although there is clearly a lagging correlation with a declining economy, can they also be considered predictive of future economic growth?

GDP begins to improve shortly after start-up businesses peak. Image by: Bureau of Economic Analysis 

GDP begins to improve shortly after start-up businesses peak. Image by: Bureau of Economic Analysis

Start-Ups Appear to Lead to Economic Growth

Superimposing the Kauffman entrepreneurial chart with economic activity between 1996 and 2013 indicates that when start-ups reach .30%, quarterly GDP growth almost immediately begins an upward trend.  Shortly after climbing to .31% in 1996, the economy rebounded from its previous sub-par numbers and posted strong gains over the next four years.

Likewise, the .30% figures achieved in 2003 led to an improved economic trend line for the next three years. Finally, the current improving conditions — albeit less-than-stellar in many respects — began about a year after start-ups hit the .34% mark in 2010.

Some will argue that it’s a chicken-and-egg scenario, in that the economy was already poised to rebound due to its natural ebbs and flows. Nevertheless, a case can be made that the greater number of small businesses generates more economic activity, and therefore becomes a significant catalyst to future GDP growth.

The Prospects for 2014

Fourth-quarter GDP results were revised upward to 2.6%, and according to Joseph Lake, U.S. analyst for The Economist Intelligence Unit, the economy will continue to pick up steam this year. He predicted that GDP growth will average 3% in 2014, which, if achieved, would be the fastest rate of increase since 2005. Although not impressive as compared to the 4% average growth of the 1990s, it’s a vast improvement from the where the country was just a few short years ago.

Have start-ups businesses led the way? Those of us who finance them for a living would like to believe that’s exactly what has happened, an assumption which arguably has validity based upon the numbers.

Speaking of which, William Lyon Phelps once said, “In a start-up company, you basically throw out all assumptions every three weeks.”

Touché, Mr. Phelps.

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