Small Business Finance at the Margins

So I read this: http://www.bbc.co.uk/news/business-20262282 yesterday with some consternation.

To be clear I don’t believe the conclusions that borderline surviving companies are holding back the economy more than failing ones, but the article does raise some interesting points.

Firstly we need to see how these companies could be harmful. If they were using labour that could otherwise be used elsewhere then this might be restricting output – very much a crowding out type effect. With unemployment in the UK as high as it is, this is not a credible concern (and in fairness not the point that was made). The other issue on the supply side is scarcity of credit.

Do these companies “use up” scarce credit in the economy? Yes and no. They do have funds invested in them, funds that could be considered a malinvestment. It would be a mistake to thing of this as something other than a sunk cost. The big issue is what happens if these businesses were to fold – would this improve access to credit for other more aggressively expansionistic companies in the same market?

If they folded, banks would go through two three steps. First of all they would have to write off the value of the loan, secondly they would recover what they could from the assets of the company and thirdly they would adjust their probability of default for that type of loan. The first two steps would yield a loss – an investment in a company in part will go to assets that cannot be redeemed – branding, market research, building human networks and relationships. The net result is that the bank takes a certain loss, and must raise the risk of further defaults on similar loans. Both of these factors act to curtail lending rather than enhance it. The only circumstance in which I can see this being a benefit is if banks have been very conservative in their estimates for loss given default – that they believe that recoverable assets are likely to be a lot lower than they are and these additional data help them decide that lending to these businesses is less risky. This view is even more pronounced if one considers an endogenous money view of banking – that banks can create credit themselves; then banks would not even be constrained by the existence of these loans on their balance sheet.

The idea of the benefit of letting companies fail can also be looked at from the demand side. Is the fact that demand is being met by these companies preventing newcomers from entering the market? To a certain extent yes, even for small businesses, but would newcomers be any better? Would a newer company, able to do things better, still struggle to raise capital? If it did would that help the economy? If you can build the same number of houses with less labour it could lower aggregate demand in the economy. Efficiency, great in good times, can be a double edged sword in bad times.

These concerns seem to often come back to Schumpeter’s “Creative Destruction”; the idea that bankruptcies and exits from the market remove the worst companies and make space for better companies to expand into. This is a view not without merit, competition does give an advantage to companies that does things better or more efficiently and it does enable resources to be allocated more efficiently. The problem arises when we consider “fitness” in a company to be some kind of scalar quantity and that we can determine “good” or “bad” companies by their survival.

I would argue that this is not just a simplification but is actually very misleading. A luxury goods manufacturer may be the best at what it does but may still find its market shrinks in a recession. A very efficient company may be put out of business by temporarily higher fuel duty and so on.

As a thought experiment, consider two very similar companies, say two builders, one founded in 2005 and one on 2012, both financed by bank loans. The first builder in 2005 acquires land at a high price, starts work on house building in 2006 with high labour costs and has the first homes on the market in 2008 as the financial crisis hits. The second company, takes a smaller loan to buy a similar about of land in a similar area as prices have dropped. It produces a similar quantity of houses using cheaper labour and materials (or possibly to a higher standard or quicker given the broader choice of labour available) and so costs are lowered. Even if both companies are surviving one is, at least in one sense of the word, more efficient. It has lower operating costs due to lower debt costs whilst producing the same product. These are similar companies – the same management structure, the same approach to risk, only differing in luck with respect to their time of entering the market. It is not hard to see that this can be extended, that a company can be worse than another but due to good fortune is in a better position.

The big problem with creative destruction is that it selects for companies that have the ability to survive in a deep recession with little regard for the benefits they bring to society the remaining 90% of the time.

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