Student Debt and the Decline of New Business Formation

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Many are the ways in which burgeoning student debt — $1.2 trillion and rising — cripple the economy. On the Bacons Rebellion Blog we’ve discussed how debt delays family formation, housing purchases and consumer spending. Recent research from the Philadelphia Federal Reserve Board also suggests that student debt dampens new business formation, an insight that ties into another line of inquiry on this blog: understanding the slow rate of job creation in the current economic cycle.

The engine of job creation in the U.S. economy is new business formation. The spawning of new businesses has experienced a long-term decline since 1978, but that decline has been particularly pronounced since 2005. In recent years more firms have exited the marketplace than have entered it, as seen in this Brookings Institution graph below, taken from “Declining Business Dynamism in the United States: A Look at States and Metros,” published in 2014. The numbers may have improved in the past two years, but probably not enough to change the long-term picture.

I have argued on Bacons Rebellion that the massive wave of regulation enacted in the past six years has dampened the economic recovery by imposing large new costs on businesses. As the regulatory burden has increased, economies of scale have shifted in favor of larger firms which have the resources to deal with the regulations. Numerous industry sectors are consolidating: banking, hospitals and health insurance most visibly. Industry consolidation may be a factor in explaining the decline in overall net business formation but it only goes so far.

The Brookings data shows that the problem isn’t an accelerating death rate of businesses — the exit rate of firms from the economy has remained fairly stable since 1978 — it’s the dearth of business births. I would suggest that regulation has dampened new business formation by creating barriers to entry in many industries.

While I still hew to that view, I think there’s more to the story. There also is strong evidence that the surge in student debt — $1.2 trillion and rising — has depressed new business creation among young people.

The authors of the recently published Federal Reserve Bank of Philadelphia paper, “The Impact of Student Loan Debt on Small Business Formation,” has found a “significant and economically meaningful” negative correlation between geographic variation in student loan debt and net business formation for small firms of one to four employees. “Based on our model, an increase of one standard deviation in student debt reduced the number of businesses with one to four employees by 14% on average between 2000 and 2010.” (Please don’t ask me to define “standard deviation.” Here’s an explanation.)

To launch a business, especially a small business, individuals need access to capital, the authors argue. Small businesses receive approximately 75% of this capital from banks in the form of loans, credit cards and lines of credit, which are contingent upon the borrower’s credit-worthiness. “Given the importance of an entrepreneur’s personal debt capacity in financing a startup business, personal debt that is incurred early in life and that restricts a person’s ability to take on future debt can have profound implications for growth in small businesses,” the study says.

The growth in student debt over the past decade has damaged the credit-worthiness of an entire demographic cohort: 17% of student loans are delinquent, and another 44% are not being repaid due to borrowers either still being in school or having received a repayment deferral or forbearance. Even students who are paying their debt on schedule find their credit worthiness downgraded.

As the Wall Street Journal noted in an editorial on August 29, the Kauffman Foundation has found that new entrepreneurs ages 20 to 34 fell to 23% of self-starters in 2013, down from 35% in 1996.

The U.S. system of higher education may be creating the best educated generation in American history, but it may be the least entrepreneurial in decades.

As Virginians seek ways to reignite a state economy hobbled by the decline in federal spending and an eroding business climate, we need to give more attention to what it takes to stimulate new business formation. And that should entail taking a closer look at the link between higher ed and student debt, and the link between student debt and new business formation. All the state and federal “programs” designed to promote new business formation, I suspect, don’t amount to a hill of beans compared to the rise in student indebtedness. Tackling student indebtedness gets us into a thicket of very complex issues that aren’t easily solved but that’s no excuse for failing to focus on what really matters.

(This article first ran in Bacons Rebellion on August 29, 2015)

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