Small Business, Small Banks & Credit–Two Views

This article by Bill Dunkelberg was published on CNBC.com
Published: Thursday, 17 Jun 2010

If you listen to Washington and New Yorkers working for bailed out institutions or in offices 100 floors above Wall Street, the recovery is weak because banks, and now small banks in particular, won’t lend money to small businesses. There has been plenty of evidence to the contrary (demand is weak rather than banks are hoarding money), but facts don’t play well in Washington.

First of all, we should stop “benchmarking” to 2006 and 2007, a period of credit excesses enabled by an apparent “weakening” of credit standards in many parts of the economy. This is not a period we should aspire to return to. Of course credit is “harder” to get than it was prior to the recession. And of course the press can find someone who thinks they deserve credit but can’t get it.

These “Man Who” statistics (“I know a man who…………) quoted in the press and in hearings are not helpful and highly misleading. Nobody did the investigatory work to see if any of these alleged cases of unfair credit rationing were really bankable. In the best of times, 5% of small business owners say their credit needs weren’t met – it was 8% in May (NFIB). Banks aren’t venture capitalists; they have no ability to recognize the next “great idea” and don’t make loans to fund such projects.

Lending is about capacity to repay – tomorrow, not yesterday.

The “message” from Washington and some New York pundits is that the banks “owe it’ to the U.S. to make more loans (it’s “unpatriotic” not to!) because they were “bailed out”.

Well, most small banks were not bailed out, but they sure are paying through the nose to cover the “bad actors” with FDIC premiums 700% higher.

The implication is that banks are not making good loans when the opportunity arises, an unlikely situation. Large banks lost a ton of bucks, and did restrict their lending. But the “small banks” for the most part did not engage in risk-taking like the larger institutions and have money to lend. Surely the administration is not suggesting that banks go back to making bad loans to create jobs.

NFIB (which surveys a sample of its 300,000 or so members each month) finds that only 3% of its members report financing as their top business problem (as high as 37% pre-1983). A third cites “weak sales” as their top problem. 92% report all of their credit needs met (or having no desire to borrow). Thirteen percent of regular borrows report credit “harder to get” than their last attempt which now dates into the post crash period – of course it is harder!! (But not as high as pre-1983 survey readings).

Loans to small business are down primarily because huge amounts of private credit demand are on the sidelines:

A. Housing starts are 1,000,000 below normal needs, normally built by thousands of small construction firms financed by thousands of community banks. At, say, $200,000 per construction loan, that’s a huge gap in private credit demand. In the first year after the more modest 1991 recession, 100,000 new construction jobs were credit by a housing recovery. Missing today.

B. Auto purchases are 5 million units below normal

C. For 6 million employer firms, actual capital outlays are at 35-year low levels, purchases that are normally financed at banks.

D. For two years, firms have been liquidating inventory, not adding, an activity usually supported by bank loans.

E. Consumers have been actively paying down their indebtedness.

In short, there are far fewer firms looking for credit these days, there is money to be lent, but a shortage of eligible borrowers. A special NFIB study of D&B firms with fewer than 100 employees in December 2009 indicated that the purpose of most borrowers (over 70%) was to supplement cash flow, not expanding their businesses or hiring. In addition to too many houses, we also built too many strip malls, retail outlets and restaurants and accumulated too much inventory to keep up with a non-saving consumer.

Now, all these firms must share a reduced level of consumer spending to support them. Not all will succeed unless, of course, consumers return to their old spending ways. In the meantime, the Treasury found it a lot easier to finance our trillion-dollar deficit. But when the private sector begins to expand and private credit demands explode, “crowding out” will provide a strong headwind to private sector growth.

Assets, whether human capital or physical assets must “earn their keep”. Workers don’t get hired unless they have high odds of generating enough sales to pay for the cost of hiring them. Equipment isn’t purchased unless it can be productively used to pay for itself. You can give owners interest free loans and they will not spend the money because they have to repay the loan and in this environment the assets are unable to earn their keep.

Business tax cuts won’t be spent on endeavors that have a low probability of paying off. Anyway, $30 billion isn’t much to throw at the problem if the Administration really believes that small bank reticence to lend is the problem. One firm with a handful of employees got twice that amount (and will not pay that back to taxpayers with all likelihood because it was a loan that rational private sector lenders wouldn’t make for that reason).

So, lending to small business is down primarily because credit demands are down, and, of course, firm balance sheets and income statements are in poor shape. In this recovery, inventory rebuilding (manufacturing) and exporting have led, not housing and the consumer. This has favored large firms (and the stock market), not small businesses that are usually the first to see the turnaround in the economy. Yes, credit standards are higher than they used to be, using 2007 as a benchmark!

But making bad loans is not the key to stimulating the economy.

Government has done this, sadly, but the private sector is more careful with the funds entrusted to its lending institutions by savers, especially small banks. Small business produces half of private sector GDP in normal times. Perhaps the reason GDP growth is rather anemic (and inventory driven) is that the small business sector of the economy is not participating. Certainly developments in Washington offer little encouragement for small business owners and the consumer is less than exuberant. But all of this is not a result of unwillingness on the part of small banks to lend and make good loans.

Small Business Tax Credits Won’t Create Jobs

The jobs numbers were lousy (as we predicted). The Administration’s solution is small business tax cuts. While this is a good idea in the long haul, it is not a solution to the short-term problem. Simple logic says you don’t hire a worker or invest in a piece of equipment that doesn’t pay for itself. Economists teach this.

The top problem faced by small business owners today according to the National Federation of Independent Business is “weak sales” (not credit availability). Translation: new workers can’t produce enough sales to cover the cost of hiring them. New equipment can produce more output, but it can’t be sold, so capital spending projects wont pay for themselves. Thus, hiring or buying new productive capacity would produce lower profits as the cost would exceed the revenue generated.

So, the basic problem is that resources can’t produce sufficient income to pay for themselves. This is true no matter how it is financed.

1. Tax cuts may give the firms more cash, but why would they spend it on employees or equipment that won’t pay for itself? These “gifts” will still be invested only when the prospect of a payoff is good. It would be crazy to do otherwise.

2. Job tax subsidies make an employee cheaper for a short period but again the employee must be able to generate enough income to pay their way or the firm loses more money.

3. How about interest-free loans? Nope, since the money must be repaid, why invest it in losing endeavors?

The Administration doesn’t understand basic business and the nature of the problems faced by owners. Consequently it designs “stimulus” programs that are counter-productive and wasteful of taxpayer money.

Short-term Tax Incentives Don’t Work

Congress has undertaken a series of attempts to stimulate consumer spending by providing tax breaks for actions taken before a certain date. First came the $8,000 tax credit for buying a new home. This was followed by “Cash for Clunkers”. And now Congress is contemplating a tax credit for hiring new workers. And there may be more ill-conceived plans to entice the consumer to spend more. It was, after all, a sharp decline in consumer spending that led us into a deep recession.

There are several important facts of life to recognize in evaluating these schemes. First, none of these plans will get someone to buy a house, buy a new car or hire an employee that wasn’t going to do so anyway in the time period close to the passage of the program. No one spends $200,000 on a house just to collect $8,000, a small percentage of the house price. The same was true for Cash for Clunkers. It is very likely that all consumers who participated in the program would have purchased a vehicle in the proximate time period without the program. All these programs did was to pull future demand into the current period, reducing future demand, a fact revealed by the precipitous decline in home purchases once the credit ended. Bottom line, the two programs were just gifts from taxpayers to consumers who would have made purchases anyway.

A proposed $5,000 tax credit for hiring a new employee will have the same result. No business will spend a salary of $30,000 or $40,000 or whatever to get a $5,000 credit which lasts only a short period of time, leaving the firm to pay the full cost in the future. Once again, such a program would just be a gift from taxpayers to firms that would have hired anyway. It will rearrange the pattern of hiring, but not increase it.

The most recent report on housing starts indicated that little was happening there. In a normal year, we would build over one and a half million new housing units. Current starts are under 600,000, because over 10 percent of all housing units are still vacant. Housing will come back, but slowly, and this is one reason why the recovery from the recession will be slower than hoped for.

Bad News from Small Business Owners

Today the NFIB reported that the Small Business Optimism Index fell from 88.3 in November (1986=100) to 88.0 in December. That marks six consecutive quarters with the index below 90. In sharp contrast, such a dismal result happened in only one quarter of the 1980-1982 period, which was marked by two recessions. Click here to read the full post and comment (Insights subscribers) »

Secretary Geithner Tells Banks to Make More Risky Loans?

As a reminder, Dr. Dunkelberg is Chairman of Liberty Bell Bank in Philadelphia as well as Chief Economist for the National Federation of Independent Business.

At a Treasury conference on jobs (11/18), Secretary Geitner railed against banks for not making enough loans, thus (his conclusion) hindering job growth. He must feel that banks are turning down good (profitable) loans for some reason. “Banks bear some responsibility for the extent of the damage caused by the crisis. And you carry a substantial obligation to help our communities get back on their feet”. Huh? It sounds like he is arguing that since taxpayers bailed out some banks, the banks owed it to society to make some more bad loans. We created a lot of construction jobs in the last expansion by making a lot of bad loans (which were sold to unsuspecting investors and government agencies who knew, but felt compelled to buy anyway). I don’t think we want to go that route again.

First, keep in mind that banks are not venture capital firms, they are not supposed to take unusual risks. So, complaints that banks won’t make loans to new ventures are inappropriately directed at banks. That’s simply not in their job description as the regulators will tell them when it’s time for an audit.

Second, according to the National Federation of Independent Business survey (of their approximately 400,000 member firms) in October, only 4 percent of the owners say financing is their top business problem, compared to 33 percent who report “weak sales” as the top issue. Plans to invest in inventories and capital equipment and expansion are at 35-year lows–no sense in spending money on these items if there are not enough customers. Better to wait. This means loan DEMAND is low for these activities typically supported with borrowing.

Third, the same is true for hiring–owners who have no customers to serve don’t hire workers. Meanwhile, consumer saving is up and community banks have money to lend to small firms on Main Street (not your typical Goldman borrowers). And a tax credit for hiring won’t get owners to hire workers (very costly) to get a few thousand dollars in tax credits. Workers will be hired when they can, in the judgment of owners, produce enough sales to pay for them. Lending firms more money won’t create more sales or jobs.

Trying to push banks to make more loans (a) assumes they are turning down good loans and that the government knows better about loan risk and/or (b) assumes consumers are storming the walls trying to buy stuff but that firms won’t get the inventory or buy the equipment to make stuff or hire workers to complete the sales because banks won’t lend into these opportunities. The facts tell a different story. Lenders were careless about risk in the expansion. Hopefully government is not pushing them to return to the old ways.

“Main Street” is NOT Wall Street

In a recent Wall Street Journal opinion piece (10/2), Meredith Whitney correctly identifies the importance of small business in the economy, but being knowledgeable about credit issues on Wall Street can result in a biased perspective on what is happening on “Main Street.”

Writing that, “Large, well-capitalized companies have no problem finding credit,” Ms. Whitney then asserts, “Small businesses, on the other hand have never had a harder time getting a loan.” Well, that’s just wrong.

Many small businesses are “well capitalized” enough to operate without the use of credit (about 40 percent have no loans). The National Federation of Independent Business has surveyed its hundreds of thousands of small business members for 35 years, covering recessions starting with 1974. The most difficult period for credit availability was 1980-82, not the current period. So, they HAVE had a harder time getting a loan. Then, as many as 28 percent of regular borrowers (those accessing credit markets at least once a quarter) reported loans harder to get than the previous attempt. In the 1983-91 expansion, complaints started at 2 percent in 1983 and rose to 12 percent in 1991. In 2003, only 3 percent reported loans harder to get, rising to 15 percent in 2009, the highest since the 1980-82 period, but only “half as bad” based on complaints. There was no “spike” in complaints that corresponded to the “credit crunch” on Wall Street.

Owners have also been asked over time to identify the “most important business problem” facing their firm. In 1979, 39 percent cited financing and interest rates in contrast to no more than 5 percent in the current credit episode. Over 30 percent reported this as their top problem for nearly all of the 1979-80 period. Clearly, by these measures, the 1980-82 recession period was a far more difficult credit period for small firms.

Over the past 12 months, we have addressed a number of bank conferences from Florida to California. By show of hands, very few Main Street banks have tightened their credit standards over the past 12 months and virtually all report that they have money to lend. Most report that they have experienced a decline in applications, consistent with NFIB survey results showing record low plans to invest in inventories and new plant and equipment. The demand for credit is down, not its supply on Main Street. Increased consumer saving is increasing the supply of loanable funds.

Over 80 percent of small businesses do use credit cards for business purposes. Nine percent reported some sort of adverse change in terms, less than 1 percent reported a cancellation (survey taken late in 2008, some further deterioration likely occurred). Most use the cards as a financial convenience, paying balances in full each month (about 75 percent), not as a source of credit to finance business operations. Although widely used, they are not a “major” source of credit (confirmed by both the NFIB national samples and Federal Reserve surveys). Banks are the primary source of credit once the firm has a track record (only about 1 percent of all small businesses have a government-sponsored loan). Banks are not venture capitalists that provide loans for new start-ups. Such loans must be secured with personal assets and guarantees (somewhat more problematic recently with the declines in house values, but it appears that this process has bottomed out according to Case-Shiller data).

The biggest problem faced by small businesses is not access to credit but a shortage of customers. After overspending disposable income for years, consumers are now under-spending, and repaying the debt they used during the expansion (record reductions in consumer credit). At some point, they will restore the percent of their disposable income spent to a “new normal.” Just when that occurs and at what level (percent of income) is less clear. The average ratio of consumption to disposable income from 1970 to 2009 was 90 percent and 94 percent from 1995 to 2009. One percentage point of disposable income (about 70 percent of GDP in magnitude) represents a lot of sales. When growth resumes, firms will want to borrow to replenish inventories and acquire new plant and equipment and Main Street banks will be there to meet their needs.

Minimum Wage, Maximum Stupidity

Congress has increased the cost of unskilled labor by 10.7 percent in the middle of the worst recession since the early 1980s. The unemployment rate is 9.5 percent. It is unclear how this is supposed to help the economy – unless you are Labor Secretary Solis or the Economic Policy Institute. The claim is that this will produce $5 billion in increased income and spending. One simple question – where does this $5 billion come from? Apparently the Administration thinks it appears from nowhere because if it doesn’t, then it has to come out of the pockets of someone else. Where do small business owners get $5 billion to give to minimum wage workers? Do the funds magically appear? If so, let’s make the minimum wage $50 an hour, eliminate poverty and stimulate the economy. The fact is that every new dollar a minimum wage worker receives must come from the pockets of business owners and consumers paying higher prices. Minimum wage workers may get more to spend, but other consumers lose an identical amount, there can be no “stimulus” here.

If GM has too many “unemployed cars” on its lots, it reduces prices to get them “employed” providing transportation. But with 14 million unemployed workers “on the lot,” Congress raises the price of labor. This defies logic and common sense. The Law of Demand applies to everything, even labor. The higher the price, the lower the quantity taken.

Companies cannot afford to pay workers more than they add to the value of the firm. The higher the minimum wage, the greater is this hurdle. A higher minimum wage makes it more difficult for young, unskilled and handicapped workers to get jobs that justify the higher wage now required. This PERMANENTLY reduces job opportunities for these workers, denying them the opportunity to enter the labor force and get “on the job” training, making them more productive workers. Instead, they return to the street corners and the underground economy.

From the Tennessean: “ ‘The way the economy is now, and for a man who is trying to raise a family, it’s not enough,’ said Julius Stoval, 26, who earns minimum wage as a worker at Shur Brite Speed Car Wash here. He has two children in Chicago and a third on the way in Nashville.”

If the minimum wage is supposed to be a welfare program supported by taxes on business owners and customers (through lower profits and higher prices), it is very poorly focused. About 40 percent of all minimum wage workers come from above-median income families. They are not “in poverty.” The earned income tax credit is designed to help people like Mr. Stoval who has more family responsibilities than he can support. The minimum wage is not an effective “anti-poverty” program.

Of course, the estimated $5 billion increase in wages that results from the new minimum wage law is just the start of the problem. A worker hired at the minimum wage last year and who worked hard and got a raise now finds that new unskilled workers get the same pay. Now a more valuable worker after a year of experience, this individual will be able to get a higher wage with the skill premium included. Thus, the increase will “bubble” through the entire wage structure over time. As prices rise to cover these costs (and they will, firms that can’t raise prices will fail, sacrificing all jobs at those firms).

So, here’s the bottom line: (1) there is no “stimulus” from the increased minimum wage. Every dollar a worker received comes out of the pockets of consumers and business owners; (2) a 10.7 percent increase in the cost of less skilled labor will cost jobs (David Neumark estimates 300,000 for those under 25 years of age); (3) a higher minimum wage permanently reduces job opportunities for unskilled and handicapped workers, denying them the opportunity to become productive members of the labor force; (4) the higher minimum requires business owners to pay more for the same labor (with no increase in output), raising unit labor costs which reduces profits in a weak economy, puts pressure on prices in a growing economy; (5) a higher minimum is a poorly focused poverty program, missing its target almost 50 percent of the time. Less skilled workers losing their jobs are seriously harmed and opportunities for them to get a job in the future are reduced.

If there were ever a bad time to raise the cost of labor, it’s now. What is Congress thinking? Or, are they?

Save Our Small Businesses Sensibly!

As a reminder, Dr. Dunkelberg, our guest blogger, is Chief Economist for the National Federation of Independent Business.

The administration has, at long last, recognized the importance of small business to the health of the American economy. Collectively, small businesses produce half of the private sector GDP and employ well over half of the private sector workforce. They are the creators of most of the new jobs as well.

Sadly, but no surprise, the government is going to rely on another government agency, the SBA, to possibly make funds available to “mom and pops” from the now widely abused (by the politicians) TARP funds. For starters, fewer than 1 percent of all small businesses have a government-sponsored loan. So, the SBA reaches relatively few small businesses and the SBA loan programs are primarily administered by the large, now troubled, banks since the paperwork burdens are substantial. So, most of the 8,000 banks that serve small firms don’t make SBA loans.

The best way to get money into the hands of our nation’s small business job creators is to give it to their customers. Small businesses need customers, not more debt. There was strong support for a tax holiday as a stimulus plan. This would have immediately put money into the pockets of consumers (and small business owners paying all of the FICA tax), a chunk of which would be spent. If consumers saved some, all the better, as the need for savings by our banks is critical as illustrated by the large banks like GE, GMAC, Wachovia and others paying very high rates to attract savings deposits (which made it difficult for small banks to get the funds to lend to their small business customers). Alas, too logical, and not enough pork to hand out that way.

Instead we have a $787 billion “stimulus” bill, little of which has been spent, much of which is allocated to 8,000-odd special pork projects. Can’t wait for work to start on that LA-to-Las Vegas high speed railroad for Senate Majority Leader Reid. What a job generator that one.

A tax cut would have delivered a huge stimulus 6 months ago and would still be fattening paychecks, making labor cheaper to retain or hire, and boosting spending and saving, both of which are needed. Instead, the government is competing with private businesses for available savings to finance a deficit that could approach $2 trillion. Go figure.

P.S. Goldman got a bailout, let’s see what happens to CIT, a “main street” lender.