ENTREPRENEURSHIP: EASE OF ACCESS TO CREDIT AND FINANCIAL RESOURCES A Public Finance Policy Issue Paper Catherine Roup, PAD

5004, April 5, 2012 University of Colorado at Colorado Springs

ENTREPRENEURSHIP: EASE OF ACCESS TO CREDIT AND FINANCIAL RESOURCES

Introduction
A World Bank economists article addressing entrepreneurship and policy issues outlined what policymakers could do to facilitate entrepreneurship and economic development in simple terms. In brief, policymakers should facilitate the ease of access to credit and financial resources (Klapper, 2011). Comments such as these are easily said and difficult to follow up in a highly volatile political environment trying to correct the market failures sustained in the aftermath of the Great Recession. It seems unnatural to maintain the status quo in a changing world and the U.S. policies are correctly being challenged. Researchers and politicians alike point out that the historic nature of government intervention to correct startup relevant market failures have inadequately address the problem (Bayh, 1979; Cowling, 1998; Parker, 2005). A key argument against government intervention is that the impact of public policies is diffused because of the high number of new businesses that fail each year. (Atherton, 2006) No surprise then that most economists and researchers commenting on policy, whether it be monetary policy, tax policy, or regulatory policy are also pointing to an antiquated system in need of a major overhaul (Acs, 2007; Atherton, 2006; Carlstrom and Fuerst, 2001; Cheng, 2011; Drabenstott, 2008). The Great Recession and slow economic recovery make the case for the critics of U.S. policies. Given its entrepreneurial activism, the U.S. has had a slow, stuttering recovery that should have rebounded much faster if the policies were as effective as they should have been. Yet, the United States still outpaces other countries in stimulating entrepreneurship. Other countries use the United States as their role model of what their intended long-term outcomes should be (Acs, 2007).

Among researchers and economists, the question is how should the policies be changed? Is it a policy issue or a market issue affecting the access to credit for entrepreneurial activity? Given there are state and local governments also engaged in economic development, are federal, state, or local policy disconnected and causing regional shifts (regional advantages) (Cheng, 2011)? As a policy issue, any misdirection of resources intended to stimulate startups contributes to significant government failure to correct the market failure. At first glance the answers seem

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elusive, yet innovative and new policy directions are proposed in the latest literature. The studies provide revealing and insightful consequences of policy interventions that were never thought of in past years. The status quo is unquestionably being challenged.
A surprising discovery in the process of preparing this paper is that at least two policy corrections discussed in this paper are implemented. One approach is Carlstom and Fuersts Monetary Policy and Asset Prices with Imperfect Credit Markets (2001). The Federal Reserve Board is using the Friedman rule as part of the U.S. monetary policy, and Ben Bernanke, Chairman of the Federal Reserve Board is one of the papers referenced sources. The second is the formation of cluster development at the local and regional level discussed by Feldman and Francis (2004) and Drabenstott (2008).

This research paper focuses primarily on the federal governments economic policies and intervention programs role in entrepreneurial startups. This research paper will also analyze and
consider the implication of policy development.

Literature Review Progressing through what seemed to be all the relevant and current literature, there seemed a consistent form of similar of ideas and methods. The first set of ideas addresses market conditions and the barriers to entrepreneurs. The second set of ideas titled troubling reality reveals shortcomings, barriers, and what occurs with the enactment of existing policies. The researchers and economists in the second set also propose policy solutions or directions for correction. The last set of ideas, titled a new paradigm, is indeed a series of research and reports that point to new directions for policy to take that would improve access to credit, financial resources and create a climate that encourages entrepreneurial development.
Credit Constraints, Monetary Policy and Imperfect Markets

Interestingly, the theoretical framework presented by Nicolas Dromel, Eilie Kolakez, and Etienne Lehmann (2009) on credit constraints relation to unemployment and entrepreneurship

ENTREPRENEURSHIP: EASE OF ACCESS TO CREDIT AND FINANCIAL RESOURCES

seem to mirror what occurred during the Great Recession. In their theoretical framework, workers lend their money in the form of deposits to banks. Entrepreneurs do not have capital of their own and borrow from banks. Bank lending is limited or constrained by the size of bank assets. When bank assets are low, job creation resulting from entrepreneurial borrowing is restricted (Dormel, et. al, 2009). The study maintains the results are preliminary and should be further examined for the stringency of credit constraints and that there are other variables that may affect unemployment aside from credit constraints. The theory seems to have some relevance as events unfolded after this report was published in March 2009. As part of the Obama Administrations effort to recover the economy, banks were bailed out of defaulted assets with the intent to alleviate constrained credit. Unfortunately, what was not addressed by administration policy are the more rigid risk qualification requirements and regulations combined with FICO scores (bank industry risk index) that continued constrain credit. As suggested in the preliminary results, the constrained credit or credit market imperfections would directly contribute to persistent unemployment (Dormel, et. al, 2009). Although the connection of the two is not entirely understood at face value, it appears that Dormels insight was relevant and predictive. Charles Carlstom and Timothy Fuerst literally speak mathematically and in economic calculations in their report on monetary policy and asset prices with imperfect credit markets. Carlstom and Fuerst begin with the Modiglianai-Miller theorem of debt versus its equity level as their point of departure from the theorem to investigate the imperfect market and the failure of information sharing. Modiglianai-Miller assumes regardless of person assets, an entrepreneur can obtain funds and that lenders have unconstrained funds and complete information necessary about the entrepreneurs business vision and possibilities. This condition is rarely true. An

ENTREPRENEURSHIP: EASE OF ACCESS TO CREDIT AND FINANCIAL RESOURCES

entrepreneurs limited equity and worth constrains their ability to borrow. In addition, all potential opportunities and information about an entrepreneurs venture are not fully known. Consequently information is also constrained. To analyze and measure their theory, Carlstom and Fuersts model considers households, entrepreneurs, addresses equilibrium, and log-linear modeling. With these variables expressed as mathematical algorithms, three experiments are conducted: shock to productivity, shock to dividends, and a monetary policy shock. The conclusion is that monetary policy cannot eliminate the long-run impact of limited information, but it does improve social welfare by smoothing the fluctuation of credit. Another finding is as long as monetary policy responds to inflation aggressively there is no reason to expect asset prices to increase. Said another way, asset prices do not lead to inflation, interest rates do. In fact, the Federal Reserve has aggressively maintained the lowest prime interest rate in over 30 years and for the longest duration of time.
Troubling Reality

In an imperfect world there will be abuses of any system. Using U.S. Department of Justice per capita conviction rates of state and local public officials on corruption charges as a measure, David T. Mitchell and Noel D. Campbell set out to determine corruptions effect on business venturing within the United States. Mitchell and Campbell focused on economic activity using Small Business Administration data, U.S. Census, Bureau of Economic Analysis, Federal Deposit Insurance Corporation and another study by Glaeser and Saks (2006). The Glaeser and Sacks study used a single measure for corruption, average conviction rate per capital over their sample period. Mitchell and Campbell used 15 key variables from Johnson and Parker (1994, 1996) models and three-stage least squares estimation in their empirical model. Their specific findings reveal two societal equilibria. One societal equilibrium has high corruption, low income, and prevalent survivalist entrepreneurship and is called the vicious cycle. The other

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equilibrium has low corruption, higher income, and a low rate of business venturing and is called the virtuous cycle. Consequently, their finding concerning corruption is that business venturing is a significant predictor of corruption. Another finding is that venturing has a negative impact on income. Venturing is spurred by low income but venturing also has a negative influence on income the vicious cycle. Further, unemployment shocks such as experienced during the Great Recession, triggers this vicious cycle and directly impacts the availability of credit and assets for entrepreneurs and job creation. (Mitchell et. al., 2009). The law enforcement does work in the U.S. Corruption is not a failure of policy but rather a failure in a humans character. An international study by the World Bank found that the business environment does matter. Using a definition of entrepreneurship as the effort of an individual or a group of individuals makes to initiate an economic activity under a legal form of business within a formal sector, helped the study group develop a methodology applicable across many countries. The data were also comparable across various regulatory and economic systems in many countries. The studys methodology used the number of registered businesses as a percentage of active population (business density) and the percentage of new businesses registered in a current year of total registered businesses (entry rate). The study results found barriers to starting a business negatively correlate with business density and entry rate (Klapper, 2006). This finding makes sense because the less bureaucracy there is to start a business the easier it is for an entrepreneur to enter into the market. Another finding is the significant relationship between starting a business and business density and entry rate. In addition, the greater the business opportunities and the better, easier access to finance generate a more robust private sector. The study concluded that reducing business barriers to start a formal business, having better collateral laws,

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contract enforcement, and credit information sharing systems can spur entrepreneurial growth (Klapper, 2006). A brief look at the effect of regional factors is appropriate because they reveal the efficacy and shortcomings of federal policy and program distribution. In a shift-share decomposition study focused on the state level and using NAICS level data, findings revealed that regional comparative and competitive advantages can be used to re-evaluate policy initiatives for new business, almost tailoring policy responses and instruments to economic and business conditions. Another finding from this study is that the aggregate numbers of new ventures is a poor indicator of regional business startups. Only half the regional-shift components are represented by the total business startups, indicating there are missing data. In addition, even if regional-shift components are the same, the magnitude of the change can vary substantially for states that have comparable numbers of new business. And, there may be positive or negative sectors within a regional shift. A negative regional shift component indicates barriers to business formation in the region (Cheng, 2010). This study goes on to suggest that national policy should consider elements discovered in the regional-shift analysis to introduce flexibility and adaptability to various economic conditions. The next study considers what policies appear to provide the most influence on entrepreneurship and job creation. The outcome is the availability of capital to operate. Using friendlier tax policies by cutting marginal rates and targeting relief to small businesses, including their capital gains is a policy approach recommended by Douglas Holtz-Eakin and Harvey Rosen (2001). In particular, they found marginal rate reductions have a more direct capitalizing effect than loans or other forms of financing.

ENTREPRENEURSHIP: EASE OF ACCESS TO CREDIT AND FINANCIAL RESOURCES

In studying data available from the Great Recession, Fairlie examines the impact of unemployment, limited financial resources, and poor labor market conditions. The greatest impact to entrepreneurial activity is at the local level. According to Fairlie, the greatest influence to entrepreneurial activity is the slack labor market, even more than financial assets. During the Great Recession, entrepreneurial activity occurred in spite of the fact that people lost equity in their homes and personal assets. Fairlie cites and Strangler (2009) study finding that 57 percent of Fortune 500 companies began in downturn markets. Fairlie concludes that the entrepreneurial outcome of the Great Recession is a work in progress yet to be realized.
A New Paradigm

Competition is not the same as entrepreneurship, although both are part of new business startup activity or even use new or transformed products that are the generated by an entrepreneurial spirit. According to Dutz et. al (2000), creative destruction rationales reveal that competition erodes profits needed for entrepreneurial activity within an existing business. Competition also inhibits natural entrepreneurial activities because of risk aversion, although there may be activities which imitate entrepreneurship. Further, this imitation undercuts real entrepreneurial risk taking and initiative. Regardless of a business size, competition will minimize the efficient benefits of successful entrepreneurial activities. A business is more likely to engage in entrepreneurship if the business has limited or no marketing power. This situation creates competitive pressure that forces the established, competitive business to step up their efforts. With their market resources, the competitive businesses are likely to be the overall winners. Hence, Dutz et. al. claims that entrepreneurship needs to be protected and policy should be changed in order to encourage and sustain productive entrepreneurial activity. Some proposed changes include protecting private property; ensuring that the benefits of entrepreneurial activity is directed to the most socially beneficial sectors of an economy, and having a legal system that

ENTREPRENEURSHIP: EASE OF ACCESS TO CREDIT AND FINANCIAL RESOURCES

resolves disputes quickly. Grass-roots entrepreneurship needs to be supported by making technology, transportation, production facilities and distribution resources readily available. Dutz et. al. also advocate for the prevention of foreclosure or denial of resources to entrepreneurial activities and businesses. Dutz et. al. maintain that in a foreclosure-based environment, entrepreneurial activity is discouraged and the creative activity is misdirected back into nonproductive (non-creative) activity of the competitive market. Dutz et. al. propose a policy strategy to examine and use the entrepreneurial start-up condition in order to foster entrepreneurship. He also concludes that a review and feedback to amend the policies is needed. Another policy strategy proposed by Dutz et. al. is to look at causal connections between procompetition and pro-entrepreneurialism. Dutz, et.al. concludes these policy strategies are used in Mexico and follow up study should be performed. Studies performed by Andrew Atherton (2005) and Zoltan Acs (2007) are similar. Where Atherton uses the term dead weight to describe self-employed entrepreneurs that do not create jobs, Acs would describe these entrepreneurs as necessity entrepreneurs. Both study teams have the desire to separate the necessity or dead weight entrepreneurs from what they would consider be as true entrepreneurs, and they focus on enabling and protecting true entrepreneurs. Atherton and Acs also have similar conclusions. Both propose a framework to assist policymakers in designing appropriate interventions. Several studies proposed examining and changing policy approach from just market based factors. One evaluation of the Markusen and Glasmeimer proposed overhaul of the federal economic development policy provides intriguing insights to changing federal place-based economic development to supplying needed resources essential to competitive regions. The emphasis is on regions: regional competitiveness, regional strategy, regional governance,

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regional innovation, and regional entrepreneurship (Drabenstott, 2008). The study points out that there is no one agency responsible for economic development. Spread across several programs and agencies, decentralization has proliferated duplication, and inefficiencies, and bureaucratic bungling. One agency could effectively improve the coordination of federal programs, create better performance standards and eligibility requirements, and evaluate existing programs to determine programs efficiency and performance. The study clarifies that the consumption base is a euphemism for arts, recreation, health, and other centers) as a source for development funding. Add to this consumption base entrepreneurs who drive development. The second aspect of the consumption base is that each region is self-contained, allowing for regional prioritization of public investments that best exploit a regions assets. Lastly, although unresolved, the authors ask to stop the bidding war among states and the recruitment of business to relocate using financial incentives (Drabenstott, 2008). Similar to Drabenstott (2008), cluster development and the entrepreneurial activity are explored by Maryann Feldman and Johanna Francis (2004). Slightly different from the perspective of federal and national policy actions, cluster development is generally local or regional interdependent activity. Feldman and Francis note that the atypical sensitivity to cost and development is not as important to entrepreneurs because they are latent within a given population or location. Referencing Schumpeter and others, Feldman and Francis recognize that a shock to the status quo is necessary to awaken entrepreneurial activity. The shock allows for entrepreneur engagement, evolution, and support. Feldman and Francis acknowledge that what entrepreneurs need to startup is difficult to prescribe because innovation is predicated on individual entrepreneurial actions. They point out that regions can develop sophisticated innovations but without entrepreneurs to develop and market them, the profit of the innovation

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will be reaped by entrepreneurs in other locations. Feldman and Francis pose that the challenge for government is how to mobilize entrepreneurs and how or what to provide the necessary skills for them to become high-tech entrepreneurs. The answer is not to replicate the formulae or processes in mature clusters because entrepreneurship is much localized. Entrepreneurs know their networks, resources, and will take on a business that large companies are disinclined to engage in either for profit or not matching their mission and vision statement and goals. According to Feldman and Francis, examining mature clusters rarely reveals the reasons it began or the process of development. There is a list of necessary conditions that is well documented: availability of supportive social capital, venture capital, entrepreneurial support services and actively engaged research universities seems consistent with what needs to be in place to support an entrepreneurial response to a local or regional shock. What stand out in the examination of conditions is that the history of each cluster is unique and that cluster development is path dependent or heavily influenced by chance historical events (Kenny & von Burg, 1999). Generally, atypical competitive state and local incentives may actually impede economic growth. Instead, cluster formation is the culmination of many individual and small events. With regard to financing, venture capitalists generally bet on the entrepreneur rather than on the business plan and public sector industrial targeting. Industrial targeting and business plan requirements can and likely limit or prohibit entrepreneurial access and entry. What the atypical financing will not allow is uncertainty and risk. Entrepreneurs learn through trial and failure, which is a risky condition, but it is also the most flexible and adaptable during a local economic shock. Failure reveals pitfalls, dead ends or ineffective strategies to avoid in the future. Feldman and Francis call for new metrics that consider the nature of inherent market failures that prompt government involvement rather than return on investments or how quickly new jobs are created. The focus

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then is for policy to create conditions to encourage entrepreneurship and information as well as business development and cluster formation. Analysis Considering the literature, the question of whether the government should intervene or not is not the right question. The right questions are how to correct how the government intervention that is failing, what the intervention looks like, and what is the effect of those interventions on economic outcomes. As previously stated, at least two of the recommended interventions appear to be at least partially implemented. The monetary policy solution proposed by Carlstrom and Fuerst (2001) appears to be implemented by the Federal Reserve and is keeping the prime interest rate at its lowest. Housing market (asset) prices for instance have not been affected by the interest rate but more by the large supply and low demand. The credit market has responded but cannot control the negative externalities such as stringent lending regulations and the use of FICO scores. These requirements and qualifications have constrained credit as predicted by Dromel et. al. (2009) and directly affect the U.S. recovery. Also predicted by Dromel et. al. (2009) is the slow unemployment recovery associated with constrained credit. Consequently, these two studies appear validated by current U.S. economic conditions. Industry or regional clusters studied by Drabenstott (2008) and Feldman and Francis (2004) are forming in various regions around the U.S. Boston, MA is one of the original cluster centers in the U.S. The clusters focus is on maritime activities and the region has flourished. Bostons cluster worked directly with the state legislature, which set in motion similar changes in adjoining states involved in the regional cluster. Similar cluster developments include Silicon Valley, CA. Because this theory has been successfully implemented, a follow up evaluation of

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local policy and necessary changes should be done. As mentioned in the literature review of this study, entrepreneurial activities need the right economic climate to prosper and there have been enough changes with the Great Recession and Californias economic bust to warrant reexamining the policies for cluster development. Mitchell et. al (2009) reveals a moral hazard of venture capital and the successful enforcement of the law that exists. The vicious and virtuous cycles in the Mitchell study were interesting and revealing. However, by their description business development would want the conditions that are neither vicious nor virtuous. These conditions might be low corruption, low income, and opportunity entrepreneurs. A moral hazard and free-rider situation seem to loom with the Holtz-Eakin and Rose (2001) marginal rate reductions approach as well as with Klapper (2006). By agreeing with Atherton (2005) and Acs (2007) about two different types of entrepreneurs there is an assumption that the necessity entrepreneurs are free riders in the marginal tax reductions. In addition, do larger businesses pay a higher tax to offset the tax revenue lost through the tax reductions? Similar questions can be posed to all the proposals of reducing the cost and improving access to credit and financial resources and for policy that protects entrepreneurs as described by Dutz et. al. (2000). Implications for Policy The World Bank credit and legal reforms by Klapper (2006) along with Atherton (2005) and Acs (2007) framework tool seem reasonable approaches that could be implemented or engaged by a task force to test at least in the short run. A task force could propose an implementation approach to policymakers that would hopefully minimize the moral hazards and address the free-rider conditions.

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The regional-shift components study (Cheng, 2010) demonstrates the shortcomings of the current federal economic development policies as well as a need for reform. However, reforming the existing institutions and methods would be a poor ideal. Instead the cluster development proposal seems far more effective and regional-shift component an excellent means of measuring program success, mediocrity, or failure. The implementation of clusters at state and federal level require some consideration since this economic development strategy is already functioning. The key take away from this concept is the change from pro-competition to pro-entrepreneurialism in the legislation and the overhaul of the separate agencies into one economic development agency. Certainly there are examples of such far-reaching endeavors and lessons learned from the implementation of Homeland Security. Conclusion Intellectually it is accepted a problem of access to credit and financial resources exists. Several concepts and ideas are new, inventive, and focused on solving the problem of access to credit and financial resources. Implementation of one or more of these techniques or approaches will take political support to achieve the desired results. However, it is important that policy change is done incrementally and over time. A strategy to implement whole, coherent modules of policy seems the most effective way to begin. Further, some method of prioritizing the order of implementing these modules should be in the strategy. [3,882 words ]

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References *Scholarly references *Acs, Zoltan J., How is Entrepreneurship Good for Economic Growth? 31 Oct 2007, Progress Foundation, The Beauty of Entrepreneurship *Atherton, A., Should government be stimulating start-ups? An assessment of the scope for public intervention in new venture formation, Environmental and Planning C: Government and Policy, 2006, Vol 24, pages 21-36 Bayh, B., U.S. Senator, Statement of Senator Birch Bayh on S. 414, The University and Small Business Patent Procedures Act, May 1979, http://bayhdolecentral.com/JoeAllen_part1/bayh.s.statement.on.S.414.pdf *Carlstrom, C. Fuerst, T., Monetary Policy and Asset Prices with Imperfect Credit Markets, 2001, Cleveland Federal Reserve Bank Research Review, http://www.clevelandfed.org/research/review/2001/imperfect.pdf *Cheng, S., Business cycle, industrial composition, or regional advantage? A decomposition analysis of new business formation in the United States, February 2010, Department of Public Administration, Florida International University, MI, Springer-Verlag 2010 *Drabenstoot, M., An Effective Overhaul of Federal Economic Development Policy, Response to Markusen and Glasmeier, Economic Development Quarterly, Vol. 22, No. 2, May 2008, pgs 92-98, Sage Publications, 2008 *Dutz, M., Ordover, J., Willig, R., Entrepreneurship, access policy and economic development: Lessons from industrial organization, European Economic Review, 44 (2000), pgs 739747, Elsevier Science B.V.

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*Dromel, N., Kolakez, E., Lehmann, E., Credit Constraints and the Persistence of Unemployment, CNRS, Paris School of Economics, Preliminary report, 25 Mar 2009 *Fairlie, Robert, Entrepreneurship, Economic conditions and the Great Recession, Discussion Paper No. 5725, University of California, Santa Cruz, May 2011, http://ftp.iza.org/dp5725.pdf *Feldman, M., Francis, J., Homegrown Solutions: Fostering Cluster Formation, Economic Development Quarterly, 2004, Vol. 18, No. 2, pages127-137 *Gavron, R, Cowling, P., Holtham, G.,Westall, A, The Entrepreneurial Society, The Institute for Public Policy Research, 1998 *Holtz-Eakin, D., Rosen, H., Economic Policy and the Start-up, Survival, and Growth of Entrepreneurial Ventures, a report submitted to the Small Business Administration, 2001 Klapper, Leora, Entrepreneurship, How Much Does the Business Environment Matter, Viewpoint, The World Bank Group, Financial and Private Development, Note Number 313, Nov 2006 *Mitchell, D, Campbell, N., Corruptions Effect on Business Venturing Within the United States, American Journal of Economics and Sociology, Vol. 68, No. 5, 2009, American Journal of Economics and Sociology, Inc.