By Tyler Mondres
Following the pandemic, there was a notable shift in the share of small businesses reporting they were not interested in credit. The share increased from just over 50 percent on average in the decade preceding the pandemic to slightly more than 60 percent over the past few years. However, this is not the first time such a shift has been observed in this series.
The Great Recession had lasting effects on both economic growth and small business psychology. But what was the catalyst for the widespread decline in loan demand? One possible explanation is survivorship bias. As Warren Buffett famously said: Only when the tide goes out do you see who was swimming naked. If highly leveraged businesses failed at a higher rate than their peers during the crisis, the pool of surviving firms may have simply skewed more towards those less dependent on credit.
The scale of the collapse also affected risk tolerance. While business leaders have a higher risk appetite than the general population, one study found that managers’ willingness to take risk took a deeper hit and was slower to recover than the broader public. CEOs and CFOs who began their careers in a recession also tend to have more conservative styles, prioritizing cost reduction and making fewer capital investments.
Finally, following the Great Recession there was a marked and sustained reduction in new business formation, and research suggests that businesses born in recession tend to start smaller and stay smaller over their entire life cycle relative to their expansion-born peers.
For one, while entrepreneurship took a prolonged hit after the Great Recession, it improved following the pandemic. After an initial sharp contraction, new business formation accelerated past pre-pandemic levels. Average monthly business formations over the past three years, as projected by the Census Bureau, were 23 percent higher than the 2009-2019 average.
There is also more geographic diversity in the location of new firms. The rise of remote and hybrid work arrangements allowed many to move from higher-cost-of-living cities to other parts of the country. In a recent paper, Ryan Decker of the Federal Reserve Board and John Haltiwanger from the University of Maryland observed a “donut effect” in the location of new businesses, with more applications based in the suburbs surrounding metro areas and fewer within central business districts.
Secondly, the psychological scars of the pandemic could have positive economic fallout. Supply chain constraints and labor shortages plagued businesses during the crisis. As a result, more firms are considering the benefits of onshoring and near-shoring and there is evidence that firms may be “labor-hoarding,” both reactions to painful pandemic experiences.
More new firms, low unemployment and an increase in domestic activity — this is not what we saw after the Great Recession and seems to contradict the observed trend in small business loan demand. So why has the share of small businesses disinterested in credit increased? A much simpler explanation seems evident: plentiful cash and higher borrowing costs.
The unprecedented scale of the global shutdowns was matched by unprecedented government support. Numerous programs funneled cash to businesses and households and, as of the end of 2023, households’ checkable deposits were more than 300 percent above pre-pandemic levels. This excess cash surely reduced small firms’ reliance on financing to meet their near- and medium-term needs.
Meanwhile, the Fed has aggressively ratcheted up interest rates to tame inflation. With expectations for meaningful cuts in 2024, we may soon find that businesses were simply keeping their powder dry for a more favorable rate environment. Predicting the path of the economy is always a tricky prospect, but there are good reasons to believe that this time really will be different.
