In This Recovery, Small Business Falls Behind

Could small businesses become the Achilles' heel of the U.S. recovery? Companies with fewer than 500 employees helped lead the economy out of the last four recessions as entrepreneurs, sensing opportunity, opened new businesses. And smaller suppliers provided the tools and equipment needed for larger companies to boost production. But this time, almost six months after the U.S. economy began growing again, small businesses continue to cut capital spending and dismiss workers.

Such caution has big implications for the speed and strength of the recovery. That's because tiny businesses have an outsize impact on employment. In fact, total U.S. payrolls would have fallen between 1980 and 2005 without the jobs created by business startups—most of them companies with fewer than four workers, according to new U.S. Census Bureau data.

So a drop in the unemployment rate, which fell to 9.7% in January from 10% in December, may stall later this year if these companies don't start hiring. And growth likely won't meet the median 3% annual rate forecast for 2010 by 68 economists surveyed by Bloomberg without more small company investment.

"Will you have a sustainable recovery a few years down the road without getting some small business spending? No," says Cary Leahey, senior managing director at Decision Economics.

The U.S. economy expanded at a 5.7% annual rate in the fourth quarter, the fastest pace in six years. That surge was buoyed in large part by capital expenditures for equipment and software by large companies. But capital spending by smaller businesses remains depressed. Only 20% plan to spend money on equipment or facilities in the next three months, near a 35-year low, according to a survey released Feb. 9 by the National Federation of Independent Business. That could hurt the economy later this year, when big increases by large corporations are expected to slow as government stimulus money runs out.

Recent numbers suggest "the official data are too heavily weighted towards bigger companies, which are doing better than credit-constrained smaller firms," says Ian Shepherdson, chief U.S. economist at High Frequency Economics. However, he adds, "The latter employ half the workforce."

Surveys of small business owner sentiment don't presage a pickup anytime soon. The NFIB's index of small business optimism has been near historic lows for 16 consecutive months, hitting 89.3 in January. During the four prior recessions, going back to 1980, it dipped below 90 only once. Just 17% of NFIB members reported sales growth in the fourth quarter, while 47% saw declines. And just 1% said they expected conditions to be better in six months. "Optimism has clearly stalled, in spite of the improvements in the economy," says William Dunkelberg, the NFIB's chief economist.

Small companies have been particularly reluctant to invest in the one area the economy needs most right now: jobs. In January, small companies eliminated 3,000 jobs, according to Automatic Data Processing (ADP), the world's largest payroll processor. And in January, 19% of NFIB members reduced employment, while only 9% added workers. "They're still apprehensive about hiring people, because they're not seeing enough customers to translate into another worker," says Holly Wade, policy analyst at the NFIB.

Lack of access to credit also affects small businesses disproportionately. The Federal Reserve reported on Feb. 1 that banks were continuing to tighten standards for loans to small businesses, while standards for large companies were unchanged.

So far, there are few signs of improvement. PayNet's Small Business Lending Index, which tracks loans of $1 million or less, was 8.6% lower in December than a year ago. Although that's less than half the level of monthly decreases in early 2009, demand for expansion loans for small businesses is still 35% below its peak in 2006. Says PayNet President William Phelan: "That's another indication of how far we have to go to climb out of this recession."

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