Why Start-ups Could Make or Break the Job Recovery

Start-up activity is at a record low—bad news if start-ups are indeed responsible for all net new jobs.

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Entrepreneurship seems as American as apple pie, but a new report suggests that it could be waning. The slice of job seekers opting to start their own businesses dropped to a record low in the first half of the year, according to a survey released today by Challenger, Gray & Christmas, a Chicago-based outplacement firm. Just 3.7 percent of job seekers were starting new businesses, down from 7.6 percent in the first half of 2009 and 9.6 percent in the second half of last year.

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Challenger, Gray & Christmas, which has been tracking the rate since 1986, says the first half of this year represented the lowest two-quarter average on record. In the first quarter of the year, the start-up rate was 3.4 percent. In the second quarter, it was 3.9 percent. By comparison, the highest rate on record was 21.5 percent, recorded for the first half of 1989. "It is difficult to pinpoint the exact reason behind the decline in start-up activity among former managers and executives," Challenger CEO John Challenger says. "On one hand, it could be that the job market has improved to the point that many do not feel compelled to take the risk of going it alone. Then there is the fragility of the recovery and the uncertainty that comes with it. Many small business owners are increasingly pessimistic about business conditions and still find it difficult to get a loan."

Start-ups are particularly critical to job growth. Federal Reserve Chairman Ben Bernanke noted last week the importance of small businesses to the job market, and in particular, the significance of start-ups. "Small businesses are central to creating jobs in our economy; they employ roughly one half of all Americans and account for about 60 percent of gross job creation," Bernanke said. "Newer small businesses, those less than two years old, are especially important: Over the past 20 years, these start-up enterprises accounted for roughly one quarter of gross job creation even though they employed less than 10 percent of the workforce."

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In a new research paper, Tim Kane, a senior fellow at the Kauffman Foundation, found that start-ups are responsible for all net job growth in the U.S. economy. During years of recession, net job losses grow at existing firms—those a year and older—while job creation at start-ups stays stable. "Start-ups create an average of 3 million new jobs annually," Kane writes. "All other ages of firms, including companies in their first full years of existence up to firms established two centuries ago, are net job destroyers, losing 1 million jobs net combined per year."

Despite his research, Kane says he is not particularly concerned about the implications of the Challenger report. The findings give an impression that flies in the face of established economic empirical evidence, that self-employment rises when unemployment rates are high, Kane says. Because the survey pool is just job seekers, it may provide a limited view of entrepreneurship activity. The report shows start-up rates are low among the unemployed, but it doesn't say much about the overall volume of new firms. "We may have more starts than ever before," Kane says. The Kauffman Foundation's own index of entrepreneurship activity found that start-up activity was high in 2009—the highest in 14 years, to be exact. The Challenger survey also saw much higher figures in 2009.

Start-up activity tends to be cyclical—spiking when the recession has ended, as unemployment is high and hiring is nil, and falling when employers start adding to their payrolls again, according to Challenger. The rate of start-ups then begins to increase again as the economy grows. Hiring appeared to rebound in the spring, when the private sector added 158,000 jobs in March and 241,000 in April, but has since dipped considerably. That's likely because of concerns over the debt crisis in Europe, as well as the end of stimulus spending and concerns over impending tax hikes.