Entrepreneurship, Economic Conditions, and the Great Recession
Robert W. Fairlie
Department of Economics
University of California
Santa Cruz, CA 95064
rfairlie@ucsc.edu
IZA and RAND
May 2011
Abstract
The “Great Recession” resulted in many business closings and foreclosures, but what effect did it
have on business formation? On the one hand, recessions decrease potential business income and
wealth, but on the other hand they restrict opportunities in the wage/salary sector leaving the net
effect on entrepreneurship ambiguous. The most up-to-date microdata available -- the 1996 to
2009 Current Population Survey (CPS) -- are used to conduct a detailed analysis of the
determinants of entrepreneurship at the individual level to shed light on this question. Regression
estimates indicate that local labor market conditions are a major determinant of entrepreneurship.
Higher local unemployment rates are found to increase the probability that individuals start
businesses. Home ownership and local home values for home owners are also found to have
positive effects on business creation, but these effects are noticeably smaller. Additional
regression estimates indicate that individuals who are initially not employed respond more to high
local unemployment rates by starting businesses than wage/salary workers. The results point to a
consistent picture – the positive influences of slack labor markets outweigh the negative
influences resulting in higher levels of business creation. Using the regression estimates for the
local unemployment rate effects, I find that the predicted trend in entrepreneurship rates tracks
the actual upward trend in entrepreneurship extremely well in the Great Recession.
Keywords: Entrepreneurship, Great Recession, Unemployment, Self-Employment
JEL Code: L26
This research was supported by the Kauffman-RAND Institute for Entrepreneurship Public Policy
through a grant from the Ewing Marion Kauffman Foundation. I would like to thank Susan Gates,
John Robertson, Danny Leung, and seminar participants at the Small Business, Entrepreneurship,
and Economic Recovery Conference at the Atlanta Federal Reserve and the CIRPEE-IVEY
Conference on Macroeconomics and Entrepreneurship for helpful comments and suggestions.
1. Introduction
The U.S. Economy lost more than 8 million jobs during the recession starting in
December 2007. The national unemployment rate rose to over 10 percent, which is twice as high
as it was at the start of the recession. Many researchers have noted that the labor market
experienced its deepest downturn in the postwar era in the recent recession (Elsby, Hobijn and
Sahin 2010). Sparking the recession was the housing crisis -- housing prices plummeted since
reaching their peak in mid 2007. The national housing price index experienced the largest decline
on record (Federal Housing Finance Agency 2009). Home foreclosures also rose rapidly over the
past few years. In the one period for May 2010, there were 323,000 foreclosure filings,
representing an alarming 1 out every 400 housing units in the United States (Realtytrac 2010).
What effect did the recent recession, and recessions more generally, have on
entrepreneurship? Were would-be-entrepreneurs dissuaded by the recent recession from starting
businesses or did they respond to layoffs and slack labor markets by turning to self-employed
business ownership? Business bankruptcy filings and closures increased sharply in the recent
recession (U.S. Courts 2010), but the effects on business formation are less clear. Recessions
might have a negative effect on business starts because of the resulting decline in demand for the
products and services produced by businesses. The recent housing slump may have limited
entrepreneurship by restricting access to capital. Equity in one's home is the main asset for most
Americans and represents 60 percent of all wealth (U.S. Census 2008). Home equity and other
forms of personal wealth are important for starting businesses because they can be invested
directly in the business or used as collateral to obtain business loans. Bank loans, venture capital
and angel investments were also difficult to obtain during the recent recession (Federal Reserve
Board of Governors 2010, PricewaterhouseCoopers 2010).
On the other hand, the recent recession might have increased "necessity"
entrepreneurship or business creation because of the rapid rise in the number of layoffs and
unemployment in the United States. Previous studies provide evidence that job loss and reduced
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labor market opportunities lead to entry into self-employed business ownership (Farber 1999;
Parker 2009; Krashinsky 2005). Although the motivation might differ for starting the business in
this case, many of these businesses may eventually be very successful. For example, a recent
study by Stangler (2009) finds that the majority of Fortune 500 companies were started during
recessions or bear markets.
Given these opposing forces, the net effect of the recent recession on business creations is
ambiguous. Indeed, the positive and negative influences may have even cancelled out resulting in
a relatively flat rate of business creation over the business cycle. To explore this question, I first
conduct a detailed analysis of the determinants of entrepreneurship using newly created panel
data from the most up-to-date microdata available -- the 1996 to 2009 Current Population Survey
(CPS). Although the CPS data are usually used as cross-sectional data, panel data can be created
from the underlying data files allowing one to measure business creation by individuals. Using
these data, the effects of rising unemployment rates and the decline in housing values on
entrepreneurship are examined by estimating the relationship between business creation at the
individual level and local labor and housing markets. The analysis covers two recessions and two
strong growth periods, and uses variation in unemployment and housing prices from more than
250 metropolitan areas. Estimates from this analysis are then used to examine whether rapidly
increasing unemployment rates and a declining housing market had a large effect on business
creation in the Great Recession.
This study is the first to provide a detailed analysis of the effects of the Great Recession
on business creation in the United States. It also improves on previous research on business
formation by capturing a broader range of new business activity than commonly-used Census
data focusing only on new employer firms. Detailed information on home ownership, initial
employment status, education and demographic characteristics of entrepreneurs and non-
entrepreneurs available in the CPS allow for a much more extensive analysis of the relationship
between local economic conditions, housing market conditions, and business formation than
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previously conducted in the literature. The study provides new evidence on the potentially
opposing influences of unemployment and housing markets on entrepreneurship, interactions
between initial employment status and local labor market conditions, and the types of business
created in weak labor market conditions. The findings from this analysis may have important
policy implications because of the focus of many government programs on promoting business
ownership among the unemployed and the potential for job creation (U.S. Department of Labor
2010, Small Business Administration 2010, OECD 1992, 2005).
2. The Entrepreneurial Decision
Theoretical models of the choice to become self-employed are generally based on a
comparison of potential earnings from business ownership and wage and salary work. In the
classic economic model by Evans and Jovanovic (1989) individuals can obtain the following
income, Y
W
, from the wage and salary sector: Y
W
= w + rA, where w is the wage earned in the
market, r is the interest rate, and A represents the consumer’s assets. Earnings in the self-
employment sector, Y
SE
, are defined as: Y
SE
= θf(k)ε + r(A-k), where θ is entrepreneurial ability,
f(.) is a production function whose only input is capital, ε is a random component to the
production process, and k is the amount of capital purchased by the worker. Individuals choose to
become self-employed if the potential income from self-employment and investing remaining
personal wealth after using it for startup capital is higher than the potential income from wage and
salary work and investing personal wealth.
This simple theoretical model is useful for illustrating the main avenues through which
business cycles might affect entrepreneurship. One of the main effects is that recessions reduce
consumer and firm demand for products and services provided by startups, thus decreasing
potential entrepreneurial earnings, Y
SE
. Recessions may also reduce total wealth, A, which in
turn would lower the likelihood of entrepreneurship. In the presence of liquidity constraints,
lower levels of wealth may make it more difficult for entrepreneurs to find the required startup
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capital to launch new ventures. Personal wealth may have declined substantially through
declining home values and home ownership rates. Recessions also make it more difficult to
acquire financing from banks, other financial institutions, angel investors, and venture capitalists.
On the other hand, the costs of production are lower in a recession, especially rent and
labor, increasing Y
SE
. The opportunity cost of capital, r, is likely to be lower in recessions also
placing upward pressure on entrepreneurship. Perhaps the largest factor having a positive effect
on the entrepreneurial decision is that compensation in the wage/salary sector decreases in
economic contractions. The positive effect of lower wages on entrepreneurship may be tempered
somewhat in recessions, however, because some workers may be reluctant to leave their jobs in a
recession because of concerns about finding another one if the business fails. The net effect of
these opposing forces on entrepreneurship is ambiguous. An empirical analysis is thus needed.
PREVIOUS EMPIRICAL EVIDENCE
The previous empirical literature provides evidence on several aspects of how recessions
affect the entrepreneurial decision. The relationship between personal wealth and business starts
has been studied extensively in the previous literature using various methodologies, measures of
wealth, and datasets from around the world. Most studies find that asset levels (e.g. net worth)
measured in one year increase the probability of entering self-employment by the following year.
1
The finding has generally been interpreted as providing evidence that entrepreneurs face liquidity
constraints and that owner's wealth is important in determining access to financial capital for
business starts. Additional evidence on the link between startup capital and owner's wealth has
been provided by examining the relationship between business loans and personal commitments,
such as using personal assets for collateral for business liabilities and guarantees that make
1
See Evans and Jovanovic (1989), Evans and Leighton (1989), Meyer (1990), Holtz-Eakin, Joulfaian, and
Rosen (1994), Lindh and Ohlsson (1996, 1998), Bates (1997), Blanchflower and Oswald (1998), Dunn and
Holtz-Eakin (2000), Fairlie (1999), Johansson (2000), Taylor (2001), Zissimopoulos and Karoly (2003),
Holtz-Eakin and Rosen (2005), Giannetti and Simonov (2004), Fairlie and Krashinsky (2010), and Nykvist
(2005).