First, a quick synopsis of the paper (available here):
“In the absence of any correlation between wealth and entrepreneurial talent, initial net wealth should have an explanatory power in the decision to become an entrepreneur only for households that are financially constrained; its importance should decrease with wealth.”
In other words, if you believe that higher starting wealth does not make for a better entrepreneur further, then only households that have no capacity to borrow – no assets to borrow against – or that have insufficient income to take on the risk of becoming an entrepreneur should be constrained in their pursuit of entrepreneurship by wealth considerations. This means that as household wealth increases, the constraint of wealth on ability to take up entrepreneurship falls.
The paper tests this theoretical predictions for the Italy, showing that: “…household's initial wealth is indeed important in the decision to become an entrepreneur and its effect is lower for the richest households.” (Point 1)
“Furthermore, the effect of net wealth is stronger when legal enforcement of the loan contract is weaker...” Which, of course means that as the regulators, government, or lenders fail to enforce lending contracts, such lax enforcement increases the role that initial wealth plays in constraining entrepreneurship, making it harder for assets-poorer households to pursue business opportunities. (Point 2)
“Finally, conditional on becoming entrepreneurs, initial household wealth does not significantly affect the size of the business.” So that once a person becomes entrepreneur, the levels of their initial asset holdings do not act to determine the rate of their success in business. (Point 3)
“In summary, it seems that imperfections in capital markets can induce people to accumulate assets in order to facilitate the decision to become entrepreneurs.”
And so now, to interpreting these results for Ireland.
Majority of our households rely on house equity to act as their main life-cycle asset. As house equity is being destroyed by the negative equity, two things happen to household financial position:
- Net wealth declines directly with increase in negative equity; and
- Net future wealth declines directly with the gap between rental value of the property and the mortgage cost (in effect, people in negative equity are paying more for their property than it is worth, thus reducing disposable income available for other savings and investments.
So on the net, the twin effects of negative equity in Ireland have so far (during this crisis) meant that as property prices declined by ca 40-50% already, while rents have fallen over 15%, Irish households worst affected by the negative equity (home buyers in 2006-2007) have seen combined effect of falling wealth to the tune of 49-58%.
That is a serious chunk of wealth being destroyed, implying some adverse effects on future entrepreneurship rates. Since the rates of success in entrepreneurship do not suffer from initial wealth effects, we can assume that entrepreneurs lost due to negative equity are of average type. Which means some serious losses to the economy over the years to come.
But wait, there is more: Point 1 clearly suggests that the adverse impact of negative equity will be felt more by those would be entrepreneurs who come from lower wealth-holding groups of Irish population. No, not exactly the poor (although them as well), but from:
- Traditionally assets-poor younger households – so Ireland is now foregoing higher future rates of entrepreneurship from younger generations (also, incidentally, most adversely impacted by rising unemployment);
- Traditionally mortgages-heavy families – so Ireland is now potentially cutting into its business potential when it comes to families, thus adversely impacting future population growth rates as well;
- Lower middle class would-be-entrepreneurs – so that Irish society is now running a greater risk of reducing social class mobility, as entrepreneurship is often the only ticket out of lower middle class;
- And yes – the poor would-be-entrepreneurs: people who like many of our best business leaders today came from the poorer family backgrounds.
Points 2 & 3 go straight to NAMA. As NAMA in effect simply means a bailout clause for bankers, it undermines enforceability of lending contracts – for bankers directly, for developers indirectly via NAMA holiday clauses, and for households also indirectly via political manipulation of lending going on behind the scenes. Which means that overall, Ireland is moving, thanks to NAMA, toward a society where entrepreneurship will be even more polarized into the domain of the better-off. Yet another obstruction on that social mobility ladder that business ownership entails.
So here you go, to all those (like some of our economics commentators) who say that negative equity only matters when people want to move, I’d say – read real evidence, folks.
I'm afraid I'm still in the camp of those 'who say that negative equity only matters when people want to move' after reading this (and the Italian research).
Implicit in your argument Constantin is that would-be entrepreneurs normally borrow money secured against the equity in their home: and negative equity prevents this. But financial institutions in Ireland are prohibited from using business customers' private homes as security.
More importantly, if instead of looking at Italian experience we look at the Irish experience (see GEM report here: http://www.gemconsortium.org/document.aspx?id=895) the incidence of entrepreneurship is fairly similar across all age groups, and not just among 30-somethings with recent mortgages.
The same report shows that three quarters of Irish entrepreneurs in 2008 needed, on average, financial funding to the tune of just €10,000. A credit card would cover that, never mind a second mortgage ...
The real issue in terms of funding for entrepreneurs is not net wealth but the availability of bank lending. Which as the recent Mazars report shows is now a serious problem especially for export companies and software/IT companies. Not how you build a smart economy!
Respectfully, I completely disagree.
1) "Implicit in your argument... is that would-be entrepreneurs normally borrow money secured against the equity in their home: and negative equity prevents this. But financial institutions in Ireland are prohibited from using business customers' private homes as security."
No, this is not what I am arguing. I made no reference to such borrowing constraints as far as I can recall.
What I am arguing is that in order to undertake entrepreneurial pursuit, a person must be relatively secure in their savings buffer and wealth acts as such security when it is liquid and positive. Note: positive housing equity is relatively liquid as you can borrow (personal loans) against it.
If wealth is illiquid and negative, relative (and absolute) risk aversion increases, reducing propensity to undertake risky gambles at any given level of returns. Thus, propensity to undertake entrepreneurial activities will fall.
But lets take your argument about restrictions on collateral. Many entrepreneurs in Ireland do not rise early debt via a business loan. Remember, Irish banks do not lend on business plans. If entrepreneurs rise at least a share of debt via personal loans, their capacity to borrow personally is proportionately related to their collateral, aka house equity!
2) "look at the Irish experience (see GEM report...)the incidence of entrepreneurship is fairly similar across all age groups, and not just among 30-somethings with recent mortgages."
I make no argument about the frequency of incidence amongst various groups. You can start with the same frequency when constraints on borrowing do not bind, but end up with different frequency when they do bind, if they bind selectively. This will be seen with a lag in the data.
GEM report is simply a report on existent entrepreneurs - selection bias. It covers 2008 data - which in all fairness refers to up to 42-month-long duration entrepreneurs. So survivorship bias is also there. And as 42-months lag suggsts, at least some entrepreneurs in the sample have funded their initial activity in pre-crisis years. Lovely... am I not surprised they show no differences: kids borrowed via parents, older generation entrepreneurs borrowed themselves. I guess it would have been the same even if their net worth was all negative, I presume?
3) "The same report shows that three quarters of Irish entrepreneurs in 2008 needed, on average, financial funding to the tune of just €10,000. A credit card would cover that, never mind a second mortgage ..."
Again, this is only about direct funding. They all also needed replacement income - hmmm, say 40K per annum? They needed operating capital (at least some). And, incidentally, they needed security of mind that they had a safety net of sorts behind them. Positive equity in their or their parents properties wouldn't have provided that? Or would it?
And lastly, their ability to use 10,000 euro limit on credit cards wouldn't have anything to do with their home equity? I mean my bank wouldn't give me a 10,000 limit with my income on the card (hence my use of the US-based card for all these years of living in Ireland).
Sorry, but there is more to entrepreneurship than ability to raise direct business financing. There are also risk aversion, incentives, and access to safety nets.
Take two persons who undertake entrepreneurship today. Neither one has recourse to unemployment should their business start up fail.
But if one - person A - has positive equity, she can at least hope to borrow, or sell (I know, it does take longer to do so, but she can).
The other one - person B - well, she has a mortgage to pay (negative equity means you do have a mortgage to pay, am I right?) and no safety net of any sort.
Who cares whether both had a recourse to borrowing 10K on a credit card? Well, actually - it does matter as well. Person A will have a greater propensity to borrow on the credit card than person B... oops.
Now to GEM report itself: page 22, table 1.7 states that 24% of early stage entrepreneur require more than 100,000 capital. And page 21 states that they require external funding. But when the authors make a statement about 'own funding' they do not exclude the possibility that 'own funding' might come from personal loans. And, again, these might be just the loans secured against property.
Furthermore "informal investors are a very important means for early stage entrepreneurs to meet the financing needs of new venture", and these informal investors are drawn from amongst family and friends. They, the informal investors, wouldn't be constrained by negative asset holdings (and subsequent knowledge of high risk to their future pensions provisions) in investing in the riskiest enterprise - the start up?
Now, lastly, page 22: "access to debt and the equity finance, particularly at the very early stages, continues to be cited most frequently by members of GEM's key informant panel". In other words, I don't really see credit cards being sufficient here.
I agree - the current credit availability environment is not optimal for building a smarter economy. Neither are our tax rates. Nor our policies in general.
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