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Freeing the Business Start-Up Sector

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In the aftermath of recession an economy is heavily reliant on the small-business and start-up sector to generate renewed growth. Historically over 80 percent of new jobs created in the three years following a recession have originated in companies in this sector.

EU economies, with only 1 or 2 exceptions, are struggling to escape recession. We'll know this week if the UK is in "triple-dip" territory, elsewhere we observe Slovenia on the brink of a government bail-out, an imploding Cyprus economy that is bleeding cash at the rate of 300 euros per person per day, a possible second bail-out for Portugal and the entire southern euro zone mired in recession. Unemployment is static or rising.

So if one was Chancellor (or "Finance Minister"), having read these two paragraphs one would think, "we must free the SME sector", right?

There is little evidence of this.Everyone is obsessed with financing for SMEs, but paradoxically this might not be the bottleneck that governments often think it is. Rather, stifling red tape in the labor market is the real culprit.

Taking the UK as an example, statistics over the last 3 years show consistently that lending to SMEs is not increasing.But banks in Western Europe are awash with liquidity, and cheap liquidity at that, thanks to central bank action. Chancellor George Osborne is extending his "Funding for Lending" scheme in an effort to boost SME lending volumes, but that is unlikely to have any significant impact on the lending statistic.

As we noted, banks and non-bank FIs have plenty of cash on them, but post-crash lending criteria are more onerous than what was observed in 2002-2008, and banks are only going to lend to companies that meet their risk criteria. No-one could argue against that logic. But in any case, the demand is just not there either. Much anecdotal evidence suggests that start-ups and SMEs prefer to fund themselves with equity, or alternative non-bank funding, than with bank debt.

If governments really wish to assist the small business sector they should look at the seemingly endless bureaucracy that surrounds the labor market. Working time directives, minimum wages, compulsory pension schemes, employee tribunals, employer payroll taxes,restrictions on hiring and firing of staff, the list is onerous. And it directly (negatively) impacts new job creation. The biggest hindrance to growth in the SME sector is labor market restrictions that are approaching 1970s proportions.

Rather than obsess with bank lending,the solution to recession problems lies in the labor market. But there are a lot less column inches associated with tidying up this side of things than there are with bashing banks.

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Professor Moorad Choudhry is at the Department of Mathematical Sciences, Brunel University and author of The Principles of Banking (John Wiley & Sons Ltd 2012).