Employment Dynamics and Business Cycles

Young, small businesses were more sensitive to the business cycle than older, large businesses.

There is considerable debate about how firms of different sizes respond to the business cycle. Some evidence shows that small firms are more sensitive to cycles, while other evidence finds that larger firms are more sensitive. In How Firms Respond to Business Cycles: The Role of Firm Age and Firm Size (NBER Working Paper No. 19134), authors Teresa Fort, John Haltiwanger, Ron Jarmin, and Javier Miranda provide new evidence incorporating a key distinction between firm size and firm age.

Using a database of employer businesses in the United States from 1981 to 2010 along with cyclical indicators such as the unemployment rate, they find that distinguishing between young and old small businesses is of critical importance. Small, young businesses (firms that are less than 5 years old and have fewer than 20 employees) exhibited very different cyclical dynamics than small but older businesses. Older small businesses responded less to an increase in the unemployment rate than younger small businesses. In addition, young, small businesses were more sensitive to the business cycle than older, large businesses - those that are more than 5 years old and have over 500 employees. A rise in the state unemployment rate reduced the differential in the net job creation rate between small, young businesses and large, mature businesses, and the effect persisted for a number of years. Therefore, young, small businesses were more vulnerable to business cycle shocks. The important decline in net job creation for small, young firms was the result of a fall in gross job creation and a large increase in job destruction. In contrast, among older businesses, the evidence of differences in cyclical dynamics based on size was mixed.

The authors attempt to explain why young, small businesses were hit especially hard in the Great Recession. Many of the hypotheses about why small firms should be more sensitive to changes in credit conditions than their large firm counterparts are more relevant for startups and young firms than for established small firms. Young, small firms typically rely on personal sources of finance, including home equity, to establish credit lines. Therefore, the pronounced variation in housing prices during the Great Recession would be especially pertinent for these firms. Using differences in housing price variations across states, the authors present evidence that the collapse in housing prices accounts for a significant part of the large decline of employment at young, small businesses. In this case, the results are driven by the greater responsiveness of young, small businesses within selected sectors such as construction, finance, insurance and real estate, retail trade, and services.

--Claire Brunel