Small businesses are too important to ignore. Photographer: David Paul Morris/Bloomberg
Small businesses are too important to ignore. Photographer: David Paul Morris/Bloomberg

America’s economy excels at creative destruction -- the process of killing old enterprises and ideas and replacing them with newer and better ones. Or, at least, America’s economy had excelled at creative destruction. A recent report from the Brookings Institution suggests there is reason to worry that this is changing:

But what about Silicon Valley? I hear you cry. Indeed, Silicon Valley is practically crawling with new social-media startups or whatever it is that the kids are into these days.

Important as that sort of entrepreneurship is, however, it is not the only sort that matters. Small businesses of all kinds are good for the economy. They have long been a vehicle to prosperity for ordinary people, and they fill an important niche in the economy:

While it's true that most of the jobs created by small businesses that start small and get big, there's a lot of value in companies that stay small. It's not economical to produce everything on a massive scale. The wire factory I profiled is doing small run jobs for enormous industrial concerns. Those jobs wouldn't be profitable at a Boeing plant; they work because it's a relatively small operation.

Obviously, this changes over time -- things that used to be done on a yeoman scale are sometimes standardized and mass produced. But an enormous amount of work is doing things like custom bins to hold very specific parts that Toyota doesn't want damaged. Toyota doesn't need a zillion of them, and no one else needs any.

This is vital, even if they don't provide a ton of net new jobs. Productivity improvements at this level mean productivity enhancements rippling up and down the supply chain. And when businesses do figure out how to standardize and grow some previously custom line of work, those businesses start small, and build on the knowledge gained by other small businesses in that space.

That's why it's important to worry about things like the regulatory burden, which falls heaviest on businesses that can't afford a small fleet of full-time staff to ensure that they are in compliance. That's why it's important to worry about whether taxation is choking off their growth -- which doesn't mean that we should grant them tax subsidies, but only that this is one of the costs that must be counted when we're considering tax hikes. These guys are one of the main factors that allow our economy to be as great as it (usually) is. Their problems become our problems very quickly.

An economy with fewer small businesses is one with fewer potential entry points into the middle class, and it is potentially also one with less flexibility.

A lot of this is simply inevitable -- a lot of retailers just can’t compete with Amazon. But at least some of this is almost certainly the tax and regulatory burden, which is much harder for small businesses -- especially small businesses that aren’t software startups -- to handle. And one of my favorite small-business blogs suggests another reason:

But there is seldom just one single cause for any trend in a complex, chaotic system (e.g. climate, but economics as well). One other reason business formation may have dropped is the crash of the housing market and specifically in the equity many have in their homes.

Home equity has historically been an important source of capital for small business formation. My first large investment in my company was funded with a loan that was secured by the equity in my home. What outsiders may not realize about small business banking nowadays is that it is nothing like how banking is taught in high school civics. In that model, the small business person goes to her local banker and presents a business plan, which the banker may fund if they think it is a good risk.

In the real world, trying to get such an unsecured loan from a bank as a small business will at best result in laughter. My company is no longer what many would call "small" -- we will do millions in revenue this year. But there is no way in the world that my banker of over 10 years will lend to my business unsecured -- they will demand some asset they can put a lien on. So we can get financing of equipment purchases (as a capital lease on the equipment) and on factored receivables and inventory. But without any of that stuff, a new business that just needs cash for startup cash flow is out of luck -- unless the owner has a personal asset, typically a house, on which the banker can place a lien.

So, without home equity, one of the two top sources of capital for small business formation disappears (the other top source is loans from friends and family, which one might also expect to dry up in a tough economy).

Is this likely to be the main reason that small businesses aren’t being created? No. For one thing, surveys of current business owners do not show that access to capital is their largest concern. But, of course, that covers existing business owners. For people who want to start a business, the No. 1 priority is figuring out how to fund it.

As Coyote Blog notes, small businesses do not have access to unsecured business loans. Small-business owners personally sign on every note, and they have to offer their home or a piece of equipment as security. Most people would be shocked to learn how many new enterprises are financed by MasterCard, Visa and home equity loans.

If those sources have diminished -- and they have -- then it will be harder to get a new enterprise going. And when you add that to all the other burdens of taxes, regulation and a bad economy, it’s not that surprising that we’re seeing relatively fewer new firms entering the market. But however unsurprising it may be, we should still find it very worrying indeed.

To contact the writer of this article: Megan McArdle at mmcardle3@bloomberg.net.

To contact the editor responsible for this article: Brooke Sample at bsample1@bloomberg.net.