The Federal Reserve recently launched the second round of its policy of quantitative easing, known as QE2, to stimulate the economy and reduce the chance the U.S.will fall into deflation. While the Fed's action might stimulate the big business sector, it isn't likely to have much effect on the small business portion of the economy. In fairness to Bernanke and crew, they never said QE would influence the small business sector. Given that small business accounts for about half the private-sector economy, however, the best case scenario for QE2 is a modest improvement in economic performance coupled with a widening gap between big business and small business. (Big business, as you know, is beginning to bounce back, while small business remains moribund close to 18 months into the economic recovery.)
Under a policy of QE, the Fed prints money (in digital form) and uses the newly created cash to buy assets from banks, which then have more money available to increase lending. Bernanke and company say that QE2 will stimulate the economy by lowering bond interest rates. Here's their argument: If the Fed creates more demand for bonds by buying them, their prices increase and their yields fall. Low interest rates on bonds trigger big companies to issue more debt. And to take advantage of the cheap money they have obtained, they expand their operations. In addition, because QE2 increases the money supply, it stimulates inflation, which lowers the value of the dollar against other currencies. A lower dollar helps the economy by stimulating exports, making them cheaper to foreign customers.
A devaluation of the dollar and resulting export stimulus will do little for small companies. According to the Small Business Administration, small companies generate more than half of nonagricultural private-sector gross domestic product but only 31 percent of exports. This means small businesses are more likely than big businesses to generate value within the country.
QE2 won't trigger expansion in the small business sector by driving down bond yields. First, small businesses don't issue bonds, so they can't take advantage of the lower interest rates QE2 might generate in the bond market.Small companies get credit from banks, and the lower interest rates on bonds won't make more small businesses interested in borrowing and more banks interested in lending to them.The National Federation of Independent Business explains that right now demand for small business loans is low, despite historically low interest rates. Small business owners face slack demand for their products and see little reason to borrow to expand their operations. If low interest rates are doing little to get small businesses to borrow, making rates even lower won't prompt an increase in borrowing.
On the bank lending side, QE2 is unlikely to get banks to lend. Banks have weakened balance sheets as a result of the financial crisis and are more likely to use the money created by the Fed's asset purchases to shore up their reserves than to lend more. In addition, because of the recession and the housing price decline, the average small business is a poor credit risk right now. Given the mess the banks made of lending to poor quality borrowers during the housing boom, regulators are unlikely to encourage banks to lower their lending standards to make more small business loans. QE2 might even discourage bank lending if it flattens the yield curve and reduces the spread between short- and long-term interest rates. Because banks tend to borrow short and lend long, a flattened yield curve will shrink margins on loans and discourage small business lending.
Proponents of QE2 also believe the policy will stimulate the economy through a wealth effect. If QE2 causes the stock market to rise, people will feel richer and spend more, stimulating the economy. This wealth effect, however, is unlikely to be strong in the small business sector. Small business owners are less likely than nonbusiness owners to respond to the wealth effect, because, adjusting for wealth, they tend to own less stock in public companies.
So what are the implications of QE2 for small business? If QE2 fails and we get rapid inflation and little expansion, small business owners will suffer just like everyone else in the economy. On the other hand, if QE2 works to stimulate the economy and we get modest inflation and economic growth, we will see a wider gap between the performance of small and large businesses. For the reasons I explained above, QE2's effects will largely be from stimulus to big business, not small business. As a result, if QE2 works, big business performance will pull further ahead of small business performance. If policymakers want to stimulate the small business sector, they are going to need something more than just relying on the Fed. The solution to the lack of recovery in the small business sector lies in fiscal, not monetary, policy.
Scott Shane is the A. Malachi Mixon III Professor of Entrepreneurial Studies at Case Western Reserve University.
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