Wealth Distribution, the Financial Crisis and Entrepreneurship

Wim Naudé and James C. MacGee

Globally, wealth is very unequally distributed, both within countries and between countries. The UNU-WIDER project on Personal Assets from a Global Perspective has found for instance that the richest 10 percent of adults in the world own 85 percent of global household wealth. Of these individuals, almost half live in the US and Japan. The common measure of inequality, the Gini-coefficient, ranges between 0.65 to 0.75 for the distribution of within country wealth. Another feature of the distribution of wealth is that the rich (advanced countries) hold greater proportions of wealth in financial assets than poorer or middle income households (countries) where wealth is predominantly held in real assets such as land, houses and farm assets (see the article by Davies, Sandström, Shorrocks and Wolff in the WIDER Angle 2006- 2 (1.4 megabytes).

With these facts in mind some may conclude that the recent financial crisis, having sharply reduced the value of financial and housing assets, especially in the advanced economies, may be expected to lead to a slight reduction in global wealth inequality, both between countries and within countries. However, while the current crisis is likely to reduce global wealth inequality today, the long-term effects are less clear. This is because there is a potentially important channel through which the crisis may impact the distribution of wealth over the longer-term:  entrepreneurship.

The Wealthy are Entrepreneurs

The large fortunes accumulated by entrepreneurs (households with considerable ownership of and active management interest in a business) account for a significant share both of total wealth and of the wealthiest 1 percent. More than half of the richest 1 percent of US households are entrepreneurs. One influential study of the US found that while entrepreneurs comprised 7.6 percent of the population in 1989, they owned 33 percent of total wealth, and that 81 percent of those in the top 1 percent of wealth distribution were entrepreneurs. Other studies have found that the median wealth of households owning a business is three times higher than those not owning a business (for references and a discussion of these studies see the WIDER Research Paper on Entrepreneurship and Economic Development.

Becoming an entrepreneur is the route many households take to achieve significant personal wealth, even though in practice average rates of return on entrepreneurship may be slightly lower than the average return from choosing wage employment. Being an entrepreneur allows households to 'play the lottery'. Shorrocks (see further reading) proposed a model in which individuals/households are willing to earn less through entrepreneurship than they would have in wage employment because being self-employed allows them to gain experience and improve their entrepreneurial ability with a view to being able to eventually 'search for large prizes' and become very wealthy, as many households in entrepreneurship indeed do.

To the extent that the financial crisis has a differential impact on the ability of households to become entrepreneurial, either across countries or within different levels of income within countries, it will have an impact on the distribution of wealth.

The Financial Crisis and Entrepreneurship

There are three major channels through which the financial crisis will impact on the decision of households to become entrepreneurs. All of these will have implications for the distribution of wealth in years to come, especially to the extent to which it will have a disproportionate impact on middle and poorer income households.

A first channel is through reduced opportunities due to slower economic growth. Economic growth throughout the world has declined, and the US and many EU economies are now in recession. In such conditions, one normally sees a larger number of firm failures, and fewer new start-ups, so that the rate of entrepreneurship declines. But the overall impact on self-employment is likely to be a priori ambiguous. This is because an economic downturn also reduces the opportunity costs to entrepreneurs, and may reduce levels of competition in an industry, easing access. Also, some entrepreneurs may hold on to their firms instead of selling, as they would not get their desired price in the current economic climate. Furthermore, the impact of slower economic growth on entrepreneurship may depend on how a particular country supports entrepreneurship, i.e. how easy it is to do business, and how countries support entrepreneurship through for instance education, low cost loans, tax breaks etc. In countries where it is easy and cheap to register a firm and where entrepreneurial ability is relatively widespread due to education and skills development, a downturn may very well make entrepreneurial ventures by highly talented households the more attractive option—and may give those countries better odds in accumulating new wealth.

A second impact of the financial crisis on entrepreneurship is through reduced government spending on education and social security. While many countries are implementing fiscal stimulus plans (e.g. the US, some EU countries, China and India) not all countries are in a position to follow suit. Many developing and Eastern European 'transition' countries do not have much leeway for fiscal expansion and may in fact have to reduce their budget deficits. Consequently, spending on education and social security may be reduced. How this will affect entrepreneurship in the future is not a priori clear. Both education and social security have ambiguous effects on entrepreneurship. Education may raise the wage rate that an individual can earn in formal employment, but it may also improve entrepreneurial ability. Similarly, social security may lower the risk involved in being an entrepreneur (by providing a fallback option), but by raising its opportunity costs it may also lower the rate of entrepreneurship. However, in the present financial crisis, which has also led to a reduction in economic growth and formal employment opportunities, it may very be the case that in countries where spending on education can be maintained, more households with higher entrepreneurial ability become entrepreneurs—instead of taking wage employment. Given that entrepreneurial ability is positively related to entrepreneurial success and firm size, this may suggest widening wealth inequalities between countries that differ in their levels of entrepreneurial ability and expertise.

The third impact is on tightening liquidity constraints on the creation of new businesses and the running of existing businesses. At present, these liquidity constraints arise from two sources. One is through reductions in the value of household wealth, both financial wealth and real estate.  Another is through reduced bank lending, as banks de-leverage and attempt to improve their balance sheet positions. Both of these will result in existing and potential entrepreneurs finding it more difficult to obtain access to capital to start and run a firm. In such cases, existing and available household wealth and ability to save may well determine the decision to enter into entrepreneurship, and consequently for the distribution of wealth. We discuss the role of personal wealth and liquidity constraints in the next section.

Liquidity Constraints and the Distribution of Wealth

Liquidity constraints play an important role in a household’s decision to enter into entrepreneurship. They prevent some households from starting a business and lead to the operation of some businesses at lower levels of capital than is economically efficient. Higher levels of wealth help a household alleviate liquidity constraints, as households can either use savings to finance their business or use personal assets as collateral for loans.

The practical significance of liquidity constraints is reflected in the fact that a substantial fraction of borrowing by self-employed business owners is collateralized by personal assets. A study in the USA found that 29 percent of entrepreneurs used personal assets, in particular real estate, as collateral for loans to start up a new business. A UK study found that increases in the value of net housing equity led to a significant increase in the rate of small business formation. Studies have also found that receiving an inheritance increases the probability of a household operating a business and increases the value of sales.

This evidence suggests that the current financial crisis is likely to make it more difficult for existing or latent entrepreneurs to use their real estate holdings as collateral for loans to finance a business. To the extent that this constraint is likely to be more binding for lower and middle income households who relied heavily on using their real estate as collateral, the current crisis is likely to widen future wealth inequality by making it harder for low wealth, poorer and middle income households to become entrepreneurs. This effect is likely to be especially significant if the financial crisis leads to a disproportionately larger and more protracted decline in the value of real estate relative to financial assets since real estate comprises a much larger fraction of the assets of (low wealth) lower and middle income households. In this case, one would expect that this would tend to increased wealth inequality over the next few years, as some households would be unable to raise sufficient funds to open a business, or be forced to operate a smaller business than desired.

A potentially offsetting force is the impact on wealth inequality within the group of active entrepreneurs. There is considerable evidence that not all households are identical with respect to 'entrepreneurial ability'. Tighter borrowing constraints are likely to lead to high ability but low wealth entrepreneurs running smaller business than they otherwise would. However, the impact of tighter borrowing limits on high ability high wealth households (who need less outside financing) or lower ability low wealth households (who need less outside financing since they run smaller businesses) is likely to be much smaller. This differential impact may lead to lower wealth inequality by making it more difficult for high ability but low wealth entrepreneurs to accumulate very large fortunes by reducing the size of firms they operate. In other words, talented entrepreneurs who would have become extraordinarily wealthy under circumstances of fewer liquidity constraints, will now be less successful.

Finally, we should note that in many developing countries entrepreneurs have long been constrained by a lack of well defined property rights/land titling which limits their ability to use their real estate assets as collateral for loans. As Hernando De Soto has pointed out, this lack of effective land title in developing countries means that the assets of poor and middle class households are 'dead' capital. As a result, declines in land values in developing countries may not have a large effect on entrepreneurs' ability to borrow. If this turns out to be true (and there is not a banking crisis in emerging markets), then it may lead to a small decrease in wealth inequalities between countries, to the extent that it is entrepreneurs in advanced countries that are more disproportionately impacted. The role of land titling and property rights in wealth distribution is discussed further in Chapter 16 of the UNU-WIDER Study Personal Wealth from a Global Perspective.

Concluding remarks

At the time of the outbreak of the current financial crisis in 2007/2008 the global distribution of wealth was already extremely unequal. It remains to be seen what the impact of the crisis will be—whether the outcome in a few years' time would be less or greater inequality. What we have argued in this article is that the outcome may depend on how the crisis impacts on the choice of households to enter into entrepreneurship as an occupational choice, instead of wage employment or unemployment. This choice depends on a large number of factors, which will differ from country to country, and as such make predictions difficult.

The crisis may turn out to increase inequality in the global distribution of wealth. To minimise the risk of this outcome, developing countries may consider improving measures to build and strengthen their stock of entrepreneurial ability and lessen liquidity and start-up constraints on business formation. Targeting low wealth, low income segments of society may be important (see for instance Ayal Kihmi’s WIDER Research Paper on Entrepreneurship and Income Inequality in Southern Ethiopia). Promoting property rights/land titling and the use thereof to access loans may also be important. In advanced economies, steps to increase the value of assets held predominantly by the middle class, such as real estate, and the rollout of social security, may contain further inequalities in wealth.

WIDER Angle newsletter, March 2009

ISSN 1238-9544