A Bad Investment
Policymakers may be well-intentioned, but most of their plans to create jobs in inner cities defy all business logic. There is a better way
Vibrant, expanding small businesses are desperately needed in low-income inner-city minority communities. Policymakers have latched onto enterprise and empowerment zones -- packages of geographically targeted development and tax incentives -- as the preferred tools to jump-start ghetto economies. The idea is that government resources can be leveraged by attracting private capital into depressed areas. Would you invest in an empowerment-zone small business?
First of all, consider trends in the ghetto marketplace. The ghetto's chief resource is its labor, and its best workers have been departing by way of the educational system and the high-wage economy to the economic mainstream, where rewards are greater and opportunities are wider.
Add to that a declining middle-class population, the rising inclination of ghetto residents to shop outside their community, and growing poverty. That is not an environment conducive to small-business creation and expansion. Nor have those trends encouraged financial institutions to reverse their long-standing aversion to lending in inner-city communities. Other complications include high crime rates, the limited availability and high cost of insurance, and the dilapidated physical plant that plagues many ghetto neighborhoods.
Although empowerment-zone incentives to investors have not been spelled out in detail by Washington, the historical record of ghetto-targeted business-development assistance provides insights into the likely strategies.
Traditionally, aid has taken the form of small loans to aspiring minority entrepreneurs. Loan programs, it is expected, will open up opportunities for creating new businesses and expanding existing ones. Yet the people government programs frequently target for loan assistance are people who lack the education, the skills, and the work experience needed to succeed. The result: the businesses falter, and the loans are never repaid.
Until recent years loan assistance was the primary type of aid provided to minority business enterprises. From the late 1960s to the mid-1980s the Economic Opportunity Loan (EOL) program, administered by the Small Business Administration, provided more loans to minority businesses than all other federal-government programs combined. The median loan size was less than $10,000, and loan recipients commonly ran small retail operations in inner-city minority communities. The default rate among borrowers starting new businesses exceeded 70%. Of those who were repaying their loans, many eventually closed down because of their inability to make a decent living running tiny businesses in the ghetto. The EOL program, its credibility destroyed by massive ineffectiveness, was terminated in 1984; yet its clones continue to be widespread in the 1990s at all levels of government and in the nonprofit sector as well. In the wake of the Rodney King riots of 1992, the SBA reestablished a modern variant of the EOL program so that ravaged urban areas such as south Los Angeles could once again receive federal loan dollars. Those funds were aimed, unfortunately, at businesses that didn't have the potential to generate the sort of economic development that was desperately needed.
The record of minority-enterprise assistance programs is largely one of failure. In the loan programs, for example, (1) lending is targeted to overcrowded, low-profitability lines of business with little economic-development potential, such as food stores, restaurants, and dry cleaners; (2) tiny loans flow to marginally viable businesses; and (3) consequently, high loan-default rates erode funds available for relending.
One leg of the empowerment-zone plan for assisting small-business creation and expansion is the Specialized Small Business Investment Co. (SSBIC). The SBA has committed itself to trying to establish an SSBIC in each empowerment zone. Those SSBICs are privately owned entities that operate with their own funds as well as with capital provided by the SBA. Before providing the required several million dollars in private-equity capital that would qualify a potential SSBIC for a license to operate (and to receive matching funds from the SBA), the prudent investor should consider the following: Of the nearly 300 SSBICs actively operating since 1976, 105 have been closed down for insolvency (in official lingo, "transferred to the SBA's Office of Liquidation") and 82 either had their operating licenses revoked by the SBA or voluntarily walked away from their licenses. Of the money actually invested in minority businesses by SSBICs in 1992, most went to small-scale retail and service businesses that do very little to create jobs or to alter the fundamental economic circumstances that undermine the ghetto economy.
Overall, the idea of business investment to reinvigorate enterprises in declining ghetto neighborhoods looks like a loser. Yet, paradoxically, minority business enterprises in the nation's large metropolitan areas have been growing rapidly in size and number over the past decade. Those with the best performance and prospects, however, are increasingly situated outside poor ghetto communities, and their markets are not minority households. Those companies, nonetheless, hire a predominantly minority workforce. (See "A New Kind of Business," July 1994, [Article link].) In other words, those successful, growing minority companies are creating jobs for the people who live in the ghetto neighborhoods.
Minority business enterprises potentially can create several million jobs in urban America over the next decade, but empowerment-zone attempts to lure dynamic minority businesses into poor ghetto communities are misguided and are not likely to succeed. After three decades it's clear that targeting aid to poorly qualified entrepreneurs operating in geographic areas where conditions are conducive to business failure doesn't work. To the extent that empowerment zones cling to such strategies, they, too, will generate no small-business development.
Certain existing state and local programs do offer models for turning minority businesses into a genuine engine of economic development. Maryland's Small Business Development Financing Authority generates substantial minority-business development and job creation at minimal cost to taxpayers. Its lending efforts succeed because (1) they are guided by a specific economic-development rationale: targeted loan recipients are to increase the number of jobs created and retained and generate additional tax revenues for the state of Maryland; (2) loans are made to businesses in high-growth industries that have substantial job-creation potential; (3) large loans -- nearly $200,000 on average -- flow to healthy, growing businesses; and (4) loan-default rates are low, thus preserving funds so they may be lent again to other minority businesses.
Programs seeking to create strong companies capable of generating jobs for underemployed ghetto residents must focus on entrepreneurs who possess the resources for successfully building small businesses. Most of those entrepreneurs would be highly educated and would have above-average incomes; rarely would they locate their business ventures in the poorest, most deprived ghetto areas, though they would draw workers from those areas.
When assistance is given to those entrepreneurs, one objection invariably arises: "Why help those who are already successful?" The response is straightforward: healthy businesses help economic development and create jobs. Their profits also support investments that permit future expansion and job creation. The thought of helping upper-middle-class minorities establish businesses outside poor areas is simply too much for those who design and implement most such programs; they prefer to aid failure-prone minority businesses operating in the bleakest inner-city communities -- in other words, businesses possessing the least economic-development potential. The result is predictable: high levels of business failure, with little or no economic development. Empowerment-zone programs that embody the practices of past ghetto business-development efforts will fail because they have been designed to fail. It's necessary to make a clean break with the dogmatism of the past to unleash the entrepreneurial talent that's waiting to turn the minority business community into an economic-development powerhouse for urban America.* * *
Timothy Bates, professor of labor and urban studies at Wayne State University, in Detroit, has done research using new U.S. Census Bureau small-business data to analyze minority-owned businesses. He is currently studying the capital needs of the minority business community for the Small Business Administration and is a consultant to the Housing and Community Affairs Division of the General Accounting Office.