The aggregate costs of uninsurable business risk
Summary
Focus
We investigate the macroeconomic costs associated with private businesses being unable to insure against sharp fluctuations in their profits. We use firm-level financial data from the Orbis database to show that firms experience large, unexpected and temporary swings in output that are not accompanied by changes in production inputs, like the wage bill. This means their labour costs don't fall quickly enough when output suddenly drops. We interpret this evidence using an economic model of entrepreneurial dynamics that incorporates both uninsurable risk and limits on borrowing.
Contribution
Limited access to credit has often been thought of as the main factor preventing private businesses from expanding. We offer an opposing view. We argue that the distortionary costs of needing to self-insure against business risk are far greater than those caused by credit constraints for privately owned firms. Entrepreneurs facing high, undiversified business risk will choose to operate at a smaller, less efficient scale to limit their exposure to bad outcomes. Our work highlights entrepreneurial risk as the central problem for overall economic efficiency.
Findings
We find that the total losses to the economy from uninsurable risk and limits on borrowing are substantial: output would be 15.8% higher if they were eliminated. Crucially, almost all of this loss is driven by uninsurable business risk, which accounts for a 15.4% loss in output. In sharp contrast, the direct effect of credit constraints accounts for only a 0.4% loss. This large difference is due to a key insight: the presence of risk causes entrepreneurs to accumulate wealth for safety, allowing them to largely self-finance their operations. As a result, the borrowing constraints rarely bind. We conclude that policies designed to help businesses manage risk are likely to be much more effective than those focused on simply easing credit.
Abstract
We use firm-level data to document that private businesses experience large fluctuations in their profit shares. These are due to large, fat-tailed and transitory changes in output that are not fully accompanied by changes in their inputs. We interpret this evidence using a model of entrepreneurial dynamics. Because firms can limit their exposure to risk by operating at a smaller scale, our model predicts large macroeconomic losses from uninsurable business risk, much larger than those stemming from credit constraints. While self-financing allows entrepreneurs to quickly overcome credit constraints, even wealthy entrepreneurs remain considerably exposed to risk.
JEL classification: E2, E44, G32
Keywords: entrepreneurship, risk, credit constraints, misallocation
