Immunising entrepreneurs from the market won’t plug the funding gap

VINCE Cable’s business bank intends to invest £1bn in small to medium-sized enterprises. In 2011, Project Merlin sought to facilitate a further £76bn in loans. But with all the talk of national investment banks, it is important to consider some economic semantics. There seems an almost universal acceptance that entrepreneurs are being starved of credit, and that this is damaging growth. But policies that aim to improve “access to finance” are hardly new.

Surveys routinely suggest that entrepreneurs believe there is a lack of credit. This is like musicians saying that there is a lack of record deals. If you talk to investors you will hear them complain about a skills shortage, or lack of profitable ventures. The truth must lie somewhere in between.

One of the problems is that “access to finance” is routinely viewed as a barrier to entrepreneurship. But it isn’t. It’s a cost. And the difference between a barrier and a cost is whether it is part of the market process. Costs of entry are part and parcel of economic reality – they reflect resource scarcity. They are a market test that prevents resources from being wasted. They help us determine whether or not a venture is indeed “profitable”. Barriers to entry, however, are a constraint on economic activity. They can prevent useful enterprises from emerging.

Things like occupational licensing and patents are examples of genuine barriers to entry. But note that they have to be conveyed by the state. In contrast, economies of scale, product differentiation or advertising are not barriers to entry at all, they are just costs of doing business. In many cases, they reflect costs that have already been incurred. As US economists Gerald O’Driscoll and Mario Rizzo said, “if potential entrants cannot afford to incur the full costs of competing, then this merely indicates that entry is not profitable and ought not to occur”. That is how markets are supposed to function.

Attempts to immunise entrepreneurs from the costs of raising finance ignore the economic reality. In the UK, Regional Development Agencies have spent over £15bn since 1999, with little discernable impact on employment, and competitive or regional imbalances. When the government attempts to “plug the gap” of SME finance, it distorts market information and entices marginal entrepreneurs into embarking on ventures that the market does not really support.

At the very least, publicly-funded schemes should recognize that they rest on an assumption that the market is passing up profit opportunities. They rely on a theory of market failure. This is possible – markets do fail. But it carries with it an easy test. Any public money that aims to correct market failures should generate above market returns. Let us see how these investment schemes fare with fully transparent accounts.

Anthony J Evans is associate professor of economics at ESCP Europe Business School. Web: www.anthonyjevans.com, Twitter: @anthonyjevans