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Start-ups and early-stage firms employ many people, innovate, and often grow rapidly. In the current recession, however, the increase in entrepreneurial activity doesn't necessarily mean good news about the state of the economy.
The Kauffman Index of Entrepreneurial Activity (KIEA) measures the percentage of adults between the ages of 20 and 64 who start a business each month. A cursory look at the data suggests that entrepreneurial activity has faired well so far. The rate of business creation increased in 2008 to 0.32 percent from 0.30 percent in 2007. Put differently, about 320 out of 100,000 adults started a business in 2008. This translates to about 6.4 million businesses throughout the year. The increasing rate of business formation may seem encouraging, but a closer look reveals potential problems. Historically, an increase in the rate of business formation tends to be accompanied by an increase in the unemployment rate. This is probably because in good times jobs are plentiful and the attraction of starting one's own business is relatively small. During recessions, though, laid-off workers may find starting their own business more attractive than unemployment. The uptick in the KIEA may just reflect higher unemployment. The news may be grimmer still. The chart below shows that the increase in business formation from 2007 to 2008 is entirely because of increases in start-up activity for businesses that historically have had relatively low- and medium-income potential. These include such staples as barber shops and landscaping services. The rate of business formation for high-income-potential businesses such as legal services or software publishing actually decreased. Consistent with the decrease in the rate of formation of high-income potential businesses, start-up activity by college-educated people declined to 0.31 percent from 0.33 percent. 
The vertical axis is the number of new businesses started per 100,000 adults in the calendar year.
(Click to Enlarge.)
This suggests that the increase in business formation may result from necessity rather than opportunity. Recessions hit less skilled workers hardest, forcing many of them out of the workforce. Given his skill set, a laid-off construction worker might decide that his best job prospect is to start his own home repair business or lawn care service. Starting a software company might be better if he had the ability or training. But without the required skills, this option is a nonstarter. In contrast, a laid-off accountant might start a consulting firm. The accountant, though, is less likely to need to start a business because he is less likely to have been laid off in the first place. Unfortunately, the difference in the rate of formation of low-income and high-income potential suggests that the economy is generating new businesses out of necessity rather than opportunity.
Ramon P. DeGennaro is the CBA Professor of Banking and Finance at the University of Tennessee and an AIER Visiting Research Fellow.
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