Why/How

Growth spurts depend on people who don’t know how bad their odds of success are.

Some people hit on something, and it resonates.

Came across 2001 New York Times article by Virginia Postrel, “A vital economy suffers fools gladly” (September 6, 2001). News article about an academic article by Dr. John V.C. Nye, published ten years earlier, in 1991: “Lucky Fools and Cautious Businessmen: On Entrepreneurship and the Measurement Entrepreneurial Failure“, published in a collection of essays in a “Research in Economic History” series: The Vital One: Essays in Honour of Jonathan R.T. Hughes, edited by Dr. Joel Mokyr. People trying to make sense of economic history. And where, when some people hit on something, it resonates.

Basic ideas of Nye from 1991, discussed by Postrel in 2001:

The traditional view, articulated by the economist Joseph Schumpeter, sees entrepreneurs as brilliant calculators who take rational risks that other people are afraid to try. Some risks don’t pay off, but enough do to cancel the losses.

The problem for economic historians is to explain why some countries, like Victorian Britain, seem to lose their edge, even though their financial markets work as well as those elsewhere and their entrepreneurs continue to take rational risks. Historians who have delved into the evidence have found no reason to believe that Victorian businessmen failed to invest wisely. Yet Britain’s economy fell behind those of the United States and Germany.

Professor Nye, of Washington University in St. Louis, offered an explanation. Suppose we think of “the entrepreneur as the valiant, but overoptimistic investor rather than the heroic seer,” he wrote. In this story, entrepreneurs miscalculate their odds of success. They start more businesses than they should, but those mistakes lead to social benefits.

It’s easy to see how people might overestimate their chances. William H. Gates and Thomas Edison become famous. We all know about the entrepreneurs who hit the jackpot. The losers are more scattered and less well known, though far more numerous.

If the few big wins cancel out the many losses, starting a business would be a risky, but rational, bet — the sort of investment a “cautious businessman” might make. But Professor Nye argued that the wins and the losses probably don’t cancel out. Even the biggest winners don’t make enough money personally to cover the losses of all the individuals who went into businesses that failed.

The big winners are usually people who, based on rational calculations, shouldn’t have bet their time, money and ideas. They overestimated their chances of striking it rich. But they were lucky and beat the odds.

Even more important, the lucky fools create huge spillover benefits for society: new sources of wealth, new jobs, new industries offering less- risky opportunities, new technologies that improve life. Entrepreneurship does generate net gains, but most of those gains don’t go to the risk- takers. The gains are spread out to the rest of us. Capitalism, in this view, works by exploiting the capitalists themselves.

“We depend upon people continuing to open up new businesses for the success of industry and of the economy and for our health and well-being,” Professor Nye said in an interview. “But on the whole it probably doesn’t make sense for the average person to open up a business. Hence, the lucky-fools phenomenon.”

Entrepreneurship is not, in this view, a sort of rational risk calculation. It is, as critics of capitalism sometimes say, a bit like gambling. But society plays something like the role of the house, gaining from the process.

“It’s like having a Powerball lottery where you say nobody should really play Powerball,” because the odds of winning are so bad, Professor Nye said. “But if nobody plays Powerball, we won’t be better off.”

And while the social benefits of real-life lotteries don’t justify the risk, he said, the metaphor does hold “true for things like technological innovation.”

Foolish optimism solves a basic economic problem. Usually when there’s some sort of positive spillover effect — say, the social benefits of education — economists suggest that the government subsidize the activity.

But this policy won’t work for entrepreneurship because there’s no way the government can guess any better than private individuals which businesses to subsidize. If anything, interest- group politics will tend to make the government somewhat worse at picking good targets.

Instead, Professor Nye said, “a dynamic society simply creates more people willing to take these chances.” They risk their own resources, rather than the public’s, but on those rare occasions when they succeed — and even sometimes when they don’t — the public enjoys spillover benefits.

Most economic activity isn’t like gambling, of course. For most businesses, the odds are reasonably well known, and the procedures are rational. Cautious businessmen can thrive. But they won’t produce a lot of innovation. And if they drive out the crazy innovators, the economy will stagnate.

The lucky-fools theory suggests, then, that Victorian Britain’s economy was successful but stagnant not because investors were irrationally afraid of risks but because they were all too mature and calculating. They didn’t tolerate the foolish chances that a vital economy requires.

Growth spurts depend on people who don’t know how bad their odds of success are. Sometimes those people are too young to know better, and sometimes they’re doing new things for which the odds simply aren’t known…

Nye is still very active. As is Mokyr, who seems to have started things a quarter of a century ago, when interested in honouring Dr. Jonathan R.T. Hughes. Hughes, the former Chair of the Department of Economics at Northwestern University, died of cancer in 1992, at the age of 64. within a year after the collection honoring him was published.

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About brucelarochelle

Practising Lawyer and Part-Time University Instructor (Accounting, Commercial Law, Organizational Behaviour); Part-Time Federal Tribunal Member. Non-practising Chartered Professional Accountant (Chartered Accountant and Certified Management Accountant).
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