I have been away this week, as my dear mother passed away and I have been in Britain for her funeral. Here, therefore is a classic column, from April 24, 2006, that has survived the test of time quite well, I think.

Entrepreneurship is popularly held to be the principal reason for the success of the U.S. economy, when contrasted with the failures of “Old Europe.” Yet if, as discussed here last week, U.S. productivity is increasing no faster than that in Europe, some seeds of doubt must be sown. Is there such a thing as too much entrepreneurship?

According to the U.S. business media, the virtues of entrepreneurship are unquestionable. Larry Page and Sergey Brin, the founders of Google, are lionized as if they had found a cure for cancer or single-handedly destroyed the Soviet Union, when in fact all they have done is built a marginally better Internet search engine. Conversely, the management of General Motors, the epitome of the non-entrepreneurial company, is vilified daily as bumbling incompetents, symbols of failed bureaucratic “Old Europe” style business methods to be swept away from the ever-innovating U.S. business culture.

There’s just one problem: there is no evidence that, with a very few exceptions (Steve Jobs, maybe Bill Gates) entrepreneurs have any capability that is not also possessed by General Motors management. Even though the best entrepreneurs may be towards the top of the managerial ability “bell curve” that is also generally true of those who rise to the top in major corporations. Conversely the spectacular flameouts and corruptions of the dot-com bubble confirm that by no means all entrepreneurs can be assumed to be managerially competent, or even honest.

An example. When I was in business school in 1971-73, two of my American-born classmates were notably similar in looks, style and background. Both were intelligent, but lacking in appreciation of the nuances of life; their identical porn-star moustaches would bristle in aggression when others questioned their wisdom, and the more sensitive and sophisticated among their classmates tended to treat them with considerable caution. Both were above average students, but nowhere near the top of the class and neither would have been picked on any “most likely to succeed” list.

One of them joined General Motors, had an honorable if unspectacular career in that company’s upper/middle management, and is entirely unknown to the outside world, although collectively held by the media to be responsible for GM’s failings.

The other went into retailing, convinced venture capitalists to back him in the middle 1980s, founded what became a major retail chain, went public and now has a net worth of approximately $7 billion.

There’s only one conclusion to be drawn: dumb luck will beat you every time!

If we de-mythologize successful entrepreneurs, and accept that, beyond minimum standards of intelligence and knowledge, they are just like the rest of us, but lucky, then there is no a priori reason why a society with a high level of entrepreneurship should be more successful than any other. Entrepreneurship does not allow otherwise-suppressed extraordinary talents to blossom; it simply rewards a random selection of perfectly ordinary talents with huge amounts of money. There is no reason to believe that a society which does this will be any more successful than one which doesn’t.

100 years ago, entrepreneurs took special risks; they invested their own savings in doubtful new ventures and suffered severely in both fortune and reputation if the new ventures didn’t work. Today, with the venture capital sector so active, that is no longer the case; the only front-end investment made by most entrepreneurs, particularly in the tech sector, is the time to write a business plan, and a little networking among the major venture capitalists. If Google goes bust in the next downturn, Brin and Page will remain extremely wealthy, assuming they have cashed in even a modest portion of their stock options. The losers will be their employees, whose stock options will become worthless before they’ve had time to cash them, and who will be thrown back on the job market with the stigma of corporate failure attached to their resumes. Ask anyone who used to work for Enron!

If entrepreneurs bring no special talents to the table, it still doesn’t follow that we have too many of them – the U.S. economy might act perfectly, steering only the appropriate number of people into entrepreneurship, while less entrepreneurial economies such as France, Germany and Japan are held back by the artificial barriers against entrepreneurship inherent in their systems.

However, when examined closely, the choice of entrepreneurship is not carried out on an entirely rational basis. There are three behavioral reasons, all attested by numerous studies, why this is so:

• People generally over-estimate their own abilities, and hence their ability to build a successful business. This is particularly the case for the kind of aggressive, self-confident people who are attracted to entrepreneurship
• People generally over-estimate the probability of success for a new venture on which they are embarking, whether a business, sports team or other activity. Hence the potential entrepreneur will overestimate a new business’s chances of success, and underestimate the difficulties facing it (this is why business plans are almost always over-optimistic.)
• Very large sums of money with a low probability of attainment have a lure far exceeding their expected value. Thus millions of people will wager $10 on a lottery ticket with a 1 in 10 million chance of winning (say) $50 million, even though the expected monetary value of that ticket is only $5. In the entrepreneurial field, every Google and Microsoft spawns a huge number of wannabes. This is true for venture capital funded investors as well as for entrepreneurs themselves; thus in 1984 the venture capital industry funded over 80 makers of 3½ inch disk drives, each with a projected 10 percent of the world market. Far more capital is attracted to temporarily fashionable sectors than their economic position would justify.

Against these incentives to excessive entrepreneurship must be balanced the restrictions on entrepreneurship imposed by government, society and the financial system. Fifty years ago the U.S. tax system was steeply progressive and heavily biased against capital gains, there were few sources of finance available for new businesses, and business failure was regarded as a social disgrace that would prevent the ex-entrepreneur from getting a good job.

All these factors have now been reversed. Finance is readily available, indeed the young technological elite must find it very difficult to make it through their 20s WITHOUT founding a new venture, so insistent are the providers of venture capital. The tax system is biased towards capital gains and the award of stock options; until January of this year stock options could be awarded at effectively no cost to the awarding company, so lax were accounting standards. Social standards heavily favor entrepreneurship and even the unsuccessful entrepreneur (though not the employees of an unsuccessful entrepreneurial company) can easily re-enter the conventional workforce or better, raise a further round of finance for a new entrepreneurial venture.

Thus today there are few economic, political or social barriers against entrepreneurship. Given the behavioral biases discussed above it follows that in the United States, in the last decade when money has been cheap and easily available, there has been more entrepreneurship than would be produced in a purely rational free market economy.

France, Germany, Spain and Italy, with their heavy burdens of social costs and limited sources of entrepreneurial finance, may still have less entrepreneurship than a rational free market would produce. On the other hand it seems likely that China, like the United States, may also have too much entrepreneurship, partly because of the freedom from Party dictation that entrepreneurship brings. Only in the long run will we know what level of entrepreneurship was “optimal” but in the current era of cheap money it seems likely that Asian countries outside China and the reforming economies of central and east Europe may have it about right.

If and when money becomes tighter, then entrepreneurship will again become correspondingly more difficult, and the U.S. economy will once again move towards an optimal level of entrepreneurship. First, however, it will have to pay the onerous costs of the tsunami of excessive entrepreneurship that it has “enjoyed” in the cheap money period of 1996-2006, as follows:

• Increased inequality and social tension. Huge amounts of money have flowed to entrepreneurs in the last decade, and to their legal and financial advisors. In addition, top management of major corporations has demanded enormous increases in remuneration, claiming correctly that they have the same abilities as the entrepreneurs themselves. Meanwhile those employed in existing companies have found their job security and living standards attacked by over-aggressive, over-compensated management, while those employed by entrepreneurial companies have frequently found themselves unexpectedly jobless. Society’s risks have increased and its rewards have become more unequally distributed; this is imposing huge costs which are only beginning to be paid.
• Destruction of capital. The huge amounts of capital that have been invested in entrepreneurial companies, and in the McMansions built to house their management, lawyers and bankers, will prove to have been misallocated and to have produced losses rather than profits. As well as managers of private equity funds, the losses will extend to many innocent third parties, owners of pensions, insurance and other investments on which they had come to rely.
• Lower levels of trust in business dealings. Whereas stable businesses need to go on dealing with their counterparts and so establish long term relationships of trust with suppliers, bankers and customers, entrepreneurial businesses are motivated by quick profits, and hence tend to cut ethical corners. The collapse of the 1995-2000 entrepreneurs has already caused the institution of costly and counterproductive regulation in the form of the 2002 Sarbanes-Oxley Act. A final end to this period of cheap money entrepreneurship is likely to produce not only more regulation and higher taxation but a culture of suspicion and legalistic quibbling between business and its counterparts that will be extremely damaging to economic growth
• Instability and unemployment. The entrepreneurs themselves, at least the successful ones, are likely to walk away scot free from the failure of their businesses, unless the collapses are so egregious that they go to jail, but employees, suppliers and customers of those businesses will not be so lucky. Careers will be ruined, families broken up and many workers will be impoverished by prolonged unemployment.
• Excessive caution. The Las Vegas “get rich quick” mentality that has prevailed in the technology and financial services sectors since the middle 1990s will collapse under the weight of losses, bankruptcies and jail sentences, and will be replaced by a period of rigidity and caution, in which it will be very difficult to get financing for any new venture, and innovation will correspondingly slow.
• Low productivity. When the bubble businesses disappear, U.S. productivity will sharply decline — the businesses and housing that prove to be superfluous will no longer be contributing to the economy, and the disruption that entrepreneurship has caused will demonstrate its inefficiency. Consequently, relative costs will soar and the economy will enter a deep recession as price-cutting from overseas drives even stable businesses into bankruptcy. Fantasies that outsourcing can occur without removing U.S. jobs, and that illegal immigrants can be added to the workforce without driving down wages to Malthusian subsistence levels will be found to be just that — fantasies.
• Leftist political movements. As entrepreneurial businesses prove to be ephemeral, and the economy declines, entrepreneurship itself and business as a whole will come under political attack, with the low wage growth and job destruction since 2000 now seen as an inevitable consequence of excessive business turbulence that has benefited only the entrepreneurial and financial elite. As in the 1930s, anti-business sentiment will push policy much further than is economically rational, which will harshly affect both our freedoms and our economic welfare.

Next time around, let’s try to get the balance right. A moderate amount of entrepreneurship is essential in a free market economy, to produce innovation and put adequate competitive pressure on established companies. However excessive entrepreneurship, combined with a Las Vegas approach to business such as we have seen in the last decade, is damaging not only to the economy but to the fabric of society itself. Since behavioral factors irrationally favor entrepreneurship, the structures of business and society should moderately discourage it.

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(The Bear’s Lair is a weekly column that is intended to appear each Monday, an appropriately gloomy day of the week. Its rationale is that, in the long ’90s boom, the proportion of “sell” recommendations put out by Wall Street houses declined from 9 percent of all research reports to 1 percent and has only modestly rebounded since. Accordingly, investors have an excess of positive information and very little negative information. The column thus takes the ursine view of life and the market, in the hope that it may be usefully different from what investors see elsewhere.)
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