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In praise of irrational optimism

The optimism bias is a great thing. Here in Oakham, the last few weeks have seen the opening of a guitar shop, record shop and ice cream parlour with a new wine bar on the way as well. The pandemic does not seem to have stopped new start-ups.

Sad to say, however, hard numbers show that the prospects for new businesses are grim. Official figures show that of the 350,000 businesses that started in 2014, only two-fifths survived for five years. And Michael Anyadike-Danes and Mark Hart at Aston Business School have found that 90 per cent of the firms started in 1998 died within 15 years.

Starting a new business is therefore a triumph of optimism over reality. But Oakham is a better place because of this. George Bernard Shaw was right: “all progress depends on the unreasonable man.”

As goes Oakham, so goes the whole economy. It needs people who can be optimistic despite the facts, or who are prone to wishful thinking or overconfidence. It is they who create new firms, new products and economic dynamism. Optimism isn’t just a private good – it is associated with better mental health for example – it also benefits the rest of us. “Optimistic individuals play a disproportionate role in shaping our lives” wrote Daniel Kahneman in Thinking, Fast and Slow. “They are the inventors, the entrepreneurs, the political and military leaders.”

But are there enough optimists? Yes, there are plenty of business start-ups. The ONS estimates that there were 390,000 of them in 2019 (the latest year for which they have data). That compares to less than 300,000 in the early 2000s.

On the other hand, though, other measures point to a decline in economic dynamism. Labour productivity has flat-lined since the financial crisis, and job-to-job flows even before the pandemic were lower than they were in the early 2000s.

Which suggests there’s a countervailing tendency to those optimists setting up new businesses. This was foretold by Joseph Schumpeter in his classic 1942 book Capitalism, Socialism and Democracy. He thought large businesses would come to be run by “rationalist and unheroic” bureaucrats who would supplant the romantic, buccaneering entrepreneur. Innovation would thus be driven not by dreams, but by dry calculation.

I suspect that this is one reason for what Harvard University’s Larry Summers calls secular stagnation. Large rationalist firms have learned that innovation often doesn’t pay – the Nobel laureate William Nordhaus has estimated that companies get only a “minuscule fraction” of the social benefits of it – and so are doing less of it.

We need, therefore, more irrational optimism.

Or do we? I’m writing this as the obituaries are published for Donald Rumsfeld, a man whose overconfidence led to a catastrophic war. That reminds us that irrational optimism has huge costs as well as benefits. And it’s not an isolated example. The 2008 financial crisis was also the result of over-optimism – such as banks generally being over-optimistic about being able to control risk, and Fred Goodwin being overconfident about RBS’s takeover of ABN Amro. 

People will always be irrational. The question is whether irrationality can be channelled into useful endeavour whilst being kept away from where it can be dangerous. The economic and political history of the 21st century does not offer us much hope here.