Despite the dot-com debacle, the Government is bullish about new businesses and
keen to channel finance towards them. But according to Professor David de Meza of
Bristol University, such policies may be misguided. Writing in the latest Economic
Journal, he identifies reasons why, despite some appearances to the contrary, there
may already be excessive funding. The key ingredients that lead to this outcome are
the unfounded optimism of entrepreneurs and the ignorance of outside investors.
De Meza describes what tends to happen as follows. Since financiers find it difficult to
identify the worthwhile start-ups, funds may not be available on terms that are
appropriate to the average business. So it is too easy for entrepreneurs who know they
have relatively poor prospects to get funding. This occurred in extreme form during the
South Sea Bubble when The London Journal of 1720 reported the attitude of investors
as ‘For God’s sake, let us subscribe to something; we don’t care what it is’. There is an
uncanny parallel with recent events.
What compounds the problem is that, in line with much psychological evidence, most
people overestimate the chance of success. The bias is especially true of
entrepreneurs. Comparing people’s financial forecasts with the outcome, the selfemployed
are even more over-optimistic than those in paid employment. Among the
self-employed, 4.6 times as many expect to be better off but end up worse off than are
pleasantly surprised to find themselves better off after forecasting a decline. For
employees the ratio is 2.9. Were expectations rational, both ratios would be 1:1.
People’s propensity to look on the bright side may help explain the high failure rates of
new businesses; over a third disappear within three years. Interestingly, women, the
old, and graduates are less prone to over-optimism, so these groups may be less likely
to lose money when starting businesses.
At first sight, unrealistic optimism plus the limited information of financiers boosts the
number of new businesses being formed. This is not necessarily so. The number of
over-optimists may be so great as to lead to such a deterioration of quality that lenders
may find lending to some groups unprofitable at any interest rate.
Policy-makers may perceive this as a ‘funding gap’, justifying subsidies and other help
to the disadvantaged groups. From an efficiency viewpoint, this would be a mistaken
inference for such ‘redlined’ groups will go on to perform badly on average. This is
confirmed by the poor performance of the UK loan guarantee scheme when collateral
requirements were set at low levels.
Does all this mean that the government should actually discourage people from setting
up businesses? Evidence from the United States does suggest that, on average,
starting a small business lowers people’s income relative to remaining in paid
employment. The difference is so great as to be difficult to reconcile with risk loving, the
presence of undeclared income, or the non-pecuniary benefit of being one’s own boss.
Other research finds that many independent inventors who receive external
assessments that their discoveries are not commercially viable nevertheless proceed to
develop them. The average return is massively negative.
For policy, the vital question is: when the costs of setting up in business - including the
cost of capital - go up, does it tend to be the worst prospects that stay out of the
market? There is evidence to this effect, though more research is certainly called for. In
the meantime, rather than a policy U-turn, it seems best simply to let the market take its
course.
ENDS
Notes for Editors: ‘Overlending?’ by David de Meza is published in the February 2002
issue of the Economic Journal. De Meza is Leverhulme Professor of Industrial
Organisation at Bristol University.
For Further Information: contact David de Meza on 0117-928-8424 (email: d.demeza@
bristol.ac.uk); or RES Media Consultant Romesh Vaitilingam on 0117-983-9770
or 07768-661095 (email: romesh@compuserve.com).