Joseph Schumpeter is probably the most underrated economist of the 20th century. Schumpeter felt that to understand the economy, it was not enough to only be a good economist. He felt that you also needed to understand history, politics, psychology, sociology, and other factors which drive the economy. This is a point that I agree with. The macroeconomy is complex — with everything affecting everything — and you need to consider a lot to understand it. The risks of this to become a dilettante — knowing only a bit of everything. Schumpeter got around this by working very hard and being very well read. In many ways, Schumpeter’s disruptive life — which included losing his family and having his country destroyed in WW1 — would be mirrored in his economic theory.
Schumpeter elaborated on his theory of economic growth in two books: “The Theory of Economic Development” published in 1911 and “Capitalism, Socialism and Democracy” published in 1949. There is also an extensive biography by Thomas McCraw called “Prophet of Innovation”. At the core of Schumpeter’s view is to praise the role of the entrepreneur in driving innovation and economic growth.
Circular flow view of economic output
In the “Theory of Economic Development”, Schumpeter provides a starting point for understanding the economy. Something common in introductory economic courses is to represent the economy using the circular flow — which shows how consumers and firms interact with the factors of production and markets.
The problem with using the circular flow is that it represents a static economy that is “essentially the same year after year”. Schumpeter compares it to the circulation of blood in an animal organism — there is a flow of blood, but the overall amount is not increasing.
Creative Destruction
To drive economic growth is to disrupt this circular flow. Schumpeter saw this role being filled by entrepreneurs — obsessive individuals who create innovative companies that would then destroy the old. Schumpeter listed the factors that drive the obsessive entrepreneur:
“First of all, there is a dream and the will to found a private kingdom, usually, though not necessarily, also a dynasty..
Then there is the will to conquer: the impulse to fight, to prove oneself superior to others, to succeed for the sake, not of the fruits of success, but of success itself…
Finally, there is the joy of creating, of getting things done, or simply of exercising one’s energy and ingenuity” (Theory of Economic Development p.93)
Schumpeter was clear about what he meant by innovation, defining it as “new combinations” of existing or new materials and could be achieved in five ways:
A new product being created, or an existing product being improved in quality.
A new “method of production”, such as an assembly plant.
New markets opening up or being created that were previously closed.
A new supply of materials obtained.
And new ways of organising.
In the book “Capitalism, Socialism and Democracy”, Schumpeter describes this process as “creative destruction”. Creative destruction is at the core of capitalism, — which should not be seen as a stationary system, but an inherently unstable one. Schumpeter understood capitalism as an evolutionary process of constant change, which was driven by disruptive innovations by the entrepreneur. It was these “new combinations” of employment — and not increases in savings or labour — that have driven economic growth. These changes involved new ways of doing things, which would then replace the old.
This is how McCraw describes creative destruction:
“Creative destruction constantly sweeps out the old products, old enterprises, and old organizational forms, replacing them with new ones” (Prophet of Innovation p.352)
This instability results in many losers, including the incumbents. Incumbents tend to not like this relentless competition and prefer to “enjoy themselves and live a better-rounded life”. This process affects individuals, families and entire towns that struggle to keep up. It creates short term inequality and is the price that is paid for economic growth led by innovation.
Role of credit
The role of an entrepreneur differs from that of an owner of capital. The entrepreneur and the capitalist are two distinct groups. Schumpeter joked that “it is not the owner of stage-coaches who builds railways”. As the entrepreneur often does not initially have the capital to start and grow a business, resources are instead provided by the capitalist who also takes on the financial risks. As the entrepreneur usually does not invent new products, they are perceived not as an inventor or risk taker but rather as an innovator and executor who utilizes existing inventions.
The entrepreneur rarely creates inventions; thus, the entrepreneur is not seen as the inventor or risk taker but as the doer and innovator who makes use of existing inventions.
Financing of entrepreneurs also comes from the creation of new money:
“Innovations, both logically and historically, must be financed by turning to a source of credit above and beyond the circular flow, namely, the commercial bank, the only private financial institution in the capitalist economy with the unique power to create new money, new purchasing power above current saving out of current income.” (Theory of Economic Development p.18)
Banks need to be solvent, hence lending needs to be combined with some sort of saving. Therefore, accumulated capital plays a role in funding entrepreneurs, through supporting bank lending or direct financing of new ventures, often entailing financial speculation.
Business Cycles
The effect of new combinations or innovations by entrepreneurs did not have a constant effect on the macroeconomy, instead the effect occurred in cycles. Schumpeter wrote an enormous book on this topic called “Business Cycles”.
Initially innovations lead to large profits for the innovative entrepreneur. The entrepreneur would try to preserve these high profits with patents, advertising, or further innovation. However, it is likely that these profits would result in imitators replicating these innovations and driving investment to this new way of doing things.
“The appearance of one or a few entrepreneurs facilitates the appearance of others, and these the appearance of more, in ever-increasing numbers.” (Theory of Economic Development p.251)
Thus, entrepreneurs appear together like “swarm-like clusters”. Innovations in one field might also drive innovations in other fields.
“So far I should only have to add one thing, that capital investment is not distributed evenly in time but appears en masse at intervals” (Theory of Economic Development p.240).
This swarm of investment would then drive economic growth, the increased competition following innovations would result in a sequence of cutting prices and increasing the real incomes of consumers. Over time, the original entrepreneur’s profit advantage is eliminated, and investment moves elsewhere and overall profits and investment in this new way of doing things declines. This boom and decline in investments results in cycles. Schumpeter focuses on three cycles:
the very long waves of 50 years (Kondratiev wave)
long waves of 10 years (Jugler cycle)
and shorts waves of 40 months (Kitchin cycle)
Later on in his life, Schumpeter would see innovations being driven not only by the individual entrepreneur, but also innovations by large corporations. The rapid growth of the railroad in the US and UK in the 1800s was an example of innovations led by corporations:
“Railroads had brought about an entirely new level of financing, particularly through stocks and bonds. In America, the movement gave birth to the modern wall street during the 1850s” (Prophet of Innovation p.263)
Schumpeter also studied the history of business in his “Business Cycles” book. His conclusion was that in the long run — except for a government sponsored monopoly — all businesses ultimately fail, replaced by those that are newer and more innovative.
Conclusion
Overall Schumpeter strongly believed that it was the act of doing new things that drove economic growth. This was driven by a certain personality type living in a capitalistic market economy — one that ensured private property, the rule of law and provided ample capital and credit for forward looking entrepreneurs.
According to Langroodi:
“The central theme of the Schumpeterian theory of economic development lies in the breaking up of the circular flow with innovation in the form of a new product by an entrepreneur raising the level of investment in the economy.”
These entrepreneurs would drive a process of creative destruction, replacing old products with cheaper and higher quality new ones, and increasing the standard of living of consumers.
Really enjoyed this piece Lyle. Great work!