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Thursday, July 12th, 2007
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Prophet of Innovation: Joseph Schumpeter and Creative Destruction

by Thomas K. McCraw

Heavy Thinker

A review by Robert M. Solow

I knew Joseph Schumpeter only in the last five years of his life, from 1945 until his death in 1950, at the age of sixty-six. To say that I knew him is actually a bit of an exaggeration. First as a returning undergraduate and then as a doctoral student in economics at Harvard, I attended his courses on advanced economic theory and the history of economic thought. The theory lectures bordered on incoherent; they alluded to everything but analyzed nothing. He would say: "Of course you know about X or Y, so I do not have to go into detail." But we didn't know about X or Y, as he must have realized. The history lectures were also disappointing. I do not remember where they began, but at the end of the term they had barely reached Adam Smith. The course felt like a stage display of multilingual erudition.

More generally, Schumpeter seemed to be playing the role of grand seigneur, and he tended to flatter where flattery was not due, no doubt satirically. All this went along with his reputation as a casual and easy grader. We used to say that he threw the exam books up a staircase: the ones that stuck at the top got an A, the ones that fell to the bottom an A minus. I was surprised to learn that in Austrian universities he had the reputation of a stern taskmaster.

You would not gather any of this from Thomas K. McCraw's account of those last years. He records that Schumpeter was troubled by the slow course of his own work, and unhappy about his relations with his departmental colleagues; but he says that Schumpeter was enthusiastic about his teaching and successful at it. McCraw may have been misled because Schumpeter's style was always flamboyant, entertaining, and exotic, and many students enjoyed the spectacle. Maybe it is just as well to slide over Schumpeter's failings at the end. He was past his peak; and the economics profession was moving in a direction -- rigorous theory couched in mathematical terms -- that he had always professed to admire but simply could not practice himself. There is good evidence that earlier cohorts of Harvard students found a slightly younger Schumpeter inspiring and a force for high intellectual standards.

In 1940 Schumpeter seriously contemplated leaving Harvard to accept a financially equivalent and organizationally more attractive offer from Yale. His senior colleagues at Harvard -- some able, more of them drab -- sent him a letter urging him to stay; it said the right things, but was perhaps a little perfunctory. A much more urgent, heartfelt, and mind-felt letter was signed by twenty-six junior faculty and advanced graduate students. The authors included the flower not only of Harvard-trained economists of that time, but of the future of American economics. You have to admire the man who evoked those words from those people.

I wish I had known him then. It is to Schumpeter's eternal credit that, at a time when mediocrity often cottoned to mediocrity in Harvard economics, he stood always for intellectual quality and energy, regardless of ideology, ethnicity, or social position. McCraw makes this very clear, and understands its importance.

In recollecting Schumpeter, it is hard to tear oneself away from the exotic manner, the dubious politics, the carefully crafted image, the hidden self-doubts, the convoluted life story, the complicated relations to three wives and several non-wives. McCraw covers all these in great and often fascinating detail. He makes full use of Schumpeter's diaries, which is where we learn of his self-doubt; it certainly was not evident in his public manner. On some issues -- in his politics especially -- he tends to give Schumpeter the benefit of the doubt, though not foolishly or blindly. One could have been harsher about Schumpeter's belief that Franklin Roosevelt was aiming at dictatorship, even if there were respectable members of the Union League Club who agreed. Still, what really matters are Schumpeter's writings -- the books and a couple of essays; and that is where I have something to add. I do not fully agree with McCraw's judgments.

In my view -- and that of most contemporary economists, I believe -- Schumpeter's most original and most lastingly significant book was Theory of Economic Development, which appeared in 1911 (and was translated into English in 1934). It was at the University of Czernowitz, not far from the beginning of his career as an economist, that he worked out his conception of the entrepreneur, the maker of "new combinations," as the driving force and characteristic figure of the fits-and-starts evolution of the capitalist economy. He was explicit that, while technological innovation was in the long run the most important function of the entrepreneur, organizational innovation in governance, finance, and management was comparable in significance.

Innovation is not the same thing as invention. Anyone can invent a new product or a new technique of production. The entrepreneur is the one who first sees its economic viability, bucks the odds, fights or worms his way into the market, and eventually wins or loses. Each win means profit for the entrepreneur and his backers, and it also means a jog upward for the whole economy. In the course of this process, which cannot possibly run smoothly, many businesses, individuals, and institutions, themselves founded on earlier successful innovations, will be undermined and swept away. Schumpeter called this birth-and-death process "creative destruction," and realized before anyone else that it was the main source of economic growth. There is no feasible alternative for capitalism; this is capitalism. Here is a characteristically strong statement: "Without innovations, no entrepreneurs; without entrepreneurial achievement, no capitalist returns and no capitalist propulsion. The atmosphere of industrial revolutions -- of 'progress' -- is the only one in which capitalism can survive."

The picture generated by classical and neoclassical economics had none of this dynamism, turbulence, and intrinsic uncertainty. (Malthus was perhaps a partial exception.) Smooth trends and stationary states, equilibria of one kind or another, predominated. There is a sense in which Schumpeter could claim to have been the progenitor of a torrent of modern research that analyzes the dynamics of profit-driven innovation and innovation-driven economic growth. Even creative destruction has been translated into equations. (The pioneers were Philippe Aghion and Peter Howitt, and others have followed.)

Schumpeter derived from this analysis a lasting bias in favor of big business. "American opinion is so antibig business," he wrote, "precisely because big business has made the country what it is now and in doing so it has set the standard of the American soul: who is not a part of big business feels he does not meet the standard and by compensation turns against it." Clearly a successful innovation confers, in his view, at least a temporary monopoly. Without the lure of those monopoly profits, there would be no incentive for anyone to bear the risks of entrepreneurship. Schumpeter believed that large firms were both the source and the result of successful innovation; and so tampering with them would be dangerous. But the issue is more subtle than that. The English economist John Hicks once remarked that "the best of all monopoly profits is a quiet life," meaning that a seller with monopoly power might settle for less than the largest possible profit in order to avoid attracting rivals who would have to be beaten off amid turmoil and uncertainty. There is much evidence that having to compete with best practice is itself an important spur both to innovation and to other aspects of industrial performance. Maybe there is an optimal intensity of competition.

I think that this is Schumpeter's main legacy to economics: the role of technological and organizational innovation in driving and shaping the growth trajectory of capitalist economies. Whole subfields of economics now pursue the subject of the care, feeding, and consequences of innovation, using qualitative and quantitative, historical and mathematical methods. McCraw gives only a few pages to Theory of Economic Development. He certainly understands that it is fundamental, but he does not place it as the summa that it is.

I agree with him, however, that the two-volume Business Cycles of 1939 was a massive failure, in both senses of the phrase. (I still have the yellowing copy that I bought as a student. It was, and still is, essentially unreadable.) Schumpeter probably intended it as his entry in a competition with Keynes's General Theory, which appeared three years earlier, but it made no visible impression on the profession or the public. The book is full of detail about the rise and fall of firms, technologies, and industries, but it does not rise to the status of a theory of business cycles. It is more like a map on the scale of one foot equals two feet: you see the potholes, but you do not learn much about the scenery.

McCraw does not really discuss the main piece of new intellectual machinery that Schumpeter hoped to impose on the jumble of business-cycle history to convert it into a comprehensible tale. That was a system of three oscillations or waves superimposed on one another: a forty-month Kitchin cycle, a roughly ten-year Juglar cycle, and a long Kondratieff cycle of about fifty years. (Kitchin and Juglar were economists of considerable obscurity, and Kondratieff only a little less.) I don't suppose that anyone under the age of eighty remembers any of this, though there remain a few devotees of the Kondratieff cycle. To see six complete cycles, you would have to go back nearly three hundred years. It makes for good stories, maybe too easily.

This three-cycle scheme is a pointer to the main theoretical flaw in the book. Schumpeter wanted to place the entrepreneurial innovation process at the heart not only of episodic growth but also of the repetitive "business cycle" (or at least of the two longer species of cycles). McCraw seems to go along. But it does not work. After considerable experimentation, economics has given up on any such periodicities. Whatever was true of the more distant past (when the data were poor anyway), the texts of modern history do not fall into a pattern of regular, repetitive cycles. Instead, "the business cycle" has become shorthand for the series of irregular, short-run, aggregative fluctuations of varying duration, magnitude, and -- probably -- causation that we call prosperity and recession.

Schumpeter had a rise-and-fall mechanism in mind. The monopoly profits collected by a successful entrepreneurial firm attract imitators and competitors, many of which are financed by fresh credit. This activity eventually erodes the initial profits; and then the time is ripe for another innovation, if one comes along. There is obvious truth to this story, but it is far from being a theory of economy-wide fluctuations.

Business Cycles was surely a great disappointment to its author. Schumpeter had, essentially single-handedly, written this detailed 1,100-page narrative of events in Britain, Germany, and the United States as seen through the lens of creative destruction. It must have used up a dreadful amount of even his enormous energy. And the world of economics just kept on arguing about Keynes.

In 1942, Schumpeter published Capitalism, Socialism, and Democracy, which was reprinted and translated many times. It was his most successful book by a wide margin, and it is certainly a big canvas. McCraw thinks of it as a landmark of twentieth-century social science, and gives it many pages of description and discussion. I do not think it comes close to being that important; but I have to admit that I have a general distrust of ambitious, overarching attempts to capture a whole socioeconomic system in a few grand generalizations.

The book reiterates the standard Schumpeterian vision of capitalist turmoil and transformation, with the entrepreneurs as the indispensable heroes. This time he suggests a mechanism within capitalist society that (inevitably?) causes it to undermine itself. The children and grandchildren of successful entrepreneurs, precisely the people with the right DNA, are seduced by inherited wealth into intellectual pursuits, the arts, aristocratic habits, perhaps even into left-wing or at least anti-capitalist ideologies. It is not the proletariat that blows up the capitalist edifice, which is in fact good for the proletariat. It is the second generation of successful entrepreneurs that lets the ground floor decay.

Is this in fact a common pattern? Is it more likely than simple chance would imply? Schumpeter can tell good tales, but it is hard to know if they are the only, or the typical, tales. He also makes the rather paradoxical argument that, with long habit, even the process of innovation itself becomes routinized and depersonalized, and therefore weakened. Can he really have believed that successful capitalism is essentially a romantic virtue? There is little doubt that the heroic view of entrepreneurship came naturally to Schumpeter. Capitalism, Socialism, and Democracy is the kind of swan song that yields willingly to Schumpeter's "vision" without a lot of critical analysis.

The chapters on socialism are written almost ironically. Many passages accept, mock-seriously, the benefits in efficiency and equity that have always been claimed for socialism and public-spirited central planning; but then come all the qualifications, Orwellian and worse, often drawn from the experience of the Soviet Union. Saving, for instance, can simply be extracted by the state. "Hardships and abstinence' have been imposed such as in capitalist society could ever have enforced." Under socialism, however, this rigor "presumably will command that moral allegiance which is being increasingly returned to capitalism." Capitalism, Socialism, and Democracy is a well-done polemic from a supremely sophisticated Central European. I don't know if it can be classified as social science, but I do think that most of it is true.

Which brings us to the "democracy" in Schumpeter's title. He was not a democrat by instinct or by reflection. He had little confidence in the ability of the average citizen to vote intelligently, or even in his own long-run interest. His book asks if democratic socialism is possible. The conclusion is that perhaps it is possible in principle, but almost surely not in practice. Democratic capitalism is what we have, but democratic resentment and demo- cratic ignorance tend to work against capitalist success, either by accepting socialism or by fostering over-regulation.

For these reasons, Schumpeter could not conceive that a permanent mixed economy was a viable proposition. He called it "capitalism in an oxygen tent." For him, capitalism is the civilization of a few family fortunes and broad inequality. Democracy, he thought, must turn out to be "laboristic," and therefore inimical to capitalist success. This conclusion was a major error, as McCraw says. It has been soundly contradicted empirically by the sixty years and counting since World War II. Nor was this a mere slip of judgment. Schumpeter's mistake was rooted in his political and social attitudes and even, to some extent, in his characterization of entrepreneurship and the dynamics of capitalism.

As against McCraw, I cannot see this book as a major work of "social economics." My guess is that Schumpeter did not really think so either. (He said as much, but that could have been false modesty.) When the publisher asked for new material for later editions, Schumpeter was content to tack on minor things that he had written about the postwar economy, especially the view that the Soviet Union had been the big winner, having picked the pockets of Churchill and Roosevelt (whom Schumpeter hated anyway). This is not how you treat your life's great work.

I will not discuss History of Economic Analysis, edited and published after his death by his wife Elizabeth Boody Schumpeter. It is very long and very recondite. Instead, I think one can learn more about Schumpeter from two books that he did not write. During his prime years, he was episodically working at a book about money. One can see why he might have tried. He had spent some years in private banking, and a shorter unsuccessful interval as minister of finance in Austria. He had published a couple of relevant essays; and Theory of Economic Development emphasizes the creation of credit by the banking system as part of the process by which banks finance would-be entrepreneurs. But he did not have much aptitude for monetary theory, or any important idea to transmit. When the bits he had written down were published as a book in the 1970s, it attracted little attention.

Then, in his later years, he thought about writing a treatise that would summarize "Schumpeterian economics." Most especially he contemplated a "preliminary volume" that would summarize the treatise to come, and would tell his story in a style that could reach a broader professional and non-professional audience. This was clearly intended as his answer to Keynes. The internalized rivalry with Keynes, his exact contemporary, for the title of World's Leading Economist seems to have nagged frequently at Schumpeter.

But he seemed not to understand what Keynesian economics was about, or why it won over the younger generation. For example, he described Keynes as the apostle of consumer spending (in contrast to his own emphasis on innovational investment). But in fact consumer spending is passive in Keynes's General Theory. The driving force of the aggregate economy is actually investment spending; and Keynes put great causal weight on "animal spirits" and "the state of long-run expectations," both of which are much more akin to entrepreneurial drive.

Similarly, Schumpeter charged Keynes with being a "stagnationist" (in contrast to his own belief that there was no natural limit to entrepreneurial energy and innovation). This is a more complicated matter. The Keynesian framework could accommodate stagnationist ideas about the drying-up of profitable investment opportunities; and in other hands it did. Keynes certainly did not admire "money-grubbing," and he would have classified a hot-to-trot Schumpeterian entrepreneur as a money-grubber. That is not stagnationism. It is probably more accurate to say that Keynes erred in a different way, by thinking that consumers might become satiated as their incomes rose and could be left with neither the wish to spend nor the capacity to enjoy leisure.

It is possible to see Keynesian and Schumpeterian ideas as complementary. Keynes is about short-run economic fluctuations brought about by erratic variations in the willingness of investors and governments to spend; Schumpeter is about the long-run trajectory driven by the erratic march of technological progress. This complementarity only became clear later, after both men had died, when economic growth became an explicit objective of public policy and topic of systematic analysis. Schumpeter was left frustrated by the younger generation's affinity for his rival. In any case, the "preliminary volume" never materialized.

The world turns. Today, some sixty years after their deaths, Schumpeter's star probably outshines Keynes's. The business cycle has receded in importance, partly because the large industrial economies have sprouted a more stable structure, and partly because the lessons that Keynes taught have been learned by central banks and finance ministries. Instead, long-term economic growth has moved to the top of the political and intellectual agenda, and that was Schumpeter's topic. As Robert Lucas memorably put it, once you have begun to think about economic growth, it is hard to think about anything else. It is a pity that troubled old Schumpeter did not live to see the triumph of his obsession.

There was another source of Schumpeter's unhappiness during that last decade, and of his tendency to withdraw from his colleagues. He had been ambivalent -- worse than ambivalent, some thought -- about the war itself. His wife had many associations with Japan, where she had done research. More importantly, Schumpeter believed that a strong Germany was all that kept western civilization from being overrun by the Bolshevik hordes. He did not exactly want to see Germany win; but he did not want to see Germany lose. He would certainly have preferred to see Western Europe and the United States join Germany in a struggle against the Soviet Union. Would he have swallowed Hitler if that were necessary? There is no way to know, but the fact that one can ask the question exposes the problem. The man was all problems, and one very important idea.

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