History of Economic Thought Series: Joseph Schumpeter

Foreword

This series of articles aims to provide a brief overview of the evolution of Economic thought through the lens of some of the key contributors to the discipline. Using Adam Smith’s Wealth of Nations as a jumping-off point, through John Maynard Keynes’ General Theory, Karl Marx’s Das Kapital, and the more recent contributions of Joseph Schumpeter and Milton Friedman. The series will conclude with an evaluation of modern-day Economic consensus.

The History of Economic Thought series consists of 6 main articles:

1. History of Economic Thought: Adam Smith

2. History of Economic Thought: John Maynard Keynes

3. History of Economic Thought: Karl Marx

4. History of Economic Thought: Joseph Schumpeter

5. History of Economic Thought: Milton Friedman 

6. History of Economic Thought: Modern Day

History of Economic Thought: Joseph Schumpeter

An Introduction to Schumpeter

Joseph Schumpeter was an Austrian-born economist famed for his theories on entrepreneurship, business cycles, Creative Destruction, and the ultimate fall of Capitalism. He is one of the most innovative, thought-provoking, and influential economists of the 20th century. (Britannica, The Editors of Encyclopaedia 2022).

Figure 1: Joseph Schumpeter, one of the most innovative and creative thinkers in the history of Economic Thought

Entrepreneurship and Capitalism

One of Schumpeter’s earliest and most essential contributions to the field of economics was to shed light on the importance of the Entrepreneur to the functioning of the Capitalist system. The Classical Economic school of thought had long emphasised the importance of stability, believing a continuous “steady state” to be the ultimate, and in fact desired, outcome of a developed society. Schumpeter, by comparison, saw a world in a constant state of flux. Capitalism, far from being stable was more akin to an ever-renewing cycle, in which the entrepreneur is an agent of change, a disruptor. In the ordinary “circular flow” of the economy, it can be effectively said that an entrepreneur does not exist. This status quo is rather maintained by “heads of firms or business managers of a different type which we had better not designate by the same term.” (Schumpeter, 1949, P. 76).

Under the existing classical doctrine espoused by the likes of Adam Smith and David Ricardo, entrepreneurial characteristics were attributed to the oft-cited capitalist class. Both classes and functions – Capitalist and Entrepreneur – were effectively presumed to be one and the same. In his text “The Theory of Economic Development”, first published in 1911, Schumpeter outlined his view of the Entrepreneur as distinct from these previous characterisations, likening the functions of capitalist and entrepreneur to that of landowner and farmer respectively. The landowner may supply the land, the essential capital resource, but it is the farmer who in turn creates, and renders value from it. For Schumpeter, the classical school of economists had fundamentally missed this point. In support of his argument, he referenced the view of renowned Classical Economist Alfred Marshall, “which simply treats the entrepreneurial function as “management” in the widest meaning” (Schumpeter, 1949, P. 77).

Figure 2: The Entrepreneur serves as the centrepiece of Schumpeter's Theory of Economic Development

The Fleeting Nature of Entrepreneurship

According to Schumpeter, “everyone is an entrepreneur only when he actually ‘carries out new combinations’”, (Schumpeter, 1949, P. 78). Rather than simply managing, an entrepreneur is someone who instigates change, who creates. Therefore, the role of entrepreneur is fleeting and unsustainable. Nobody exists in a constant state of innovation but rather does so transiently. For Schumpeter, an entrepreneur “loses that character as soon as he has built up his business, when he settles down to running it as other people run their businesses.” (Schumpeter, 1949, P. 78).

In Schumpeter’s view, entrepreneurs are motivated – at least in part, by the potential for entrepreneurial or monopoly profit. By virtue of innovating and in the process of creating a product or service that has not previously existed, the entrepreneur ensures that they are for a time without competitors. In the absence of such, the entrepreneur is free to set a “monopoly price”. Something they could not do in a more orthodox competitive market structure, where their ability to influence the market price would be significantly more limited.

As with any economic model, this concept operates under certain assumptions. Firstly, nobody will simply steal the given entrepreneur’s idea and run with it themselves. Secondly, some means of legal enforcement or protection exists to ensure that this won’t happen. In real life terms, patents offer an excellent example of this principle in action. They generally operate on a set term limit, patents serve as a means of protecting both the motivation of potential entrepreneurs, and latterly, their customers. During the limited time in which the Patent remains active, the entrepreneur enjoys the exclusive right to production. The potential profits that can be accrued during this period serve as apt reward for the time, effort and resources employed in achieving the innovation in question. Upon the patent’s expiry, fresh competitors are permitted to legally enter the market. This increased competition drives the price downward, restoring ordinary market conditions in favour of potential consumers.

Creative Destruction, Capitalism’s Constant State of Evolution

The major break that Schumpeterian economics makes from the pre-existing classical and neo-classical schools of thought, is in the inherent assumption that Capitalism is not, and never can be stable. In Schumpeter’s own words “Capitalism, then, is by nature a form or method of economic change and not only never is but never can be stationary” (Schumpeter, 1942, P. 82) For Schumpeter the capitalist system is one that “incessantly revolutionizes the economic structure from within, incessantly destroying the old one, incessantly creating a new one.” (Schumpeter, 1942, P. 83).

Schumpeter labels this process “Creative Destruction”, describing it as, “the essential fact about capitalism.” (Schumpeter, 1942, P. 83). Schumpeter directly provides many examples of this process in action. Perhaps the most poignant being the destruction of the pre-existing Feudal order by the advent of the Capitalist system itself. This simple, yet profound observation is arguably Schumpeter’s most important and tangible contribution to the field of economics, with no end of practical application in everyday life. The advent of smart phones as a contemporary technological Swiss army knife serves as an excellent example. Even a basic smartphone model today offers the functions of calculator, stopwatch, alarm clock, camera, torch, and of course phone, all in one. Alongside a great many more. Naturally, this has served to the detriment, and ultimate “destruction” of a great many producers of these previously specialist items.

Figure 3: The Smartphone offers an excellent example of Schumpeter's principle of Creative Destruction in effect

Business Cycles and The Entrepreneur as Driver

Another of Schumpeter’s most enduring contributions to the field of Economics is his theory of “Business Cycles”. His thesis arising from the observation of recurring “crises” throughout economic history. The pre-existing Classical doctrine offered no means of explanation for the irregular nature of economic growth, and its tendency toward periods of boom and bust. The classical notion of a “static” economy allowed for continuous and predictable growth – if the economy were managed correctly. The flow of economic history however, ran counter to this notion.

In Schumpeter’s view, these cycles of strong economic growth followed by periods of economic contraction were a natural function of a capitalist structure, “the phenomena which we have got in the habit of calling "depression" are no irregular heap of disturbances, but can be understood as the reaction of business life to the situation created by the boom” (Schumpeter, 1927, P. 9). Economic growth is not a smooth, predictable function of a “static” economy. It is rather an irregular, unstable energy. This summation aptly characterises Schumpeter’s view of the Capitalist order as a constantly evolving one.

Once again it is the entrepreneur that is key to Schumpeter’s economic vision. It is they who are responsible for the innovation which prompts the wheel of the business cycle to commence its turning. In the aftermath of said innovation, “the potential for monopoly profits spurs investment in factories, machinery, equipment, and perhaps additional research.” (Sobel and Clemens, 2020 P. 32). This initial breakthrough could in turn be replicated by other entrepreneurs, allowing the relevant discovery to be further implemented throughout the broader economy. This “expansionary phase” leads directly to a period of pronounced economic growth, and brings with it the corresponding benefits of reduced unemployment, higher wages and increased investment (Sobel and Clemens, 2020).

Figure 4: The Entrepreneur is once again central to Schumpeter's theory of Business Cycles

This period of heightened economic expansion must inevitably however be followed by a period of contraction. A new innovation has the effect of increasing productivity in the short-run. As competition in turn increases, and more and more businesses firms elect to get involved, “Firms are forced to adapt to compete with new products, new processes, new markets, and other innovations” (Sobel and Clemens, 2020, P. 34). This process of entrepreneurial “creative destruction” serves to undo some of the initial gains wrought by the innovation in question, and the accompanying economic expansion. As the market adjusts once more, many less competitive firms simply do not survive, with the resulting consequence of increased unemployment. This loss of jobs has a knock on effect throughout the wider economy, reducing consumer purchasing power and in turn, overall demand for products and services.

It is worth noting that Schumpeter’s notion of economic growth being cyclical, of periods of recession being as inevitable as those of expansive economic growth, ran directly counter to the prevailing ideas of the time. Many of Schumpeter’s counterparts active in the early goings of the 20th century “believed economic fluctuations could and should be managed by the government” (Sobel and Clemens, 2020, P. 32). A view perhaps best and most notably espoused by John Maynard Keyes.

On the Fall of Capitalism

Intriguingly, Schumpeter shared Karl Marx’ view of Capitalism being a doomed system. Pronouncing bluntly in answer to his own question “Can capitalism survive? No. I do not think it can.” (Schumpeter, 1942, P. 61). Marx had, of course, been a staunch proponent of his own Socialist system, predicting that the fall of Capitalism would manifest in the form of a triumphant socialist revolution. The underdog Proletariat rising together as one to overthrow their long standing Bourgeoisie masters, and in the process ushering in a new era of “Scientific Socialism”. Schumpeter by contrast, did not assume that Socialism would replace the Capitalist system by default, cautioning; “the socialist phoenix may fail to rise from the ashes”, (Schumpeter, 1942, P. 57) and may in fact be usurped by “chaos” instead. Schumpeter, somewhat ironically, saw the ultimate fall of Capitalism coming about through an excess of success, rather than failure.

Amongst the changes that might lead to said failure, he foresaw an inevitable migration of economic activity ordinance from the private to the public sphere. The presence of naturally occurring efficiencies in the centralised, as opposed to privatised, governance of industries “such as means of communication, docks, power production, insurance and so on” (Schumpeter, 1942, P. 120) serving as a key driver of this evolution. Capitalism, as a system whose origins lie in the eternal striving for greater levels of efficiency, is left with no recourse but to acquiesce to these changes.

The Trouble with Perfection and The Death of Inspiration

In the event of the, as Schumpeter perceived it unlikely, perfection of the production process. Capitalism would effectively be left at odds with itself. According to Schumpeter, capitalism is a system whose very nature is one of constant evolution, the development of a stationary state would serve as a death knell. Entrepreneurs, Schumpeter’s drivers of dynamic expansion and evolution would find themselves at a loose end, “in much the same situation as generals would in a society perfectly sure of permanent peace” (Schumpeter, 1942, P. 131).

Figure 6: Capitalism as a structure today remains intact, but for how long?

As Capitalism is a systemic structure which relies on each of its component parts working in tandem – unfairly or otherwise. The death of the entrepreneurial class through the coddling of perfection would, in itself, be a disaster for the Bourgeoisie who “depends on the entrepreneur and, as a class, lives and will die with him” (Schumpeter, 1942, P. 134). The prospective fall of the entrepreneur for Schumpeter, amounts effectively to the death of individuality, from which, for Schumpeter inspiration itself directly flows. Though his analysis with regard to the prospective fall of Capitalism is generally remarkably detached, there is an almost palpable sense of lament in his observation; “The romance of earlier commercial adventure is rapidly wearing away, because so many more things can be strictly calculated that had of old to be visualized in a flash of genius.” (Schumpeter, 1942, P. 132).

As innovation is increasingly centralised, becoming ever more the product of “the perfectly bureaucratized giant industrial unit” (Schumpeter, 1942, P. 134) than the inspired individual. A change in the prevailing structural order must follow. The Capitalist structure in this vision, effectively amounting to a house of cards. As the entrepreneur’s spark of ingenuity is no longer required, neither is the capital provided by the Bourgeoisie. The prevailing owner class losing in the process “not only its income but also what is infinitely more important, its function.” (Schumpeter, 1942, P. 134). In contrast to Marx’ vision then, for Schumpeter, the fall of Capitalism will come from within, not without. “Since capitalist enterprise, by its very achievements, tends to automatize progress, we conclude that it tends to make itself superfluous—to break to pieces under the pressure of its own success.” (Schumpeter, 1942, P. 134)

Conclusion and Legacy

Joseph Schumpeter was a truly extraordinary economic thinker whose legacy and ideas remain as vital as ever in the economic environs of today. Though his innovations and theoretical concepts may one day fall prey to the process of creative destruction which he so eloquently espoused. From this current vantage point, that day still appears a very long way off.

References

Britannica, The Editors of Encyclopaedia (2022). Joseph Schumpeter. Encyclopedia Britannica. Retrieved from https://www.britannica.com/biography/Joseph-Schumpeter

Schumpeter, J. A. (1927). The Explanation of the Business Cycle. Economica 21: 286-311. Retrieved from https://delong.typepad.com/files/schumpeter-1927--the-explanation-of-the-business-cycle.pdf

Schumpeter, J. A. (1939). Business Cycles, A Theoretical, Historical and Statistical Analysis of the Capitalist Process. Discover Social Sciences. Retrieved from https://discoversocialsciences.com/wp-content/uploads/2018/03/schumpeter_businesscycles_fels.pdf

Schumpeter, J. A. (1942). Capitalism, Socialism & Democracy. EET Pixel Online. Retrieved from https://eet.pixel-online.org/files/etranslation/original/Schumpeter,%20Capitalism,%20Socialism%20and%20Democracy.pdf

Schumpeter, J. A. (1949). The Theory Of Economic Development. Internet Archive. Retrieved from https://archive.org/details/in.ernet.dli.2015.187354

Sobel, R. S. and Clemens, J., (2020). The Essential Joseph Schumpeter. Essential Scholars. Retrieved from https://www.essentialscholars.org/sites/default/files/essential-joseph-schumpeter.pdf

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