True freedom

"Freedom means that in some measure we entrust our fate to forces we do not control; and this seems intolerable to those positivist / rationalist who believe that men can master his fate; as if civilization and reason itself were the fate of his making"
F.A. Hayek

Monday, May 28, 2012

Joseph Alois Schumpeter, Entrepreneurship, Innovation and Disequilibrium

Pablo Paniagua                                                                                                              May 28, 2012

Professor Schumpeter was an Austrian-Hungarian Economist and Political Scientist, born February 8th, 1883 in what is now known as the Czech Republic. He came into this world at the very beginning of the most exciting entrepreneurial-based society: the capitalist and innovative society of the XX century. 

Schumpeter started his academic life studying law at the University of Vienna, where he also obtained his PhD in 1906. The Law School of Vienna University was under the Austrian-Hungarian Empire control. At the time, this was considered one of the most important studying centers in the world, alongside Stockholm University (where Knut Wicksell studied) and Cambridge (Keynes).  Since Economics was not yet a widespread degree, the Law School of Vienna was the closest thing in Central Europe offering a comprehensive and profound study of Economics.

It was actually at the University of Vienna where the Austrian School of Economics was started. By Schumpeter’s time, it was on its second generation of Austrian School of Economics already active, with professors Eugen von Böhm-Bawerk and the founder of the Austrian School, Professor Carl Menger (already retired at the time). They were among the most influential scholars and important economic thinkers of Central Europe. This was the effervescent environment in which Schumpeter was first introduced to Economics, forever changing his mindset. Although we cannot consider Schumpeter’s work as actual orthodox Austrian Economics, his early writings and market economy view with its adaption mechanisms have deep Austrian and Mengerian roots. Therefore he is sometimes considered part of the third generation of Austrian Economists, along with Professor Ludwig Von Mises.   

Before WWII, Schumpeter moved to the United States after being invited by Harvard University in 1939, where he lectured for several years. His lectures where not very popular or easy to follow since his views clashed with the fashionable economic thinking at the time: Keynesianism. But this did give Schumpeter a small prestige among Harvard colleagues during those years.  

Professor Schumpeter, as Hayek defined: “had the biggest intellectual adaptability, which helped him always to quickly accommodate current intellectual fashions.” This assisted him throughout his life in the U.S. to adapt to current economic thinking and it was there which he decided that economic studies should take a mathematical approach. That decision was considerably influenced during his early student life by the hard mathematics of Leon Walras; this guided Schumpeter to be one of the founders of the Econometric Society, serving as its president 1940-1941. 

However, Schumpeter was not a mathematician and had no profound mathematical background. He therefore adopted a more eclectic approach towards economic analysis, introducing a sociological understanding of economic theories (much more in line with his mentors from the Austrian School).  This novel approach of seeing economic models led Professor Schumpeter to be a pioneer in several economic theories and ideas that were beyond any practical mathematical representation. He is considered relevant for founding and dispersing many theories in the United States, such as: the business cycle theory (originally Austrian and Russian) and Economic Development through innovation and growth. He concentrated his ideas mainly on entrepreneurship and risk-taking business. Schumpeter’s groundbreaking works and theoretical foundation were very well received in the U.S., largely because he truly captured the entrepreneurship and innovation-driven growth of American society. This is why Professor Schumpeter is considered one of the greatest economists of our times.    

Throughout his professional life, Schumpeter defined innovation in several ways: the creation of a new good or new quality of a good, the creation of novel methods of production, the opening or discovery of new markets to sell your goods, the capture and restructure of new sources of supply, and a new organization of the chain of production and a reorganization of the factors of production. Innovation therefore is an essential activity for entrepreneurs.

He established that innovation did not need any new or special kind of knowledge; he believed that innovation may appear when existing knowledge has not yet been utilized in different industries. According to Schumpeter, 

“There never has been anytime when the store of scientific knowledge has yielded all it could in the way of industrial improvement, and, on the other hand, it is not the knowledge that matters, but the successful solution of the task sui generis of putting and untried method into practice….there may be, and often is, no scientific novelty involved at all, and even if it be involved, this does not make any difference to the nature of the process.” 

Therefore innovation is an act of will and not intellect; it deeply depends on leadership and risk-taking activities and much less on intelligence. 

Schumpeter’s Most Relevant Works

History of Economic Analysis

In addition to all the economic theories that Schumpeter developed throughout his life, he was also considered one of the most knowledgeable scholars on economic history and the development of economic thought; therefore he wrote the History of Economic Analysis, which was posthumously published. Professor Hayek called this book one of the finest ever made in the field of history of economic thought. The book is an extensive review of the history of Economics through a Schumpeterian point of view (very personally biased). In the book, Professor Schumpeter established that the greatest 18th century economist was Turgot and not Adam Smith. Schumpeter was also very critical about Keynes, whom he said relied too much on reasoning through abstract models.

The Business Cycle Theory 

The Schumpeterian idea of the business cycle is rooted and primarily based in the static view of the economy defined by Leon Walras. He was the 19th century French economist who created the basic and well known “Walrasian Equilibrium,” which elegantly explained a mathematical formula of the theoretical and ideal equilibrium set in markets. Schumpeter built off of this equilibrium but believed it was overly simplistic, therefore he added theoretical complexity: he applied a dynamic approach and the introduction of disequilibrium through entrepreneurship and innovation. He introduced the Austrian notion of constant disequilibrium in his model on a real market-based economy; disequilibrium and constant adjustment of spontaneous coordination are the constant in the market, not equilibrium.

The stationary state of the economy in a Walrasian world is also known as the “circular flow.” Under this set of thought, we exclude innovation and risk-taking entrepreneurship in the economy. This system has a reciprocal circulation of income between producers and consumers. Producers provide goods and services in exchange of the consumer’s “factors of production” (their labor hours). This creates a very stable and never ending monotonous flow, but it lacks innovation and is missing sudden creations of goods and services, which both positively disrupt the economy. This interruption, according to Schumpeter’s insight, is the leading path to an exponential and sustainable growth for societies. In Schumpeter’s perspective, the Walrasian Equilibrium is therefore not the way to societal growth and wealth creation. Something was missing in the big picture, therefore Professor Schumpeter added the hero of our story: the entrepreneur

It is the entrepreneur, and no other, who disrupts the monotonous equilibrium of the economy and who is the prime cause of economic development and increases societal wellness. Therefore innovation and development are disturbances in the Walrasian circular flow. However, this disruption of the formerly established equilibrium leads to both a highly unstable growth phase and a volatile market for competitive industries. This led Professor Schumpeter to believe in the market system’s inherent instability and the problems of these disruptions. He also understood the risk of massive entrepreneurial failure as a threat anda potential flaw of Capitalism itself; this pushed him to conclude that economic cycles are endogenous in our economic system.

He suggested that in a capitalist system, these problems are the very core of the money flow, which is the credit to entrepreneurs; Professor Minsky later enriched this view in the XXI century. With the incorporation of several entrepreneurs in the economy, along with the growing extension of credit, the system develops a rapid economic boom or expansion. At the same time, this massive incorporation of entrepreneurs to a single industry will create excessive competition and eventually some will fail. This creates a negative economic shock, severely dampening the system. Schumpeter also suggested that a system which relies on spontaneous innovation will have periods in which entrepreneurial success is less likely, leading to stagnation or recessions (when massive entrepreneurial miscalculations happen). This is the cycle’s dual face and the twin entity of entrepreneurial disruption and innovation. The name is not quite accurate since ‘cycles’ give the idea of time dependence and a pattern of sorts; a more accurate term may be ‘economic fluctuations.’ 

Capitalism, Socialism and Democracy

This work was Professor Schumpeter’s most popular one in English. In this book, he is sympathetic to Marx’s view that Capitalism will eventually fail, leading to a form of Socialism. However Schumpeter believed that this change in the economic system will not happen in the way that Marx predicted; Schumpeter envisioned the fall of Capitalism could be described with one of his more famous terms, “creative destruction.” 

Creative destruction means that the economic organization’s old ways will be endogenously destroyed and replaced with new ways of order from within. According to his view, this will happen with Capitalism. Schumpeter’s idea of Capitalism’s evolution is that it endogenously will transform itself into a form of large, programmed Corporatism that will slowly erode small entrepreneurship’s values. Therefore in an advanced capitalist stage, we will see mainly big companies with little space for small entrepreneurs to convey their business ideas. Consequently there will be no space for entrepreneurial values in the common society and the system will then be replaced by some form of Socialism. He argued that Capitalism's collapse from within will come about as democratic majorities vote for restrictions upon entrepreneurship, burdening and destroying the capitalist structure and values.

In this book, Schumpeter also enlightens us with a very novel perspective of Democracy. Following Max Weber’s view, he establishes that democratic systems are no more than mere mechanisms of competition among leaders, very similar to a competitive capitalist market structure.  It is true that the public democratic vote legitimizes governments but the policy programs of different parties are, in the end, their own programs and not the plan of the entire spontaneous society. So in this way, individual participation and liberties are severely reduced.  

Schumpeter in Today’s World

Considering all the incredible contributions that Professor Schumpeter brought to Economics and Social Politics, he is nowadays mostly associated with the expression ‘creative destruction’ and the relevance of innovation and entrepreneurship in keeping companies and economies competitive. His ideas are currently thriving more in Management rather than in Economics. He was one of the pioneers who believed that most technological changes and sustainable growth must come from Unternehmergeist, the German expression for entrepreneur-spirit.  He also believed that this incredible source of innovation should come from large companies that should encourage innovation from within in order to survive in a competitive global environment. Schumpeter simultaneously argued that technological innovation often creates temporary monopolies and allows uncharacteristic profits. He realized that these temporary monopolies were unfortunately necessary in order to provide the incentive required for large firms to continue developing new products and production processes in the long-term. 

Overall Schumpeter is still obviously influential and very much indeed fashionable. He was the economist that profoundly understood the fundamental spirit of innovation and risk-taking business, which is at the very core of American values. It is what keeps granting U.S. supremacy in business success; just think about Apple as a XXI century living example of Schumpeter’s ideas.   

This spirit was further carried on in 2009 when The Economist inaugurated a column on business, management and innovation named "Schumpeter." The publication has a history of naming columns after significant figures or symbols in the field. The initial Schumpeter column praised him as a "champion of innovation and entrepreneurship whose writing showed an understanding of the benefits and dangers of business that proved far ahead of its time.”

* Edited by Victoria Finn

Selected Works:

1912. The Theory of Economic Development. Leipzig: Duncker and Humblot.    Translated by R. Opie. Cambridge: Harvard University Press, 1934. Reprint. New York: Oxford University Press, 1961.
1939. Business Cycles. 2 vols. New York: McGraw-Hill.
1942. Capitalism, Socialism and Democracy. New York: Harper and Brothers. 5th ed. London:   George Allen and Unwin, 1976.
1951. Ten Great Economists. New York: Oxford University Press.
1954. History of Economic Analysis. Edited by E. Boody. New York: Oxford University Press.

Professor Schumpeter’s photograph, Harvard University, 1940.