Schumpeter Economics Theory and Growth

Schumpeter and Growth, Schumpeter Theory and Economics

Before Schumpeter was thirty years old he had laid the foundation for his theory of economic growth in The Theory of Economic Development, first published in 1912 and translated into English in 1934. A brilliant conception, it has lain almost dormant because it is so broad-based that it does not lend itself to the economic model building that has been the vogue in mainstream economics for some fifty years. In the foreword to Eduard Miirz's recent study of Schumpeter, Nobel Prize winner and model builder James Tobin comments that Schumpeter's "theories of development and business cycles were difficult to incorporate into the style and method that came to dominate economics, especially American economics, over the past fifty years." Ironically, Schumpeter was a strong proponent of the greater use of mathematics in economics and econometric testing of hypotheses, the areas in which he was at a comparative disadvantage.

Schumpeter's explanation of the process of economic growth does not fit into the orthodox mold, because he stressed the noneconomic causes of growth. Though he examined some strictly economic factors, he insisted that the princi­pal elements in the past growth of the system and the elements that will reduce growth in the future are noneconomic.

First let us look at his novel analysis of economic factors. He essentially accepted Say's Law, although he recognized and analyzed the fluctuations in economic activity under capitalism. To him depressions were self-correcting, and there could be no equilibrium at less than full employment. Where Marx had seen depressions as a manifestation of the contradictions in the system that lead to its ultimate collapse, Schumpeter considered depressions beneficial to the system; they were an integral part of the entire process of economic growth. Growth was tied to the prosperity stage of the cycle, because this phase represented the ultimate outcome of the introduction of new products and technology into the economy. But excesses develop as credit is overexpanded and businesses overextend themselves. The resulting depression is beneficial in that it shakes out the economy, removing the less efficient firms, and thereby prepares the way for a growing economy of healthy, well-managed, efficient firms.

But the principal agents of economic growth are noneconomic, according to Schumpeter, and are to be found in the institutional structure of the society. Schumpeter attributed to the activities of what he called entrepreneurs the tremendous growth that took place in the industrialized world. An entrepreneur to Schumpeter is not just a businessperson or manager; this person is a unique individual who is by nature a taker of risks and who introduces innovative products and new technology into the economy.

Schumpeter clearly distinguished between the process of invention and that of innovation. Only a few far-sighted innovative businesspersons are able to grasp the potential of a new invention and exploit it for personal gain. But their gain is the economy's gain. After the introduction of a successful innovation by the entrepreneur, other businesspersons will follow suit and the new product or technology will spread throughout the economy. The real source of growth in the economy, therefore, is found in the activities of the innovative entrepreneur, not in the activities of the mass of the business community, who are risk-averting followers.

Therefore, economic growth is fostered by an institutional environment that rewards and encourages the activities of entrepreneurs; early capitalism, with its private property and laissez-faire government, was ideally suited to economic growth. Insofar as it stresses the importance of incentive and laissez-faire government, this part of Schumpeter's analysis is in theoretical and ideological accord with the classical theory of growth; but where classical theory stressed the economic factor of the size of capital accumulation, Schumpeter emphasized a noneconomic, cultural, sociological factor in his analysis of the role of the entrepreneur. The contrast between this view of growth and that of mainstream neoclassical economics was stated succinctly by Schumpeter:

What we are about to consider is that kind of change arising from within the system which so displaces its equilibrium point that the new one cannot be reached from the old one by infinitesimal steps. Add successively as many mail coaches as you please, you will never get a railway thereby.

Still more novel are Schumpeter's observations about the future growth and development of capitalism. Where Marx had predicted that the demise of capitalism would proceed from its contradictions, Schumpeter speculated that its end would be the product of its success. He was an ideologically conservative economist who had a somewhat romantic vision of the growth of the economy as proceeding from the daring deeds of swashbuckling entrepreneurs. He wished to see the continuation of this process, yet he expected capitalism to be brought to a halt because of its success. The main elements in this scenario were the demise of the entrepreneur and, to a lesser extent, the greater role of the intellectual as the society became more affluent. The successful entrepreneur will promote the growth of a large firm that will eliminate by competition the less efficient, risk-averting firms in an industry. But the large firm will soon become risk-avert­ing and cautious and will be run by bureaucratic committees, not by innovating entrepreneurs. The bureaucratized giant firm will then eliminate the entrepre­neurs and replace them with "prudent" managers. As the hired managers replace the entrepreneurs, ownership of the large corporation will become an absentee ownership. "The true pace makers of socialism," Schumpeter said, "were not the intellectuals or agitators who preached it but the Vanderbilts, Carnegies, and Rockefellers."

Schumpeter believed that once the giant firm has eliminated many of the small, owner-operated firms, a large part of the political support for capitalism will have been removed. The success of capitalism will destroy, moreover, the old conception of private property and the willingness to fight for it, Schumpeter contended. Once the entrepreneur is gone, the paid manager and the stockhold­ers will no longer defend the concept of private property. Their attitude will also prevail among the working class and public at large. "Eventually there will be nobody left who really cares to stand for it—nobody within and nobody without the precincts of the big concerns."5 Again, the success of capitalism will speed this process, for the increases in income and wealth produced by capitalism will permit the growth of an intellectual group in the society who "wield the power of the spoken word" and who have "no direct responsibility for practical affairs."6 The success of capitalism will permit these intellectuals to live off the fruits of the system but, at the same time, to criticize it. They will radicalize the labor movement; although they will not usually run for public office, they will work for and advise the politician. Occasionally they will become part of the government bureaucracy; but most important, with the ever-increasing growth of mass communication, they will be able to disseminate throughout the society a discontent with and resentment of the institutions of capitalism.

Schumpeter envisioned the end of the system he loved approaching slowly but surely. He feared that with the demise of the entrepreneur and the end of laissez faire, government would intervene more and more in the economy. Some, like Keynes, welcomed this intervention as a way of saving capitalism, but to Schumpeter it was a sign of the imminent end of capitalism. Because of what he called "Evaporation of the Substance of Property" and the end of the entrepre­neur, Schumpeter predicted that the dynamic element in the economy that accounted for its past growth would disappear.

Schumpeter received some acclaim, but not from significant mainstream economists. Its informal nature did not fit the formal modeling approach that was becoming the standard. It was only in the work of Roy Harrod, Evsey Domar, Robert Solow, and Trevor Swan in the 1950s, which created formal models of growth, that growth theory caught on and became part of the core of macroeco­nomics. Interest in these formal growth models was, however, totally overshad­owed as the profession digested the depression of the 1930s and concentrated on the theory of business cycles.

The Underconsumptionist Arguments

Interest in growth theory was paralleled by concern about whether a market economy would lead to full employment and whether the government should intervene in the economy to help maintain a full utilization of resources. Mercantilists specifically wanted to understand the forces that determine the capacity of an economy to produce goods and services and to ascertain whether the actual level of output reached the potential level. Many mercantilists perceived a fundamental conflict between private and public interest and there­fore believed that the economy would fail to achieve its output potential unless the government intervened. Their argument was twofold: first, following Jean Bodin, they believed that private interest led to monopoly and that monopoly restricted output; second, they believed that when individuals either saved or bought foreign goods, a shortage of demand for domestic goods ensued, which weakened the economy. The mercantilist position was that the government should regulate domestic and foreign trade so that the economy would show a balance-of-payments surplus and increase the country's gold, which served as its money supply.

As mercantilism evolved into classical economics, attitudes toward govern­ment intervention changed dramatically. Unlike the early mercantilists, Adam Smith believed that competitive market forces were sufficiently strong that private interests, as though led by an "invisible hand," would be directed to work for the public interest. The economy would reach its output potential only if the government followed a laissez-faire policy. Smith's analysis in favor of laissez faire was a contextual argument made in view of feasible alternatives. He agreed with the mercantilists that monopolies reduced output, but he asserted that the methods control them—government control of trade and allocation of monopolies—made matters worse, not better. Thus, he argued that the preferable policy was to rely on laissez faire and competition to bring about utilization of resources as fully as possible. A laissez-faire policy that allowed markets to flourish encouraged division of labor, specialization, and technologi­cal development, thereby encouraging growth. This tendency of markets to create growth was also emphasized by Marx. But Marx drew quite different implications from the analysis. He focused on the unequal distribution of income that accompanied that growth and its implications for the political and social structure.

Smith and other classical economists attacked mercantilist underconsumption arguments. They argued that savings would automatically be translated into investment spending, because a decision to save is a decision to invest. The proposition that a laissez-faire economy would automatically produce full utilization of resources was called Say's Law, and it became a central element of classical and neoclassical economic thinking. Classical economists also attacked the mercantilist argument for increasing the stock of gold by running a trade surplus, contending that the wealth of a nation is measured not in precious metals but by real output, and that a country would be better off allowing free trade, thereby gaining the advantage of foreign competition.

Classical economists, particularly Smith and J. S. Mill, agreed that market forces did not work perfectly but maintained that the market worked better than the alternatives. With the exception of Thomas Malthus, from 1800 through 1930 the analysis of business cycles was left to heterodox and nonmainstream economists such as Karl Marx, Mikhail Tugan-Baranowsky, and J. A. Hobson. The classical conviction that markets could be relied upon to control the economy shifted the focus of economic inquiry from monetary and financial forces to real forces, and the classical analysis of macroeconomic issues generally accepted a dichotomy between real and nominal forces.