The Riddle of Schumpeter

I first studied Schumpeter’s History at the behest of the great Lionel Robbins, who had just become my doctoral supervisor. My intention was to write a thesis on John Stuart Mill and I felt I needed to be well versed in economics before approaching Mill’s work. Robbins told me to start by reading two books: Alfred Marshall‘s Principles of Economics1 and Schumpeter’s History—two weeks for each, he said. It took me much longer than that! The two books set me on the path to becoming an economist but also left me with an ambivalent attitude to their two authors. Marshall made me impatient with his ploy of banishing difficult theoretical problems to the mathematical appendix, especially his crucial exposition of a general equilibrium model. Not for nothing did Joan Robinson call him “Marshall, the old fox”. As to Schumpeter, I did not know what to make of his choice of heroes: François Quesnay extolled for his Tableau économique, Antoine Cournot placed above David Ricardo, Karl Marx presented as a better economist than Mill, Leon Walras portrayed as the giant above all others—and Adam Smith demoted to being a late mercantilist. Also, I was confused by his constant sniping at free trade. On the other hand, the broad canvas on which he painted his story I found beguiling. Let me leave Marshall for another day and concentrate my attention on ‘Schumpeter, the seductive sphinx’.

It is not easy to know what to make of Schumpeter. Devotees of the Austrian School of Economics would classify him as one of their own, on account of his efforts to move beyond perfect competition to a new economic dynamics. His admiration for Karl Marx as economist fits less well with such an affiliation. His rejection of the general validity of laissez faire excludes him altogether from the wider camp of classical liberalism. This has not stopped him from becoming a revered figure in business schools, where his main title to popularity is the choice of the entrepreneur and creative destruction as the defining characteristics of the capitalist system.

The Theory of Economic Development, which he published in German in 1912 at the early age of twenty-nine, did not receive the acclaim it deserved, principally because it did not appear in English until 1934.2 This book was ‘Austrian’ in that it linked booms and busts to the expansion and subsequent contraction of bank credit. To the explanation of economic growth it incorporated a crucial ‘Austrian’ actor, the entrepreneur. But he gave a personal twist to both elements. There could not be a dynamic capitalist economy without cycles; excessive credit was not such a bad thing, as it was the way of selectively financing entrepreneurs at the expense of the more staid part of the population. And in capitalist societies entrepreneurs were neither the providers of capital nor the inventors of new techniques but rather innovators who put new ideas in practice and tried to make a profit by exploiting the advantage of their temporary monopoly.

His book appeared in English when John M. Keynes’s much simpler theory of depressions (and cycles) was to gain the attention of the profession. In any case, by the time the translation appeared Schumpeter was working on a two volume work on Business Cycles (1938).3 It was not a success and could not have been, for it was virtually unreadable. Also, Schumpeter presented cycles as phenomena occurring at set intervals, when he should have thought of them as the random result of the bunching of entrepreneurial innovations. And his detailed historical exposé was not easily translatable into mathematical models, which is the way growth theory was moving. Thus the positive contributions of these volumes, as those of his youthful book, went underground, so to speak. The central role of innovation driven by entrepreneurs and new firms in the search for profits; the role of bank credit in sustaining the whole process; and the resulting continuous change that endangered the position of existing interests were ideas of Schumpeter’s that would take time to move back center stage.4

Creative destruction

Another concept was still to come, that of “the gale of creative destruction” as the center of the capitalist process. With those words he summed up the idea that the economy only progressed by destroying existing modes of production and substituting innovative ones, much to the disarray of those employed in the up to then useful activities. That felicitous phrase appeared in his next book, Capitalism, Socialism and Democracy (1942)—paradoxically a book that described the slow death of the capitalist economy. It was an instant success and is still read today by friends and foes of capitalist society. It was published in 1942, barely two years before Friedrich Hayek‘s Road to Serfdom. The contrast between those books could not be starker. One is a detached, almost cynical picture of the undoing of capitalism by its success and its replacement by planned socialism that would discipline the working classes. The other is a heartfelt warning that liberty is in danger because of the slow whittling down of the free market and the mindless drift towards planned welfare.

I find it surprising that Schumpeter should be held in such high esteem precisely because of this book and its one short chapter on “creative destruction”. Thus Michael Cox and Richard Alms in their entry in the Concise Encyclopedia of Economics,5 praise Schumpeter for turning a spotlight on the role of new technologies, new markets, and new organizational ideas in transforming the economy. Innovation undercuts old ways of doing things and destroys the jobs linked to them. But it also brings about new employment through the continued (though no doubt irregular) growth we have enjoyed in the West and now in the whole world. One could say that ‘creative destruction’ is not a new idea.6 However, many years of static analysis had turned the attention of the profession away from the dynamics of capitalism, except for Marx who got this dynamics all wrong. So that it is true that Schumpeter did a signal service to economics when he said that capitalism “is by nature a form or method of economic change and not only never is, but never can be stationary”.

But Capitalism, Socialism and Democracy contains much more than the chapter on creative destruction. In fact, one of the curious features of Capitalism, Socialism and Democracy is that the gales of creative destruction of chapter seven disappear from sight as soon as Schumpeter starts discussing the capitalism of his day. Socialism came as the inheritor of a monopolistic kind of capitalism, not the competitive kind (Capitalism, Socialism, and Democracy, page 169). It was needed to rescue “big business capitalism” from its “fetters” (page 179).

What ails the capitalist society?

The rest of the book makes one look askance at the ambivalence of its author. It is no mere coincidence that the 2010 edition was prefaced by fashionable Joseph Stiglitz.7 This is another case where a presenter does not appear to have read the book carefully. Stiglitz says that the threat to capitalism does not come from the left (as if Schumpeter had said that) but “from the right, from the capitalists themselves”: large corporations that lord over markets for long periods and put capitalism in jeopardy. As an example he points at the prolonged monopoly of Microsoft over PC operating systems. This does not capture the whole of Schumpeter’s view of the decay of capitalism. First, he would have observed that this firm’s privileged position is now being undermined by creative destruction. Secondly, he laid the blame of the loss of innovative capacity of the capitalism of his time not only on big business but on idle managers, unionized workers, and disgruntled intellectuals.

The book opens with a long discussion of Marx, whose back Schumpeter pats with paternal indulgence. The real matter of the essay is broached in Part II on Capitalism, with the following shocking answer to a loaded question: “Can capitalism survive? No. I do not think it can.” (page 53) For Schumpeter capitalism is being brought down by its very achievements. The monopolies it fosters, the unequal wealth it creates, the seeds of envy it sows in its thrust for growth expose it to destructive criticism, so that different forces conspire to make its walls crumble. When capitalism nears maturity there is a noticeable obsolescence of the entrepreneurial function. Enterprises grow into firms and firms into corporations which then become content to enjoy the advantages of the status quo. The population of mere employees grows steadily and with it a conservative attitude suspicious of any change. Organized labor endangers work discipline. Finally, a swarm of underemployed intellectuals are spawned by an educational system that does everything in its power to rob capitalism of all legitimacy. Dare I place Schumpeter himself in this category? In his discharge I will note that he said, “If a doctor predicts that his patient will die presently, this does not mean that he desires it.” But, as we shall see, he did present socialism as a possible rescuer of capitalist society in its death throes.

The pure logic of socialism

Part III starts with another revealing question and answer: “Can socialism work? Of course it can.” (page 149) In fact, socialism as Schumpeter conceives it works on the same analytical principle as capitalism, only better. “There is nothing wrong with the pure logic of socialism”. This is “so obvious” that “the only authority standing for denial is Professor Ludwig von Mises.” It is only a question of discovering individual wants and calculating existing factors of production by a method of approximation that mimics the price system of a free market. The economist who settled the question, said Schumpeter, was Enrico Barone” in his article on “The Minister of Production in a Collectivist State” (1908). The minister would ask consumers about their reactions to price schedules and producers their reactions to intended quantities, see the replies, and by iteration discover the arguments of the general equilibrium at which welfare would be maximized. This method he saw as much more ordered than the fumbling of the free market. Nothing was said of the temptation of demanders and producers to cover up their real utility functions, nothing of the unavoidable ignorance of the central planners due to consumers and producers not knowing their utility functions until they actually contract. As James M. Buchanan remarked more than once, these socialists presume that individuals “carry around with them fully determined utility functions, and [that] in the market they act always to maximize utilities subject to the constraints they confront.” This assumption is wrong.

[… T]here is no means by which even the most idealized omniscient designer could duplicate the results of voluntary exchange. The potential participants do not know until they enter the process what their own choices will be. From this it follows that it is logically impossible for an omniscient designer to know, unless, of course, we are to preclude individual freedom of will.8

More than fifty years had to pass before Ludwig von Mises’ depiction of the market as an engine of discovery and Hayek’s insistence on the dispersion of knowledge in society were proved true and the free market superior to any socialist mimicry: down went the Berlin wall and up went the true face of real socialism for all to see.

Be that as it may, Schumpeter clearly held socialism a superior type of organization of society. Chapter 17 has a section III, titled “The case for the superiority of the socialist blueprint”. There one can read that socialism will perform better “as soon as the capitalist economy permanently slacks down”, which seems to indicate that Schumpeter thought the demise of capitalism was at hand.

Socialist management may conceivably prove as superior to big business capitalism as big business capitalism has proved to be to the kind of competitive capitalism […] of a hundred years ago. (page 174)

In his view, socialist planners could start the process from a desired (and more just) distribution of resources and manage the economy with less disturbance and loss than in the free market. “As a matter of blueprint logic it is undeniable that the socialist blueprint is drawn at a higher level of rationality.” (page 175)

How to get from here to there

But before going on to describe the socialist society in its practical functioning rather than as a blueprint, let us take a look at the transition from one system to the other as Schumpeter saw it. “The first thing that must be done is to bring about inflation.” Price increases would be inevitable with the new wage claims. “Inflation expropriates the holders of claims in terms of money in a delightfully simple way.” Then he went on to paraphrase Lenin: “in order to destroy the bourgeois society you must debauch its money.” Thus Schumpeter begins to show ruthlessness unexpected in him.

There would follow an extensive program of nationalizations. Such a program “might […] accomplish a big step towards socialism”: banking, insurance, railroads, mining, electricity, iron and steel, building and building materials, “and for non-economic reasons armament, movies, shipbuilding, trade in foodstuffs” would be taken over. (pages 208-209) Here Schumpeter was showing an uncommon power of divination of what Clement Attlee in Britain and Charles de Gaulle in France would do after the war, with the results everyone knows.

The great lie of democracy

Among the more interesting chapters of the book are those concerned with democracy. Schumpeter took a realistic view of this great political ideal. “Democracy is a political method.” It is simply an arrangement to arrive at political decisions and “not an end in itself”. (pages 217-218) It is not a procedure whereby the people take decisions for the common good by choosing the issues and who will carry them out. The reality of democracy is the inverse: some individuals acquire the power to take decisions “by means of a competitive struggle for the peoples’ votes.” (page 241) He thus drew an interesting parallel between the imperfect competition of the political and the economic world.

Under capitalism democracy could work well given certain conditions, such as good human material, a restricted sphere of political decisions, a competent bureaucracy, democratic self-control and a large measure of tolerance for differing opinions. The achievement of these conditions, however, Schumpeter regarded with some justified skepticism, but that skepticism became Machiavellian expediency when he admitted with equanimity that “as a matter of practical necessity socialist democracy may turn out to be more of a sham than capitalist democracy ever was”. (page 269)

The reason for limiting democracy under socialism was that “no responsible person can view with equanimity the consequences of extending the democratic method […] to all economic affairs.” (page 266) His conclusion was stark: “effective management of the socialist economy means dictatorship not of the proletariat but over the proletariat in the factory”. (pages 266-269) In effect, popular sovereignty would be reduced to voting in general elections. If the men used this sovereignty to relax the discipline in the factory, a socialist government, having the future of the country at heart, could restrict even this degree of sovereignty. In any case, tools of discipline would be much more powerful under socialism. Dismissal would mean loss of sustenance. The government could be strict in the guidance of the young. The authorities could also forbid strikes and treat shirking as sabotage.

There even are passages in the work extolling the control of workers in Russia after 1932: the voluntary extension of working hours without extra pay; no democratic ‘meetingism’; “and nothing more […] heard of the right to strike”. (pages 192-193) Schumpeter was not totally unaware “of the sinister connotations of all this,” but he excused this regimentation as being demanded by “the unripeness of the situation” in a country like Russia having just set foot on the path to socialism. (page 194)

Schumpeter’s conception of economics

How could Schumpeter go so wrong? The answer, I hold, can be found in The History of Economic Analysis. Of course, there is his personality to be taken into account, a personality that speaks of contradiction, of being pulled in different directions, of living passionately in diverse countries and cultures. People who know central Europe only from hearsay will be confused by this strange man. Some have said that he was a snob trying to feign aristocratic roots; they do not understand what it was to be a traditional Austrian gentleman. Some marvel at the number of languages he spoke, but a central European would be thought uneducated if he did not know many languages, including Latin if he was born before World War I. Some think he tended to show off his intelligence and erudition; in Continental Europe it is not done to hide your light under a bushel. Also, the fastidious gentleman that he was did not hold democracy in high regard and thought that the working class lacked self-discipline. He was one of the more distinguished products of the bourgeoisie that had “put up a splendid fight for heart and home,” he said in his very Capitalism, Socialism and Democracy. He even went out of his way to praise “the impressive economic and even more impressive cultural achievements of the capitalist order.” (pages 113-144) So there is need for a deeper explanation of why Schumpeter uncharacteristically took the side of socialism and why he was so unnaturally detached from the society that was his heart and home.

Many a writer has seen the same paradox in Schumpeter’s History that I saw when I first read it: he proclaimed that “histories of economics should confine themselves to economic analysis” and then proceeded to weave in” intellectual history, biography and economic sociology”.9 I now think there is no paradox but a conscious application of a distinctive methodological point of view. There is no contradiction in the History but the result of keeping to the definition of what the task of economists should be: to use the set of neutral instruments discovered by economists through the ages for the analysis of the problems and policies of each time and place. The History focuses on telling how those instruments were slowly fashioned and whence they came. I now also think that deciding to write on the development of economic analysis rather than the history of economic thought is the symptom of a much deeper mistake.

A passage in the methodological introduction to the book will make my thesis clearer. Economic theory, he says, devises ‘gadgets’ in its study of the manifold phenomena of the real world, with whose help resulting reality may be analyzed. Examples of these gadgets are the

‘marginal rate of substitution’, ‘marginal productivity’, ‘multiplier’, ‘accelerator’ […], relations between concepts and methods of handling these relations, all of which have nothing hypothetical about them. And it is the sum total of these gadgets […] which constitutes economic theory. In Mrs. Robinson’s unsurpassably felicitous phrase, economic theory is a box of tools. (History of Economic Analysis, page 15)

One could ask, where have the multiplier and the accelerator gone? The discarding of these two gadgets may indicate that the point of economics is not fashioning of tools but discovering the laws and regularities of society. As I say, Schumpeter saw the advance of economic knowledge as the slow discovery and definition of these neutral analytical instruments, which could then be applied to different problems or situations. In this way,

“… we construct a composite instrument or engine or organon of economic analysis […] which functions formally in the same way whatever the economic problem to which we may turn. (page 16)

Schumpeter is thus content with analyzing social problems with his box of tools and tries to harbor no preconception as to what the results of given policies or institutional reforms will be. For him, those preconceptions simply constitute the pre-scientific view or Weltanschauung of the different economists and it is not very productive to try to tell one from the other. The consequence of his formal conception of economics is that at bottom he is indifferent to the various ways of organizing social affairs. He congratulates himself for his kind of economics being free from ‘ideology’. (See Part I, chapter 4, “The Sociology of Economics”.) He even goes as far as to say that Marx “as a matter of fact” was not influenced by his very definite philosophical views when doing his “work of analysis”. (page 32)

Now, there is another conception of economics that is not merely formal or instrumental. It sees economics as a systematic effort to discover reality. The knowledge slowly gathered by economists allows us to foresee how individuals react to incentives and how the universal ‘laws’ of human societies function. In the field of economics the profession has accumulated knowledge that is substantive and allows us to predict with some confidence the effect of certain policies or institutions. It would be easy to give examples in microeconomics: think only of the interesting results of Gary Becker and his followers in the application of economics to social questions, such as the war on drugs, or the size of families, or gains from education. Even in the field of macroeconomics, under a cloud at present because of the late financial crisis, we can with confidence make predictions. For example, we can predict the long term effects of persistent increases in money supply on inflation and the rate of exchange; or the beneficial effects of free trade in the reducing the number of the poor.10

Schumpeter reasons differently. He continuously proclaims his agnosticism as to the truth of economic theorems. Thus, he explains the hostility against classical economics because of “the alliance of economic theory with the liberalism of the nineteenth century”. He proceeds to say that “many people hated economic theory because they thought it was just a device for bolstering up a political program of which they disapproved”. And he even traduces the professional economists of the time because “they did all they could to harness their analytic apparatus into the service of their liberal political creed”. (page 19) The result of his ‘neutral’ position can be seen in the distance he repeatedly takes from the doctrine of free trade in many places of his History. But, what if free trade, in inauspicious circumstances and against the expectations of so many, does in fact have the observable results deduced by the classical economists? Is this ideology or science?

Value-free science

There is great confusion about the role of values in science. Of course we should not, in as far as we can, let our values, political or moral, distort our account of the facts. But this does not mean that we cannot observe the effects of a policy in application of a theoretical conclusion. Schumpeter’s pronouncements verge on the absurd when he writes:

We may […] prefer the world of the modern dictatorial socialism to the world of Adam Smith, or vice versa, but any such preference comes within the same category of subjective evaluation as does, to plagiarize Sombart, a man’s preference of blondes over brunettes.

He even perversely applies Robbins’ interdict to the observable results of the predictions of economic theory, when he says that, “there is no objective meaning to the term progress in matters of economic or other policy because there is no valid standard for interpersonal comparison.” (page 40) Personal evaluation surely refers to our liking or disliking the actual outcome of policies but not to the deriving predictions from an economic theory or to the accuracy of the predictions themselves. Let us take an instance where a theory may have been colored by political valuation, the theory that it is necessary to create ‘the new man’ for centrally planned economies. The prediction of their failure in achieving their aims and especially the measurement of the effects of such policies on the population are not a matter of personal preference. There will be people who think that the predicted unfeasibility of such a theory and the observation of the death of tens of millions of people of the present generation is a price worth paying for the creation of the future just society but that does not change what the results of real socialism have been in the 20th century: the economic theory with whose help those consequences were predicted by von Mises and Hayek ceases to be ‘ideology’ if the observed consequences of disregarding those predictions can be linked to the theory. They cease then to be a matter of personal preference.

It should be unnecessary to say that this does not mean that all has been done and discovered in the field of economic research. Even the best established theories can be refuted by facts and turn out to be wrong. But over the centuries economists have accumulated a respectable amount of useful knowledge about the workings of society—quite enough to give the free market the benefit of the doubt. Given the destructive consequences of the kind of economic philosophy he favored, Schumpeter is a thinker in need of re-evaluation.