WEBVTT NOTE 11.16. Schumpeter’s Theory of Business Cycles 1 00:00:00.000 --> 00:00:06.000 16. Schumpeter's Theory of Business Cycles 2 00:00:06.000 --> 00:00:19.000 Joseph Schumpeter's business cycle theory is one of the very few that attempts to integrate an explanation of the business cycle with an analysis of the entire economic system. 3 00:00:19.000 --> 00:00:27.000 The theory was presented in essence in his Theory of Economic Development, published in 1912. 4 00:00:27.000 --> 00:00:39.000 This analysis formed the basis for the first approximation of his more elaborate doctrine presented in the two volume Business Cycles, published in 1939. 5 00:00:39.000 --> 00:00:51.000 The latter volume, however, was a distinct retrogression from the former, for it attempted to explain the business cycle by postulating three superimposed cycles, 6 00:00:51.000 --> 00:00:58.920 cycles. Each of which was explainable according to his first approximation. Each of these cycles 7 00:00:58.920 --> 00:01:06.520 is supposed to be roughly periodic in length. They are alleged by Schumpeter to be the three-year 8 00:01:06.520 --> 00:01:16.040 Kitchen cycle, the nine-year Uglar, and the very long fifty-year Kondratiev. These cycles are 9 00:01:16.040 --> 00:01:22.920 are conceived as independent entities, combining in various ways to yield the aggregate cyclical 10 00:01:22.920 --> 00:01:24.360 pattern. 11 00:01:24.360 --> 00:01:30.440 Any such multi-cyclic approach must be set down as a mystical adoption of the fallacy 12 00:01:30.440 --> 00:01:33.320 of conceptual realism. 13 00:01:33.320 --> 00:01:39.800 There is no reality or meaning to the allegedly independent sets of cycles. 14 00:01:39.800 --> 00:01:46.160 The market is one interdependent unit, and the more developed it is, the greater the 15 00:01:46.160 --> 00:01:49.320 interrelations among market elements. 16 00:01:49.320 --> 00:01:56.280 It is therefore impossible for several or numerous independent cycles to co-exist as 17 00:01:56.280 --> 00:01:58.540 self-contained units. 18 00:01:58.540 --> 00:02:07.080 It is precisely the characteristic of a business cycle that it permeates all market activities. 19 00:02:07.080 --> 00:02:13.100 Many theorists have assumed the existence of periodic cycles, where the length of each 20 00:02:13.100 --> 00:02:19.200 successive cycle is uniform, even down to the precise number of months. 21 00:02:19.200 --> 00:02:25.560 The quest for periodicity is a chimerical hankering after the laws of physics. 22 00:02:25.560 --> 00:02:31.120 In human action, there are no quantitative constants. 23 00:02:31.120 --> 00:02:48.560 It is best, then, to discard Schumpeter's multicyclical schema entirely, and to consider 24 00:02:48.560 --> 00:02:55.320 his more interesting one-cycle approximation as presented in his earlier book, which he 25 00:02:55.320 --> 00:02:59.920 attempts to derive from his general economic analysis. 26 00:02:59.920 --> 00:03:06.700 Schumpeter begins his study with the economy in a state of circular flow equilibrium, that 27 00:03:06.700 --> 00:03:11.740 is, what amounts to a picture of an evenly rotating economy. 28 00:03:11.740 --> 00:03:18.140 This is proper, since it is only by hypothetically investigating the disturbances of an imaginary 29 00:03:18.140 --> 00:03:24.340 state of equilibrium that we can mentally isolate the causal factors of the business 30 00:03:24.340 --> 00:03:25.340 cycle. 31 00:03:25.340 --> 00:03:33.540 First, Schumpeter describes the E.R.E., where all anticipations are fulfilled, every individual 32 00:03:33.540 --> 00:03:42.040 and economic element is in equilibrium, profits and losses are zero, all based on given values 33 00:03:42.040 --> 00:03:43.620 and resources. 34 00:03:43.620 --> 00:03:49.500 Then, asks Schumpeter, what can impel changes in this setup? 35 00:03:49.500 --> 00:03:54.940 First, there are possible changes in consumer tastes and demands. 36 00:03:54.940 --> 00:03:59.860 This is cavalierly dismissed by Schumpeter as unimportant. 37 00:03:59.860 --> 00:04:05.540 There are possible changes in population and therefore in the labor supply, but these are 38 00:04:05.540 --> 00:04:10.180 gradual and entrepreneurs can readily adapt to them. 39 00:04:10.180 --> 00:04:14.220 Third, there can be new saving and investment. 40 00:04:14.220 --> 00:04:22.060 Wisely, Schumpeter sees that changes in saving investment rates imply no business cycle. 41 00:04:22.060 --> 00:04:25.940 New saving will cause continuous growth. 42 00:04:25.940 --> 00:04:33.420 Sudden changes in the rate of saving, when unanticipated by the market, can cause dislocations, 43 00:04:33.420 --> 00:04:38.540 of course, as may any sudden unanticipated change. 44 00:04:38.540 --> 00:04:43.880 But there is nothing cyclic or mysterious about these effects. 45 00:04:43.880 --> 00:04:49.180 Instead of concluding from this survey, as he should have done, that there can be no 46 00:04:49.180 --> 00:04:56.060 business cycle on the free market, Schumpeter turned to a fourth element, which for him 47 00:04:56.060 --> 00:05:03.600 was the generator of all growth as well as of business cycles, innovation in productive 48 00:05:03.600 --> 00:05:05.820 techniques. 49 00:05:05.820 --> 00:05:13.220 We have seen that innovations cannot be considered the prime mover of the economy, since innovations 50 00:05:13.220 --> 00:05:20.200 can work their effects only through saving and investment, and since there are always 51 00:05:20.200 --> 00:05:27.540 a great many investments that could improve techniques within the corpus of existing knowledge 52 00:05:27.540 --> 00:05:31.780 but which are not made for lack of adequate savings. 53 00:05:31.780 --> 00:05:38.500 This consideration alone is enough to invalidate Schumpeter's business cycle theory. 54 00:05:38.500 --> 00:05:44.980 A further consideration is that Schumpeter's own theory relies specifically for the financing 55 00:05:44.980 --> 00:05:53.420 of innovations on newly expanded bank credit, on new money issued by the banks. 56 00:05:53.420 --> 00:05:58.960 Without delving into Schumpeter's theory of bank credit and its consequences, it is 57 00:05:58.960 --> 00:06:05.560 clear that Schumpeter assumes a hampered market, for we have seen that there could not be any 58 00:06:05.560 --> 00:06:09.720 Money Monetary Credit Expansion on a Free Market. 59 00:06:09.720 --> 00:06:17.040 Schumpeter, therefore, cannot establish a business cycle theory for a purely unhampered 60 00:06:17.040 --> 00:06:18.040 market. 61 00:06:18.040 --> 00:06:25.280 Finally, Schumpeter's explanation of innovations as the trigger for the business cycle necessarily 62 00:06:25.280 --> 00:06:32.520 assumes that there is a recurrent cluster of innovations that takes place in each boom 63 00:06:32.520 --> 00:06:33.960 period. 64 00:06:33.960 --> 00:06:38.040 Why should there be such a cluster of innovations? 65 00:06:38.040 --> 00:06:43.560 Why are innovations not more or less continuous, as we would expect? 66 00:06:43.560 --> 00:06:47.960 Schumpeter cannot answer this question satisfactorily. 67 00:06:47.960 --> 00:06:54.260 The fact that a bold few begin innovating, and that they are followed by imitators, does 68 00:06:54.260 --> 00:07:01.280 not yield a cluster, for this process could be continuous, with new innovators arriving 69 00:07:01.280 --> 00:07:02.960 on the scene. 70 00:07:02.960 --> 00:07:09.760 Schumpeter offers two explanations for the slackening of innovatory activity toward the 71 00:07:09.760 --> 00:07:14.460 end of the boom, a slackening essential to his theory. 72 00:07:14.460 --> 00:07:20.960 On the one hand, the release of new products yielded by the new investments creates difficulties 73 00:07:20.960 --> 00:07:28.120 for old producers and leads to a period of uncertainty and need for rest. 74 00:07:28.120 --> 00:07:35.040 In contrast, in equilibrium periods, the risk of failure and uncertainty is less than in 75 00:07:35.040 --> 00:07:36.920 other periods. 76 00:07:36.920 --> 00:07:44.720 But here Schumpeter mistakes the auxiliary construction of the ERE for the real world. 77 00:07:44.720 --> 00:07:50.440 There is never in existence any actual period of certainty. 78 00:07:50.440 --> 00:07:57.560 All periods are uncertain, and there is no reason why increased production should cause 79 00:07:57.560 --> 00:08:27.320 Schumpeter's second explanation is that innovations cluster in only one or a few industries, and 80 00:08:27.320 --> 00:08:31.960 and that these innovation opportunities are therefore limited. 81 00:08:31.960 --> 00:08:37.800 After a while they become exhausted, and the cluster of innovations ceases. 82 00:08:37.800 --> 00:08:44.240 This is obviously related to the Hansen stagnation thesis, in the sense that there are alleged 83 00:08:44.240 --> 00:08:52.400 to be a certain limited number of investment opportunities, here innovation opportunities, 84 00:08:52.400 --> 00:08:59.560 at any time, and that once these are exhausted, there is temporarily no further room for investments 85 00:08:59.560 --> 00:09:01.440 or innovations. 86 00:09:01.440 --> 00:09:07.440 The whole concept of opportunity in this connection, however, is meaningless. 87 00:09:07.440 --> 00:09:13.960 There is no limit on opportunity as long as wants remain unfulfilled. 88 00:09:13.960 --> 00:09:21.400 The only other limit on investment or innovation is saved capital available to embark on the 89 00:09:21.400 --> 00:09:29.400 Projects. But this has nothing to do with vaguely available opportunities which become exhausted. 90 00:09:29.400 --> 00:09:36.840 The existence of saved capital is a continuing factor. As for innovations, there is no reason 91 00:09:36.840 --> 00:09:43.720 why innovations cannot be continuous or take place in many industries or why the 92 00:09:43.720 --> 00:09:55.720 as Kuznets has shown, a cluster of innovation must assume a cluster of entrepreneurial ability as well, and this is clearly unwarranted. 93 00:09:55.720 --> 00:10:05.720 Clements and Doody, Schumpeterian disciples, countered that entrepreneurial ability is exhausted in the act of founding a new firm. 94 00:10:05.720 --> 00:10:12.760 is exhausted in the act of founding a new firm, but to view entrepreneurship as 95 00:10:12.760 --> 00:10:19.200 simply the founding of new firms is completely invalid. Entrepreneurship is 96 00:10:19.200 --> 00:10:26.640 not just the founding of new firms, it is not merely innovation, it is adjustment, 97 00:10:26.640 --> 00:10:33.080 adjustment to the uncertain changing conditions of the future. This adjustment 98 00:10:33.080 --> 00:10:41.640 takes place, perforce, all the time, and is not exhausted in any single act of investment. 99 00:10:41.640 --> 00:10:48.000 We must conclude that Schumpeter's praiseworthy attempt to derive a business cycle theory 100 00:10:48.000 --> 00:10:51.960 from general economic analysis is a failure. 101 00:10:51.960 --> 00:10:59.200 Schumpeter almost hit on the right explanation when he stated that the only other explanation 102 00:10:59.200 --> 00:11:06.760 One that could be found for the business cycle would be a cluster of errors by entrepreneurs, 103 00:11:06.760 --> 00:11:14.540 and he saw no reason, no objective cause, why there should be such a cluster of errors. 104 00:11:14.540 --> 00:11:19.820 That is perfectly true, for the free unhampered market.