Chapter 13 Schumpeter's Theory of Economic Development
Josef R. Schumpeter always took the middle ground in areas of politics and academics.
His work cannot be readily categorised even today. He felt himself obliged to the Austrian
School on the one hand, and when he got to Harvard, was happy to introduce American students
to Austrian teachings. But he also made all kinds of concessions to socialism, holding
the German Historical School and Gustav Schmoller in particular in high esteem in the 1920s.
When he was 28, he tried to weave together these different traditions in the later famous
Theorie der wirtschaftlichen Entwicklung 1912, The Theory of Economic Development.
As a starting point, he applied the equilibrium theory of Lausanne economist Leon Walrass
1834-1910, which stands in marked contradiction to the thinking of the Austrian School.
Unlike Walras, however, Schumpeter was of the view that a static theory alone was insufficient
to fully explain economic phenomena.
In the preface to the Japanese edition of his Theory of Economic Development, he noted
that one would have to assume a source of energy within the economic system that would
upset the equilibrium of economies, as external factors alone could not be made responsible
for such a change.
Furthermore, in his strongly psychology-biased description of the role of entrepreneurs,
Schumpeter drew on the groundwork of the Berlin political economists Adolf Friedrich Johann
Riedl 1809-1872 and Albert Eberhard Friedrich Schäffler, neither of whom, however, he cited.
Schumpeter's German, Original Theorie der wirtschaftlichen Entwicklung, has been published
nine times to date. It has been translated into numerous languages, including Italian,
French, Polish, Brazilian, Japanese, Russian, Slovak and Hungarian, with a considerable
The book was received in the Anglo-American world in the form of an abridged, rewritten,
and imprecise translation from 1934, also based on the second edition, The Theory of
Economic Development, 1934. The remarkable consequence is that the original text remains
largely unknown to this day. Indeed, Schumpeter's name is linked in many cases to theses which
he had explicitly opposed in his original work. Schumpeter, who proceeded on the assumption
of a categorical distinction between static and dynamic economics, stated from his second
These changes would come about while implementing new combinations of production goods, the
manufacturing of a new product, for example, or the introduction of a new production method,
the opening up of a new market, access to a new source of natural resources, or the
The creation or breaking of a monopoly. These processes of industrial mutation, which continuously
revolutionise the economic structure from within, wrote Schumpeter, amount to a process
of creative destruction, and constitute the essential reality of capitalism. To be in
a condition of dynamic imbalance is in the nature of capitalist markets. Old structures
are periodically replaced by new. If a capitalist society were in equilibrium, it would be doomed.
In this sense, innovation and creative destruction are its pivotal features.
It is ultimately the entrepreneurial will, the entrepreneur's leadership, that spurs
on economic growth and social change. Schumpeter stated in the original German edition that
entrepreneurs even force their products onto the market, but in the fewest of cases our
entrepreneurs themselves also create it. It is not part of the entrepreneur's function
In the first volume of his Business Cycles, 1939, German Konjunkturzuchen, Schumpeter
Miser repeated that without doubt the great majority of changes in commodities consumed
has been forced by producers on consumers. In most cases the consumers would have resisted
and would have first had to be educated by elaborate psychotechnics of advertising. Railroads
did not emerge because some consumers took the initiative in displaying an effective
demand for their service in preference to the services of mail coaches. Nor did consumers
The English version of this passage dissented slightly from the German original in that
it omitted the naïve and quixotic undertone in the character sketch of the entrepreneur.
Apart from that, a quintessence was preserved in the translation.
First of all, there is the dream and the will to found a private kingdom, and usually, though
not necessarily, also a dynasty.
Then there is the will to conquer, the impulse to fight, to prove oneself superior to others,
to succeed for the sake of success itself.
From this aspect, economic action becomes akin to sport.
There are financial races, or rather boxing matches.
Finally, there is the joy of creating, of getting things done, or simply of exercising one's energy and ingenuity.
This is akin to a ubiquitous motive, but nowhere else does it stand out as an independent factor of behaviour with anything like the clearness with which it obtrudes itself in our case.
Our type seeks out difficulties, changes in order to change, delights in ventures.
Schumpeter's fundamental distinction between entrepreneurs and their imitators,
Leaders, those he called mere managers, can be traced back to the leadership elite theory
of his teacher Friedrich von Mises.
According to Mises, only people of a very special kind occupy an exceptional position
by having the courage to innovate and the desire to form the world in their image.
They play the part of the trendsetter in the world of fashion, but also as founders of
joint stock companies, as leaders of political parties or as strike leaders.
Leading and following, writes Wieser, is the basic form of all social action.
Mises do not unite because of contracts, they unite through leading and following.
Although Wieser understood leadership in terms of social function rather than in terms of
people's drives or character traits, Schumpeter placed special emphasis, even in the first
edition, on the psychological profile of the business leader.
The psychological side of the entrepreneurial portrait was tied unmistakably to Friedrich
Nietzsche, 1844-1900, and also to Max Weber's 1864-1920 Charismatic Leader, or Oswald Sprenglas,
1880-1936, Faust-like human being, bringing to mind the emerging leader cult in Germany.
In the first, German edition Schumpeter saw the entrepreneur as analogous to the creative
artist and thinker, or described him as chieftain specialising in business matters, but from
the second edition on he placed more emphasis on the function of the entrepreneur.
What he depicts is an elite that enjoys flaunting its accomplishments and strengths, and moulds
social reality, casting a spell over it with restless ambition. Members of this elite can
be found among property owners or company founders, but the leading man might also be
a manager, a majority share owner, or even someone who has no capital at his disposal.
It is leadership rather than ownership that matters.
In order to produce something innovative and to offer it on the market, an entrepreneur
would have to withdraw already existing production goods from their previous use. For this purpose,
he would need purchasing power, but he seldom possesses the needed investment capital. The
entrepreneur does not usually save up to acquire the necessary means, nor does he accumulate
any goods before beginning to produce, so funding is necessary in order to introduce
Entrepreneurs could only invest with the help of credit. Such credit is essentially the creation of purchasing power for the purpose of transferring it to the entrepreneur, but not simply the transfer of existing purchasing power.
Accordingly, it is ultimately the banker who enables the introduction of new combinations, who authorizes people in the name of society, as it were, to form them. He is the effort of the exchange economy.
The entrepreneur, writes Schumpeter, is never the risk-bearer. The one who gives credit
comes to grief if the undertaking fails. Risk-taking is in no case an element of the entrepreneurial
function. Even though he may risk his reputation, the direct economic responsibility of failure
never falls on him. It applies that the lender, the banker, simply transfers purchasing power
yet by no means actual stock. In the original German version, Schumpeter had still noted,
somewhat unassertively that one could say without any great sin that the banker creates
money. Later in the English edition this self-absolution was retained. After the second German edition
Schumpeter refined the language of his explanatory model even further. It is always a question
not of transforming purchasing power, which was already in someone's possession, but
of the creation of new purchasing power out of nothing. This is the source from which
With the help of loans, an entrepreneur could crush the attempts of others and establish
his new products on the market. This would provide him with substantial profits. Since
he has no competitors when the new products first appear, the determination of their price
proceeds wholly or within certain limits, according to the principle of monopoly price.
But his success would soon attract imitators. His profit margin would in turn decrease and
soon give way to the competition. The entrepreneur's profit slips from the entrepreneur's grasp
as soon as the entrepreneurial function is performed. It attaches to the creation of
new things, to the realization of the future value system. It is at the same time the child
and the victim of development. The appearance of imitators taking advantage of the pioneering
The work of the entrepreneur would on balance cause an economic boom. This would be evident
in the creation of new jobs, on the one hand, and in wage increases and a higher interest
rate on the other. But this would also result in a decrease in the demand for credit, and
many of those new companies, in contrast to established ones which can fall back on accumulated
resources, would go bankrupt. In other words, the wave of innovation would again subside,
where the economy would slide into crisis. After a period of economic recession, innovative
entrepreneurs would again emerge in some branches of industry and the cycle would begin anew.
The idea that the modern economy is mainly financed with the help of credit had been
discussed years earlier by Rudolf Hilferling in Boehm-Bawerk's seminar. Hilferling published
the same, but Schumpeter made no reference to it, even at the time critics thought it
It was easy to prove empirically that innovations were indeed not, or by no means exclusively
financed by debt. All in all, Schumpeter's theory of economic development enjoyed a mixed
reception. He later remarked that the book had been rejected generally. Schumpeter's
denial of capital interest in static economics and his thesis of the inflationary financing
of innovative production processes elicited displeasure on the part of his former teacher
Eugen von Boehm-Bawerk, who in a lengthy critique warned against the danger of false teaching
presented in such a disarming manner, full of spirit and eloquence. Schumpeter's meek
response and Boehm-Bawerk's rejoinder showed all too clearly how deep the rift between
Schumpeter and the Austrian School had grown. After the First World War, the Austrian School
got to the bottom of the link between credit financing and business cycles. Unlike Schumpeter,
members saw in the creating of purchasing power out of thin air a beguiling illusion
that would undermine and ultimately distort the workings of the economy.
Schumpeter's Theory of Economic Development nevertheless enjoyed a remarkable renaissance
in the last decades of the 20th century.
It served as the inspiration for what is called evolutionary economics and also modern research
on innovation.
With his work Capitalism, Socialism and Democracy 1942 written during the Second World War,
Schumpeter dedicated himself among other things to the question of whether capitalism can
survive in the long term. Schumpeter answered in the negative, large corporations would
take on the role of innovator more and more, key decisions would no longer be made by ambitious
small entrepreneurs driven by their desire for social advancement but by paid managers.
of Lively Contact between all people and things involved in production. Schumpeter had already
written in Socialistische Möglichkeiten von heute, 1920-1921, Socialist Prospects of Today,
there would be ever more administration from some distant boardroom, and the capacity for
technical innovation increases with the size of the company. It will be systematically
undertaken by research and development departments of large businesses. Finally, in the late
Capitalist era business administrators whose actions generally resemble those of civil
servants rather than innovative entrepreneurs would drive the economy. Everywhere we find
industries which would not exist at all but for protection, subsidies and other political
stimuli and others which are overgrown or otherwise in an unhealthy state because of
them. The classic entrepreneur will be left with no arena in which to operate. Bureaucratic
Capitalism will slowly metamorphose into centrally planned socialism.